Under the Radar: Enron's Flickering Bulb

Though the lights have dimmed at the energy giant, the company can survive.
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The bulb at

Enron

(ENE)

may not have burned out, but it's clearly flickering. To date, investors aren't sure whether Chairman and CEO Ken Lay is up to the task of re-energizing the company he once built to greatness.

What's happened at the Houston energy giant-turned-dwarf could've been imagined with any number of ne'er-do-well companies during the well-chronicled bubble. But this is

Enron

. As one longtime Enron bull and shareholder said, "I never had to worry about Enron's ability to survive until this week. I still find it hard to believe."

Peter Eavis has done an exceptional job of chronicling Enron's adventures for some time. If you'd listened to him earlier this year, you'd have profited from his knowledge. His reporting on Enron's

partnership shenanigans to the

departure of Chief Financial Officer Andrew Fastow has been outstanding.

The rumors -- from a pending bankruptcy to a Justice Department investigation -- are, for now, just that. And Enron did not single-handedly cause the California power crisis, nor is

Royal Dutch/Shell

(RD)

about to make a bid to buy the company. Sources do tell me that head-count reductions are likely through employee buyout offers, and that the company is set to refocus on its core energy business. And though former CEO Jeff Skilling shares culpability for the current mess, his departure appears only indirectly related to Enron's current woes.

Now Enron faces the daunting challenge of rebuilding its business and, more importantly, its reputation.

The Company's Challenge

But what does Enron do now? It's very simple. Come clean, clean up the mess and refocus on its core business: wholesale energy markets, risk management and retail energy services. They support each other and create a platform that can be plenty profitable without a lot of gimmicks.

"Our gut feel is that Enron can pull it off, and long-term investors should hold firm, as eventually the stock gets valued on earnings, with upside potential to $25 per share over the next 12 to 18 months," says Jeff Dietert, power analyst at Simmons & Co. and a member of the

TSC

Energy Roundtable. "We believe new money with high risk tolerance should wait until Enron announces its intentions for communicating a clear path to recovery."

Dietert outlines four challenges for Enron. One, management must regain the Street's confidence and persuade investors that it can resolve balance-sheet strength and generate the expected earnings and cash flow. Two, Enron must maintain its investment-grade credit rating. Three, Enron must successfully execute its divestiture plans. Four, Enron must control the timing of the recognition of the writedown in the value of any assets where market value is less than book.

Straightforward? Yes. Easy to accomplish? No.

Though Enron says additional writedowns are unlikely -- except a $200 million charge early next year as the result of an accounting change -- analysts aren't so sure. They're focused on the company's Global Assets portfolio, which has $6 billion in book value but generated an EBIT (earnings before interest and taxes) loss of $18 million over the past 12 months.

The divestitures include $390 million in exploration and production assets in India, $250 million in a Puerto Rico power plant and $250 million in a Brazilian power plant in the fourth quarter as well as the pending sale of Portland General, which is set to close in 2002. There will probably be others. However, Enron has to execute here, and given the current state of its affairs, the seller will feel the pressure.

The credit-rating issue is a fine line. The current ratings, BBB-plus from Standard & Poor's and Baa1 from Moody's, are three levels above non-investment grade. However, both rating agencies now have Enron on their radar screens for possible downgrades. Dietert estimates that Enron's debt-to-market cap will be about 48% by yearend, and the company has interest coverage (EBITDA/ interest expense) of about 3.5 times. By comparison, the average S&P BBB-rated company has a debt-to-cap of 47.4% and interest coverage of about 6.1 times. The average BB company has debt-to-cap of 61.3% and interest expense of 3.8 times.

Frankly, everything falls on Enron's management team and its ability to reassure investors. "If Enron's management does not step up to calm investor fears, these fears could become a self-fulfilling prophecy," Dietert says. "In the potentially vicious cycle, investor fears could drive stocks down; the lower stock prices force the rating agencies to consider downgrades; potentially lower credit ratings force counter-parties to reduce exposure to Enron, limiting Enron's ability to generate earnings and cash flow."

It's time for Enron to grow up. Despite a lot of uncertainties and risk, I think it will. Investors with risk capital should do their homework on the stock and think about strategy. It's a tough call that requires strict, individual discipline.

There's an irony to this whole story, especially in Enron's lack of candor in reporting its financial results. In a much-lauded advertising campaign, Enron, looking to challenge conventional wisdom, asks the simple question, "Why? Ask why."

Investors are now asking. It's time for Ken Lay to answer.

First Things First

Many readers have asked about my relative quietness this week. Thank you for your concern. My father has fallen ill after fighting the effects of a brain tumor for more than a decade.

The choice was easy. I'm with him and my family.

Enjoy your weekend with family and friends.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, Edmonds' firm was long Enron, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to

Chris Edmonds.