The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (33 page)

Enron was already taking steps to change that, using one of its tried-and-true tactics. In mid-1997, Andy Fastow’s finance group began working on a plan to sell a piece of EES to some institutional investors. The buyers Fastow ultimately found were the Ontario Teachers’ Pension Plan and JEDI II, Enron’s 50/50 partnership with CalPERS. Together, the two investors agreed to take a 7 percent stake in EES for $130 million.

This sale did three big things for Enron. First, it helped offset the retail business’s start-up costs. Second, Enron used the investment to establish a franchise value for all of EES, the reasoning being that if 7 percent of the business was worth $130 million, the entire effort was worth $1.9 billion—about $5.50 per Enron share. Although EES wasn’t close to making a profit—it wasn’t really even much of a business yet—Lay and Skilling hoped Wall Street would start giving Enron credit for this value and push up the company’s stock. At an analysts’ meeting that took place a few weeks after the deal was announced, Skilling tried to make that happen, arguing that Enron’s share price should be at least $5 higher.

Here’s the third thing the deal did: it allowed Enron to book a $61 million profit in 1997. That amounted to 58 percent of the company’s net earnings for the year, keeping the 1997 results (which included the big J-Block write-off) from being even more dismal than they already were. Enron booked the entire gain from the deal, even though EES received its money in three annual installments (and an Arthur Andersen in-house expert had advised the Enron audit team that only one third of the gain should have been recorded in 1997). But Enron needed the earnings in 1997, so that’s what happened. A group of finance officials scrambled to close it by December 31. Some circulated a list of Top 10 Reasons Why We Thought That It Was a Good Idea for You to Spend Your Christmas Holidays and Year End with Us. (Number 9: “One of your 1997 New Years’ resolutions was to make sure that Enron made its earnings targets.”)

Only a few months after Enron booked this gain from selling part of EES, the company finally threw in the towel on its residential energy campaign. Lay and Skilling acted partly on the recommendation of a newly hired consumer-marketing expert named Jim Badum, a veteran of Pepsi and Taco Bell. Just three months after coming to Enron, Badum, with Pai in agreement, told them that the company “needed to slow things down.” States simply weren’t deregulating fast enough, and Enron was spending so much on landing customers that none of the early ventures had a prayer of turning a profit. “They wanted to go into the markets and hope the markets would get better,” says Badum. “We said, ‘Maybe it’s time to take a wait-and-see approach in these states.’ ” Lay, who had relished his role as populist crusader, seemed crushed. “This is the last thing I expected from this meeting,” he said, pushing his chair back from the table. Says Badum, “When it came to the simple realities of the consumer business, Enron simply didn’t get it.”

Reluctantly, Enron stopped signing up new residential accounts in California and returned its hard-won customers back to the hands of the “monopolist” utilities in most of the states with pilot deregulation programs. And it returned its customers—all 300 of them—in Peterborough, New Hampshire, too.

 • • • 

Not that Enron was about to back away from EES—how could it, after Skilling and Lay had touted it to Wall Street and the company had sold a piece of the division to some highly reputable investors? No, Enron would just have to shift strategies, that’s all. Instead of targeting homes, it would target businesses, from hospitals to fast-food chains to big corporations with scores of office sites around the country. And instead of just selling them power, it would subcontract to take care of all of their energy needs.

Can you see how this would be an alluring notion for a big company that spends tens of million of dollars each year to light, heat, and cool its offices?
Just as consultants had cropped up to handle the complicated computer needs of large corporations, saving them money in the process, Enron was promising to do the same with energy. Its ability to lock in prices on the trading floor would eliminate the worry that volatile energy costs would blow a hole in a company’s budget.

In addition, Enron was promising to use its energy know-how to make efficiency improvements that would save even more money. “That was the pitch,” recalls an early EES executive: “ ‘You go focus on building your widget, and we’ll worry about the energy side of the business. We’re the energy experts.’ ” Depending on the size and term of the contract—some ran as long as 15 years—EES was promising savings of anywhere from 5 percent to 15 percent.

