Practical analysis for investment professionals
28 October 2015

Enron Revisited: Highlights from Bear Stearns Research

A fantastic piece of financial market history resurfaced this week.

Somebody found a 26 January 2001 research note on Enron from Bear Stearns and posted it on Wall Street Oasis (WSO).

The Bear Stearns team initiates coverage on the stock (then trading at 79 3/4) with an “Attractive rating” noting the “unlimited potential in broadband services” as just one of many opportunities.

So there’s no way you can’t keep reading, right? I couldn’t help myself either.

First, you have to just take a second and think about what this company was to the world at the time. Today, it’s hard to remember Enron as anything but a classic example of hubris and fraud. But the market didn’t always know that.

“Already an established leader in the natural gas industry, Enron is moving rapidly — through revolutionary communications systems and interfaces — to become the world’s preeminent energy and commodities marketer, high-density Internet distributor, and distributed energy leader. We believe that Enron should be compared to leading global companies like GE, Citigroup, Nokia, Microsoft, and Intel, and that its valuation reflects this eminence.” [All emphasis mine.]

And take care to note the trajectory that the market saw. Frauds can seem like the hottest ticket around. Remember: People called up Bernie Madoff asking to invest with him and he turned a lot of them down. In the market’s perception, Enron was on fire:

“$98 PRICE TARGET. Our Attractive rating and 12-month price target reflect Enron’s highly successful existing businesses, customer relationships and contractual agreements; its advanced online systems and business models; and its valuation relative to potential financial results (based on both a conservative DCF and comparables analysis).”

Just a quick tangent here. When I was a kid, my dad taught me the meaning of the term “conservative basis” as it’s commonly used on Wall Street.

I caught on quick. He asked me how much soda I wanted, and I said that on a conservative basis I’d need seven 12 packs.

So I don’t want to go back in and list all the aspects that are just ironically amusing here. But there are a couple of things that we should look at and remind ourselves to be wary of in the future. Here is a company whose long-term vision is more blindly ambitious than anything I can imagine.

“All told, with consistent earnings and cash flow from the Transportation business, market dominance in the Wholesale and Retail sectors, and projected hyper-growth in its Broadband business, Enron’s long-term vision is to possess unbeatable scale and scope in every business and region in which it operates.”

And look how the arguments for Enron rest on fundamentally true assumptions that are just being thought of in the wrong timeframe.

“Bandwidth Technology and Applications — The Future of Enron? By now, we have all heard of the benefits afforded Internet users through assorted bandwidth technology. Enron truly believes that this technology will fundamentally alter how business (and life in general) will be conducted in the future. Currently building out a worldwide bandwidth network, Enron is focused on having the ability not only to transmit high-content data but also to trade bandwidth as a commodity between customers. While unsupportable at this time, Enron sees a future (sooner rather than later) where earnings from bandwidth could surpass the combined earnings from the rest of the company.”

Something else to be wary of: buying stock in a trading operation. “These guys are great traders” is a firm foundation upon which to build magical thinking. Imagine how such a sentence could make you feel inclined to worry a lot less about the downside.

“Short-Term Pricing and Long-Term Demand Projections Favor Enron. We consider Enron (and other wholesale energy companies) to be ‘long volatility.’ In essence, high prices and price volatility are Enron’s friends due to the company’ s growing marketing, trading, and retail (energy management) operations. We expect this trend to continue throughout 2001, with prices decreasing from their current highs and high volatility continuing throughout the year. For the long term, we envision demand for natural gas increasing significantly faster than in the past, with domestic demand rising approximately 5–8 Tcf over the coming decade. Of course, given Enron’s flexibility and the trading culture it has established, we would expect the company to go ‘short’ volatility at some point, in advance, perhaps, of a dampening in the volatility of the gas and power markets.”

And the first risk in the “risks” section of this outlook spells out something that feels like it should have been a much bigger red flag. This is a paragraph that must prompt an analyst to wonder how much they are paying for growth at minimum. Think about the many logical premises that you need to grant in order to write this passage and then walk away recommending the stock.

“Wholesale’s Performance Overshadows Everything Else Enron Does. With the Wholesale Energy segment consistently generating 85%-plus of the company’s revenues and earnings — and a large portion being driven off of unpredictable commodity pricing volatility — we are concerned that building and maintaining a meaningful forecasting model will become virtually impossible. As with most wholesale energy companies, Enron provides analysts with little information beyond end-of-reporting-period bottom-line figures with regard to its respective marketing and trading operations. In the financial world, these types of inherently volatile and unpredictable earnings streams have historically garnered lower valuation multiples due to their lack of visibility and predictability.”

