Streetside Chat: Ken Lay of Enron, Part Three

Christopher Edmonds: Now that you have opened the political door, I will walk through it. There has been a real debate over the current administration's energy policy, most recently the release of oil from the Strategic Petroleum Reserve. Any thoughts?

Ken Lay: Well, I think it was politically motivated. And, of course, very poorly executed.

Frankly, it's crazy. You say you're releasing this oil because you have this fuel emergency and then you end up selling 30% of what you released to parties that aren't even in the business and aren't creditworthy. If you want to get product into the marketplace, you want people that can very quickly translate crude oil into heating oil. And obviously, here, they've had to go back a second time.

There's a separate question on the whole Strategic Petroleum Reserve as to how beneficial it is and how wise and costly it is. But I think there's no doubt that this recent action was strictly political and very poorly executed.What we found out is, basically even natural gas is almost an infinite commodity, certainly in the foreseeable future, and maybe much beyond that, depending on some other theories about how natural gas is formed.

Christopher Edmonds: Let's turn to broadband, which is obviously the most recent buzz. Again, back to your annual report letter, the most striking comment in that letter to me, was your comparison of the broadband industry to the natural gas industry in the mid-1980's. Walk me through the similarities.

Ken Lay: Well, I think that surprised Jeff [Schilling, Enron's President and COO] and me, and I'm sure a lot of other people, too. It was almost eerie as we got into it. You're basically looking at pipes. You've got an industry, as I said earlier, that basically has been trying to put together end-to-end contracts, with every provider of capacity having different types of contracts. And, as a matter of fact, even those providers develop a different contract style on every deal. That reminds me an awful lot of the way we contracted for natural gas back in the '70s and early '80s. In every natural gas supply contract, every customer contract was different. Tailored to that particular deal. They were very rigid. Of course, in the case of the natural gas pipeline industry, it's a very linear industry. I mean, producers in certain regions could only sell their natural gas to certain pipelines that served certain markets. There wasn't any way of swinging those supplies around as markets changed and conditions changed. The contracts, for the most part, were long-term contracts, usually 20-year contracts or more. Very inflexible, very rigid. And that's exactly what we started seeing in the broadband business as we got into it.

And it seemed to us that there's a lot better model out there for both natural gas and broadband. It is working in gas; we want to make it work in broadband.

Christopher Edmonds: Still, with the exception of broadband, all of the products, the commodities you make markets in, are tangible, diminishing resources. Natural gas, pulp and paper, electricity -- all of those things are resources that are tangible and they don't repeat; once they're used, they're gone. With broadband, there's a time element and a capacity element, but availability is theoretically infinite. Does that present any unique challenges for you as you develop the broadband market? Does that create a different approach to developing the market?

Ken Lay: I think I'd argue even more strongly for more efficient markets and more real-time markets, because it is, as you say, a kind of use-it-or-lose-it situation. If the capacity is not used this instant, it'll never be used in the future, at least not that instant of capacity.

Where, in fact, in the case of things like natural gas, you can store it, use it later. And, of course, even electricity, you can just not generate it for now and roll back and you still have more capacity later. But in the case of fiber capacity, at least on a time basis, whatever's not used, and used efficiently now, will not be used tomorrow.

But it's kind of interesting. We used to talk so much about natural gas being a finite resource, a depleting resource. Even some of our tax codes are driven around those concepts. And, of course, particularly back in the Carter administration, the late '70s and early '80s, it was more a matter of how we're going to ration this limited resource and how we're going to develop more of it. And, of course, how we were going to prohibit its use in certain purposes.

What we found out is, basically even natural gas is almost an infinite commodity, certainly in the foreseeable future, and maybe much beyond that, depending on some other theories about how natural gas is formed. In the case of electricity, you have to add capacity and build more capacity to meet the increased market demand, but that again is more a matter of just planning and trying to anticipate growth.

So I'm not sure there's any particular big difference between transmitting data over fiber, for example, vs. the other two industries. It's not a physical commodity like the other two, as you point out, but very similar, particularly in the way it's transmitted. In the case of broadband, you're transmitting data. In the case of electricity, you're transmitting electrons. In the case of pipelines, you're transmitting molecules. The fact that two of them are physical and the other is not is less important than the characteristics of how they're transmitted and how they're accounted for. How they're transferred among different transporters is very similar.

