FOOL ON THE HILL
Enron as Icarus

This has to be the most fascinating, tragic, business story of the decade. Enron, less than a year ago valued at $66 billion, collapsed in a heap of ignominy with nothing left before it but bankruptcy. It is a story where the seeds of the company's destruction were sown as it was achieving its biggest success. When a management team seems more interested in appearances than good corporate governance, look out.

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By Bill Mann (TMF Otter)
November 30, 2001

The story of the demise of Enron (NYSE: ENE), a company with a market capitalization of more than $60 billion less than one year ago, has already been and will continue to be reported (and misreported) to death over the next weeks and months. This is a company that had no natural predators, it was the top of the food chain, and it was a company with which institutions, analysts, journalists, and individual investors all fell deeply in love.

If you follow the Enron story at all, you are going to find a few things. First, there will be a great deal of revisionist history, with pundits wagging their fingers at investors for taking big (read obvious) risks with Enron. You will find more than a little glee at the comeuppance of Enron's heretofore lionized management team as they are dragged through the dirt for their poor decisions, their lack of fiduciary control, their exorbitant (read undeserved) pay packages, their complete lack of ethics.

To some extent, this will all be true, which is exactly why revisionist history even exists. But it misses several points, first and foremost is that the thing that should define Enron is hubris. Over the last two decades, its management, from CEO Ken Lay on down, was unwilling to accept Enron's position as a regional natural gas pipeline company, and simply ignored the playbook every other company used. Enron created trading markets for commodities where none previously existed, and in doing so not only carved an ironclad position for itself, but solved some real inefficiencies in these markets. Enron even went so far as to attempt to create a bandwidth-on-demand market at a time when most of the providers of bandwidth needed a minimum of 60 days to turn up a data circuit. The incumbents laughed, but you can bet that they watched Enron very closely.

Yes, Enron's success, and its ultimate destruction, were both caused by hubris. Like Icarus, who tried to escape captivity with wings made of feathers and wax, a lack of respect for the conventional wisdom released Enron from its minor role in an obscure business. And just as Icarus' success was also the seed of his destruction, Enron flew too close to the sun, leveraging its assets higher and higher, and using increasingly deceptive accounting legerdemain in order to maintain its highly lucrative image as one of the most successful companies in America.

Enron revenues reached $100 billion in 2000, up from an already enormous $31 billion two years prior as companies rushed to trade on its proprietary platforms. Management basked in the glow of running one of America's most admired companies, all the while exploiting weaknesses in U.S. GAAP (generally accepted accounting principles) by hiding enormous amounts of risk in unconsolidated subsidiaries. Presumably, some of the sophisticated institutional investors in Enron, such as CalPERS would have assigned it a much lower multiple had they known the risks management was taking in its derivative trades.

I wish I could say I had sniffed out Enron's problems ahead of time. No, I swallowed the Enron story hook, line, sinker, pole, fisherman, and boat. I lobbied hard for Enron to be included in the FOOL 50 Index. The only thing that prevented me from investing in Enron was my complete inability to make sense of the company's financial statements, a condition that would seem prophetic once all of the company's off balance sheet shenanigans came to light. Once the run against Enron's assets started, there was nothing that could be done to stop the bleeding. Each reduction in asset value increased implied leverage, which caused partners to trade less with Enron, which caused debt covenants to be violated, which decreased asset value further, until the company disintegrated. The problem was that the original risks were never disclosed.

The reality is that Enron did a great job of hiding the risks that ultimately brought it down. But the company has given off hints of potential impropriety that started years ago, that through the degree of its cynical treatment of its shareholders' (and employees!) interests have only recently come to light. And that's why Enron story is truly sad. The seeds of its destruction were sown by a lack of management honesty.

Companies that use derivative instruments have a great deal of latitude when reporting assets and particularly liabilities -- even those who are scrupulously honest can have sharp disagreements in regard to trading reserves, debts, and other components. It is for this reason that banks and insurance companies are so heavily regulated, particularly in regard to asset/deposit ratios. Even in the hands of well-intentioned managers, mistakes can happen. In the hands of people willing to hide liabilities in unconsolidated subsidiaries, such esoteric notions as derivative liabilities become a playground for unsavory financial practices.

Enron's managers had everything to gain from playing such games, and they were willing to do so. Their perceived financial strength helped attract customers to the seeming safe haven of Enron trading floors, and their creditors kept inherently illiquid markets well capitalized. Moreover, for an executive team that had done nothing but dazzle Wall Street with double-digit growth, there is significant pressure to continue to turn in such numbers. However, in a situation such as Enron's, where its activities are necessarily going to improve efficiency in these markets and thus lower the spreads for market makers and counterparties alike, heroic, or in this case, infamous action would need to take place in order to maintain such growth.

Enron is dead because its management got caught up in playing Wall Street's stupid little games, promising and delivering big revenue and profit growth, damn the debt and other balance sheet contortions it took to get there. Management withheld key information from shareholders, and then, even after the troubles came to light last month, refused to answer questions about the nature of its deals with partnerships that were controlled by Enron executives. Looked at in this way, the pursuit of hypergrowth seems to have caused Enron executives to take undue risks with shareholder funds. Maintaining Enron's (and its managers') darling status in the investment world apparently caused these same men to take that short walk across the aisle from being aggressive with company assets to being downright deceptive by hiding information individual shareholders MUST have to make good investment decisions.

Apparently, 8-10% growth projections were not an option. In an August interview with BusinessWeek, Lay said Enron had grown earnings per share 32% in the second quarter, with operational physical volume delivery up 60%. He said investors would "continue to see strong growth in all of our business areas. Our revenues and income quarter-to-quarter continues to be strong and we have strong momentum. We think that will be sustained, and eventually, if we continue to do that, investors will recognize and reward us for that."

Contrast this with the strategy of deliberate growth and conservative asset management at crosstown rival Dynegy (NYSE: DYN). This strategy, if much less exciting than Enron's way of doing things, has ultimately proven to be more successful. There may never be a better contrast to show the power of investor-centric corporate governance over that of management greed.

Unlike Icarus, who was ultimately responsible only to himself, Enron's management's actions have cost hundreds of thousands of investors, tens of thousands of employees and pensioners, and scores of partners, untold billions of dollars. The full scope of loss will not be known for some time, though we can already assume that it will be more than some can withstand. Ken Lay and company, brilliant as they undoubtedly are, seem to have forgotten just whom they were working for. I'd hope that Enron's commercials come to their minds, with dozens of suddenly poor investors and long-time employees wailing at them "Why? Why? Why?"

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

This is a public service announcement for marketing managers everywhere: Replacing an "S" in a word with a "$" is not, repeat, NOT, clever. Bill Mann owns none of the companies discussed in this article. The Motley Fool is investors writing for investors. Go Navy!