El Paso Bucks the Transparency Trend

At first glance, El Paso ( EP) looks like a bargain stock, unfairly punished for the company it keeps.

With onetime energy-trading steed Enron broken down and other rivals tottering, El Paso is battling to distinguish itself from a stable of unstable peers. Fans of the Houston energy company point to a cash-rich pipeline system that's the envy of the sector. Bulls say the company is financially far more solid than rivals like Williams ( WMB) and Dynegy ( DYN) -- a fact they say isn't borne out by El Paso's single-digit price-to-earnings ratio.

But some investors call the company's accounting aggressive and say it leaves El Paso open to earnings-sapping charges in the future. They also question the company's hefty use of rose-tinted pro forma financials, saying they fail to depict the true health of El Paso's complicated operations. El Paso defends its accounting as appropriate. Still, with investors increasingly demanding transparency and accountability from managers, some observers wonder how long El Paso can keep its stock afloat without simplifying its books.

"I am concerned about the questionable, Enron-like accounting practices the management of El Paso seems to have adopted," says Oscar Wyatt, one of El Paso's largest individual shareholders, who is carrying the torch for disgruntled investors in search of clearer financial statements. "And I cannot understand, nor do I know anyone who really does understand, their reported cash flows -- period."

Rosa's Cantina

The debate on El Paso stock starts with the numbers. Based on the bottom line the company posted in its Securities and Exchange Commission filings, according to generally accepted accounting principles, El Paso earned just 18 cents a share for 2001. That means that on a GAAP basis, the stock is trading at a rather robust 98 times earnings.

But few dwell on this figure, noting a host of merger-related costs and other so-called nonrecurring charges. Analysts look instead to the more generous pro forma earnings favored by the company. Last year, El Paso reported pro forma earnings of $3.31 a share.

World of Difference
Pro forma treatment boosts El Paso earnings
Source: Company press releases, SEC filings.

Weighing that and other numbers, many analysts describe El Paso as clearly undervalued, offering a mean 12-month price target of $24.53. The stock recently traded at $17.50, which is less than a third of the 52-week high.

But an ambitious "Honest EPS" study recently undertaken by the Aeltus Investment Management division of ING cautions against buying stocks with wide differences between actual and reported earnings. El Paso ranks as one of the companies with the biggest discrepancies between actual GAAP earnings and the pro forma numbers that, in the wake of the collapse of Enron, WorldCom and practically the entire tech sector, are now widely discredited on the Street.

"Some argue that pro forma numbers are based on the future -- which is of more concern to investors -- but the past is relevant, too," said Douglas Cote, the portfolio manager behind the study. "It's evident. This is making our clients money."

Cote, who examined eight years' worth of earnings reports from 500 companies, found that investors would earn 11% more annually by purchasing companies with high "honest EPS" numbers and selling those without them.

Five Mounted Cowboys

Questions about El Paso's books are nothing new. Despite the market's current obsession with transparency, the company has routinely dodged questions about its off balance sheet debt. Pressed again for disclosure, El Paso finally revealed that it carries $1.95 billion in off balance sheet debt for which it is ultimately responsible.

That debt, if shifted onto the balance sheet, would increase El Paso's total debt load by 12%. Such a hike would curry little favor with ratings agencies, which have ordered stronger balance sheets throughout the sector and earlier this month gave El Paso's strong investment grade rating a negative outlook.

Critics have started to fret about El Paso's accounting for exploration and production costs as well. They claim El Paso's use of so-called full-cost accounting is aggressive to start with. But more confounding, they say, is the company's insistence to treat as extraordinary the charges that periodically arise under this accounting treatment when fuel prices fall. Doing so, they conclude, could make the company's earnings look considerably better than they are.

El Paso declined to address how earnings would be hit under a more conservative accounting treatment favored by its peers. But the company did defend its accounting method as common.

"It's what most large independents use," an El Paso spokesman said. "We're just following suit."

Although he cited some companies that use similar accounting -- including Apache and Devon -- experts have described large companies in this category as the exception to the rule.

White Puff of Smoke

So far, El Paso has managed to beat earnings expectations both quarters this year -- and generate criticism each time for the manner in which it did so.

Earlier this summer, the company came under fire for a transaction that created a one-time gain that substantially boosted first-quarter results. Critics -- led by the ever-vocal Wyatt -- cried foul, accusing the company of sacrificing future earnings to fatten current profits.

More recently, El Paso has caught heat for a massive second-quarter charge that blindsided analysts and revived alarm about the company's accounting. That controversy centers on El Paso's use of full-cost accounting and the asset writedowns the method mandates.

Most major energy companies use "successful efforts" accounting that requires them to expense exploration-and-production losses at the time they occur, said John Olson, an analyst at Sanders Morris Harris who owns stock in the company. But many smaller companies -- and a handful of large ones -- avoid that hit to earnings by using the full-cost method, which allows them to capitalize expenses at the risk of massive writedowns if fuel prices decline.

Because fuel prices are anything but static, the writedowns occur with some regularity. El Paso has taken these so-called ceiling-test charges in three of the last five years, and in both of its fiscal quarters this year. Still, the company continues to consider the costs nonrecurruing. But subtracting these and other "extraordinary" charges from El Paso's earnings would result in a 21% cut to first-quarter earnings and a $45 million loss for the quarter just ended.

"The questionable thing to me is ignoring the charge-off for ceiling tests -- the very measure that was put in place to make full-cost accounting honest," said Douglas Carmichael, distinguished professor of accounting at Baruch College. "Any analyst who ignores those charges is just ignoring reality."

Bernstein Research said it was "caught by surprise" by the second-quarter charge because El Paso already had taken a major ceiling test charge against its Canadian assets less than a year earlier. Together, these two ceiling test charges nearly equal the entire $332 million El Paso paid for Velvet Exploration during its expansion into Canada last year.

The charges indicate that El Paso heavily overpaid for Velvet Exploration during the height of a natural gas boom. But they also raise concerns about further writedowns -- viewed by many as inevitable -- for other assets on El Paso's books.

"You don't see these kind of charges occurring under successful efforts, which is a higher quality of accounting," Olson said. "At some point, one wonders whether El Paso will finally make that shift."

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