Enron: A Tale of Forensic Accounting

Posted on August 4, 2016 by Travis Lane

It seems like in every line of study, there’s one big cautionary tale that gets told over and over across the years to highlight the dangers inherent in the field.

In my undergraduate engineering program, it was the Challenger disaster. We studied Thiokol engineer Roger Boisjoly and his objections to the cold January launch that resulted in one of the most high-profile and devastating engineering disasters of the space era. We used the Challenger story as a jumping off point for discussions on engineering ethics and the importance of clear communication (see: Richard Feynman famously dropping rubber into ice water). It was a formative topic on what can happen when mistakes are allowed to pile up and compound.

In my business program, the ethical investigation centered around one of the most high-profile, devastating corporate collapses in history: Enron.

At the turn of the century, Enron was a burgeoning corporate darling. They were winning awards for innovation, making massive gains in share price, and aiming to take over the entire business world with their ever-expanding markets in energy and beyond. Their shares hit an all-time high price of $90.75 in the summer of 2000, but by the time we opened Christmas presents in 2001, just a single year later, Enron was dead. Over the years, investigations into what in the world happened at Enron revealed a complex web of financial misrepresentation, outright deception, and absolutely deplorable behavior from the very bottom ranks all the way up to the C-suite.

So that’s the playing field. There’s a lot to say about Enron, and many different perspectives we could take. But this isn’t Travis’ Corporate History Corner or Travis’ Business Ethics Forum, it’s a “finance mini-lesson.” Even restricting ourselves to that vantage point, there’s plenty to learn from here.

I’m always talking about how financial data is useful for answering real, interesting questions, and not just deciding whether or not to shed your company stock. Today, we’re going to take a critical look at Enron’s financial reporting and follow the breadcrumbs that led a handful of corporate analysts and business reporters to begin unwinding the web of lies that supported Enron. Using what we’ve learned previously, would you be able to spot these irregularities and see through the shining public image of a dubious, faltering giant? Let’s find out!

While there are heaping piles of figures we could look at to illustrate Enron’s financial woes, we’re going to look at just three. While they’re three of the most basic, which should be accessible to long-time readers of these lessons, they’re also three of the most telling, quickly highlighting Enron’s problems using a strictly numbers-based approach.

Much of the supporting material for this post comes from the publication “Red Flags in Enron’s Reporting of Revenues and Key Financial Measures,” from Bala G. Dharan, PhD/CPA, and William R. Bufkins, CCP. The full report can be found here: http://www.ruf.rice.edu/~bala/files/dharan-bufkins_enron_red_flags.pdf

I suggest the full report for further reading.

Let’s begin.

Gross Margins

In the lesson What’s in a Margin?, we discussed the three most prominent types of “margins” used to assess a business’s health, and what each of them means individually as well as within the context of the full set. In that lesson, I said:

Gross margin corresponds with the strength of our business model.

Keep that in mind as we look at Enron’s top-level margins from 1996-2000:

Here we see massive revenue growth over 4 years (almost ten times!), but anemic gross profit growth (just over two times). This is shown in the steady dilution of gross profit margin. Many businesses highlight revenue as a key figure in showing health, and Enron was the standard-bearer of this metric. They bragged about all the markets they were entering, how much business they were doing, and just look at that revenue growth – 251% in the year 2000 alone.

I feel like maybe I’ve downplayed the importance of revenue in the past. Revenue is the start of everything. Increasing revenue means we’re doing more stuff, and doing more stuff is usually a good sign. It’s a catalyst for growth and a sign that there’s demand for our business in the marketplace.

But remember, gross margin shows the strength of our business model. If revenue is increasing, it means we’re doing more stuff, but if our gross margins are declining, it just means we’re doing more of the wrong stuff. Enron’s obsessive focus on increasing revenues and showing off revenue growth served to distract from the very obvious fact that their growth was not healthy or profitable.

Gross margins should have been the first sign of this, but operating and net margins also showed massive declines as the Enron bubble inflated.

Cash Flow

We’ve talked at length about the importance of cash in a business. At the end of the day, profit is just a number on a calculator, but cash moving in and out of the corporate coffer is real.

