Financial analysts take a post-Enron quiz

By Kathleen Davis, Associate Editor

Shakespeare’s famous As You Like It snippet “all the world’s a stage and all the men and women merely players” seems to be even more poignant in this post-Enron era. Of course, some of these current Enron players didn’t intend to get so caught up in the drama.

That drama has played out in Texas, in the deregulated markets, in the energy industry, in Congress and even in the White House. And there are tough questions to be answered—not just by Enron executives, but by accountants, consultants and paper shredders.

One unexpected twist on the Enron story has been the bright spotlight focused on financial analysts. Congress and investors alike want to know why these ratings specialists never saw the errors in Enron’s books.

EL&P decided to take that question straight to the source. We asked three financial analysts about their take on the Enron crisis and the ensuing fallout: Chris Ellinghaus with Williams Capital, Jay Dobson with Deutsche Banc Alex. Brown and Andre Meade with Commerzbank Securities.

EL&P: An inquiry into the system of analysis: Was it possible for analysts to see Enron’s fall coming? Were there red flags that were ignored, or were there simply no warning signs at all?

Chris Ellinghaus, Williams Capital
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Ellinghaus: I think that analysts should have seen it coming. I thought there were warning signs. Some of those signs were gut feelings: Enron was very, very, very aggressive, and there was too much arrogance. And I thought they were pretty darn secretive, which bothered me the most. They spent too much time marketing “Enron the stock” and not enough time with the fundamentals.

That being said, when there’s not enough information, it’s up to [the analyst] to try and find it. If you can’t find enough information to make you comfortable, you should just avoid it. I believe—although I don’t know for sure—that there’s been a lot of evidence in the last few weeks that Enron did a lot to hide the realities of their accounting and their partnerships, and that would have been very difficult to ascertain. I’ve looked through their disclosure statements, and there was not a lot of plain language about some of the items which caused their downfall: the ratings triggers, their debt, their partnerships. Those were not widely known. If that information had been widely disseminated, my guess is that some of the analysts would have had different opinions.

At the same time, there are most certainly conflicts of interest, but I don’t think that was the principal reason analysts didn’t know. Partly it had to do with the fact that Enron had been a good story in many ways, and then, on top of that, the company was not completely honest with the analyst community.

So I think there is plenty of blame. Analysts should have been more cautious, but, clearly, the accounting statements for Enron were faulty, which are big elements in how analysts make their decisions.

Jay Dobson, Deutsche Banc Alex. Brown
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Dobson: Looking in hindsight, it certainly appears there were some red flags. I think this is symptomatic of an environment of relatively easy capital, that perhaps people were a little more aggressive than they might have otherwise been on the debt side, but I would argue that it was probably possible to see [the fall].

Ultimately, as the company deteriorated, it deteriorated with such alacrity that it was probably difficult to understand where it was going. I know having lived it—although not having covered it specifically—and having to talk to my sales force every day, it seemed we were finding new information every day that could cause a change in opinion.

I would argue that most Fortune 500 companies don’t fall with such alacrity here, and there is a little more time in between. So the combination of time—or lack thereof—and relatively obscure signs made this one relatively difficult to call.

Meade: I think it was difficult for analysts to forecast the bankruptcy of Enron, but I think there were plenty of warning signs on valuation. We [Commerzbank Securities] began coverage of Enron in the spring of 2000 with a hold rating, basically because of concerns on the high level of valuation. A lot of the warning signs on valuation were more qualitative than quantitative, but certain things were clearly of concern to us throughout the past year and a half. One was the valuation that was priced in for Enron’s broadband unit—a business that was unproven, that had significant hurdles to jump before there was even the ability to do what they were planning on doing, which was trading broadband. The market priced in about 30-plus billion dollars worth of market cap because of that; that, in and of itself, was a reason for us to question the valuation of Enron.

Andre Meade, Commerzbank Securities
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There were other reasons: The management was extremely focused on the stock price, always tried to guide how analysts built their models and really wanted them to value the company on volume growth alone. Those are some of the things that clearly disturbed us, and we built a discounted cash flow model of Enron. We didn’t do it based on volumes; we didn’t just look at their reported earnings. And we came up with a hold rating in 2000.