And I think the other interesting thing with the broadband is, because it is a new market, a new business, a new industry, and it's not highly regulated, there's a lot more flexibility on how you can develop the rules. I mean the standardized contracts, the technology for transferring data from one system to another, the platforms, the units you're going to do business in and the pooling points. It's kind of fun to start with a business that's being built from the ground up where you can do all those things, where in the case of electricity and natural gas, you came in on a big legacy system and had to superimpose a lot of that on the existing structure because of the regulated, rigid way it had been run all those years.

Christopher Edmonds: Is there any chance that you're a little ahead of yourselves in the broadband business? With the financial issues facing telephony companies, the meltdown of many Internet companies and problems at other technology companies, is there any risk that there won't be the demand you anticipate? And I think the other interesting thing with the broadband is, because it is a new market, a new business, a new industry, and it's not highly regulated, there's a lot more flexibility on how you can develop the rules.

Ken Lay: Let me say first, thus far, that has not been the case. If anything, we're ahead of our ramp-up schedule right now. But, secondly, let's come back to the similarities, the eerie similarities between the natural gas business in the late '80s and the broadband business today.

In the natural gas business in the late '80s, when all the banks pulled out of lending any money to producers, particularly independent producers, you had a lot of very weak, undercapitalized E&P companies with good positions in the marketplace. They had good reserves, good acreage, many of them even had good discoveries, but they couldn't get the capital to develop those fields and, of course, as part of the model we put together, Enron became the financier for those companies. We'd step in, and with our risk management products, we could again lock in prices on future production, give them production payments to develop their properties and produce them, [which] basically recapitalized those companies. And we took many small companies that became very large companies, basically, just with the Enron capabilities behind them.

We're seeing the same thing today in the broadband area. Where, in fact, as you said, you've still got some very significant companies out there, both on the content side, on the delivery side, transportation side, that in fact are grossly undercapitalized. And, of course, many of them also, particularly users or content deliverers, currently have contracts which are out of the market, significantly out of the market, as the bandwidth prices have been coming down. That's just like you had many producers back then that were out of the market. Particularly on the consuming side, where they'd bought at much higher prices and they needed to find some way to average those down. And we had all kinds of products to do that

Starting on the risk-management side, we have to create the futures market; we have to get the trading started, create liquidity and a forward market. And then you start all kinds of risk-management products, and we're already doing some. And then you're able to start hedging out risk and putting together financial packages for some of these participants.

Christopher Edmonds: Which is really creating an entire market in the broadband business you really haven't even talked about.

Ken Lay: We've maybe mentioned it in passing with analysts from time to time, but we've never emphasized it. But, indeed, as I say, part of this eerie similarity is also the economic condition [of many of] the participants today as compared to particularly the E&P participants, as well as some consumers, back in the mid-to-late '80s. Many contracts had been entered into assuming a totally different economic environment and particularly a much higher price environment.

Christopher Edmonds: One part of the business we haven't talked much about is Enron's retail business, most notably your retail energy services business.

Ken Lay: Well, of course, there is Enron Energy Services, which is a powerful vehicle for us. Some of the things we're now seeing in that business -- it's not just a matter of energy outsourcing and running somebody else's energy cost center -- will be key businesses for us in the future. Items like deploying new technologies and distributed power. To the extent we start getting control of a lot of facilities in certain regions, and we're controlling all of those thermostats remotely, we can go to real-time pricing with utilities before there is real-time pricing. We're not there yet, but we will be pretty quickly. Contracts like we have with Starwood (HOT Quote - Cramer on HOT - Stock Picks) for energy management will be very important to Enron very soon. ...We think, particularly now with the Internet, you can let people participate in your quarterly earnings conference call -- can't ask questions, maybe, but they can at least listen in.

Christopher Edmonds: Let me ask you quickly about valuation of your company, trading at about 50 times earnings estimates for next year. Are you comfortable with that?

Ken Lay: Comfortable that it's worth that, yes. As a matter of fact, some of us here and, of course, many analysts would maintain that even that is undervaluing the company.

But I think one thing that many people also don't understand is that Enron is always doing a lot of R&D. A lot of that's commercial R&D. Now, in the case of broadband, you see it. In the case of Enron Energy Services, you saw it, because you see those operating losses. You don't see it in Enron North America or Enron Europe or the wholesale business. And yet all the time, we're spending a lot of money creating the next big franchise. Now, that may be metals, that may be pulp and paper. That may be, in fact, continental Europe, that may be Japan. But we've had a fairly large team in Japan since fourth quarter last year and spending quite a bit of money trying to build up that franchise, just like we did before that in Australia and in Scandinavia and, of course, in the U.K. about four years ago. And, of course, over the last two or three years, we have on the Continent.