Here’s where the more direct manipulation from Enron’s top brass comes into play. Mysteriously, they focused on ensuring that annual cash flows showed positive, while leaving breadcrumbs in the quarter-to-quarter results.

Check out the cash flow from operations quarterly data for the year 2000:

In earnings analysis, adding “from operations” to any figure basically means focusing in on the core business. Big companies, especially publicly traded ones, have a lot of things going on financially. The “from operations” designator says “this figure is from repeatable stuff accomplished from our core business operations, rather than discontinuous activities that might vary over time.” This makes it especially important for analyzing growth trends and assessing the company’s place in the market.

On the table above, you can see Enron absolutely hemorrhaging cash from their continued operations in the first two quarters, then executing a somewhat realistic (but impressive) turnaround in the third quarter and a… wait… what in the world… your cumulative cash flow going into Q4 was $100M and you ended the year at almost FIVE BILLION?

You would have to grow extra eyebrows to be able to raise enough of them at this figure.

Investing Activity

In the last section, we saw that there was something fishy about cash flows. Now, we’ll look at how that manipulation was accomplished. Top-level cash flows were controlled in two primary ways: debt and equity.

Taking on debt is a positive source of cash with an offsetting liability. You get cash now, but make payments along the way. But those are on different pages of the financial report so you can try to hide it by squirreling away debt on the balance sheet and highlighting your awesome cash flows. Very novice level ratio analysis would uncover this, but Enron had a strong façade, dissuading critical inspection. To give analysts some credit, Enron additionally cheated this system by hiding its debt in an unending stream of special purpose entities and shady shell corporations that were nearly impossible to unravel.

Equity is using your shares as a financial device and issuing stock, which dilutes per-share value but gives you immediate cash. As we’ve talked before with share repurchases, selling more shares is generally not a good sign; it means organic growth isn’t proving sufficient to support the business. Because Enron’s shares were valuable, they had easy access to equity cash, since banks were of course happy to be part of the rampaging Enron train and investors were gobbling up the vogue stock of the time. So, Enron had cash because its shares were valuable, and its shares were only valuable because they had access to cash… which came from selling shares… see the house of cards being built here?

Both of these activities, as well as some other more complicated ones, are what we would call investingactivities, which are separate and distinct from operating activities. Remembering how operating cash flows are critical in highlighting core business performance and trends, check out what happens to Enron’s total cash flow (from both sources) when the investing component is taken out:

Blam.

Oh, and the positive $515M in 2000 actually ignores $2.35B in repayments to California utility customers, so that one should actually be negative $1.835B. That’s over eight billion dollars in cash lost by the business segments that Enron claimed were making it rich.

They were supporting themselves strictly with debt and equity issuance, while bleeding literal billions out from their meager operations – operations which, despite a ton of media hype over big, tenacious projects, were anemic at best and pure, uncovered losses at worst. Famously, they had used sneaky accounting to book millions in future profits on a power plant that never once turned on. And that was just one of many instances.

We’ve covered a tiny sliver of the insanity that was Enron. I hope this has been an illustrative and informative look into an applied use of finance that some might call forensic accounting. If you’re interesting in learning more about the fascinating, though tragic tale of Enron, I strongly suggest the documentary Enron: The Smartest Guys in the Room. It’s currently available on Netflix. Additionally, for a bit more depth on the financial side, check out the report that I referenced for this lesson here.

Spirit AeroSystems – Q2 2016

Posted on August 4, 2016 by Travis Lane

Happy earnings day, all!

Boy, what an exciting quarter this was! For a number of quarters now I’ve talked about how boring good performance can be. Appreciated, preferred, but a little uninteresting. This quarter was the best of both worlds – good performance and positive news coupled with some interesting financial concepts and a new personality to study in Mr. Gentile.

I’ll warn you, because of the richness of some of the ideas covered in this quarter’s call, this might be a little longer than the norm. Hopefully I’m able to add value and clarity. If not, file it under TL;DR (Travis Lane; Didn’t Read) and I’ll see you next time.

Financial Summary

Here’s the quick financial overview, then we’ll dig in:

This shows declines in incomes reflecting a one-time item occurring within the quarter, but otherwise continued strong performance.

