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Enron is trying to improve disclosure to investors, but its decisionto reduce equity by $1.2 billion in the third quarter has created dismayand confusion in the market.

The action was disclosed in a dubiously discreet manner. Moreimportant, investors are struggling to pinpoint how the shrinkage willaffect Enron's balance sheet, profits and earnings guidance.

Enron didn't provide answers to questions submitted on the equityreduction.

Enron doesn't include a balance sheet in its earnings release, so theequity decrease couldn't be spotted in numbers supplied Tuesday. And eventhough Enron did break out $1 billion in earnings charges in its release,the company didn't feel it necessary to mention the equity write downanywhere in the text.

Instead, the public first heard about it on a Tuesday conference call.CEO Kenneth Lay said Enron had shrunk its equity as a result of terminatinga so-called "structured finance arrangement."

The Wall StreetJournal

later reported that Enron's counter-party in this transactionwas an investment partnership called LJM2 Co-Investment, which has set upand run by Enron's finance chief, Andrew Fastow.

This is what Lay said on the Tuesday call about the equity move: "Inconnection with the early termination, shareholders' equity will be reducedapproximately $1.2 billion, with a corresponding significant reduction inthe number of diluted shares outstanding." According to

The Journal

,Lay then said Wednesday on another call that Enron had repurchased 55million shares.

Enron's supporters count Lay's mention of a reduction in the sharecount as bullish, because it should boost earnings per share numbers in the future.

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But there are two possible problems with this theory.

First, Enron affirmed its previous earnings guidance that it expectsto make $2.15 per share in operating earnings next year. Critically, thecompany did not say whether its guidance was given using a share countwithout the 55 million shares or not. If the forecast does assume theexclusion of the 55 million shares, the company should have upped its 2002per-share earnings forecast by around 6%, since that's the amount by whichthe share count will be reduced. Enron needs to say what share count it'susing in its guidance.

Second, it's almost impossible to determine where these shares wereever recorded, casting a certain amount of doubt on Lay's assertion thatthe share count will come down.

Why question the CEO? Well, in its 2000 annual report, Enron includedsome disclosure of the 55 million shares connected with LJM2. Itreads: "At December 31, 2000, Enron had derivative instruments...on 54.8million shares of Enron common stock." The derivative instruments appear tobe types of options, or agreements that give the counterparty the right tobuy or sell stock at agreed prices.

But these derivatives-linked shares don't show up where they should inthe annual report: in the table that breaks out the difference between thebasic and diluted share counts. The line item in this table that showsoptions-related shares totals only 43 million shares, which is close to theamount of employee pay options that qualified for inclusion. Therefore,that number almost certainly doesn't include the 55 million LJM2-related shares. Thefact is, at least some of the 55 million derivatives-linked shares shouldbe included if the derivatives were like normal options. That's because theLJM2 derivatives appear to have been "in the money", or profitable for theholders. Typically, all in-the-money options-based stock has to be includedin the diluted share count. And these LJM2 derivatives did appear to have thatstatus at the end of 2000. Back then, Enron stock was trading around $80,way above the average $68 level at which these derivatives made money forLJM2.

Maybe these weren't simple options and had other conditions attachedthat excluded them from the diluted share count. That's what disclosureelsewhere in the annual report appears to imply. Alternatively, the optionswere embedded somewhere else in the share count table or equity disclosure, though it's hardthink where.

Presumably, investors will get a full explanation in Enron'squarterly financial results filing with the

Securities and ExchangeCommission

, due by the middle of November.

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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.