Now a lot of that stuff is qualitative, and part of the reason it was difficult to forecast and value Enron was because the earnings reported were aggregated. Within one business unit, there was gas trading, power trading, coal trading, oil and gas trading on multiple continents—some long-dated contracts, some near term—and it was very tough to really determine, quarter to quarter, what was truly driving the company’s earnings. When you have a lack of disclosure, it’s very tough to produce a forecast that’s reliable; most analysts had problems there.

So, I think there were some red flags; certainly on a relative valuation call there were plenty of warning signs. For the bankruptcy, however, I think it would have been very hard to predict that this company would collapse the way it did.

EL&P: Mark-to-market accounting is now considered a black mark against energy companies these days. Is that an accurate label?

Ellinghaus: The perception is that mark-to-market is an evil thing, and you will find a lot of companies trying to explain just how much of their earnings come from mark-to-market accounting sources. I think that most companies treat mark-to-market pretty fairly, but it’s undeniable that there is a lot of guesswork that goes into mark-to-market. And, it is one of those places that you could manipulate earnings if you wanted to, which is certainly something to be wary of.

Companies are trying to explain what their mark-to-market policies are so that investors will be more informed and feel more secure. Now, mark-to-market is required, so it’s not as if this is an elective that companies chose to use, but investors should be diligent in keeping their eyes open to see if there are any signs that the mark-to-market earnings are a problem.

Unfortunately, it’s not as simple as: revenue comes in the door, and cash comes in, and you take out the expenses, and you get that income.

Dobson: Well, I would argue that mark-to-market is probably the most accurate way for a lot of these companies to record many of the contracts that they get involved with now. Mark-to-market accounting, as prescribed by FASB 133, is by no means perfect, but I would argue that the risk of hiding assets—or more importantly, hiding liabilities—in a company by using accrual accounting over mark-to-market accounting is probably more dangerous than mark-to-market in its own right.

I think that mark-to-market has a black mark right now only because investors don’t fully understand how companies are employing mark-to-market accounting. And, simply, the biggest concerns are (a.) companies under FASB 133 mark-to-market accounting are permitted to essentially book certain earnings upfront for cash proceeds to be received in the future, and (b.) the, at times, relative obscurity of what market the company is marking these contracts or assets to. Certainly, with short-dated contracts, where you are saying, “I have agreed to sell power for the next year,” you can go to Bloomberg or Dynegy Direct, or any number of services to tell you what is the price of the current spot market for a one-year contract. Whereas, if you say, “I’m going to supply power to the California Department of Water Resources for the next 10 years,” there is no liquid market for a 10-year contract in California. So, you end up getting more into a situation of “mark-to-model,” i.e. the company’s expectation of what that contract is worth in the marketplace today. And, of course, that is subject to—for lack of a better word—manipulation.

Although I don’t think many companies are purposefully manipulating their earnings this way, that is the one major issue that, in my opinion, the accounting standards board has to deal with. They have to say, “Hey, to the extent that these contracts go out over longer periods of time where there is not a liquid financial forward that you can market these things to, perhaps there ought to be.”

I do believe that mark-to-market is an acceptable accounting rule and makes a lot of sense relative to accrual accounting, but I also think there are still a number of items that have to be “cured” before investors will accept it as being a reasonable way to disclose a company’s earnings.

Meade: I think mark-to-market accounting is a double-edged sword. Clearly it was designed to give investors more information on the future liabilities of all companies—not just energy companies. So, if there was an energy company that had a contract to sell gas or power at prices well below the market price, mark-to-market would show that. Under accrual accounting, you wouldn’t know that there was this big future liability. However, I think a lot of people in the market, both analysts and investors, use earnings multiples, and mark-to-market clearly inflates them. So, what we’ve done—and what we’ve done all along—is use discounted cash flow valuation models. And, we follow the cash flow produced by the businesses, not just reported earnings.

I think, once you know the shortcomings of mark-to-market accounting and adjust your modeling appropriately, though, you can live with it.

EL&P: What kinds of disclosures does an analyst need to get an accurate portrait of an energy company? Are you getting those disclosures, or has there been a tightening up in that area?

Ellinghaus: Actually, they’ve gotten better. There was a time when things were tighter, but then the stocks started to take a hit, which began with the stories of an energy glut and the falling prices. That started people thinking about disclosure. Then, mark-to-market became an issue—and did so before the Enron scandal. So, they were starting to do things about mark-to-market.

