Predicting Distress 8. Enron Red Flags Case Jon Goodwin is the head of investment banking services for Barra Partners, a small investment banking firm with headquarters in San Francisco. In May 2002, Jon was meeting with Seamus Hatch, the newly hired managing director of research. JON: Our firm is excited about a new business opportunity that all these financial accounting and investment banking scan- dals have created. With the Securities and Exchange Com- mission (SEC) pushing for the separation of investment banking and research functions, we should be able to de- velop our independent research services. I want you to ex- pand our basic industry and company research capabilities. SEAMUS: Thanks. This opportunity was the major reason I wanted to work for your firm. Hopefully, we will not have the appearance of a conflict of interest between investment banking and research activities, like the big investment banking firms. For example, one big firm actually fired an analyst for changing his rating to a “sell” recommendation on Enron at $38 per share, and another firm told its analysts to maintain a “buy” recommendation for Enron no matter what! Jon: Barra usually executes transactions within a valuation range of $15 million to $50 million. The big New York in- vestment banking firms usually won't touch any transactions under $50 million. With the big firms' research credibility as This case was prepared by Hugh Grove, Tom Cook, and Jon Goodwin. 71 72 Investigation Phase Enron Red Flags Case 73 banking investments and our major investment banking ac- tivities of strategic advice, financial advisory services, corpo- rate finance, and mergers/acquisitions. This project is very important to us as a small investment banking firm, espe- cially as we need to maintain the trust of our existing in- vestors and expand our networks of investor relationships. I look forward to seeing your report. Let's meet at the end of next week to discuss it. Barra Partners Company Background "sell-side” analysts being questioned, we should have an op- portunity to expand our research capabilities to sell both basic industry and company research to the mutual funds, in- surance companies, and other “buy-side” analysts and in- vestors. We will first focus on the investment prospects of a select group of growth industry sectors and then recom- mend companies within such industries that have the ability to develop a sustainable competitive advantage. A major issue, of course, is how to profit from providing such com- prehensive research. In the past, many investors had not val- ued such painstaking research, but they should now, due to the credibility problems of the big firms constantly “touting” individual companies in order to be awarded large invest- ment banking fees. SEAMUS: All the negative publicity from the New York attorney general fining Merrill Lynch $100 million for such question- able business practices should help smaller firms like us who are interested in expanding their research services. Jon: One way we may be able to create a market for our research services is to develop a set of red flag procedures that help identify companies using earnings management and other deceptive financial reporting strategies. I have always been surprised about how little knowledge of financial accounting and financial reporting bankers and financial analysts have. That is why I went back to school to get a Master of Ac- countancy degree. Your first task will be to develop a set of red flags. Then, I'd like you to back test them against com- panies such as Enron, WorldCom, Qwest, Global Crossing, etc. Start your red flag analysis with Enron. If the red flags don't work for Enron, they probably won't work on any firm. Contrary to what all the “sell-side” analysts said in congressional testimony, I can't believe that no red flags ex- isted in Enron's reported financial numbers! SEAMUS: I am excited about your proposal to create a set of red flags. Such a capability should enhance our research contract proposals to the “buy-side” analysts and investors. Starting with Enron should be very interesting since it was such a high profile case. Jon: Independent, unbiased, basic industry research and related company research are fundamental to both our merchant Barra partners is a private research, investment, and merchant bank- ing partnership serving the needs of emerging growth companies. Its capabilities include providing timely strategic research and advice; raising private debt and equity financing; arranging mergers, acquisi- tions, and divestitures; advising on financial restructurings; and valu- ing businesses and corporate securities. It has engaged in transactions with a valuation range between $15 million and $500 million. Its in- dustry sector expertise has included biotechnology, medical devices, wireless communications, energy, power generation, transportation, recreational products, and financial services. Headquartered in San Francisco, Barra has maintained small offices in Denver; New York; Chicago; Dallas, Kuala Lumpur, Malaysia; and Chenni, India. Barra currently has three managing directors, nine other full-time employ- ces, and twelve independent contractors. Barra was founded in 1997 by Mike Bock, managing director of the merchant banking group at Barra. Prior to joining Barra, Mike operated his own investment banking firm for twenty-four years, spe- cializing in private equity investments in public companies, project finance, and project development in the international power industry. Prior to that, Mike was the director of corporate finance at Boettcher and Company. Mike was a graduate of the U.S. Air Force Academy and also earned an MBA from Harvard. Jon Goodwin joined Barra in May 2001 as managing director of strategic advisory services. Prior to joining Barra, Jon was a vice pres- ident in the telecommunications investment banking group of Gerard Klauer Mattison & Company in New York City. Before that, he spent six years with International Capital Strategies (ICS), a New York-based boutique investment banking firm providing private eq- uity and merger/acquisition advisory services. Prior to ICS, Jon earned 74 Investigation Phase Enron Red Flags Case 75 a Master of Accountancy degree in 1992 from the University of Den- ver. Jon had begun his financial services career in 1984 (after earning an undergraduate business degree from the University of Denver) with Capital Services Group, a Denver asset-based finance firm and sponsor of tax-advantaged limited partnerships. Before he returned to school in 1991, he had become vice president of syndications. Seamus Hatch joined Barra in May 2002 with a sixteen-year background in technology firms that did digital asset management, web site management, data modeling, and business modeling. Prior to that, Seamus was a director in the investment research department of Hoare Govett, a UK-based investment bank. He started his career at Andersen Consulting, specializing in the design of securities trading systems in both London and New York. His undergraduate degree in computer science and accounting was from the University of Man- chester, England. Barra's principals have extensive investment banking experi- ence. Collectively, they have completed over 150 transactions with an aggregate market value in excess of $3.5 billion. As a result, they have developed close relationships with numerous strategic and financial investors. More information on Barra partners may be obtained from their web site: http://www.barrapartners.com. and cash effective tax rates to help indicate financial reporting prob- lems. Concerning Enron, a citizens' taxpayer group had alleged that Enron had not paid any U.S. income taxes in the last three years. For this effective tax rate comparison, Seamus made the following ex- cerpts from Enron's 2000 10-K footnotes. For 2000, 1999, and 1998, Enron's GAAP income tax expenses were $434 million, $104 million, and $175 million, respectively, but its income taxes actually paid in cash were $62 million, $51 million, and $73 million, respectively. Seamus classified these emerging ratios into four categories: op- erating cash flow, long-term debt solvency, effective tax rate, and eco- nomic value added. Seamus realized that it was just as important to understand why certain ratios did not work as red flags as it was to identify the ones that did work. (See tables 1-3.) From previous company research and investment banking expe- riences, both Jon and Seamus believed that about 80 percent of a company's success was having a good management team. They thought the other 20 percent was having the technology and market- ing to exploit business ideas and opportunities. Thus, they decided that more Enron company background was needed before Seamus started his red flag analysis. TABLE 1. Irrational Ratios for Earnings Manipulation Detection Financial Red Flags: Starting Point Benchmarks Nonmanipulators' Manipulators' Mean Index Mean Index Ratio Formula Days' sales in receivables 1.031 1.465 Gross margin 1.014 1.193 Asset quality As a starting point for creating financial red flags, Seamus decided to use the five "irrational” ratios from prior earnings manipulation re- search. These five ratios were the most significant ones in detecting 1990s earnings manipulations, based upon a comparison of nonma- nipulators' mean indexes to manipulators' mean indexes. Seamus also decided to use eleven key “investor” ratios that were provided for each company tracked by Yahoo Finance, the most heavily used finan- cial web site. These ratios were grouped by Yahoo Finance into four major categories: valuation, income statement profitability, manage- ment effectiveness, and financial strength. Also, from various financial press articles, Seamus had compiled ten nontraditional or “emerging” ratios that various short sellers, mu- tual fund managers, and other investors had used to flag financial re- porting problems at Enron, Qwest, World Com, and other recent finan- cial accounting scandals. For example, several analysts had advocated a comparison of generally accepted accounting principles (GAAP) (Accounts Receivable,/Sales) (Accounts Receivable,-1! Sales,-1) (Sales,-1 – Cost of Sales,-1/ Sales,-1)/(Sales, Cost of Sales/Sales.) (1 – Current Assets, + Net Fixed Assets,/Total Assets)/(1 – Current As- sets,-1 + Net Fixed Assets,-1/Total Assets,-1) Sales/Sales-1 Changes: (Working Capital – Cash Current taxes pay- able) - D&A/Total Assets 1.039 1.134 1.254 1.607 Sales growth Total accruals to Total assets 0.018 0.031 Source: Joseph Wells, "Irrational Ratios," Journal of Accountancy August (2001): 80--83. Note: D&A - depreciation and amortization, Enron Red Flags Case 77 TABLE 2. Key Ratios for Investing Enron Company Background Benchmarks S&P 500 (year 2000) Industry Average Ratio Formula Valuation ratios Price/Book 4.10 2 to 3 Book value per share In 1985, Houston Natural Gas merged with InterNorth, a natural gas company based in Omaha, Nebraska, to form Enron, an energy com- pany with a thirty-seven thousand mile interstate and intrastate gas pipeline. In 1986 Kenneth Lay was appointed chairman and CEO of Enron. He had a vision for Enron that went far beyond that of a tra- ditional energy company. He understood that deregulation of the energy business would offer new opportunities and hired Jeffrey Skilling, an industry consultant, in 1991 to help take advantage of them. Enron was a pioneer in trading natural gas and electricity and by 1997 had become one of the largest natural gas and electricity trading companies. Revenues increased from $9.2 billion in 1995 to $100.8 billion in 2000, and its stock returned 500 percent over that period. 4.10 2 to 3 Price/Earnings 35.70 20 to 25a Common Share Price/ Book Value per Share Total Stockholders' Equity/Basic Common Shares Outstanding Common Share Price! Diluted Earnings per Share Net Income [Common Shares Outstanding + Stock Options + Convertible Common Shares) Common Share Price/Sales per Basic Common Share Common Share Price! Operating Cash Flows per Basic Common Share Diluted earnings per share 35.70 20 to 25a Price/Sales TABLE 3. Emerging Red Flag Ratios 1.90 Ratio Formula Benchmark Price/Cash flow OCF/Net Income 21.5 15.10 Income statement probability Profit margin Top-line growth Operating cash flow (OCF) ratios Quality of earnings Quality of earnings before interest, taxes, depreciation, and amorti- zation (EBITDA) Cash flow liquidity Cash flow solvency 4%-8% 21.0 2.0 Net Income/Sales Sales Change (Prior Year to Current Year)/Prior Year Sales Net Income Change (Prior Year to Current Year)/ Prior Year Net Income OCF/EBITDA OCF/Current Liabilities OCF/Short- and Long-Term Debt 5%-20% 20.5 Bottom-line growth Long-term debt solvency Sales comparison Equity comparison 5%-15% Management effectiveness Return on assets Return on equity Long-Term Debt/Sales Long-Term Debt/Stockholders' Equity at Year End Market Value 8%-12% Net Income/Total Assets Net Income/Total Stock- holders' Equity 9%-16% Effective tax rate Generally accepted accounting prin- ciples (GAAP) effective tax rate Financial strength Current ratio (GAAP Current + Deferred In- come Tax Expense)/Net In- come before Taxes Cash Income Taxes Paid/Net In- come before Taxes 22 Cash effective tax rate Current Assets/Current Liabilities Total Debt (Short-Term + Long-Term)/Total Stockholders' Equity Debt/Equity ratio Iconomic value added Return on invested capital 20.50 Source: Yahoo Finance, the most heavily used financial web site. a Benchmark: Industry average (1990s). Net Income/Long-Term Debt + Stockholders' Equity at Year End Market Value (calculated by Chanos for Enron as 9%-12%) Weighted average cost of capital 78 Investigation Phase Enron Red Flags Case 79 99 In January 1997, Skilling was named president and chief operat- ing officer of Enron. His strategy was to create an “asset light” com- pany by applying Enron's trading and risk-management skills to power plants and other facilities owned by outsiders. Enron would become more like an investment bank than an industrial company weighed down by tangible assets. Skilling's strategy focused on expanding Enron's energy trading