Financial Troubles Reached Core Trading, Marketing Operations

As Enron Corp. circled the drain late last year, the Houston company insisted that its core energy trading and marketing businesses were still in fine shape.

In reality, interviews and documents show, Enron’s crown jewels may not have been so shiny without the help of fancy accounting and the infamous off-the-books partnerships.

“Enron was like that old joke: We’re losing money on every trade but we’re going to make it up on volume,” quipped Cary Wasden, an energy analyst who began warning about Enron two years ago.

Wasden and others were worried by hints in Enron’s murky financial reports that all was not right in key Enron businesses. Now Enron’s own internal investigation and accounts from former employees of Enron Energy Services make those misgivings appear prescient.

Enron’s energy trading operation, led by its Internet trading forum called EnronOnline, was the biggest in the world, and to hear Enron tell it, the best. Its retail arm, Enron Energy Services, sold electricity, natural gas and energy management services to businesses in deregulating markets, and was “a tremendous business,” Enron’s then-Chief Executive Jeffrey K. Skilling, and then-Chairman Kenneth L. Lay told shareholders in the company’s rosy 2000 annual report.

But even these units that were championed to investors were struggling and perhaps masking hundreds of millions of dollars in losses through the aggressive use of legitimate accounting techniques and other, less legitimate means, according to analysts and former high-level employees.

Managers of Enron’s wholesale trading business, which provided most of the company’s revenue in 2000, were not content to merely bring buyers and sellers together.

Instead, Enron played the role of market maker, putting itself on the other side of each transaction. If you had electricity to sell, Enron would buy it and resell it to someone else, dealing in commodities from coal to toilet paper.

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Burning Through So Much Money

In that role, Enron needed an enormous amount of cash. But in the last quarter before it filed for bankruptcy-law protection in early December, Enron ran through more than $6 billion in cash, Portland, Ore., energy economist Robert McCullough calculates, based on the company’s public statements.

McCullough and others think the trading business was burning through so much money because it was struggling to make a profit but that the pain was partly hidden by Enron’s enthusiastic use of an accounting method known as mark-to-market, which let Enron recognize the predicted earnings of a deal in the current quarter even if the contract stretched 20 years or longer.

Although that technique is standard in commodities trading, problems emerge when there is no liquid market that can establish with a degree of certainty what future market values will be.

Enron’s trading business initially enjoyed healthy trading profits, but as imitators rushed in to become the next Enron, trading margins shrank and the company was forced to look for new markets to dominate.

Although the volumes of power and gas sold continued to rise, Enron’s trading profits began falling in 1998, said Wasden, managing director of Reed, Wasden & Associates, a merchant bank in Bellevue, Wash. Enron’s trading margins before interest and taxes, one way to measure profitability, peaked at 5.26% in the first quarter of 1998 but fell to 1.65% in the third quarter of 2001, he said.

Enron also made operations look better by recording asset sales as revenue instead of as one-time gains, the more common accounting treatment, Wasden said. In the second quarter of last year, the company booked $700 million of asset sales as revenue, Wasden figured. “Once you factor that out, they were losing money on energy trading.”

Analyst James Chanos was troubled more than a year ago by what he called the trading operation’s “abysmally low” return on capital, a widely used measurement of profitability. Chanos’ New York company, Kynikos Associates, makes money by “shorting” stock, or betting that a particular stock is about to decline in price.

Chanos saw a 7% return on capital for trading in 1999, meaning that for every dollar of outside capital that Enron was using, it was earning only 7 cents. Chanos also figured that Enron’s cost of capital was more than 7%, “which meant, from an economic cost point of view, that Enron wasn’t really earning any money at all, despite reporting profits to its shareholders,” Chanos testified Wednesday before a House panel.

The recently released investigation by Enron directors shines a flashlight into only a small corner of the company’s labyrinth of off-the-books transactions but raises a significant question about Enron earnings, economist McCullough said. If at least $1 billion, or about 70%, of Enron’s recent earnings were illusory based on the examination of only a few partnerships, as the report concludes, then how healthy could the core operations really have been?

Perhaps the most telling sign is that Enron, after conducting an auction to unload its energy trading business, ended up giving it away to UBS Warburg, a unit of Swiss bank UBS, in exchange for a share of future profits. On Monday, EnronOnline, the once vaunted online trading unit, became UBS Warburg Energy, virtually ending the energy giant’s involvement in the industry it once dominated.

