FOOL ON THE HILL
Lessons From the Enron Debacle

Whitney Tilson argues that Enron was a stock to avoid long before the shenanigans that led to the company's bankruptcy came to light. It simply was too hard to understand -- even for its own CEO -- and, as was evident on its 10-Qs, its financials were clearly weakening.

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By Whitney Tilson
December 4, 2001

The recent Enron (NYSE: ENE)  bankruptcy -- the largest in U.S. history -- has hurt tens of thousands of innocent people, especially employees and pensioners who have seen their jobs and in many cases savings wiped out. My heart goes out to them, as they are the innocent victims of an unscrupulous, arrogant management team.

Whenever such a debacle occurs, I like to look back and see if there were any warning flags that might have tipped off a savvy investor, so that I can avoid similar situations in the future. In this case, even the most superficial analysis would have revealed many warning flags. Of course, that's easy to say now, but let's take a look at what an analysis might have looked like in mid-August, when Enron filed its 10-Q for the second quarter (at the time, the stock was at $43).

While there are many approaches to evaluating stocks, I believe all sensible investors consider -- to one degree or another -- the factors I laid out in my column, "Three Steps to Evaluating Stocks." First, determine if a stock is within one's circle of competence. Then, analyze the financial statements to answer two questions: Is this a good business, and is the stock cheap? Finally, there's the "soft stuff": evaluating a company's sustainable competitive advantage, management and culture. In this column, I'm only going to focus on the first two factors -- the answers there make the third a moot issue.

Circle of competence
Before wasting any time seriously analyzing a company, an investor should ask, "Do I understand -- or will I ever be able to understand -- this company: its industry, products, sources of profits, and so forth?" If the answer is no, don't even consider investing!

In the case of Enron, an evaluation should have started -- and stopped -- here. It turns out that the company's own CEO didn't understand his business, but even before this was public knowledge, Enron was well known as a "black box." In other words, no-one -- not the Wall Street analysts nor the institutional or individual investors who blindly piled into the stock -- was really sure how the company made money, and the risks it took to do so. (This reminds me of GE Capital, which is one of the reasons why I suggest avoiding GE.)

Financials
OK, I can understand how some people might have deluded themselves into believing that they understood Enron well enough to consider investing in it, but I can't understand how anyone who spent even five minutes analyzing the most basic elements of the financial statements could have invested. Sure, growth was phenomenal: Sales were up a mind-boggling 234% in the first half of 2001 and earnings surged 34%. But even these numbers should have served as a warning flag, rather than a cause for euphoria.

Enron's trailing 12-month revenues through Q2 of last year were $52.8 billion. Over the next year, through Q2 2001, sales had skyrocketed to $171.0 billion, a gain of $118.2 billion in only one year. For perspective, there are only seven companies in the S&P 500 with annual sales greater than Enron's incremental growth of $118 billion. That kind of growth for such a large company is unprecedented -- and obviously fraught with peril.

As sales soared, Enron's margins fell from low to abysmal -- another warning flag. Enron had a 5.1% net margin in 1995, but this fell steadily and in the first half of 2001, the net margin was a mere 0.8%, down from 2.1% in the same period in 2000. Low margins aren't necessarily bad if asset turns are high enough -- take Costco, for example, which earns decent returns on capital despite sub-2% net margins. But Enron's returns on capital were poor and getting weaker: Returns on invested capital were consistently in the 9-10% range through the first half of the 1990s, but then fell to the 6-8% range since then. At best, Enron was barely earning its cost of capital.

The balance sheet wasn't pretty either. Debt was only $2.8 billion at the end of 1995, but rose steadily thereafter. Even adding back cash, it was $7.9 billion at the end of 1999, $8.9 billion at the end of 2000 and $12.0 billion by mid-2001. This might not have appeared to be much debt for such a large company, but the trend was worrisome and the debt was equal to 10 years of trailing 12-month net income of $1.2 billion.

Speaking of net income, this was yet another warning flag. Here was the data over the previous six quarters:

Quarter   Net income
Q1 00    $338 million
Q2 00    $289 million
Q3 00    $170 million
Q4 00    $182 million
Q1 01    $425 million
Q2 01    $404 million

While the year-over-year growth was impressive in the first half of 2001, the marked decline through 2000 was worrisome, and I can't figure out why such erratic earnings would be rewarded with a premium valuation multiple. Perhaps investors believed the "pro forma" earnings of $0.73 per share that Enron reported in the second half of 2000, and ignored the fact that actual GAAP (generally accepted accounting principles) earnings were 53% lower at $0.34 per share. It reminds me of the investor myopia around Lucent (NYSE: LU) when it was a high-flyer (see "Lessons From Lucent's Cash Flow").

Enron's cash flow was even more erratic than net income:

Quarter  Operating cash flow
Q1 00       -$457 million
Q2 00        -$90 million
Q3 00        $674 million
Q4 00      $4,652 million
Q1 01       -$464 million
Q2 01       -$873 million

Those numbers scare me for two reasons: First, they're not just erratic, they're bizarre. Seasonal retailers might have cash flows like this, but Enron? Second, such a huge year-over-year drop in the second quarter of 2001 is a major cause for concern.

Finally, let's look at Enron's valuation, which was very rich on any dimension. At $43 in August, at less than half its peak price not much more than a year ago, the stock was trading at 51 times trailing 12-month earnings of $0.84. Even using Enron's pro forma earnings of $1.66, the P/E was still 26. And neither of these figures includes Enron's hefty debt load.

Conclusion
The stocks of many companies have plunged 80-90% over the past year or two and, in most cases, investors can only blame themselves for ignoring the perils of excessive valuations. But at least this is somewhat forgivable if the financial metrics were spectacular. For example, I've panned Cisco on multiple occasions, but I'll freely concede that, at its peak anyway, its financial characteristics -- growth, margins, cash flows, returns on capital, balance sheet strength, and so forth -- were amazing.

But this wasn't the case in any way, shape, or form for Enron. Nearly every warning flag imaginable was waving briskly, yet countless investors either didn't take a few minutes to identify them, or chose to ignore them and instead followed the herd -- led, as usual, by Wall Street's so-called "analysts" -- right over the cliff. It's so distressing to see this happen again and again. Will people ever learn? I'm not holding my breath.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of any company mentioned in the article at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/