Lessons From Enron's Meltdown

The Nasdaq crash was expected in many quarters. But only a tiny number of stock market skeptics foresaw the equally gruesome meltdown in large energy stocks such as Enron (ENE Quote) and Calpine (CPN Quote).

Who were the prescient few? A handful of short-sellers, people who seek to profit from a stock's decline, and a couple of independent analysts. But investors of all stripes can learn from their willingness to question Wall Street's assumptions.

First off, why would anyone have thought about betting against the likes of Enron and Calpine? Neither company has missed earnings targets recently. In fact, Calpine confirmed Friday that it still expects to post 26% earnings growth next year. Both firms' profits growth has been outstanding for many quarters. Neither sported the stratospheric valuations that were common in the tech sector. Unlike tech, the energy segment of the economy isn't in recession and appears to have solid long-term growth prospects.

What's more, both companies are leaders in their field. Enron is the world's dominant energy trader and Calpine excels at producing electricity from its cutting-edge gas-fired plants. Both are adored on Wall Street. Sell-side analysts have long backed both companies with unabashed enthusiasm -- and continue to do so even as their stocks have fallen over 60% from their 52-week highs.

But none of that bothered the doubters -- not one iota. Why?

Checking the Bottom Line

One of the first skeptics on Enron was James Chanos, head of New York-based investment firm Kynikos Associates, which has sold short shares in Enron. Chanos started looking at the giant energy trader toward the end of last year, when it was trading at over $80. What caught his attention was Enron's low return on capital. Sure, the company was posting impressive earnings-per-share growth -- over 30% at the end of 2000.

The Depths Enron, Calpine dropping sharply

But another, perhaps more rigorous, way to measure the profitability of a company is to look at what it makes on its total capital. That can be calculated by adding net debt, long-term liabilities and shareholders' equity. Using earnings before interest and taxes, Chanos calculated Enron was returning around 6%, not much more than practically risk-free government bonds. "That was a red flag," he says.

He then noticed that top Enron executives were selling lots of stock in the company, which can also indicate problems. The company's disclosure was difficult to understand and it wasn't possible, even after talking to analysts who cover the company, to get a firm grip on how Enron was making such strong profits, the hedge fund manager adds. At the beginning of March, Fortune published a large negative article on Enron. By the end of that month, the stock was down 30% from the beginning of the year and Wall Street analysts were at a loss for an explanation.

One Enron analyst who had broken from the pack was Andre Meade, of Commerzbank Securities. He says: "The buy side reacted quicker than the sell side." Meade had a hold rating on Enron, when nearly all his counterparts at other firms had buy recommendations. (Meade now rates Enron accumulate and his firm hasn't done underwriting for the company.)

Meade has never been as bearish as the short-sellers. However, he took issue with the valuation that Enron was placing on its new broadband business. The stock had run up partly on hopes that broadband would be a big earner. But Meade couldn't go along with Enron's view that the business was worth $35 per share. He was right: Enron has since admitted prospects for this line are extremely poor.

Other events then took their toll on Enron. Research boutique Off Wall Street published a blistering analysis of the firm in early May, saying Enron should trade 50% lower at $30. The California energy crisis roiled energy markets, and in mid-August CEO Jeff Skilling suddenly left. Once-mighty Enron closed Friday at $27.23.

Horse of a Different Fire Department

As for Calpine? "That's a different animal from Enron," says Chanos. (Kynikos is also short Calpine.) Here, the hedge fund manager saw parallels with the telecom market, where a glut of supply had depressed prices. "Despite what the bulls were saying, there was a surplus of power coming," says Chanos. While that may not be upon us right now, Calpine's sagging stock reflects the fact that demand for the power it sells may not be as strong as once considered. Meade was also cautious on Calpine. The company's plan is to build around 70 gigawatts of power plant capacity. "That's seven New York Cities worth of power," he says.

Meade was concerned about the construction risk involved in building that much capacity. True, Calpine hasn't had construction problems. But the company has a lot more capacity to add. "So the jury's still out," says Meade. "And construction costs are rising across the board."

Moral of the story? Don't believe the hype.