The more perplexing question is why this would be an alluring idea for Enron. The commodity part of this new business—providing electricity and gas at a discount to customers—was often a money-loser at the retail level because most states were still refusing to deregulate retail energy. That meant the only way Enron could cut the cost of energy for a customer was to buy electricity from a local utility and resell it at a loss.

Amazingly, Enron was willing to do this because it remained convinced—despite much evidence to the contrary—that the states would soon open up their markets and the company would begin making money at the tail end of long-term contracts. When it started its retail push, back in 1996, Enron had forecast that half the U.S. retail markets would be open by 2001. Then by early 2000, it pushed back its projection of hitting that mark to 2004. In fact, by 2001 only a quarter of the U.S. power market had opened up and the deregulation effort had ground to a standstill.

What’s more, this new thrust by EES was taking Enron somewhere it didn’t belong. A business like the one EES was launching requires attention to detail, devotion to customer service, and a willingness to understand—and care about—the nitty-gritty of a company’s energy issues. Enron was promising, for instance, to make energy-efficiency improvements, many of which would require big up-front expenditures. But what did Enron executives know about energy efficiency? Nothing. Enron was promising to run the cooling and heating systems, hire the energy-maintenance staff, change the lightbulbs, and pay the bills. Enron had never shown that it could manage that sort of operation.

Pricing energy costs for customers was especially tricky. In a typical long-term EES deal with a large corporation, Enron had to establish models with multiyear tariff curves—predictions about how dozens of factors would affect electric rates—for every utility in every locale the customer had a business site. In just one of its contracts, Enron was required to manage 252 properties in 36 states. “It’s like duplicating the rate department for every single utility in the country and having to do it on the fly and keep it updated,” says an electrical engineer who worked on the EES tariff-risk desk.

One thing Enron
was
good at quickly came into play, though: cutting deals. EES started out signing pure commodity contracts—selling gas or electricity to companies. When it became clear these weren’t going to generate big profits, EES started bundling the sale of power and gas with energy-management services, in what it called total energy outsource contracts. Offering big custom-
ers millions in guaranteed savings, EES began rapidly signing up high-profile clients.

The University of California and California State University systems signed up for four years to let Enron provide electricity and efficiency projects for their 31 campuses. (Enron had promised to provide them electricity at 5 percent below the utilities’ rate, saving a projected $16 million.) Lockheed Martin struck a four-year deal for electricity and energy infrastructure. The San Francisco Giants signed a ten-year commodity contract “totaling $60 million” for their new ballpark; Ocean Spray, a $116 million ten-year agreement; Owens Corning, a ten-year contract said to be worth $1 billion; the Simon Property Group signed up for a ten-year $1.5 billion “alliance” to manage energy needs for its malls. Chase Manhattan Bank and IBM each signed ten-year contracts. Tom White won EES the first contract for privatization of utility management at a U.S. military base. Enron even claimed the blessing of the Roman Catholic Church: a seven-year energy deal with the Archdiocese of Chicago. In 1998, Enron announced, EES had signed contracts with a total “value” of $3.8 billion. By the end of 1999, the company had signed up so many new customers that the “total contract value,” according to Enron, was a stunning $8.5 billion.

It’s important to note, however, that this “total contract value”—the phrase Enron was using to keep score—bore no relation to either revenues or profits. The term merely represented Enron’s calculation of the cost of all the energy and infrastructure needs a customer had outsourced to EES over the life of the contract. If Enron agreed to supply $500 million worth of electricity to a large corporation over a ten-year period, that $500 million was included as part of the total value of the contract, even if Enron was likely to lose money on the sale. But the number was still useful to the company: it was a way to show growth and to dazzle Wall Street.

