Enron – What Went Wrong: How a Sleepy Little Utility Became a Trading Giant and Through a Series of Missteps Brought Its Nefarious Dealings to Light, Precipitating Its Ultimate Collapse by Bob McCabe September 25, 2002

1
Enron What Went Wrong How a Sleepy Little
Utility Became a Trading Giant and Through a
Series of Missteps Brought Its Nefarious Dealings
to Light, Precipitating Its Ultimate
CollapsebyBob McCabeSeptember 25, 2002
2
The Cast of Characters Kenneth Lay

• CEO and Chairman of the Board
• The J.R. Ewing of Natural Gas tremendous
  political influence and deal-making saving.
• Ph.D., Economics, University of Houston
• Former
• Energy Deputy Undersecretary at the Interior
  Dept.
• Believed Fervently in Free Markets

3
Cast of Characters Jeffrey Skilling

• CEO and President
• Became COO in 1996 and was CEO from February 2001
  to August 2001 Joined Enron in 1990
• MBA, Harvard
• Former Partner at McKinsey Company
• Came up with the Idea of the Gas Bank
• Known as Darth Vader at Enron big proponent
  of PRC Performance Review Committee became
  known as the 360 degree review or rank and
  yank.

4
Cast of Characters Andrew Fastow

• CFO
• Hired by Skilling in 1990
• MBA, Northwestern undergraduate at Tufts in
  Economics, of course.
• Became CFO in 1998
• Former Senior Director of Continental Bank in
  Chicago specialized in securitization,
  leveraged buyouts and derivatives.

5
Cast of Characters Sherron Watkins

• Enron Vice President
• Author of the famous anonymous memo to Lay in
  August 2001.
• Former Andersen employee

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Gas Industry

• There are 200,000 miles of pipeline versus 42,000
  miles of Interstate Highway.
• Before Deregulation prices were relatively fixed.
  Regulation guaranteed profits to everyone and
  effectively rewarded inefficiency
• In the mid 80s, the Reagan administration began
  the process of dismantling price regulations.
• Deregulation brought with it wild fluctuations in
  prices.
• Enamored of technology

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Enron Background 1

• Founded in mid-80s from the merger of Houston
  Natural Gas and InterNorth
• Principal assets included
• Natural gas pipelines spanning much of the U.S.
• Oil and Gas wells
• Highly leveraged From its beginnings and to
  fight off a hostile takeover, Enron was saddled
  with the costs of supporting junk bonds that
  were issued with Michael Millikens help.

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Enron Background 2

• The 1985 Pipeline deregulation meant that Enron
  no longer had exclusive control over them.
• Enrons Strategy
• In the beginning, it sold off its oil wells.
• EOG Resources
• Large asset sales enhanced Enrons apparent
  earnings growth.
• Lays fervent belief in free markets led to Enron
  becoming a market maker.
• Lay, also believed that Enron had to grow quickly
  or die.

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Enron Background 3

• Enrons Strategy
• Hired McKinsey Company
• Jeffrey Skilling
• Enrons culture focused on two things
• 1. Profits
• 2. How to make greater profits

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Enron Background 4

• Financials at December 31, 2000
• Net income 979 million Comprehensive income
  672 million.
• Total assets 65.503 billion an almost 50
  increase from 1999.
• Equity 11.470 billion a debt to equity ratio of
  4.7
• Current ratio 1.06

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The Gas Bank

• Enron entered into long-term contracts with
  natural gas suppliers
• Outright purchases unlike electricity, gas can
  be stored.
• Options to purchase
• Securitized these contracts to make them
  attractive to consumers. It then sold options
  giving the customer the right to buy the gas in
  the future at a stipulated price.

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Energy Market Accounting Issues

• Enron used Mark-to-Market accounting. For many
  of these contracts, no market reference point
  existed so Enron used a Mark to Model approach.
  
• Since Enron was the counterparty, i.e. for
  every sale, Enron was the buyer, and for every
  purchase, Enron was the seller. Should Enron
  recognize as sales the gross sales price or just
  the spread?

