What was wrong with Enron's financials?

[Cigarbutt]

^Interesting CPA journal link.

The fundamental flaws were likely difficult to effectively be detected on a prospective basis but, in retrospect, the SPEs were the main elephants in the room. After the fact, it was found that the basic tenets of FAS 140 had not been respected. Enron had retained control of the SPEs (with the CFO on board) and the economic substance and risks had not been transferred. “Sales” should not have been recorded and the SPEs should not have been consolidated. A factor leading to the difficulty in spotting the fraud was related to the leading individuals (culture) who did not only try to take advantage of reporting ambiguities but basically set up creative structures destined to fool investors, regulators and even auditors. It’s interesting because some of these guys were very smart (but somehow did not realize how this would invariably end; this happens also with authors of Ponzi schemes who seem to believe that they can permanently delay the inevitable). One of the creative features was the use of total return swaps in order to avoid GAAP reporting requirements for financial obligations. A way to appreciate their objective is to consider that their aim was to somehow revalue their book value in order to reflect market value, something which was unavailable with US GAAP (but possible to some degree with IFRS –as a “revaluation”). By capitalizing the SPEs with Enron stock, their idea was to use the stock as a hedge (assuming the stock would keep going up and not be correlated to other assets) to other SPE assets, capturing the premium allocated to the Enron stock by the Market. Abuses are bound to happen again. Even if SPE reporting criteria were then strengthened, SPV in mortgage securitizations became widely used and the problem was not the bankruptcy-remote status of the entities but the actual products being fed into them. It was very hard to assess the endurance and trend of earnings from core operations with Enron and that always signals the need for at least a heightened level of scrutiny.

 

@Longhaul

It’s interesting that you recommend a book whereby the author of the preceding post had made the exact same recommendation before. I remember asking you how you assessed the quality of evidence in general (I guess a relevant step if you’re looking for fraud, red flags or something) and you had answered that you sometimes focused on summaries and used consensus opinions. You’re lucky then because dissecting reports can be tedious exercises.

 

[Spekulatius]

Actually, even if you new nothing about the SPE, just a casual look at the balance sheet , the lack of profitability (ROIC) and valuation should have been enough to keep you away from investing in Enron.

[RadMan24]

Some of the other posters have hit upon some of the things that Enron did and some of the questions that should have been asked.  However, if you are really curious, I would highly suggest reading Financial Shenanigans: How to detect accounting gimmicks & frauds in financial reports, as they have sections about each of the companies you mentioned.

 

Can't recall if it was this book or not, but it's always useful to put together 10 years of financials which will catch any huge discrepancies that suggest deeper dives or red flags. Sometimes the 5 year does it but another 5 years really puts things in perspective. i.e. big jumps from one account to another; no corresponding impact on cash flow; boosts earnings later on.

 

Edit: 10 years of all statements, cash flows, earnings, balance sheet, change in equity

[Cigarbutt]

Actually, even if you new nothing about the SPE, just a casual look at the balance sheet , the lack of profitability (ROIC) and valuation should have been enough to keep you away from investing in Enron.

1-

I guess one can uses nonspecific filters (nonspecific in the sense that the filter will not discriminate between poor profitability, high valuation multiples, fraud or else). But when fraud is involved, numbers reported cannot be relied upon and, in theory, numbers could have been presented in a way to bypass your usual filters. How do you evaluate trust? I guess investing in a large number of companies can help but I would say that a more concentrated approach does require a deeper level of evaluation for trust.

 

2-

This comment is not about fraud but about the difficulty in quantifying the future. Enron was profitable (these days, there are a lot of companies which require discounting of future profitability far into the future) and many described a promising future (involvement in the internet broadband sector etc). Of course, Enron used this uncertainty in order to feed the narrative and I would say the disconnect was far from obvious when looking through contemporary eyes.

https://archive.fortune.com/magazines/fortune/fortune_archive/2001/03/05/297833/index.htm

"In the end, it boils down to a question of faith. "Enron is no black box," says Goldman's Fleischer. "That's like calling Michael Jordan a black box just because you don't know what he's going to score every quarter." Then again, Jordan never had to promise to hit a certain number of shots in order to please investors."

 

The lesson I'll keep from the Enron story is that faith is very hard to handicap and, in my humble book, rapidly results in a zero position size, which means that many lucrative bets are missed. Too bad.

