Message-ID: <28805737.1075840424904.JavaMail.evans@thyme> Date: Fri, 11 May 2001 15:11:00 -0700 (PDT) From: chris.dorland@enron.com To: keith.holst@enron.com, robert.benson@enron.com, michael.cowan@enron.com Subject: Why One Firm Thinks Enron Is Running Out of Gas Mime-Version: 1.0 Content-Type: text/plain; charset=us-ascii Content-Transfer-Encoding: quoted-printable X-From: Chris Dorland X-To: Keith Holst , Robert Benson , Michael Cowan X-cc: X-bcc: X-Folder: \ExMerge - Dorland, Chris\Sent Items X-Origin: DORLAND-C X-FileName: chris dorland 6-26-02.PST Just a little something to brighten up your weekend! ---------------------- Forwarded by Chris Dorland/HOU/ECT on 05/11/2001 12:= 10 PM --------------------------- =09Dan Dorland 05/11/2001 07:50 AM =09 To:=09Paul Devries/TOR/ECT@ECT, Jan Wilson/TOR/ECT@ECT, Jeff Borg/TOR/ECT@E= CT, Dave Ellis/TOR/ECT@ECT, Garrett Tripp/TOR/ECT@ECT, Stephane Brodeur/CAL= /ECT@ECT, Chris Dorland/HOU/ECT@ECT, kdorland@flint-energy.com cc:=09=20 Subject:=09Why One Firm Thinks Enron Is Running Out of Gas http://www.thestreet.com/_yahoo/comment/detox/1422781.html Why One Firm Thinks Enron Is Running Out of Gas By Peter Eavis Senior = Columnist Originally posted at 5:23 PM ET 5/9/01 on RealMoney.com = A small research boutique with a reputation for rigorous analysis is tell= ing clients to quickly dump Enron (ENE :NYSE - news ), believing that the e= nergy trading giant's 2001 earnings will fall well short of Wall Street's f= orecasts. Cambridge, Mass.-based Off Wall Street, led by analyst Mark Robe= rts, thinks Enron's 2001 earnings will fall 6 cents short of the consensus = estimate of $1.79. The firm also believes Enron stock should trade around $= 30, nearly 50% below Wednesday's $59.20. The firm's 26-page report, publis= hed May 6, highlights Enron's declining profitability and increasing levera= ge and suggests that the company should trade on the same sort of multiple = as a trading firm like Goldman Sachs (GS :NYSE - news ), which has a 2001 p= rice-to-earnings ratio about half of Enron's 33 times. OWS also alleges tha= t Enron's earnings quality is poor and that key parts of its financial stat= ements are confusing and opaque. Houston-based Enron didn't comment by pub= lication time on elements of the report that Detox sent the company. An en= ergy analyst who is bullish on Enron's outlook says the OWS report contains= fundamental misunderstandings about the energy market and Enron's business= model, but he says the report does include some ground-breaking and valid = insights. (The analyst's firm doesn't give stock recommendations.) Economi= es of Scale Why care what Off Wall Street writes, compared with, say, analy= sts at Merrill Lynch (MER :NYSE - news )? For one, OWS has an excellent tra= ck record. Particularly sweet was 2000, when the tech stocks it had bashed = came crashing down. It has also shown itself to be well ahead of the curve,= recommending that clients sell e-tailer priceline.com (PCLN :Nasdaq - news= ) in June 1999, when faith in Internet stocks was at its blindest and thei= r prices at their most insane. Pulling Back Enron retreats after long = rally Enron, with its domination of a burgeoning energy market, annual re= venue of over $100 billion and impressive earnings growth, can hardly be ra= nked alongside the likes of priceline. But OWS thinks Enron is set for a pr= ecipitous drop nonetheless. Why? OWS's main beef is that key profitability= measures are in decline. Margins on Enron's pretax operating earnings (whi= ch the company's earnings releases call IBIT, or income before interest, ta= xes and other items) are falling. Total IBIT of $795 million in the first q= uarter amounted to only 1.59% of the $50 billion in revenue for the period,= compared with a 2.08% margin in the fourth quarter and 4.75% in the year-e= arlier period. Revenue in the first quarter was nearly quadrupled from the = year-earlier period, yet IBIT rose only 27%. This shrinkage is due to lower= -margin trading income making up an increasingly large share of Enron's rev= enue base. OWS thus calculates that for the remainder of 2001 Enron needs = to generate an extra $2.1 billion in revenue for each additional penny it m= akes over its 2000 EPS of $1.47 to reach analysts' expectation of $1.79. T= he energy analyst counters that OWS apparently hasn't grasped how Enron can= continue to increase earnings even when margins shrink. It does so simply = by increasing volumes as the energy market balloons in size. In other words= , margins may decline, but since revenues are so much higher, earnings stil= l go up. Illustrating this, first-quarter 2001 EPS of 49 cents was 23% ahea= d of the year-ago figure, even though the IBIT margin shrank by 3.2 percent= age points. The analyst thinks Enron will make $1.82 per share in 2001. Gr= owing On You In addition, the huge growth in the energy market that has so = helped Enron is likely to continue for several years, according to the anal= yst. He notes that roughly 75% of the electricity available in the U.S. sti= ll isn't traded in a market. "Eventually it will be part of a competitive e= nvironment, but it'll take five to 10 years," says the analyst. And he beli= eves the extreme volatility in energy-related commodities that has also ben= efited Enron will exist for longer than OWS projects. Still, OWS's point o= n profitability is bolstered by other profit measures. Return on capital (n= et income as a percentage of equity plus debt) was 6.6% in 2000, down on 19= 99's 6.9% and well below the 2000 returns on capital at Duke (DUK :NYSE - n= ews ) (11.8%), Dynegy (DYN :NYSE - news ) (12.1%) and even Goldman (8.9%). = Even Enron bulls will admit that its financials are hard to follow. For ex= ample, it doesn't give a gross margin number for its wholesale services, or= trading, business, which accounts for 96% of revenue. But one area of the = company's financial statements registered with the Securities and Exchange = Commission that consistently bugs analysts is the part that describes Enron= 's related party transactions, which are the deals it does with entities th= at have some sort of link to the firm. In fact, one of the related entities= that Enron has traded with is headed by Enron's CFO, Andrew Fastow. The en= ergy analyst comments: "Why are they doing this? It's just inappropriate." = The reason for maintaining these hard-to-follow related party deals has be= en a source of speculation. But OWS analysis shows how a sales of optical f= iber to a related party may have been used to goose earnings in the second = quarter of 2000. Estimated profits from the so-called dark fiber (optical c= able without the gear to send data over it) transaction allowed Enron to be= at analysts' second-earnings earnings estimate by 2 cents a share, rather t= han missing by 2 cents. How soon before Wall Street follows Off Wall Stree= t on Enron? =09