At minimum, there seems to be no consideration for Wall Street’s history of valuing irregular profit streams. Maybe everything is fine at the company and revenues are just uniquely hard to predict. Wouldn’t you think that would create a valuation impairment?

There are some passages in between the one above and the one below that are seriously amusing. But this one will make you a better analyst.

I present to you (without comment) how the team came up with their $98 estimate and “Attractive rating.”

“For our own purposes, and because the company is seeking significant growth in several nascent businesses that are currently under development (most specifically bandwidth intermediation and content delivery, but also the Enron Net Works business area developing within the Wholesale Energy segment), we are relying primarily on two methodologies, DCF and DCF-based terminal IBITDA multiple, to value Enron. Using projections through 2005, as well as a terminal/perpetual growth rate of 4.5% and a discount rate of close to 7% (based on our calculation of Enron’s weighted average cost of capital or WACC), we arrive at a present value of around $89 per share. This discount rate figure was determined using both a tax-adjusted cost of equity and cost of debt calculation, drawing on an approximate corporate tax rate and a long-term risk free rate of 5.65% (30-year government bond rate quoted on January 24, 2001). Using a 12x terminal IBITDA multiple through our second valuation method, we arrive at a present value of approximately $108 per share. Splitting the difference between these valuation techniques, we arrive at our 12- month price objective for the shares of $98 as well as our Attractive rating.”

You should really go and read the whole thing. After all . . .

And you can’t say they weren’t insightful.

And this a just a sample of all the interesting data I found. So happy reading!

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
Sloane Ortel

Sloane Ortel is the founder of Invest Vegan, an ethics-first registered investment adviser that manages distinctive discretionary portfolios of public equities on behalf of aligned individuals and institutions. Before establishing her own firm, she joined CFA Institute’s staff as a sophomore at Fordham University and spent close to a decade helping members adapt to a changing investment landscape as a collaborator, curator, and commentator. She is also a co-host of Free Money, a podcast for sustainability-oriented investors with a sense of humor.

4 thoughts on “Enron Revisited: Highlights from Bear Stearns Research”

  1. In hindsight, this would be one of the classic pieces and at as bare minimum should be made compulsory reading (redact company name ofcourse…for the fun) for Finance students, who intend to make a career in equity or credit research.

    1. Will Ortel says:

      BD —

      Great idea, and totally agreed! I’ve actually got an old Enron stock certificate up on my desk, along with Global Crossing and International Mercantile Marine (the company behind the Titanic). It’d be fun to mix it in with a blindly optimistic report on a company that totally worked out too.

      Good to hear from you man! Thanks for reading — hopefully see you again soon. All best!


  2. Jameson says:

    dude. that post was awesome. history really is so very important, obviously and especially, for investment research. i wonder who the next enron will be? you know, one could possibly make the argument that the Fed is enron-ish. but i would imagine that is a touchy subject, and i’m quite biased in that regard. at any rate, excellent post, Mr. Ortel.

    1. Will Ortel says:

      Jameson —

      Many thanks for your kind comment! I tend to be of the opinion that much of the back and forth over what the “next Enron” will be is a lot like the “next Buffett”…an interesting question, but likely better at attracting page views than profitable investing ideas.

      That said, there are definitely things to look for. Blindly ambitious expectations that aren’t rooted in a rational development are certainly one of them. Seen in that context, it makes sense to be a bit nervous about the Fed. Nothing is too touchy for this forum — we’re after the truth, and the Fed is an important subject!

      After all, what’s the precedent for the massive moves that they are making? Humanity has never seen a banking authority charged with so much authority nor granted so much trust.

      But I would caution you on making investment decisions rooted in the thesis that the Fed is the next Enron. Even if every negative thing that could possibly be said about the fed is true: their balance sheet is a fabrication, they have no idea what they are doing, and so on…they still get to pay everything back in a currency that they control and can create out of thin air.

      That’s a massive distinction. If Enron could have done that, they’d still be in business. So at least for my account the old adage “don’t fight the Fed” will stay in play.

      Cheers and all best. Thanks very much for reading!


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