expertise into a vast array of new commodities to sustain earnings growth. He operated on the belief that Enron could commoditize and monetize anything from electronics to pollution-emission tax credits to advertising space. In August 1997, Enron expanded beyond energy trading by introducing commodity trading of weather derivatives (based on actual temperature deviations from 65 degrees for risk management by energy companies). In July 1998, Enron paid $2.4 bil- lion for a British water company for its new global water business. It also had purchased a $3 billion power plant in India in the early 1990s and a $1.3 billion power distributor in Brazil in July 1998. Skilling developed the belief that older, stodgier competitors had no chance. At an industry conference, Skilling told these competitors that he was going to eat their lunch.” A banner in Enron's lobby said: “The World's Leading Company.” Skilling was credited with cre- ating a system of forced rankings for all employees, in which those rated in the bottom 20 percent would be fired. Employees attempted to crush not only outsiders but each other. They believed that they could handle increasingly exotic risks without danger and often traded just for the sake of trading, as opposed to using trading as a part of a corporate strategy. To maintain a high credit rating and raise capital for business ex- pansion, Skilling hired Andrew Fastow, who subsequently became the CFO of Enron. In a 1999 interview, Fastow explained that the key to Enron’s trading business was the fact that “the counterparties who enter into these contracts with Enron have to be able to take Enron counterparty risk and, thus, Enron needed to have strong investment- grade credit.” Fastow chose to maintain such a credit rating for Enron not by the traditional methods of issuing equity (which would cause dilution) or selling assets outright (since cash doesn't earn much). In- stead, Fastow shifted debt off the balance sheet through special pur- pose entities (SPEs) and other unconsolidated affiliates. He said: “We had to be very creative but we're very conservative in our accounting approach." Prior to Fastow, Enron had used a publicly traded subsidiary to raise off-balance-sheet debt. However, Fastow preferred private SPE partnerships for this purpose because he said: “they were much more cost-effective and flexible.” For such creativity, Fastow was given the 1999 CFO Excellence in Capital Structure Management Award, cosponsored by the CFO magazine and Arthur Andersen. The award guidelines were “to applaud strong and creative individuals who have taken bold steps to add value for shareholders, employees, partners, and/or customers." By 1999, Enron had moved many of its assets and debt off the bal- ance sheet into hundreds of SPEs and had approximately thirty-five hundred subsidiaries and affiliates. In 1999, Enron created three new private investment limited partnerships (SPEs), Cayman, Raptor, and Condor, to be operated by Fastow. To help capitalize these SPEs, Enron issued its own common stock in exchange for SPE note receiv- ables. Subsequently, Enron increased these SPE note receivables and its own earnings from a series of transactions with these SPEs. For example, Enron had made a $10 million pre-IPO (pre-initial public offering) or insider investment in Rhythms NetConnections, a Colorado corporation that went public in early 1999. As Enron's in- vestment increased in value by $290 million, Enron recognized this holding gain as other revenue, using the mark-to-market investment accounting method. However, pursuant to the typical pre-IPO secu- rity lockup regulations, Enron could not sell this Rhythms stock for two years, until early 2000. To hedge against the Rhythms stock price going down after the IPO, Enron wanted to sell a put option, but no investor would buy such an option. Thus, Enron forced the Cayman SPE to grant a put option to Enron to lock in the Rhythms holding gain. However, the Cayman SPE, capitalized primarily with appreci- ated Enron common stock, did not have enough cash to cover the put option unless Enron's stock continued to increase in value. Fastow earned more than $30 million from managing these part- nerships while still CFO of Enron. Enron's financial statements dis- closed Fastow's SPE management arrangement as "a senior officer of Enron” and did not disclose that such SPE partnership deals had credit “triggers.” Such “triggers” would make Enron responsible for the partnership debt if its stock price fell below a certain price or if its credit rating dropped below investment grade. Enron's management had developed a “culture of arrogance,” ac- cording to outsiders who had dealt with the company. These managers