 

[rb]

WOW! Those financials look horrible.

 

I mean maybe it's very easy to say that today vs. back then. But Enron was essentially an utility with a trading operation. Yet for those years that Spek posted financials, their income is below what an utility should earn. This means that the trading operation was sucking wind all that time. The cherry on the top of course comes in 2000 when they grow the business by 150% at zero margin.

 

But then those times were different that today. The market was going up like crazy and nobody cared about ROIC, valuation, and income. All that mattered was top line growth and your next big idea. Actually.... wait a second, maybe times were not that different.

[Spekulatius]

1-

I guess one can uses nonspecific filters (nonspecific in the sense that the filter will not discriminate between poor profitability, high valuation multiples, fraud or else). But when fraud is involved, numbers reported cannot be relied upon and, in theory, numbers could have been presented in a way to bypass your usual filters. How do you evaluate trust? I guess investing in a large number of companies can help but I would say that a more concentrated approach does require a deeper level of evaluation for trust.

 

2-

This comment is not about fraud but about the difficulty in quantifying the future. Enron was profitable (these days, there are a lot of companies which require discounting of future profitability far into the future) and many described a promising future (involvement in the internet broadband sector etc). Of course, Enron used this uncertainty in order to feed the narrative and I would say the disconnect was far from obvious when looking through contemporary eyes.

https://archive.fortune.com/magazines/fortune/fortune_archive/2001/03/05/297833/index.htm

"In the end, it boils down to a question of faith. "Enron is no black box," says Goldman's Fleischer. "That's like calling Michael Jordan a black box just because you don't know what he's going to score every quarter." Then again, Jordan never had to promise to hit a certain number of shots in order to please investors."

 

The lesson I'll keep from the Enron story is that faith is very hard to handicap and, in my humble book, rapidly results in a zero position size, which means that many lucrative bets are missed. Too bad.

 

I think 1)  - applying nonspecific filters - is the way to go for most individual investors to avoid getting into fraudulent investments. Proving fraud is very very Hard  and few have the forensic accounting skills and resources to dig deep enough.

 

Enron is a good example where the story looked much better then the numbers. A more recent example was Valeant, where the GAAP results as well as the balance sheet looked horrible, and management provided all kind of mental gymnastics to justify the business model.

 

Perhaps a more recent one is Tesla,  it it’s overused, so I won’t elaborate on this. I believe now thwt tech and specifically SAAS companies are probably misrepresenting, although I am not sure their financials are fraud, I think the fraud lies more in the fsct that the GAAP financials may be more representative  of the economic reality than the adjusted numbers that management is representing. Case in point may be YEXT, a SAAS company. I have no idea about their product an TAM etc, but I have rarely seen a company that has a gross margin of ~72% and manages to spent an even higher percentage on sales and marketing and losing 50% of their revenue on a GAAP basis. one would think that such a company gains economy of scale on S&M too, but that’s actually not the case, this outfit managed to increase their S&M expenses since the IPO more than revenues actually, indicating negative operating leverage.

 

Perhaps there is a good reason for all this, but I fail to see any explanation why all this expense will lead to an explosion in profitable revenue in the near future. It’s not accounting fraud per say in a sense that the GAAP numbers may well be correct, but if just the GAAP numbers matter in this case, this company would be absolutely worthless and you would have to pay a buyer to take it. YEXT isn’t a sole exception either, but it’s one I have taken a closer look after some folks mention it on Twitter. I hope they know what they are doing, but my sense is that those folks tend to ignore operating results altogether and invest solely based on some momentum or qualitative factors.

 

For me, when the numbers don’t make sense on a first principle basis,  I tend to stay away from these stocks as far as possible.

[writser]

For me, when the numbers don’t make sense on a first principle basis,  I tend to stay away from these stocks as far as possible.

 

I do the same. That doesn't even have to mean these companies are fraudulent - I just don't want to own something I don't understand. It is pretty clear to me that Enron would belong in that pile. As did Valeant, as does Tesla.

[Cigarbutt]

^Helpful.

 

I took a rapid look at Yext and it's clearly out of my league. It reminds me though of TRUP (Trupanion, the pet insurer) in the sense that a path to future profitability is defined and there is a risk of deep disappointment just because aggressive targets are not met.