I’ll also include the cash flow table for you to refer back to when the mini-lesson makes you curious about it:

This quarter reflected our continued evening-out on the financial front, showing a pretty good trendline from Q2 of last year on important metrics. We raised our guidance (estimates) for free cash flow, and also our earnings per share (EPS) after taking out an adjustment for a one-time item. Don’t worry, I know you’re all wondering about that “one-time item,” and I won’t leave you hanging.

Now let’s take a break before the actual details of the call to talk about the elephant in the room: the $135.7M forward loss on A350.

We’re all a little sensitive to the term “forward loss” from some catastrophic results experienced a few years back. We’re tuned to the idea that the words “forward loss” precede layoffs, executive shakeups, declining share prices, and general pandemonium.

And yet, Spirit’s shares were up about 7% on the day after accounting for this news. Our leadership is claiming solid and exciting results. Ummmm… what now?

Context is key. Gathering context is the reason I suggest you listen to the earnings calls even if you don’t fully understand them. Breaking slightly from convention, I’m going to lead with an explanation of why this forward loss isn’t a dire sign, then fill in some of the details via the Q&A. I want to take this approach because a large portion of the questions focused on this subject, and it would be rather deep and piecemeal to try to splice a coherent understanding from just the questions below. Let’s jump in.

We need to preface with a reminder of terminology. Note that these graphs are all rough representations, not actual program performance. (Professional driver on a closed course.)

Deferred inventory is a bucket that we keep track of that says whether we’re ahead or behind on our estimated production costs for a program. Each and every unit we produce will either add to or take away from the deferred inventory balance. If it cost more to make than forecast, it will add to DI and vice versa. Deferred inventory is a representation of our internal performance – our cost controls in supply chain, our build efficiency, and our cost estimate accuracy.

Revenue is what our customer pays us for each unit we deliver. Gross profit is our revenue (what we’re paid) minus what it cost for us to produce it (cost of goods sold).

A forward loss is taken when some of the deferred inventory balance is judged to be unrecoverable. In other words, as we’ve learned more about our production schedule, internal costs, and revenues from the customer, we found out that we can’t make up for some of that balance, and we write it off against our profits in order to adjust to the revised expectations. Put another way, due to a change in either revenue or cost estimates, the area under the curve between those two figures became smaller. Remember, it’s not a cash charge, it’s only an adjustment made in the current quarter to square us up with our future expectations.

Now, ordinarily, less profit is a sad time. As we’ve experienced in the past, forward losses are not a fun occasion. And really, all else equal, we’d have been happier without this forward loss. But, the context for this one is what makes it alright. Let’s dig into that now. I’d like to draw you an analogy.

Since 1928, the S&P 500 stock index has had a compounded annual growth rate of around 10%, meaning if you put money in the S&P in 1928, you could pretty closely calculate your present value using the basic compound interest formula and plugging in 10% for the rate. However, that smooth, parabolic curve is… not quite what has actually happened. Some years have been down more than 40%, and others have been up by more than 50%. 10% is the compounded rate, but it’s not the constant return you’d get every year. There was a whole lot of volatility involved.

As someone with a 401k, or an IRA, or a college fund for your kids, would you trade 1% of long-term returns in exchange for eliminating the ups and downs of the market?

If you’re in a bond fund or a stable value fund, your answer is almost certainly yes. Even some of the more intrepid investors would probably trade a bit of their overall return for far fewer headaches and fingernail biting along the way. It’s pretty universal that people prefer certainty over uncertainty. Even if we understand the mathematics in our rational brains, the emotional brain is always there nudging us toward stability.

Well, this is pretty close to what Spirit has done here. Certainty and stability are the reasons our shares are rallying and we’re celebrating a good quarter in spite of taking a 9 figure forward loss on one of our most critical new programs.

By reaching a contractual pricing agreement with Airbus, we have secured our revenues on that program going forward. The forward loss didn’t necessarily come from poor performance, but from aligning with what we are now legally entitled to receive in payment for our services. We adjusted our profits to account for going from 10% return (with crazy volatility) to 9% (steadily every year). But you can still retire pretty nicely on 9% annually. You’ll have a little less money in the end, but a lot fewer sleepless nights. It’s more or less analogous.

