Pumping it up- Enron and Broadband

How NOT to make money on Broadband

The collapse of Enron has resulted in a number of details coming to light of deals and initiatives in the Broadband arena at Enron. One such deal was between Enron and Blockbuster. It illustrates how Enron was able to create millions in profits with a little hype and wishful thinking about the broadband future. It is a fascinating story of how Enron combined creative accounting with a little broadband technology.

The story begins with the announcement in July 2000 of a deal between Enron Broadband Services and Blockbuster. The press release announced the deal as : a 20-year, exclusive agreement to deliver a Blockbuster entertainment service, initially featuring movies on-demand, via the Enron Intelligent Network™.

It went on:

“Entertainment on-demand is perhaps the most visible example of the power of Enron’s broadband applications. With Blockbuster’s extensive customer base and content, and Enron’s network delivery application and the capabilities of the distribution providers, we have put together the ‘killer app’ for the entertainment industry,” said Kenneth L. Lay, chairman and CEO of Enron Corp.

The full text of the press release can be found here:

http://www.enron.com/corp/pressroom/releases/2000/ec/68-Blockbuster.html

The plans announced in the press release were for Enron and Blockbuster to introduce the entertainment on-demand service in multiple U.S. cities by year-end. Beginning in 2001, Blockbuster expected to extend the service to other domestic and international markets. Enron would encode and stream the entertainment over its global broadband network infrastructure, provision bandwidth on-demand, store the entertainment content and provide quality of service.

Distribution providers SBC, Verizon, Qwest, Covad, Telus and ReFlex had been signed to design the architecture of the high-performance network to deliver a complete service package, including both entertainment on-demand and high-speed access to the Internet. A later memo in December 2000 announced specific agreements with ReFlex Communications of Seattle and Portland, Switchpoint Networks and FiberRide. ReFlex Communications – a DSL service provider focused on apartment complexes subsequently went bankrupt. FiberRide is a very small FTTH provider based in Irvine, California. Switchpoint is a systems vendor for broadband networks.

In March 2001 Blockbuster called off the deal for reasons, which are still not clear. Publicly Enron blamed Blockbuster for the slow signup of content owners.

At the heart of the so-called innovative trading at Enron was an accounting rule. When Enron agreed to supply power to a company or municipality on a fixed price contract, it made projections on the level of future prices and the likely profit over the lifetime of the contract. Under the accounting rule in question it was then able to report that profit as soon as the contract was signed rather than booking the gains over time. However, this was inherently risky because the assumptions of the price projection were not confirmed as accurate and correct when the profit was reported.

Accounting based on this rule is known as mark-to-market accounting. In established markets such as for stocks and bonds it is easy to mark- to-market the value of trades at any point in time. But where there is no such market companies are allowed to use their own models to estimate fair value, and to treat that as market value. It appeared the models used were more wish fulfillment than being based on rational assumptions.

Enron asserted that there was a market in broadband so it could also apply mark–to-market accounting. How it did so is shown below. Enron was able to conjure up not only profit but also a very large sum of money that did not appear as a loan on the Enron financial earnings reports.

Here are the steps in the deal:

Enron signs a 20-year agreement with Blockbuster to deliver videos over the Enron broadband network.
Enron established a series of pilot projects in Portland, Seattle and Salt Lake City streaming movies to a few dozen apartments from servers set up in the basement.
Enron creates a partnership called Braveheart. The purpose was to get an investment bank to advance Enron the money it expected to make on the deal with Blockbuster. To capitalize Braveheart a small amount of money came from outside investors and Enron lent the partnership some stock.
Enron raised $115million from an undisclosed Canadian bank in return for a promise that the earnings from the deal would go directly to the bank if the earnings were not sufficient for the bank to recoup its investment Enron promised to repay the bank.
Enron used an undisclosed model to calculate how much revenue it could report from the transaction. It reported more than $110million as profit. Auditors from Arthur Anderson approved the accounting transaction.

Kristin Mordaunt, the Chief Counsel at the Broadband division who previously had established some of the complex partnerships for Enron’s Chief Financial Officer Fastow, established the Braveheart partnership.

Apparently the calculation of revenue was treated with some skepticism within Enron. The New York Times reports a former senior executive in the broadband division as saying It just didn’t make any sense. When we heard what they did, everybody’s mouths just hung open. We weren’ t doing business on any scale even close to those numbers. Enron was able to report the transaction as a sale rather than a loan because of the accounting rules covering the securitization of assets.

It is not clear whether the Enron Blockbuster deal was merely a device to pump up the earnings on Enron and its troubled Broadband division or was a genuine attempt to realize a killer-app for broadband. Certainly it was a very clever way to use accounting to raise money from a fairly insignificant broadband trial. Unfortunately Mark-to-Market accounting is widespread in telecommunication companies. It has been reported that Williams Communications has made extensive use of such transactions. The full uncovering of such transaction will add to the woes of the industry. I know of a number of broadband startups that could have made much better use of such an amount of money, especially at the time when significant investment dried up as a result of the NASDAQ downturn.