The Interdependence of Markets



Enron

A cautionary tale in business growth

Not many companies come bigger than Enron, and none bigger has ever filed for bankruptcy, as Enron did on the 1 December 2001.

Enron seemed to have everything going for it, being the largest energy trader in the United States with 25 per cent of the market. In 2000, Enron earned $100 billion in revenue and turned a profit of $1 billion. By 1 December, the 7th largest company in the United States had seen its market value collapse from $80bn to less than $400m. Its shares fell from a high of $89.50 in 2000 to a meagre 26 cents. How did it all go so horribly wrong and so quickly?

Enron was created in 1986, following the merger of two gas pipeline companies, Houston Natural Gas and InterNorth. As US energy and utility markets were deregulated, Enron diversified rapidly into alternative sources of energy supply such as electricity, and established interests in areas such as water. This diversification in Enron’s interests was not restricted to the US market: Enron embarked upon a global growth strategy, which involved it acquiring interests in utilities throughout the world.

As Enron grew, it also shifted its business focus. It gradually reduced its role in gas and oil production, its traditional core business activities, and moved into the new world of on-line energy trading. This would have appeared to have been a wise move, as by November 1999 it had traded more than $1trillion of electricity and gas on-line. Enron was at this time the largest business on the Internet. So what went wrong?

The weakness in Enron’s growth strategy lay in both the speed of its expansion and, most crucially, in how its growth was financed. On declaring bankruptcy in December 2001, the scale of Enron’s debts were revealed to be both massive and global. Creditors are estimated to be owed (the figure is still uncertain) some $18.7 billion.

Who is owed money by Enron

JP Morgan: $900m

Citigroup: $800m

Credit Lyonnais: $250m

Bank of Tokyo-Mitsubishi: $248m

Chubb Corp: $220m

Canadian Imperial Bank $215m

Sumitomo Mitsui Banking Corp: $210m

Abbey National $164m

National Australia Bank: $104m

Duke Energy Corp: $100m

Royal Bank of Scotland: $855m (unconfirmed)

Barclays Bank: $428m (unconfirmed)

Aegon: $300m (unconfirmed)

Clearly, Enron has financed an overwhelming part of its growth through borrowing. As a source of finance for business growth, this only becomes a problem if revenue begins to fall and you are unable to meet the payments on the money owed. Given the public picture presented by Enron, and its apparent success, revenue and profits seemed to be guaranteed. The business was a clear winner. Such a picture would certainly have helped Enron to attract significant amounts of capital to fund its expansion plans.

However, everything was not as it seemed. Enron’s financial position was precarious. In October 2001 Enron announced unexpected losses, which led it to reduce capital by $1.2 billion. A series of bad investments overseas were held to be the main reason for this decision. The announcement of losses was swiftly followed by the revelation that Enron was to be investigated by the US Securities and Exchange Commission for financial irregularities. It was subsequently revealed that through some accounting loophole Enron had been overstating its earnings since 1997 to the value of some $600 million. Predictably many of Enron’s trading partners had by this stage begun to lose confidence in the business and started to pull out of deals.

At this point Dynegy, one of Enron’s smaller rivals, agreed to buy the company for $9 billion in stock. However, as more losses were disclosed, and the need to get regulatory approval for the acquisition was established, Dynegy pulled out of the deal. Shareholder confidence had by this point totally collapsed and Enron’s credit rating plummeted.

In an attempt to offer Enron a life-line, and to salvage as much of their existing debt as possible, Citibank and JP Morgan, on 3 December 2001, offered Enron a credit line of $1.5 billion. Enron may yet survive, but it is unlikely, at least in the short term, that its finance for growth will come from borrowing.

Enron’s rise and fall reveals a tale of unsustainable growth and expansion that was bought on debt. It reveals not only the folly of such a strategy, but the need to have a strong system of financial regulation to ensure that a business’s true financial position is reflected in its balance sheet.

|Questions |

|1. Why might a business favour borrowing, as a means of financing growth, over other sources of finance? |

|2. What are the strengths and weaknesses of diversification as a business growth strategy? |

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