Although we’ll cover more details in the Q&A, that’s the gist of the whole quarter. We took a little loss, but it was in exchange for massive gains in long-term stability (as well as cash flow). Nothing is ever final; time is rather immutable and its realities become emergent. Spirit will never be completely finished with forward losses and cumulative catch-ups, because we will never be perfect at predicting the future. But we can be pretty confident that we’re improving, and that our position going forward is as steady, or steadier, than it was before.

Now let’s get to the actual earnings call.

Executive Comments

Hey, there’s a new voice! Let’s welcome Mr. Gentile to his first earnings call session with Spirit. Tom introduced himself and laid out some of his priorities for Spirit moving forward. Other than that, he mostly said the usual stuff – talked about the Airbus contract, mentioned that deferred balances and growth on A350 and 787 are stable or improving, talked about Spirit achieving an investment-grade credit rating in the quarter (which saved us a handful of millions in refinancing debt to lower rates), and celebrated our first quarter delivering more than 400 units (I think I heard 408).

Mr. Kapoor added a few points, reinforcing our $47B backlog which gives around 7 years of revenue visibility, the $10M in annual interest we’re saving from our refinancing efforts, and the change of the A350 accounting block from 400 to 800 units. He also mentioned that Mr. Lawson’s retirement package was responsible for a one-time $0.11/share impact. Career goals: get a retirement package significant enough that it registers on a corporation’s quarterly earnings. For the curious, I’ll save you the effort of calculating: $0.11/share comes out to around $14.3M. Maybe if I run into Mr. Lawson around town he’ll buy me a Coke.

As Tom was getting warmed up this quarter, Sanjay did a lot of the heavy lifting on the call today. It’s been funny over Mr. Lawson’s tenure to hear the change in his diction and voice. When he first arrived, he was pretty heavy-laden, as was Mr. Kapoor. The calls tended to be of a much more serious and conciliatory tone, and there were definitely moments where they were notably concerned or disarmed a bit. As time went by, they both adjusted to the chair, and their confidence grew. There were fun moments on the calls, a few jokes, and a lot more polish. In my estimation, as a complete outsider, Mr. Gentile seemed to reflect a bit of the “New CEO” nerves on the call, which I found funny in contrast to Sanjay’s practiced evenness. That’s not to say Tom was jittery or presented poorly, just that the new-ness was there. Having said that, new CEO, new opportunity for me to get fired for personal observations on earnings analysis!

In all seriousness, I’m excited to see how things develop under a new captain. I have high hopes for what Spirit can become under Mr. Gentile, and I’m appreciative of his communication and character thus far. We’ll see what the future holds!

Now, ordinarily, the Q&A is the real content of the earnings call. This quarter, it was definitely good, but it was very dense, inspiring the separate section above. What you’ll find here is a lot more of the specifics of the stuff we did, so read on for more granularity.

Q&A

Due to the unusually high concentration of questions on pricing contracts with Airbus and Boeing and the fact that I’ve already discussed that key topic above, I’ve parsed the Q&A portion pretty heavily. If you’d like my full notes on the Q&A session, send me an email and I’ll pass it along.

As a side note before beginning, keep in mind I am far from an expert on these things. If I’ve made mistakes or misrepresentations, feel free to tell me. I try to learn as much as I can from compiling these reports, and I’m always open to input from those that know the subjects better than me. This quarter’s subject matter is pretty heavy, and I am naught but a stress engineer by day. There’s your disclaimer. Let’s rock.

Question: How are the Boeing contract negotiations going?

o Sanjay: We really can’t divulge the details of negotiations. However, for confidence, reference the successful, mutually beneficial agreement with Airbus this quarter.

o Travis: After an incredibly slow start, we finally got to last quarter’s hot topic. And once again, we can’t openly discuss the terms of ongoing contract negotiations, or even details of finalized inter-business contracts. I swear, Mr. Kapoor could probably save himself some effort by recording that response and just playing it on repeat during the earnings calls. I get it – it’s a big deal and deserves follow-up, but… man. They’re not gonna tell ya secrets, guys.