Then Enron was really the final straw, which made people go to the next level of disclosure. I don’t think they are done yet, but we were really demanding more disclosure for some time because the energy trading and marketing business is not entirely transparent.

It’s far better—in my opinion—to have a power plant and explain how you made money from that than it is to explain how you made money from a trading desk or from originating a long-term energy deal. Their challenge is to provide enough disclosure so that an investor feels comfortable doing just that—investing.

Clearly, the risk in those companies went up after Enron. So, the greater the disclosure, the less the risk premium will be for a given company. I think they recognize that, and they are taking steps to clear that up.

Today, it’s far from perfect, but it did get a lot better in the fourth quarter earnings reports. For instance, Dynegy was a company who, at one time, had disclosed where earnings came from in terms of trading vs. generation. Then came a big trend in the industry where companies said, “You can’t separate out the earnings from generation and trading because they are symbiotic.” What that did was cloud the sources of earnings and revenues. We didn’t like that. Well, they’ve reverted to the old way, because now people have a lot more confidence in the earnings from assets.

Calpine did a similar thing. One of the things they did was disclose how much they sold their electricity for and how many MWh. So, you get a perspective on how they made their money, which helps you to forecast how they will make their money in the future.

I’m reasonably pleased with the direction we’re going with disclosures. That may be one of the only benefits of this Enron thing: better disclosure from the energy sector.

I’m afraid that the stock market has been pretty badly hurt by Enron. Owning equities is all about optimism and confidence, and Enron hurt both of those—not just for the energy sector, but for stocks in general. It takes awhile to get that back, and the only way to get it back is to have more information for investors.

Dobson: I would argue that we are in the process of seeing more financial disclosure, not less. That’s probably true throughout the market, not just in the energy arena.

I would say, though, that what I need to do my job, what I need to do accurate analysis, is to understand exactly what a company’s liabilities are, exactly what a company’s assets are, and exactly what the cash and earnings flowing out of those assets and liabilities are. Once I can get an accurate picture of those four items, I have a very good idea to start with, to overlay with my understanding, beliefs and outlook for an individual industry or business line.

Think of each one of those as classes of information—understanding liabilities and assets. Well, if more people understood assets and liabilities in a number of companies, including Enron, you might have been able to see quite clearly into the amount of debt that the company truly had on its balance sheet. If you looked at the earnings and cash flow of a lot of different companies, you could have a much clearer way of understanding how a company makes its money and sustains its margins and cash flow. So, those are the four areas we really need extra work in, but I would argue that most companies, over the balance of 2002, will increase their financial disclosure?and, maybe, in the ideal sense, their financial transparency?rather significantly, particularly on the fronts of mark-to-market accounting and special purpose entities such that investors will have a much clearer way to see through these companies.

To punctuate that, if there is a silver lining of Enron, it’s going to be the fact that companies are going that way—in part bred by their own volition, in part bred by investors, and, perhaps, even forced a little by the SEC [U.S. Securities and Exchange Commission] taking a pretty big stick to a pin~ata, so to speak.

Companies with good disclosure, in my opinion, over the next 12 months, will probably get a premium in the marketplace.

Meade:An energy company is hard to define these days. You have everything from regulated utilities that are still vertically integrated, pipelines, all the way to unregulated gas and power companies, and energy trading and marketing companies. In my view, the business where there was a real issue with lack of disclosure in this area was energy trading and marketing. Period. That was Enron’s primary business. They were really the market leader; so I think most companies followed their lead in what type of disclosure was produced.

In the wake of Enron’s collapse, there has been a call for more disclosure and a better understanding of what’s really driving the business. As a result, companies are producing a lot more data for us. They are showing us the size of their mark-to-market book vs. their accrual book, when they realize the cash they’ve recorded under mark-to-market, some earnings-at-risk limits related to their trading and marketing businesses. I think all these things are good, and it will be a continuing process that moves back-and-forth between companies and investors to figure out what is needed exactly. The companies have taken a good first step though.

EL&P: As an analyst, are you feeling more exposed, more “under the gun” these days? Could such pressures cause you to be more conservative?

Ellinghaus: I’m a pretty bullish guy on the energy sector, and the recession took me by surprise, how quickly we went from economic strength to economic weakness. Then Enron came along and made things go one level further, which made it more difficult to feel good about the energy sector.