In fact, this new metric had been cooked up for that very purpose. In September 1997, a high-level EES executive named Dan Leff sent out a memo proposing that Enron adopt a new term he called TCEE—total customer energy expenditure. “The overall objective of creating and deploying TCEE is to communicate, in a simple manner, the size, growth and success of EES to investment analysts, the investment community, shareholders, employees, and customers. We will endeavor to create a new index . . . where Enron is number one out of the box, as the metric is announced.” Leff proposed refining the metric for formal presentation to Skilling two weeks later. By the time it was unveiled, TCEE had been changed to TCV: Total Contract Value. Just as the new dot-coms had such uneconomic measures as “eyeballs” and “hits,” Enron now had TCV. Enron used the term so freely—in press releases, earnings announcements, and annual reports—that it made some of the company’s accountants nervous. “It was a PR message embedded in a financial disclosure,” says one former divisional EES accountant. “That even made Rick Causey cringe.” It served the same purpose as the dot-com metrics: it gave Wall Street something to focus on besides profits.

For most of 1998 and 1999, EES was still reporting losses: $119 million in pretax losses in 1998, another $68 million in 1999. Skilling, as ever, raised the bar. He’d promised the Street that the division would go “earnings-positive” by the end of 1999. Sure enough, in the fourth quarter, Enron announced a $7 million profit, and management promptly declared victory. “In 1999, we proved that Enron’s retail business works,” Lay and Skilling declared to shareholders in Enron’s annual report, written in early 2000. “Enron Energy Services achieved positive earnings in the fourth quarter, and its profitability is expanding rapidly.”

Swallowing Enron’s story, Wall Street analysts declared victory, too. Goldman Sachs’s David Fleischer gushed: “Enron has redefined the worldwide energy marketplace with its vision for both the wholesale and retail markets.” In April, Credit Suisse First Boston’s Curt Launer calculated that EES alone was worth a staggering $19 billion, about $24 per Enron share. Four months later, he raised his valuation target on EES
alone
to $30 per share.

 • • • 

Back in January 1998, at a time when Skilling was intent on convincing Wall Street that EES was taking off, Enron invited the analysts who covered the company to Houston for an annual meeting with the company’s top executives. As part of the event, Enron officials gave the analysts a tour of the company’s operations, including EES. The group was escorted to the sixth floor of Enron headquarters, where they were shown what was described as the EES war room.

There, they beheld the very picture of a sophisticated, booming business: a big open room, bustling with people, all busily working the telephones and hunched over computer terminals, seemingly cutting deals and trading energy. Giant plasma screens displayed electronic maps, which could show the sites of EES’s many contracts and prospects. Commodity prices danced across an electronic ticker. “It was impressive,” recalls analyst John Olson, who, at the time, covered the company for Merrill Lynch. “It was a veritable beehive of activity.”

It was also a veritable sham. The war room had been rapidly fitted out explicitly to impress the analysts. Though EES was then just gearing up, Skilling and Pai had staged it all to convince their visitors that things were already hopping. On the day the analysts arrived, the room was filled with Enron employees. Many of them, though, didn’t even work on the sixth floor. They were secretaries, EES staff from other locations, and non-EES employees who had been drafted for the occasion and coached on the importance of appearing busy. One, an administrative assistant named Kim Garcia, recalls being told to bring her personal photos to make it look as if she actually worked at the desk where she was sitting; she spent most of the time talking to her girlfriends on the phone. After getting the all-clear signal, Garcia packed up her belongings and returned to her
real
desk on the ninth floor. The analysts had no clue they’d been hoodwinked.

Just as Enron’s financial executives convinced themselves that their financial shenanigans stayed within the rules, it seemed, so EES executives reasoned that this deception wasn’t a problem. Eventually, EES really would use all that space. Eventually, there would be hundreds of busy employees working the phones and trading energy and the division would be every bit as fabulous as they were telling investors. It just wasn’t quite there yet. In many ways, Skilling’s little Potemkin Village stood as the perfect metaphor for EES: so much of what outsiders were led to believe about the operation was at odds with what was really going on. Listening to Skilling and Pai describe it, EES sounded like a business that made sense; that’s one reason all the analysts were so willing to buy in. But it never made sense for Enron.

For instance: if you tell all your highly aggressive deal makers that the only thing that matters is total contract value and add to that horrible controls
and
an extreme urgency to get deals done quickly
and
a compensation system based on the projected profitability of long-term deals, you’re inevitably going to get an awful lot of bad contracts. That’s precisely what Enron did.