Kynikos Associates’ Jim Chanos in his response to the U.S. House of Representatives discusses why he started shorting Enron, the troubles at Enron and flawed business plans. Also see: Chanos Talks GMCR Short; Steve Kuhn: Bonds Are Talking

Remarks by Jim Chanos

Founder and Manager of Kynikos Associates

Delivered to

The U.S. House of Representatives on February 6, 2002

Good afternoon. My name is Jim Chanos. I would like to take this opportunity to offer my perspective on the tragic Enron story.

I am the President of Kynikos Associates, a New York private investment management company that I founded in 1985. Kynikos Associates specializes in short-selling, an investment technique that profits in finding fundamentally overvalued securities that are poised to fall in price.

Kynikos Associates employs seven investment professionals and is considered the largest organization of its type in the world, managing over $1 billion.

Prior to founding Kynikos Associates, I was a securities analyst at Deutsche Bank Capital and Gilford Securities. My first job on Wall Street was as an analyst at the investment banking firm of Blyth Eastman Paine Webber, a position I took in 1980 upon graduating from Yale University with a B.A. in Economics and Political Science. Neither I nor any of our professionals is an attorney or a certified public accountant, and none of us has had any direct dealings with Enron, its employees or accountants.

Jim Chanos: About Kynikos Associates

On behalf of our clients, Kynikos Associates manages a portfolio of securities we consider to be overvalued. The portfolio is designed to profit if the securities it holds fall in value. Kynikos Associates selects portfolio securities by conducting a rigorous financial analysis and focusing on securities issued by companies that appear to have (1) materially overstated earnings (Enron), (2) been victims of a flawed business plan (most internet companies), or (3) been engaged in outright fraud. In choosing securities for its portfolios, Kynikos Associates also relies on the many years of experience that I and my team have accumulated in the equity markets.

Jim Chanos: Enron Hits Our Radar Screen

My involvement with Enron began normally enough. In October of 2000, a friend asked me if I had seen an interesting article in The Texas Wall Street Journal (a regional edition) about accounting practices at large energy trading firms. The article, written by Jonathan Weil, pointed out that many of these firms, including Enron, employed the so-called “gain-on-sale” accounting method for their long-term energy trades. Basically, “gain-on-sale” accounting allows a company to estimate the future profitability of a trade made today, and book a profit today based on the present value of those estimated future profits.

Our interest in Enron and the other energy trading companies was piqued because our experience with companies that have used this accounting method has been that management’s temptation to be overly aggressive in making assumptions about the future was too great for them to ignore. In effect, “earnings” could be created out of thin air if management was willing to “push the envelope” by using highly favorable assumptions. However, if these future assumptions did not come to pass, previously booked “earnings” would have to be adjusted downward. If this happened, as it often did, companies addicted to the crack cocaine of “gain-on-sale” accounting would simply do new and bigger deals (with a larger immediate “earnings” impact) to offset those downward revisions. Once a company got on such an accounting treadmill, it was hard for it to get 0.

Jim Chanos: First Signs of Trouble

The first Enron document my firm analyzed was its 1999 Form 10-K filing, which it had filed with the U.S. Securities and Exchange Commission. What immediately struck us was that despite using the “gain-on-sale” model, Enron’s return on capital, a widely used measure of profitability, was a paltry 7% before taxes. That is, for every dollar in outside capital that Enron employed, it earned about seven cents. This is important for two reasons; first, we viewed Enron as a trading company that was akin to an “energy hedge fund.” For this type of firm a 7% return on capital seemed abysmally low, particularly given its market dominance and accounting methods. Second, it was our view that Enron’s cost of capital was likely in excess of 7% and probably closer to 9%, which meant, from an economic cost point-of-view, that Enron wasn’t really earning any money at all, despite reporting “profits” to its shareholders. This mismatch of Enron’s cost of capital and its return on investment became the cornerstone for our bearish view on Enron and we began shorting Enron common stock in November of 2000.

See full Remarks by Jim Chanos in PDF format here.

Via: ridgewoodinvestments