It now seems clear that growth in EPS became ever harder for Enron to deliver. So its laser focus switched to looking for accounting fiddles that would make it look as if EPS was going up, and also hive debt off its books. To that end, several off-balance-sheet entities were set up. These were not wholly independent of Enron, but were judged sufficiently separate that their profit or loss did not have to be consolidated into the company's results. Assets, or portfolios of assets, were then "sold" to these entities.
For example, swaps were created on Enron's balance sheet that would compensate the buyer of assets in the event of an unexpected loss. Sometimes the quality of the assets sold was doubtful (a block of Internet shares, say); sometimes the third-party entity would pay using a loan from Enron, which then booked the interest on the loan as income. For illiquid assets, Enron had considerable discretion in deciding what constituted a fair price. According to Off Wall Street, a consultancy, around 28% of Enron's EPS in 2000 came from gains on sales of securitised assets, mostly to third parties connected with Enron.
Andersen, Enron's auditors, may have allowed these transactions because they were considered too small to be material. But a combination of bigger losses to hide and the success of the disguise meant that the partnerships soon grew so big that it now seems surprising, to put it no stronger, that the auditors did not revisit their accounting treatment and legality.
The thorniest question of all is why Enron ever had to resort to these financial shenanigans. Perhaps evidence of simple, criminal activity will be found. Yet greed was surely not the only factor. Although Enron's accounts remain a black box, there are growing suspicions that even its energy-trading business — the jewel that Dynegy wanted so badly — may not have been as impressive as it seemed.
This is not to deny that Enron's traders were formidable. Harvey Padewer of Duke, an American utility that was a big rival of Enron's, concedes that "Enron had the biggest and strongest energy-trading business in North America." The company accounted for 15-20% of gas and power trading in the region. John Martin, an economist at Baylor University, reckons that the internal risk management of the trading business was basically sound.
But did high volumes really add up to big profits? At first, yes. However, partly as a result of Enron's success in expanding competitive markets, dozens of rivals flocked into trading. There proved to be few barriers to entry in energy trading; and Enron's skilled employees were snapped up in droves by rivals.
One indication of Enron's growing difficulties was the declining returns on extra revenues. Revenues grew by $10 billion from 1998 to 1999, and then jumped by another $60 billion to $100 billion in 2000. Profits before tax, on the other hand, rose by $1 billion in 1998, and by rather under $500m in both 1999 and 2000. Enron's return on capital was only 6.6% in 2000, less than rivals such as Williams and Dynegy.
More pointedly, notes Cary Wasden of Reed Wasden, an investment firm that has long been sceptical of Enron, the firm's trading margins collapsed, from 5.3% in early 1998 to less than 1.7% in the third quarter of this year. He notes that "margins have fallen in spite of the company's practice of selling fixed assets (ie, generation plants) and booking the gains as operating revenues."
Whether Enron pumped up its trading revenues is a crucial question. The spectacular growth of the past year or so was due almost entirely to Mr Skilling's embrace of the "disintegrated", asset-light trading model. Dean Girdis of the Petroleum Finance Company, a consultancy, points to other possible wheezes. He reckons Enron may have used limited partnerships and other financial vehicles to inflate profits. Another technique he points to is the lumping of assets such as pipelines into its trading business. In fact, profits from hard assets may have masked the shrinking margins of Mr Skilling's virtual trading business and encouraged him to bet the company on his radical, risky view that Enron could create markets in just about anything.
With margins shrinking, Mr Skilling tried to stretch the brand into new areas. Enron grew to have contracts with some 8,000 counterparties, in hundreds of business lines ranging from credit insurance to metals trading. In practice, this meant taking ever bigger bets, such as trading telecoms bandwidth.
As these bets started to go horribly wrong all at once, Enron may have felt compelled to pump up its revenues and profits using ever more ingenious tactics. Dynegy's Mr Watson puts it this way: "Enron tried to be a worldwide commodities broker and market maker to the world, open 24 hours a day, with just a BBB rating, unlike banks, which have a much stronger balance sheet — and the market fell for it."
The Limits to Markets
In one sense, the saga is far from over. In bankruptcy, Enron can borrow from banks, which know that fresh loans will be senior to old ones. The plan now seems to be to sell what assets it can (the ownership of its main gas pipeline is disputed by Dynegy), so as to keep alive the core trading business and the Internet operation, EnronOnline, perhaps with a view to selling them to a bank.
Yet it looks unlikely that Enron can stay alive, even in truncated form. A buyer of its trading and online operations would surely ditch such a besmirched brand. In any case, the company may be crippled by lawsuits that are likely to drag on for years. A better strategy for a would-be buyer might simply be to hire away Enron's best staff and start a new business.
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