However, in some ways, I want to be bolder, but I tell you what: I will pay vigorous attention to the disclosure notes when the 10Ks come out to try and find any little nitpicky thing that may be a red flag. I think everyone should be careful on the details nowadays, and Enron is a good reminder that you need to pay attention to the fine print.

People will notice the auditors’ page a lot more this year. I can tell you that.

Dobson: Absolutely. I would argue that anyone who tells you they don’t feel more “under the gun” probably ought to do a little self-examination. I didn’t even cover Enron, and I can tell you for several days during the month of December, I had lots of time to sit there and think, “How could so many people have missed Enron?”

Again, that’s what convinces me that, yes, there were probably ways to see that Enron was going South, but they certainly weren’t very clear. And, you could apply that old adage about a broken clock being right twice a day. So, you’re going to find, in this situation, people who were very negative, who are now right, and people who were very positive, who were once right.

One guy in Houston, who was negative on Enron for 10 years, is now considered to be in the know. Was he always right? Well, if you were positive all the time, you were right for eight of the 10 years, but, if you were negative, like our friend in Houston, you were wrong for eight years and right for one and a half. It’s a hard argument there.

I have personally and professionally used the Enron rallying cry to redouble my efforts to read and absorb exactly what financial statements are telling me. I want to bring a new breath of objectivity to the way I approach analysis. Not that it was non-objective before, but certainly events like the demise of Enron—and other situations—should redouble management’s efforts, analysts’ efforts and investors’ efforts to look for realistic sustainable rates of growth, earnings and returns on assets.

The investor psychology—like commodity prices—is cyclic in its evolution: highs and lows. At the highest highs, people think prices are going up forever. When prices are at their lowest, people are in the mindset that the market will never, ever recover and this is death and destruction forever. I would argue that this situation will make people more conservative now, but the normal sine wave of a commodity cycle has a way of improving itself.

I can tell you I sense a little—a hint—of more optimism on the front of investors, but, certainly, I would say all investors will approach this sector, and, for that matter most other sectors in the marketplace with a lot more skepticism than they once did. I’m not sure that’s such a bad thing.

Meade: We feel pretty good about what we’re doing. We started off doing analysis the way a lot of critics are now saying analysts should be doing analysis: 10-year discounted cash flow models, business by business. We roll it up from the fundamentals in the market. We don’t use simplistic earnings multiple analyses. I think the results speak for themselves. We were very bearish on Enron for a very long time. We’ve been bearish on Calpine when that stock was very popular.

I think our style of investment is now “in vogue,” where it wasn’t a year ago. I feel pretty confident that what we’ve been doing all along is what should be done. And, we’re just going to keep doing what we’ve been doing.

Ellinghaus, Principal in equity research, Williams Capital, provides fundamental research coverage of the electric & gas utility, diversified natural gas, and electric generation industries. He can be contacted via e-mail (

Dobson, Managing Director, is an equity research analyst covering the electric power industry for Deutsche Banc Alex Brown (a unit of Deutsche Bank) in New York City. He is responsible for leading the North American research effort on electric power-related equities.

Meade, Utilities Analyst with Commerzbank Securities, leads the coverage of U.S. utilities companies. He can be contacted at

Editor’s note: Moody’s, Merrill Lynch, Fitch, and Arthur Andersen all declined to be interviewed for this article. Lehman Brothers and Standard & Poor’s did not return inquiries.

Learning the lingo


Financial Accounting Standards Board (FASB): the body that establishes standards that govern accounting practices and financial reporting.

FASB 133: according to FASB, “this statement establishes accounting and reporting standards for derivative instruments

cash accounting: a process of simply recognizing and recording transactions, as with a personal checkbook. Basic concept: cash in, cash out.

accrual accounting: accounting that brings in the ideas of economic value and matching principles. Basic concept: it’s like your car, with value stretched throughout the life of your vehicle.

mark-to-market accounting: a process which allows companies to report the full profits from a multi-year contract as current earnings. Basic concept: you’re slated to deliver two apples a week to your neighbor at the price of 50 cents per apple. Instead of recording the profits at one dollar a week over the next year as you deliver the apples and get your dollar bill, you record a $52 profit now.

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