13
Enron Timeline 1

• 1985
• Set up a trading company in Valhalla, NY that
  operated much like a hedge fund.
• Made many bets on the future price of oil and was
  usually wrong.
• To Houston, Enron Oil, added 50 million to the
  corporate profit.
• Two sets of books and no oversight from Corporate
• Enron reported a loss of 85 million but some
  estimate it as high as 142 million.
• Head of Enron Oil went to prison.

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Enron Timeline 2

• 1987 Stock Market Crash enabled Enron to
  attract financial talent to Houston
• 1990 Lay hires Jeffrey Skilling
• 1990 Skilling hires Andrew Fastow
• 1993 Formed Enron International with Rebecca Mark
  as President.
• 1995 Enron International signed contract to build
  and operate a power plant in Dabhol India.

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Enron Timeline 3

• 1996 Skilling appointed COO and convinces Lay
  that the Gas Bank model can be used to develop a
  market for electricity.
• 1997 Acquired Portland General Electric Corp
  for 2 billion. Revenue from trades of gas and
  electricity reach 7 billion.
• 1998 Enron spun off a water company called
  Azurix and took it public in 1999.

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A Note on Skillings Strategy

• While Skilling took office in 1996, it took
  sometime for him to implement his asset light
  strategy. For the most part, Enron under Richard
  Kinder and Rebecca Mark believed that hard assets
  could become cash cows. Skilling believed that
  
• Hard assets are dogs.
• Enrons real product was to create markets.

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Enron Timeline 4

• 1999 - Azurix through Enron acquires a water
  concession to supply water to five areas of
  Argentina for 438 million.
• 1999 - First stage of Dabhol project completed
  and plant becomes operational. However, the cost
  to produce power from the plant is four times
  that of other plants in India.

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Enron Timeline 5

• 1999 - Azurix announces that it is firing
  one-third of its employees.
• 1999 Launched Enron Online investment
  community lauded Enron for their leadership.
• 1999 Enron enters Broadband market by acquiring
  hard assets.

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Enron Timeline 6

• 1999 Enrons trading profit margins are being
  pinched by its competitors (Duke Energy,
  Williamsen, Dynergy, etc.)
• 2000 Announced a plan to build a high-speed
  broadband telecommunications network and trade
  broadband capacity.
• 2000 Energy prices fall with downturn in world
  economy.

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Enron Timeline 7

• 2000 Enron inks a 20-year deal with Blockbuster
  to supply videos on demand.
• 2000 Enron stock hits all time high 90.56.
• 2001 Enron announces a 150 increase in sales
  from 1999 to 2000. Pretax profits hit 1.41
  billion and a net of 1 billion. Unrealized
  gains account for more than half of pretax and
  about a third of net.

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Enron Timeline 8

• February 2001, Skilling becomes CEO and
  President. Tells analysts that stock should be
  trading around 126 per share (when it was about
  80).
• February 2001, Fortune magazine article, Is
  Enron Overpriced?
• March 2001, Blockbuster deal cancelled.

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Enron Timeline 9

• April 2001 At Lays request, Colin Powell
  visits India to try to salvage the Dabhol
  project. No success.
• April 2001 Released financial results for first
  quarter.
• Earnings up 18 over last years first quarter.
• Revenues up a whopping 280.

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Enron Timeline 10

• May 2001 J. Clifford Baxter, vice chairman
  resigns to spend more time with his family.
• May 2001 First quarter 10Q shows profits of
  425 million. But, cash used from operations was
  464 million.
• August 2001, Rebecca Mark resigns from Azurix
  blaming British government. Cashes out her Enron
  stock for 82 million.

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Enron Timeline 11

• August 2001 Second quarter 10-Q shows earnings
  of 823 million and cash used in operations of
  1.337 billion.
• August 2001 Jeffery Skilling resigns for
  personal reasons.
• August 2001 Lay sends email to all employees
  announcing Skillings resignation and says among
  other things, our performance has never been
  stronger.

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Enron Timeline 12

• August 2001 The day after Skillings
  resignation, Sherron Watkins sent her famous
  anonymous email to Lay. In it she said, Im
  incredibly nervous that we will implode in a wave
  a accounting scandals.September 2001 Qwest
  and Enron Broadband swap broadband with a price
  of 500 million. How do you measure the value of
  nonmonetary assets? Was a gain recognized?

