Enron Restatements Don't Go Far Enough

The energy trader cuts reported earnings, but some transactions still appear to be left out.
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Enron

(ENE)

still hasn't come clean on the shadowy deals that led to many of the company's problems.

The battered power giant restated more than three years' worth of financials Thursday because previous numbers failed to take into account complex deals with a number of affiliated entities. As a result of the restatements, annual recurring earnings in the 1997-2000 period are now 10% to 25% lower than originally reported.

However, the picture could be even worse. The restatements of recurring earnings left out nearly $1 billion of losses suffered by a related entity called LJM2 in 2000 and 2001. Losses suffered by a similarly structured entity called LJM1 were factored into the restatement, while LJM2's were not. Enron didn't comment, but the press release detailing the restatements appears to argue that LJM1 was too thinly capitalized and, as such, it should always have been consolidated in Enron's core numbers. The inference, therefore, is that LJM2 losses weren't included because the entity was better capitalized than LJM1.

But that explanation isn't holding water in many quarters. In fact, the exclusion of LJM2 could be a source of further controversy for Enron. Enron fell 64 cents Thursday to $8.41.

Pulling a Fastow?

LJM2 has received much scrutiny in recent weeks, and is primarily responsible for events that have cratered Enron stock. The entity was led by Enron's now-ousted CFO Andrew Fastow, and the

Securities and Exchange Commission

is looking at the transactions Enron did with LJM2. In addition, these transactions prompted a $1.2 billion reduction in Enron's equity in the third quarter. Among investors in LJM2 were Credit Suisse First Boston,

Wachovia

,

General Electric

and the Arkansas Teachers Fund, according to recent reports in

The Wall Street Journal

.

It appears from other public documents that LJM2 could not have entered the deals that led to the losses if Enron had not agreed to issue $1.2 billion of stock. If so, the LJM2 deals weren't as arms length as Enron might want to project right now.

Therefore, to get a truer picture of Enron's profitability, investors should factor the LJM2-related losses into restated numbers. The result isn't pretty: The $1 billion of LJM2-related losses would've reduced the restated recurring earnings for 2000 and 2001 by some 30%. True, a portion of these losses were included in October's initial release of third-quarter financials, but they were taken as a charge that Enron asked investors to leave out of the recurring profits number that is supposed to give investors a view of core earnings power.

As a result of the restatements made Thursday, Enron said 2000 recurring earnings per share was $1.33, compared with the originally reported $1.47. But if the $501 million of LJM2-related losses were included, Enron only made 88 cents in 2000. If the $453 of losses were included in profits calculation for the first nine months of 2001, Enron actually made 98 cents per share, instead of the restated $1.36.

What is the basis for including these LJM2 losses when Enron doesn't? Well, Enron says in the Thursday press release that LJM1 was consolidated into the restatement "because of inadequate capitalization." It later says that it believes that initial capital commitments for LJM1 totaled $16 million, whereas the "aggregate capital commitments to LJM2 were $394 million."

Trimming the Hedges

The LJM2 number is certainly larger, but in and of itself the equity number means little when you look at sheer size of the deals LJM2 and Enron did together.

Enron asked LJM2 for protection against swings in the value of broadband and other assets. These so-called hedging deals were struck through specially-formed entities collectively known as Raptor, according to Thursday's press release. Through the Raptor deals, LJM2 agreed to make Enron whole for losses sustained if the assets declined in value, and it hoped to profit if these assets went up in value. Enron SEC filings show that the notional value of these Raptor hedges was a sizable $2.1 billion.

However, to make hedges of this size, Raptor would've needed adequate cushion against potential losses. The value of the equity LJM2 put into Raptor hasn't been disclosed. But it appears Enron took a radical step to give Raptor the cushion it needed. Enron seemingly created assets for Raptor to make it big enough to handle the hedges. From what can be pieced together from Enron disclosure, the company did that by agreeing to issue stock valued at $1.2 billion to Raptor under certain conditions. This stock pledge essentially served as Raptor's assets; in return, Enron took a note receivable, or simply a loan, from Raptor for $1.2 billion.

As it happened, Enron benefited massively from the assets hedge. It protected itself against a $500 million decline in the assets in 2000 and $453 million in 2001. These hedging gains were netted out to zero in Enron core earnings, because they were offset by declines in asset values. But without the hedges, Enron would've taken the losses in its expense line.

Vince Carter

Of course, the problem was that Raptor, and therefore LJM2, was losing from the hedges. That might've been tolerable if Raptor were making money from the stock agreement. But Enron's stock began falling sharply in 2001, depriving LJM2 of potential profits. Meanwhile, as the stock price slid, Enron was having to agree to issue more stock to keep the equity pledge to Raptor at $1.2 billion. As the decline continued into the third quarter, and the issuance commitment grew, it made sense to unwind all the Raptor deals with LJM2.

At this point, Enron took the $1.2 billion charge to equity in the third quarter to reverse the equity pledge. Enron did take some of Raptor's hedging losses itself, but it did so through a $711 million pretax charge, which it chose to exclude from operating earnings in the third quarter.

The big question is whether LJM2 actually took any losses itself from Raptor. Why is that crucial? If Enron shielded LJM2 from losses, it was essentially dealing with itself. The SEC and investors wouldn't like that. What clues are there that LJM2 didn't take a loss? Well, the Thursday press release says that Enron bought out LJM2's stakes in Raptor for $35 million. That makes little sense. How can LJM2 have had any Raptor equity left after the losses it appears to have sustained? If Enron made LJM2 whole, then this was all little more than a shell game.

Seems like Enron still has a whole lot more to tell us.

Know any companies that the market may be misvaluing? Detox would like to hear about them. Please send all feedback to

peavis@thestreet.com.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.