 

For the understanding part, some companies' disclosures and communications with investors seem to be meant to help understand. For example, concerning bankruptcy-remote entities formed to securitize receivables, I find KMX (Carmax, the used car dealer) does a good job at delineating the key criteria that allow to verify (trust but verify) the economics of material transactions, even if the substance of the transactions is off-balance sheet. For Enron and perhaps similar entities along the quality of earnings spectrum, disclosures are often unclear, obtuse and, in a way, one feels that their aim is to discourage efforts to understand, which is clearly a red flag unless you decide to rely on trust alone.

[SharperDingaan]

^Helpful.

 

I took a rapid look at Yext and it's clearly out of my league. It reminds me though of TRUP (Trupanion, the pet insurer) in the sense that a path to future profitability is defined and there is a risk of deep disappointment just because aggressive targets are not met.

 

For the understanding part, some companies' disclosures and communications with investors seem to be meant to help understand. For example, concerning bankruptcy-remote entities formed to securitize receivables, I find KMX (Carmax, the used car dealer) does a good job at delineating the key criteria that allow to verify (trust but verify) the economics of material transactions, even if the substance of the transactions is off-balance sheet. For Enron and perhaps similar entities along the quality of earnings spectrum, disclosures are often unclear, obtuse and, in a way, one feels that their aim is to discourage efforts to understand, which is clearly a red flag unless you decide to rely on trust alone.

 

When you get an opportunity, look at the MD&A risk management disclosure of a Cdn Sched-A bank. Not a lot different to any other major global bank, but you really need a PhD in Finance to fully understand the transactions/stress tests. You also need a CPA to understand that you are only reading what had to be disclosed. To buy the bank, is to bet on the quality of the governance structure within the bank, and within its regulatory oversight. To sell the bank is to anticipate a breakdown; hence euro-banks as a favoured fishing hole.

 

Every time you use a forward curve to estimate today's value, you are essentially doing the same thing. It is well known that forward curves are useless predictors; less well known is that when using them - you also need to see the ongoing graph of actual vs prediction, and the stress tests. Ever seen that in the financial statements of a resource company?

 

Enron, and others, just show investors what they want to see. Greed does the rest.

And if you suspect early on that there is manipulation? It is very much in your interest to abet: keep on buying the shares (pushing price up), while also buying puts (profit on the way down). Not walk away, not short the stock in a rising market, etc.

 

For most of these, look at the governance then make a decision.

Is it an opportunity worth the risk?

 

SD

 

 

[DooDiligence]

I think it may be time to bring out the nukes and just start over.

---

Enron's tainted history and Skilling's role in its financial demise should not have a significant impact on Veld's ability to attract business, said Ed Hirs, an Energy Fellow and lecturer at the University of Houston. The bankruptcy caught many investors by surprise. The company claimed to have $100 billion in revenue the year before it collapsed.

"I don't see it as a positive or negative," Hirs said, referring to Skilling's reputation. "To succeed, they have to compete with the established firms in the business."

 

www.reuters.com/business/energy/ex-enron-ceo-taps-mckinsey-colleagues-energy-investment-venture-sources-2021-06-03/

[Spekulatius]

18 hours ago, DooDiligence said:

I think it may be time to bring out the nukes and just start over.

---

Enron's tainted history and Skilling's role in its financial demise should not have a significant impact on Veld's ability to attract business, said Ed Hirs, an Energy Fellow and lecturer at the University of Houston. The bankruptcy caught many investors by surprise. The company claimed to have $100 billion in revenue the year before it collapsed.

"I don't see it as a positive or negative," Hirs said, referring to Skilling's reputation. "To succeed, they have to compete with the established firms in the business."

 

www.reuters.com/business/energy/ex-enron-ceo-taps-mckinsey-colleagues-energy-investment-venture-sources-2021-06-03/

LOL, he makes his comeback at exactly the right time. He should probably hail in with Andrew Fastow and bring the band together again.

 

[DooDiligence]

4 hours ago, Spekulatius said:

LOL, he makes his comeback at exactly the right time. He should probably hail in with Andrew Fastow and bring the band together again.

 

The day I get out of prison, my own brother picks me up in a police car.

---

The resemblance to this guy is uncanny