So in many ways, particularly if you think we're going to be successful on a majority of these efforts -- I'm not saying all of them, because we're not -- but if you think on the vast majority of these we will be successful, we're creating whole new franchises. But near term, it's hitting our bottom line. We think the continental European market, some of these other new markets, like metals, like pulp and paper, maybe storage, plus the potential we see in Enron Energy Services and broadband, will carry us strong into the future.

There's no reason to think that we can't sustain our growth for years to come. And, of course, the best example of that would be the wholesale energy business, [in which] we have, for the last several years, had consistent 35% per year compound growth. Actually, we've seen a little more this year, which has, in large part, been created by EnronOnline.

We're not more than 15% or 20% of the way to fully deregulated and efficient electricity markets in North America, like natural gas. In the case of continental Europe, we're not even 2% or 3% of the way there. And in the case of Japan, we're zero percent there. But yet we're putting money into those markets, and there's no reason to think that, particularly [in] continental Europe, it's not going to kick in in a big-time way over the next three or four or five years.

So we can see visibility on several years of continued high growth in volumes and earnings in what is now our traditional wholesale business, which we weren't in 10 years ago. And then you've got these other kickers, like Enron Energy Services and broadband coming in right behind it, plus the new industry approach. If the model works on the new industry approach, you've got enormously big markets you can immediately stamp into and start making money.

Christopher Edmonds: Let me conclude with just two more general questions. The first is a practical regulatory question about new Securities and Exchange Commission regulations regarding Fair Disclosure, the so-called Reg FD. What do you think of those regulations, and what is their impact on Enron?

Ken Lay: We don't think they impact us that much because we've always been a very open company about what we're doing. We give speeches and are on panels talking about that all the time, any number of us. And, of course, we think, particularly now with the Internet, you can let people participate in your quarterly earnings conference call -- can't ask questions, maybe, but they can at least listen in; probably from the standpoint of analysts' presentations, sometime over the next quarter or two, we will start putting at least one of those presentations each quarter on the Internet, where they can see not just the slides, but also the presentations that are made and then the questions that are asked in that general audience.

So, using the Internet -- like our annual analysts' conference in January here in Houston, we can certainly put that on the Internet. So I think with the Internet, those things we do mainly for analysts, we can at least make them available to any shareholder. At least to listen in on. And I think that that will pretty well meet the requirements.

But, really, we don't see a whole lot of change, because we don't have selective disclosure. We've always thought that was something illegal. And certainly not fair. So if we have anything that we're going to talk to anybody about, we always try to get a press release out on it before we start talking about.

Christopher Edmonds: The final question is more personal and maybe more difficult. Through your career, you've had mentors and you've also come into contact with a number of competitors. Which of your competitors -- the people and the personalities -- do you admire most in your business?

Ken Lay: Well, Chris, that's very dangerous, because you start being selective on that list, why, you're going to get a lot of noses out of joint. Of course, the easy answer is I admire all of them, and I certainly pay attention to all of them. I think we do. I mean, we're watching our competitors all the time.

So I think I'd be reluctant to single out any single competitor. Our biggest competitors are companies like Dynegy and Duke. AEP in electricity. But certainly many others -- Southern. Internationally, in certain markets, maybe the French utilities or others.

But like I say, I respect and admire all of them, I watch all of them, but yet I'm not too concerned about any of them. I mean, I think we've always taken our independent course as to what we thought made sense and, as you indicated earlier, usually have done things earlier than other companies, whether it be leapfrogging the deregulation of natural gas and creating new nonregulated marketing activities long before most of the industry was doing it, at least aggressively. Certainly, jumping into electricity, taking it to Europe and internationally, globally. Broadband, Enron Energy Services, I'm sure several companies talked about retail early on, but none of them were willing to make the type of capital commitment that we did to really create a nationwide capability and, of course, incur fairly large losses doing that for two or three years.

And, of course, EnronOnline. But as long as we continue to do things that are ahead of the pack, I think we'll be fine. And, certainly, we intend to continue being a leader.

Christopher Edmonds: Thank you very much.

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