Similarly, Enron’s massive retail arm, Enron Energy Services, was not the profit center that it seemed, former managers and executives say. The unit sold energy under contract and otherwise managed the energy needs of tens of thousands of retail clients, from the University of California to J.C. Penney and Carl’s Jr.

Next to the wholesale trading arm, EES was touted by management as having enormous growth potential for the company. That message never waned, even as the unit’s massive customized contracts lost money and California’s energy crisis in early 2001 battered the unit’s book of business--heavily weighted toward California clients, former employees said.

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Restructuring Hid Losses, Ex-Worker Says

An e-mail sent by a disgruntled manager to then-Chairman Lay in August alleged that more than $500 million in EES losses had been obscured by a restructuring effort. The missive by Margaret Ceconi, reported last month, was somewhat vague on the bookkeeping but made it clear that the unit was portrayed as profitable although it was heavily burdened.

Enron Corp. spokeswoman Karen Denne declined to discuss specifics of the trading business or retail operation, saying the company prefers to look ahead. An EES spokeswoman said that “all the facts are not in [Ceconi’s] letter and the facts will come out soon.”

Several other former EES managers have since supported Ceconi’s assertions, painting a picture of a company that used legitimate accounting methods in questionable ways to achieve what many now say were deceptive ends.

As with Enron’s larger trading business, at the heart of the EES story is aggressive mark-to-market accounting that allowed the company to book as current earnings massive future profits that might never materialize, former employees and analysts said.

The future profits on Enron’s retail energy contracts--some of which stretched out as long as a decade--were based on the company’s own models. And those were “crystal ball” curves that predicted the wildly unpredictable, such as exactly when certain states would pass legislation to deregulate their energy markets, said former EES executive Glenn Dickson.

“The only reason the contracts were worthwhile was that mark-to-market,” he said. “You were able to take today 10 years’ worth of minimal profit. But once you’re into it, if your curves aren’t as good as what you hoped for, your revenue line deteriorates. You lose money.”

And lose money EES did. Unforeseen problems with California deregulation threw off the models that predicted profits for the California book of retail customers. The exact amount is unclear, but Dickson said, “We had a couple hundred million dollars of position that EES had taken for that regulatory risk, where we predicted one thing and now it was different.”

The unit also was burdened by the types of contracts it was seeking--large deals custom-tailored to individual industrial and commercial clients that could take one or two years to close.

By that time, there was a lot at stake to ensure they would be profitable. Dickson said that sometimes meant changing the variables of the underlying model to make the deals appear like winners. Those future profits were then booked even though the likelihood they would materialize was slim.

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An Effort to Clean Up the Bad Deals

By February 2001, new managers at EES--once headed by Thomas E. White, now secretary of the Army--was taking stock of the mess. They launched Project Phoenix, an effort to clean up the bad deals and renegotiate contracts. They temporarily put the brakes on new deals. When they started again, a more conservative approach meant “no more pressure to fudge with the curves,” Dickson said.

Then the whole risk desk--which modeled the curves and traded in retail energy--was moved out of EES into Enron Wholesale Services, the company’s touted wholesale trading unit.

Dickson said the reasons for moving the retail trading desk were legitimate--to do away with redundancies. But it served another purpose: The bad deals were moved off the EES books while management was still promoting the unit as highly promising.

“There was definitely a huge side benefit to not show the world that the early deals were not good,” he said.

Others were even harsher in their assessments.

“Within EES there wasn’t a person who had any understanding of the business who didn’t know the reason it was being moved was because of the [California] book of business and our position,” said one former executive. “They told the analysts it was because of synergies. It wasn’t. The reason was ... to cover up these huge losses.”

It was all about timing, he said.

EES had not become profitable until the fourth quarter of 2000, and then it did so largely on the strength of its California retail business and its trading positions here, the former executive said. But when California wholesale power prices went through the roof in the first quarter of 2001, EES suddenly faced “massive losses of well over $100 million,” he said.

Meanwhile, it was clear that Enron’s foray into broadband was tanking. To admit losses in another unit held forth as an engine of profitability was not an option managers cared to entertain, he said.

As part of the restructuring, Enron restated its second-quarter 2000 results for EES, Securities and Exchange Commission filings show. Originally, the unit had revenue of $840 million and operating income of $24 million. After the restatement, revenue was cut in half to $420 million, but profit almost doubled to $46 million.

Accounting experts say that companies have leeway to restructure but that doing so is improper if the purpose is to obscure losses and misrepresent profitability.

Economist McCullough said much remains hidden about the condition of Enron’s businesses: “The fundamental question we all wonder about is are these people basically con men or did they represent a combination of recklessness and pride.”