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How were some analysts able to figure out that Enron was fudging its numbers? originally appeared on Quora: the place to gain and share knowledge, empowering people to learn from others and better understand the world.
Answer by Stan Hanks, CTO of Columbia Ventures Corp, on Quora:
Analysts were able to determine that Enron was fudging the numbers because of one simple event. On March 21, 2001, this ran in the press: Enron and Blockbuster Terminate Partnership for Video-on-Demand.
Now, to understand why this mattered, you need to rewind to July 20, 2000, when Enron and Blockbuster Partnered For Movie Mania on a twenty-year deal, whereby Enron Broadband and Blockbuster agreed to a deal wherein Enron would deliver video-on-demand (sidebar: Netflix was still shipping DVDs, and wouldn’t deliver streaming video for another seven years; in point of fact, Netflix was in acquisitions discussions with Blockbuster as this news was breaking).
This was huge - it was the mega-hype event of the year. Streaming video across the Internet at that point was bad, being mostly crafted in Adobe Flash or RealPlayer, with ultra low bit rates and very small images. No one believed that you could actually deliver broadcast quality images over the Internet at that point.
At least until the 1999 Internet edition of the Victoria's Secret Fashion Show, three days after Super Bowl XXXIII (it was announced in a halftime commercial). That pulled in over two million viewers, and completely “broke the Internet” as all the traffic went to a single point-of-service rather than being load leveled across content distribution networks - because they didn’t exist yet!
At Enron Broadband, we were changing that. My group pioneered edge distribution servers and had a pretty good track record - we’d simulcast the Country Music Awards in 1999 and an episode of The Drew Carey Show, and the response was pretty good. We knew that there was still a pile of work to be done, mostly in getting good last-mile partnerships and better control software. And that was work which was on-going.
So, after the January 2000 analyst conference, much work was put into “doing something big” which would emphasize the cool and sexy to which Enron Broadband aspired. Enter Blockbuster.
And enter mark-to-market accounting. Mark to market is brilliant, and used for its intended purpose, provides incredible insight into where you need to invest for the future. One of the things that it lets you do is take the entire future value of a contract and book it as revenue at the time of recognition. If the value changes in the future, you re-book it at the new value - either up, or down.
At Enron, it was used to obfuscate many things. One of those was the value of the Blockbuster deal. Taking twenty years of forward projections on video-on-demand views for movies gives a really huge number - in this case, $110 million of profit (not revenue, profit). All booked to the financials for mid-year 2000. The future looked bright, the stock shot up even further.
And then, it un-wound. Turned out that the studios got a little testy about Blockbuster contracting to provide video-on-demand over the Internet when they didn’t have the right to do so. Deal fails - no biggie, value in mark-to-market gets set to zero.
And that’s where the ride really began. Richard Grubman noticed this and started thinking about it - a lot. And he was a serious activist and pain the ass for everyone at Enron - see this story for some color. But sooner or later, he managed to get enough people looking at not just the Blockbuster deal but other deals which Enron had marked to market - and re-marked, and re-re-marked - to have the whole house of cards unravel.
For most people who were covering Enron at the time, there was huge pressure to focus on the positive and promote the notion that it was a hot stock - the “Chinese wall” between the buy-side and the analyst pool was porous and paper thin. A bad report would lead to the clients of the firm wanting to shed the stock, instead of buying more, or holding - and that flux would have consequences, of Enron moving their more valuable investment banking business to other firms.
The hedge funds didn’t have that on board, and were able to take a harder look at things. Rather than taking the press releases from investor relations at face value, they went deeper. They had a lot more money on the line, and no competing business models to protect.
These days, it would be a lot harder to create that level of obfuscation. The Sarbanes–Oxley Act completely re-structured the nature of reporting, for starters, and the vast amount of info on the Internet publicly means it’s a lot harder to hide, if anyone, anywhere has a negative thought about financial news.
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