26
Enron Timeline 13

• October 2001 Announced sale of Portland
  General. Its still for sale.
• October 2001 Released third quarter results
  showing a loss of 618 million.
• October 2001 Announced change in plan
  administrators. Employees prevented from selling
  shares from their 401k plans.

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Enron Timeline 14

• October 2001 Lay fires Fastow.
• October 2001 Another email from Watkins put
  the blame on Skilling and Fastow.
• November 2001 Enron issues corrected financial
  statements covering the past four and one-half
  years. Losses of 591 million and additional
  liabilities of 628 million are picked up from
  consolidating JEDI and Chewco.
• November 2001 stock price 26 cents.

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Enron Timeline 15

• November 2001 Rating agencies finally reduce
  Enrons credit rating from low investment grade
  to junk bond status.
• December 2, 2001 Filed for Bankruptcy
  protection under Chapter 11
• January 17, 2002 Enron dismisses Andersen.
• January 25, 2002 Baxter commits suicide (was
  it?)
• March 2002 Sold Wessex Water for 777 million
  original purchase price 1.9 billion.

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Enron Timeline 16

• August 27, 2002 Announced the availability of
  electronic data rooms that provide detail on 11
  Enron businesses. Request initial indications of
  interest by October with final bids in November.
  The businesses include Portland General,
  Transwestern Pipeline, Elecktro, Cuiaba, Sithe,
  etc.

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Related Party Disclosures

• From the 2000 report Enron entered into
  transactions with limited partnerships whose
  general partners managing member is a senior
  official of Enron. Management believes that the
  terms of the transactions were reasonable
  compared to those which could have been
  negotiated with unrelated third parties.

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Special Purpose Entities

• The basic presumption under ARB 51 is that
  consolidation is required. To overcome this, two
  conditions must be me. First, an independent
  owner of the SPE must make a substantive capital
  investment and that investment must bear the
  risks and rewards of ownership over the entire
  term of the transaction. (The SEC staff say that
  it shall be at least 3 of total capital
  (assets)). Second, the independent owner must
  exercise control over the SPE.

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JEDI 1 (Joint Energy Development Investment)

• Started in 1993 with Enron and CalPERS
• In 1997 Enron wanted to redeem CalPERS interest
  so that CalPERS would invest in JEDI 2.
• Formed Chewco to acquire CalPERS interest.

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JEDI/Chewco

• Chewco invests 383 million in JEDI for a 50
  interest. Of this 240 million was borrowed from
  a bank with Enrons guarantee. JEDI advanced
  Chewco 132 Million. The general partner invested
  11.4 million in Chewco all of which was borrowed
  from the same bank. Chewco sent 6.6 million
  back to the bank to be held as a reserve on the
  11.4 million loan. Chewco paid Enron a 10
  million guarantee fee. Under the terms of the
  contract JEDI had to pay Enron a management fee
  of 28 million through June 2003.

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JEDI/Chewco continued

• JEDI invested in Enron stock.
• Enron accounted for its investment in JEDI using
  the equity method.
• Can revenue be recognized from your own stock?
• When Chewco was unwound, Kopper received 10.5
  million on his 115,000 investment.

35
LJM Rythms Swap

• Ive simplified the facts below
• LJMs general partner was Andrew Fastow
• Enron held 5.4 million shares of Rythms that it
  had acquired for 10 million and could not sell
  until 2000. The value in mid 1999 was 300 mill
  and Enron had recognized 290 in unrealized
  gains.
• Enron issued 3.4 million restricted shares to LJM
  in exchange for a 5-year Put Option on Rythms at
  56 a share and a note from LJM for 64 million.
• Subsequently, the value of the Rythms stock fell.

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LJM Rythms continued

• Enron recognized the decline in the Rythms stock
  as a loss but offset this loss from an unrealized
  gain on its put option.
• Is this an economic hedge, i.e. was LJM ever in a
  position to honor its obligation?