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October 22, 2001 


Enron's Departure from Core Business
Takes a Toll on Performance 



By Will McNamara
Director, Electric Industry Analysis 


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[News item from Reuters] Enron Corp. (NYSE: ENE) stock sustained further heavy losses on October 19 as investor confidence in the former Wall Street favorite remained at a low ebb after it reported its first quarterly loss in over four years. The energy giant's stock was off $3.32 or 11.45 percent at $25.68 per share at mid-day trade on Oct. 19, making a cumulative loss of 28 percent for a week in which it reported a third-quarter loss of $638 million. As of early morning trading on Oct. 22, Enron shares were priced at $21.99, a reflection of new developments (including a new Securities and Exchange inquiry) that have caused uncertainty about the company among investors. 

Analysis: Enron's first financial report since the departure of former CEO Jeffrey Skilling in August has not done much to once again instill investor confidence in the company, which has experienced one of its most turbulent years in recent memory. While Skilling cited personal reasons for his departure, many analysts suspected that a significant drop in Enron's share price and financial losses in its diversified businesses also played a role. At the time of Skilling's departure, Enron's stock had tumbled to a 52-week low. However, based on the new 3Q report, it now appears that Enron's downward turn may be continuing despite the return of Kenneth Lay to the company's top spot. In essence, Enron's financial problems have been caused by businesses that the company has established as a way to diversify from its core focus on wholesale power sales. It appears that Enron is learning a costly lesson-namely that investors are not responding favorably to the company's innovation, especially if bottom line performance is in any way compromised. The road ahead may remain uncertain for Enron, as a good number of unresolved issues and a new Securities and Exchange Commission (SEC) inquiry into financial dealings of its chief financial officer continue to overshadow the company. 

Let's first establish the financial losses that Enron has reported in the third quarter. As noted, as a whole the company reported $638 million in losses, after taking $1.01 billion in charges associated with several of its non-core businesses. When we break down the losses, it becomes clear that Enron is struggling with its operations in three businesses: water, broadband and the retail power market. Specifically, Enron reported $287 million in charges from Azurix, its water and wastewater business; $180 million in charges related to the downsizing of its broadband operations (including severance costs and losses on inventory sales and customer contracts); and $544 million in what the company is calling "investment losses." Evidently, about half of the $544-million figure is related to Enron's investment in NewPower Company, the retail electricity and natural-gas provider that Enron launched about two years ago with partners America Online and IBM. Enron owns 45 percent of NewPower. In addition, Enron's debt to total capitalization ratio reportedly will increase to about 50 percent, although Lay says that pending asset sales may reduce that amount to 40 percent by the end of 2002. However, it is important to note that Enron's 3Q recurring net income (before the write-offs) did increase 35 percent to $393 million, or 43 cents a diluted share, and revenue in the quarter rose to $47.6 billion from $30 billion in 3Q 2000. 

The losses associated with NewPower are particularly interesting. As one of the leading investors in the company, Enron drove NewPower's aggressive business focus on retail residential power sales, despite ongoing concerns about the development of retail competition across the United States. NewPower went public last year at an opening price of $21, and in the early days of its initial public offering was trading above that price. However, the company's stock has experienced a devastating drop in value, and is currently priced at $1.25. NewPower is not scheduled to release its own 3Q financial statement until early November, but it is expected that the company will continue to incur significant losses for the foreseeable future. Specifically, NewPower recently reiterated its earlier expectations of a 3Q loss of $65 million to $70 million, or $1.12 to $1.20 a share. Third-quarter revenue reportedly will be slightly lower than the $60 million to $65 million that the company had forecast in August. 

In analyzing NewPower's 2Q financial losses (see IssueAlert from 8/8/01 at www.scientech.com/rci <http://www.secure.scientech.com/IssueAlert>), I argued that the company is really struggling from a mix of positive and negative factors in its efforts to become the leading retail energy provider in residential and small business markets in the United States. On the positive side, NewPower has recently secured a large number of new customer accounts, most significantly from its purchase of customers and related assets from AES Corp. and DTE Energy. These purchases prompted an impressive growth spurt for NewPower, and the company reportedly now has a customer base in 22 markets in 10 states. However, the bad news for NewPower is that its losses continue to widen, apparently resulting from a combination of weather factors and financial hits absorbed in several of the states in which the company operates. This dichotomy does not appear to be getting any better, and the company's stock has continued to drop as a result. 

In an effort to alleviate some of its financial woes, NewPower recently revised an existing master netting agreement with Enron Corp. and several of its subsidiaries. The revised agreement essentially lowers the amount of cash collateral that NewPower is required to post to the Enron subsidiaries through Jan. 4, 2002. With the lowered financial obligations that it must make to Enron, NewPower believes that it will have sufficient financial resources to conduct its business in the near term until it secures ongoing asset-based financing. 

However, from Enron's perspective, the losses associated with NewPower (and, by the same token, the losses in water and broadband) have contributed to a steady drop in its own stock price. The message is clear: The businesses that Enron plunged into as a way to diversify have tainted the company as a whole. Further, what some analysts perceived as brash hubris on Enron's part has not translated into measurable profits, and consequently Wall Street has reacted by sending Enron's stock to a level that is about half of where it was a year ago. The individual sectors that Enron has pursued are all unique, but they share the common denominator of taking Enron away from what was a successful core business. Further, they are similar in that Enron aggressively sunk large sums of capital into new business lines for which it arguably had unrealistic expectations for growth. The problem with Enron's bandwidth unit is that the company has faced an unanticipated excess of fiber-optic lines, which has prevented the demand for the division's services from materializing as anticipated. The problem with Azurix, which has been losing money since its formation in 1998, is that privatization of the water sector has not materialized as quickly as Enron and other companies anticipated. In addition to these problem areas, Enron also faces challenges related to its investments in India (where it is locked into a legal battle with the state government) and California (from which Enron has yet to receive full payment for previous power sales). 

In addition to the losses outlined in the 3Q report, there are new issues that are brewing at the start of this week. First, the SEC has requested that Enron provide information regarding "certain related party transactions." Not much additional information is presently available about this inquiry. However, it is probably connected to earlier reports about concerns related to the dealings of Enron's Chief Financial Officer Andrew Fastow, who up until very recently had run a limited partnership that bought assets from Enron. Ken Lay has said that Enron will cooperate fully with the SEC's request. In a separate development, several mutual funds (including AIM Constellation that once held large positions in Enron) have either liquidated or reduced their holdings in the company, which has further weakened Enron's stock value. Portfolio managers of the mutual funds have cited concerns about Enron's ability to balance its new businesses with its core strength as an energy trader. 

The present challenge for Enron is to convince investors that the company remains on solid ground despite the losses. Thus, Lay has been quick to reiterate that earnings from the company's energy and gas-pipeline business are still strong. Further, Lay says that the charges reported in the third quarter should be seen as a way to "clear away issues that have clouded the performance and earnings potential of our core energy businesses." Nevertheless, the fact remains that Enron has invested huge amounts of money toward its diversification effort, and in addition to water and broadband the company has invested into the steel and pulp and paper sectors as well. Thus, several questions remain at this juncture. Are the losses reported in the third quarter only a temporary setback for Enron that will clear the way for the company to return to a primary focus on its core business of energy trading? Or, will the losses continue into the fourth quarter and 2002? Moving forward, will Enron once again reshape its business model and eliminate the various businesses to which investors have reacted less than favorably? Only time will tell as the industry continues to watch the developments at Enron, which is clearly a company in the midst of another wave of change. 


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