Balancing Act

Will a new accounting rule aimed at off-balance-sheet financing trip up Enron?


Companies worried about the impact of a proposed change in the rules for accounting for unconsolidated subsidiaries should keep their eyes on Enron Corp. With an aggressive growth strategy taking the company into newly deregulated businesses here and abroad, the Houston- based energy company, with $31 billion in revenues, needs substantial amounts of capital.

"If you look at natural gas and electricity as one industry today, which it is in all practical respects, it is the largest industry in the world, in terms of both capital investment and revenues," says Andrew Fastow, Enron's 37-year-old CFO. "I would also argue that, given two major trends that are in the energy industry around the world, namely deregulation and privatization, it is arguably the second-fastest-growing industry in the world after the Internet. And we're the fastest-growing industry that earns money."

But conventional financing techniques to exploit the industry's current and potential size would jeopardize the BBB+ credit rating Enron earns from such agencies as Fitch IBCA Inc. and Standard & Poor's, raising the company's cost of capital. That reflects the fact that Enron's investments take considerable time to produce significant income. As a result, notes Ralph Pellecchia, senior director at Fitch, "most conventional cash-flow and interest-coverage ratios are currently weak for Enron's rating."

Fastow concedes as much. "Our industry is characterized by high capital investments, with low initial cash flow and earnings coming off those investments," he says. "[So] you can't just issue equity and dilute shareholders in the near term."

On the other hand, Fastow notes that Enron can't simply let its credit rating slide by issuing debt instead. Not only would that raise Enron's cost of capital, but it would also hinder its energy- trading operations, an increasingly important source of revenue, by increasing the credit risk faced by counterparties. "My credit rating is strategically critical," says Fastow.

In Control?

The financial balancing act this situation requires has turned Enron into a master of creative financing. Yet the Financial Accounting Standards Board shows signs of becoming a much tougher critic of such activities.

At first glance, FASB's new proposal, which the board expects to put into final form before the end of the year, would seem to drastically increase Enron's consolidated debt level from roughly 40 percent of total capital to more than 70 percent. The reason: Enron does not consolidate a number of highly leveraged subsidiaries in which it owns-- or plans to own--no more than 50 percent of the voting stock.

Under current practice, Enron can use the equity method of treating these subsidiaries' results, which keeps their debt and assets off Enron's own books. The proposed rule would require companies to consolidate such subsidiaries unless the parents can show they do not control them, regardless of their ownership position.

The question facing Enron is whether it can accommodate such a change in the rules without sacrificing its BBB+ rating. To understand what's at stake, consider its $2.3 billion acquisition last October of Wessex Water Plc, a U.K. water company. In a conventional deal, Fastow notes, Enron might have simply issued roughly equal amounts of equity and debt in its own name. But that would have immediately diluted Enron's earnings and added significant leverage to its balance sheet. To prevent that, Enron created Atlantic Water Trust, and issued $1.3 billion of Enron shares into it. The trust, in turn, went to the capital markets to raise $1 billion in debt against the shares.

As a result, Enron experienced no immediate earnings dilution from the deal. And because Enron owns no more than 50 percent of Wessex, the $1 billion in debt isn't found on Enron's balance sheet.

Even if FASB goes ahead with its proposed rule change, Fastow contends that Enron wouldn't have to consolidate the Wessex debt, because it is convertible to Enron equity. Conversion, to be sure, would dilute shareholders, but that isn't expected for at least three years, and wouldn't in any case affect Enron's credit rating.

Enron achieved similar objectives in financing the acquisition announced last October of three New Jersey power plants from Cogen Technologies. In this case, however, Enron itself went to the capital markets to issue roughly $1.5 billion in equity and debt. But again, the company was able to keep that capital off its own balance sheet, this time by creating a special-purpose entity to which Enron sold a 50 percent interest in the plants. As with Wessex, Enron accounts for its half of Cogen using the equity method, meaning it need include only a proportionate share of the earnings on its consolidated statement of income, because the special- purpose entity, not Enron, controls the assets.

The stakes again are high. Fully $1.05 billion of the total amount of capital for the Cogen deal represents debt, which, thanks to the equity sell- down through the special-purpose entity, is nonrecourse to Enron. As Fastow notes, "We accessed $1.5 billion in capital, but expanded the Enron balance sheet by only $65 million." With some $200 million of the debt yet to be sold, he adds that "you've got very significant leverage here, much higher leverage on these facilities than you have at Enron."

Fastow is confident that Enron will be able to keep the Cogen debt off its own balance sheet, even if FASB changes the rule on consolidation policy, because he contends the company would still be able to show that it does not control the assets. But even if it couldn't, Enron's credit rating might not be jeopardized. That's because the rating agencies already take into account the fact that, although the debt capital raised in the deal may not appear on Enron's balance sheet, the company still has an interest in making sure the obligations are paid.

Beyond Ratios

Assessing that interest isn't easy, to be sure. For example, while the creditors of the special-purpose entity used to finance the acquisition of the Cogen plants have no claim on Enron's assets, analysts have to weigh the likelihood that Enron would step in anyway if the deal went bad.

While the company's equity stake suggests it has a strategic interest in the project, the fact that it's a small amount also suggests that Enron would step away if the project failed.

But analysts say failure is unlikely, because of its strong prospects. The point, says John O'Connor of Duff & Phelps Credit Rating Co., in Chicago, is that analyzing Enron's creditworthiness entails more than assessing balance-sheet ratios. "As a credit analyst," says O'Connor, "I look through the accounting."

Not that analysts don't try to quantify the risks such deals pose to debtholders. Ronald M. Barone, an analyst for S&P, adds back into Enron's debt anywhere from 10 percent to 15 percent of its loan guarantees, 10 percent to 20 percent ore more of its nonrecourse debt, and the present value of its operating leases and syndications. All told, he says, that adds up to roughly another $3 billion in debt obligations, bringing Enron's total to around $10.4 billion.

That's a far cry from the additional $10 billion in long-term debt and other liabilities that would be found on Enron's balance sheet if the company were deemed to control all of its unconsolidated subsidiaries. No wonder Fastow goes to great lengths to convince credit analysts that such nonrecourse debt shouldn't be consolidated, regardless of FASB's position.

No wonder, too, that analysts think of Enron as much more than an operating company. "To the degree that it can monetize assets," says Pellecchia, "Enron operates like an investment bank."

Of course, analysts see nonfinancial risks facing the company as well. Barone, for example, worries that Enron's aggressive expansion strategy might spread its management team too thin. Eventually, he says, "they have to decide what's core and what's noncore." In that vein, the analyst notes that Enron recently sold off some solar-energy assets, and he contends it might do the same with telecommunications assets, which include a nationwide network of fiber-optic lines.

Fastow rules out that possibility, noting that both the water and telecom businesses fit neatly into Enron's strategy. And he asserts that Enron has more than enough senior talent to exploit new opportunities. Fastow himself is relatively new to the CFO spot, having been named to the position a little over a year ago, after serving as senior vice president of finance for two years. But Barone already thinks highly of him, describing Fastow as "bright" and "top-notch."

If Enron keeps expanding at its recent pace, investors will have to hope there's plenty more at the company where he came from.


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