Finding Value Way Down in Enron's Pit

As the Enron (ENE) story continues to unfold, many of Wall Street's sharpest investors are focused on the $20 billion puzzle of how to value Enron's various securities. The only one of the 25 or so pieces of paper on which there is near unanimity is the common stock, which is nearly worthless under all scenarios.

For bond investors, Enron offers something for every taste. There are senior debt issues secured by specific Enron assets such as pipelines, subordinated bonds at various subsidiaries that have value only after the senior, secured debt at those levels is satisfied, and massive amounts of unsecured bonds issued by the parent company.

Each bond has its own risks and rewards, and many hours will be expended solving this complicated puzzle. For the average investor, the playing field is too steeply tilted in favor of the distressed security professionals to warrant competing with them.

There is a simpler way to profit from the collateral damage of the Enron meltdown. The common stock of EOTT Energy Partners, L.P. (EOT) has been crushed over the past two months, falling from $22 to $8. The E, as you might expect, stands for Enron, and that relationship has sent investors running panicked for the exits.

That decline is unwarranted and represents an attractive investment.

EOTT transports and markets crude oil and other refined petroleum products. It owns pipelines and storage facilities across the country, and services some 33,000 oil wells.

EOTT is part of a breed of securities called master limited partnerships, which are sold primarily to individual investors. It distributes virtually all of its available cash flow in a tax-advantaged, pass-through manner. EOTT was spun out of Enron and brought public at $20 a share in 1994 by Kidder Peabody, and has paid a quarterly dividend of 47.5 cents for the past six years.

The shares of EOTT currently offer a 23.7% dividend yield in an environment when other similar MLPs offer about 6%. Clearly, the market is skeptical of its ability to sustain its dividend. At $8, the market seems to be skeptical of EOTT's ability to even survive!

The biggest consideration in any investment that brushes up against the Enron train wreck is "How can Enron hurt me?"

Let's look at the connections between EOTT and Enron:

An Enron affiliate serves as EOTT's general partner in exchange for 2% of EOTT's annual cash flow, worth about $2 million this year. Enron provides administrative support, a $1 billion credit facility to EOTT. Finally, Enron is on the hook to make up any shortfall in the dividend. Enron also owns about 30% of the equity of EOTT though common units and subordinated units, which were in the process of being swapped for common units in a now-canceled recapitalization.

Some of these concerns can be disposed of quickly: Enron's dividend support, which hadn't been drawn on in two years, expires Dec. 31. Its $1 billion credit support was in the process of being replaced by a $300 million facility with an unrelated bank, and in the meantime has been stopgapped with a $150 million facility that will get EOTT through until a larger facility can be put in place.

Enron and EOTT are also parties to a complicated take-or-pay contract in which Enron, through its Enron Gas Liquids subsidiary, is obligated to deliver feedstock to a conversion plant and to buy minimum quantities of various chemicals. This agreement supported EOTT's purchase of the plant from Enron and guarantees a $23 million annual cash stream for 10 years. In the absence of this agreement, EOTT may do better or worse than the $23 million, but would be subject to commodity price risk to a degree inappropriate to its mission of delivering steady dividends to holders.

Enron's bankruptcy filing seems to put EOTT in the clear -- at least for now. Neither EOTT, the Enron entity that acts as general partner of EOTT Energy Partners, nor EGLI, the entity that is a party to the take-or-pay contract, filed for bankruptcy Sunday. EOTT may experience only minimal and temporary business disruption due to the Enron filing.

Of course, Enron may seek to raise cash for its reorganization by selling EOTT Energy. But it is hard to see how Enron could do a deal with a buyer that would not benefit the public shareholders who have good protection in the limited partnership agreement. And it makes no sense for Enron to simply walk away from EOTT, as being general partner has real economic value.

One additional concern is that the Houston office of Arthur Andersen is the auditor of EOTT as well. As the truth about the Enron meltdown begins to come to light, it's apparent that the only significance of an Arthur Andersen signature on an audit conducted by its Houston office is proof just that its audit bill has been paid.

It is unwise to trust that any Enron affiliate's financial statements fully disclose all of the risks an investor would like to know. Fortunately, in a simple business like EOTT, there is less room for shenanigans than there is at Enron, so I am less concerned. The debt level of $235 million is just two times cash flow, limiting liquidity and solvency risks.

At 4.5 times cash flow, the shares offer the margin of safety required to buy a distressed security. Even in liquidation, the hard assets should return more than where the stock is trading.

It's not hard to understand how this opportunity has been created. EOTT is a retail product, sold on the basis of the size and safety of its distributions. Neither holders nor their brokers who sell these types of securities are likely to be expert in the intricacies of bankruptcy and financial distress. Enron is extraordinarily complex and is flummoxing even the most experienced and successful distressed-debt investors. The rational decision for a retail holder confronted with unexpected and complex Enron exposure may be to exit regardless of price.

Even if the dividend is skinnied as a result of short-term disruption, it seems to me that EOTT is more fairly valued at $15 than here.

EOTT appears to be a case of shoot first, ask questions later. A bargain may have been created out of the Enron chaos.

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