Question: On the Airbus agreement, now that we’ve stretched the block from 400-800 units, how do we feel about stretching out the timeframe for reclaiming deferred inventory?

o Tom: Now that we have visibility over the full, extended block, we did our reassessment of the overall program, which resulted in the adjustments we made within this quarter.

o Sanjay: There’s about $450M in cash that we would expect to recover over the next 700 units, which amortizes out to about $600k reclaimed per shipset over the block. We feel like this agreement is a really good result going forward, not only relationally with a major customer, but also financially via future cash flow gains and revenue certainty.

o Travis: We went from slow-pitches to heaters reeeeeeal fast here, and it’s here where the dirty details start getting airtime. Refer to my explanation above of what our deferred inventory balance is. In short, it’s how much we’ve overrun our estimates so far. Our goal is to work it down to zero by program completion. Well, as part of our adjustments this quarter, we changed our estimates from half the program or so (400 units) to the entire program (800 units) because we now have contractually guaranteed revenue commitments from the customer – we know enough to make valid predictions over a longer timeframe. The analyst asking this question is wondering if our performance is worse than we expected, because we’re now burning down our deferred inventory over 800 units instead of 400. Read on for a further answer.

Follow-up comment: Prior to this quarter’s adjustment, we would’ve expected to reclaim the $700M deferred balance over 300 units, and now we had an additional forward loss after having 400 extra units to use.

o Sanjay: Keep in mind that we’re now incorporating not only cost but also revenue impacts over the 800 unit block, so this paints a fuller picture and we feel that all things considered, it’s a very solid result.

o Tom: We felt it was most transparent to convey the full impact over the total 800 unit block rather than parsing it out over 2×400 units. Also note on deliveries we’re seeing declines in deferred inventory additions, and we should be positive by the end of the year.

o Travis: The analyst asked a really good question. We’re spreading the same amount of butter over twice the toast – do we have a shortage of butter? Sanjay’s answer to his follow-up here, as I understand it, is basically saying that incorporating the last 400 units didn’t make much of an impact because we were already pretty close to the eventual agreement with our original estimates. In other words, our deferred inventory burn-down plan remains relatively unchanged over the next 300 units that were part of the original block, and the additional 400 units are pretty close to projections.

Question: (Again on A350) Are we going to stay cash positive once we turn the corner, or is it going to be impacted by future price changes?

o Sanjay: We expect to get cash flow positive and stay cash flow positive. We do expect to recover $450M over the block still, which amortizes out to some $600k per unit on average.

o Travis: At one point, Tom said there’s a good chance we could be “positive” within 2016, and certainly within 2017. Referring to the deferred inventory chart above, what he means is that we’ll cross that transition point where we’re no longer addingto our DI balance on a unit basis, but instead subtracting from it (which is good). Now, cash flow positive as Mr. Kapoor answered would indicate profitability rather than deferred inventory, so I may be off-base. Either way, Sanjay believes throughout the twists and the turns of the program, once we achieve positive cash flow, we’ll stay there, and that’s the critical part of the message.

Question: R&D declined slightly this quarter – why?

o Sanjay: Mostly just timing of various expenses, nothing specific.

o Tom: Reinvesting is a priority for us. We can probably even do more. Expect more internal reinvestment going forward.

o Travis: This was a quick, tangential question, but it deserves inclusion. I’m intrigued to see what Tom’s directives will be on internal investment, and if his approach to retained earnings will vary from Mr. Lawson’s. It’s very early, but it’s worth highlighting so we can all keep an eye on how it develops.

Question: 787 accounting block discussion – in the absence of a firm contract, are there going to be any surprises when we land a final contract?

o Sanjay: This is why we didn’t put interim pricing assumptions in cash flow guidance. We separated those out to remind people they’re tentative, but they are based on realistic numbers.

o Travis: He’s asking if when we sign the deal with Boeing, we’ll get an accompanying forward loss adjustment like A350 did this quarter. The answer is… well of course it’s a possibility. We don’t know until we know. However, Sanjay has been heavily emphasizing that the Airbus agreement was a positive, and that the forward loss adjustment was pretty minor when you consider the scope — $135.7M over 700 aircraft is less than $200k per unit that we adjusted for. It’s just not that bad. But, yeah, there might be a similar situation with Boeing. It shouldn’t be anything to fret over though.

Question: Normally when you extend the accounting block, you get a benefit. My assumption since we have a loss is that we’re giving up a little bit on price with Airbus?

o Sanjay: (sighs) True, but keep in mind we talked about pricing over the entire block, not just the short term. We’re relatively stable.

o Travis: It’s pretty natural to have price stepdowns later in a program’s maturity. We made the forward loss adjustment because we did “give” a little in contract negotiations. But again, it’s to the tune of $200k per unit. It’s money, yeah, but it’s not big money that we need to be concerned about.

Question: Based on calculations, I figure your non-recurring costs were about $60M this quarter? Is that accurate?

o Sanjay: Not quite that high… we’re active on 737 MAX, 777X, and more. As we develop things, we have “lumpy” costs like tooling and studies, but we’re doing really well on development programs and meeting our commitments. (Good job, engineers)

o Travis: Included this mostly to remind everyone that the engineering side matters too, and not just production. We know that engineers improve the end-product by designing it well, but we often feel a step removed from the bottom line financial data. Mr. Kapoor treated our current engineering efforts like a point of pride and called it out as a success. So good job.

Question: 787 deferred balance growth was $1M last quarter and nothing this quarter, what’s with the efficiency? Is it getting to 12 units a month that de-risks the program?

o Sanjay: We laid out a plan years ago and now it’s coming to fruition. (Sanjay credits the whole team, all 16,000 that have worked hard on our programs).

o Travis: Another short one, the analyst was pretty impressed with our gains in production efficiency on 787. Sanjay says… yeah, we told you that was our plan, and we executed to it. Maybe stop asking me about Boeing contracts and have some faith.

Question: (asked about both 787 and A350 by separate analysts) Looking at OEM’s deliveries of final products, it seems Spirit is delivering a lot more to them than they’re pushing out. Is that going to affect us or do we have conservatism baked into our plans to account for this?

o Tom: Their deliveries are downstream, but they’re still requiring our upstream product at the rate we’re used to.

o Sanjay: We should absolutely expect our production and delivery rates to stay steady and consistent.

o Travis: Analysts are concerned that the OEMs are creating a logjam at the final assembly stage, and that that backup could cause them to delay receipt of Spirit’s units, costing us time and money. I’m not the person to answer things like this about the intricacies of supplier/OEM release schedules, but the two guys at Spirit’s helm probably are, and they don’t seem to think it’s an issue at all.

Question: It’s unusual, you’d almost call it “extraordinary” to extend an accounting block – why not take a big loss now instead of extending that into the next?

o Tom: We thought it would be best to give the full picture over 800 units. We could have addressed risk and made adjustments within 400 units, but it would have left uncertainty on the table regarding the back half.

o Sanjay: We have orders and contracts for more than 800 units. We have certainty for costs and revenues for that whole block. It’s true that we rarely change blocks, but it’s been very methodical, with oversight from the board and from our auditors. We just thought this was the best way to communicate our current positions with respect to the information we have now.

o Travis: This has been the theme… why did we change so much about how we’re reporting financials on A350? The answer seems to be full transparency, which is a reasonable answer considering the nature of the pricing agreement. As we’ve explored in this writeup, there are lots of complexities associated with something of this magnitude and timescale. The takeaway is that Spirit is moving forward with production, customer relations, and financial integrity. It’s an analyst’s job to prod and pry and ask the hard questions with a bit of a cynical approach, looking for problems that could cost their investors. Spirit’s reasoning seems sound and valid, and is a continuation of the stability that we’ve gradually seen added over the last several years.

Boy, this feels like it’s even longer than usual… brevity really is not my strong suit. I think it’s justified – I’ve had many people already asking me about the forward loss even though the STIP and share price tell a pretty positive story, so hopefully the extra explanation has been valuable in understanding what’s going on.

I had another pre-written mini-lesson for the quarter based on something I wanted to study on my own time, so I’m going to go ahead and include it, but if this has already been an overwhelming “summary,” I wouldn’t blame you for putting it on hold or giving it a miss. If that’s the case, thanks for reading and see ya next time! If you’re sticking around, let me think of a tie-in here…

If you think Spirit’s finances are complicated or seem to be “fudged” sometimes (I hear this sentiment frequently enough to know you’re out there), part of it may be because you haven’t seen what real manipulation looks like. So this quarter, I submit for your comparison and consideration the mini-lesson Enron: A Story of Forensic Accounting.