The Con(fidence) Game

May 15, 2020

I recently finished reading a fascinating book about the Enron financial crisis – The Smartest Guys in the Room by Bethany McLean and Peter Elkind.  The book was released in 2003 and turned into a documentary in 2005 which I need to watch.  I am sure it is good, as it was directed by Alex Gibney who is one of the best documentary filmmakers out there.  It’s hard to believe the events of this story took place about 20 years ago.  I know a lot of the history of how and why Enron fell apart (I was in the auditing profession during this time and one of the outcomes of the scandal was the collapse of Enron’s auditor, Arthur Andersen) but the book digs into a lot of the details of how the executives who ran Enron pulled off a staggering level of fraud to mislead investors about the company’s real financial condition.  The machinations that Enron used were very complex, so the book is pretty dense in terms of technical details, but it’s catnip for a self-aware accounting nerd like me.  As I was finishing the book, I couldn’t help but connect the themes in the book to our current situation.

Some Background

For those of you who don’t know the background, I’ll give a quick recap.  And for those of you who are not fellow accounting nerds, I’ll try to simplify.  Enron used a complex set of financial transactions to overstate the amount of money they were making each year, hide their true debt, and mislead their investors that they were in a strong financial position, when in reality, they were a ticking timebomb.  It’s helpful to note the difference between “accounting income” and “cash income.”  When companies report their “earnings” each quarter, they are reporting income as defined under accounting rules, which is not the same as when cash is transacted.  The easy example is this:  When a company ships a product to a customer, they count it as revenue, even if they are not paid in cash a few months later.  Also, companies can value some of their assets based on “market value”, regardless of when that value will be realized – in essence, creating profits on paper but not yet realized in cash. 

While “earnings” get a lot of headlines when companies report their results, the astute investors and analysts judge the strength of a company based on their cash flows (how much cash they are collecting vs. dispersing) and their balance sheet (assets compared to liabilities).  Enron reported great earnings using fraudulent accounting gimmicks, but terrible cash flow and a weak balance sheet.  In addition, they incurred a material amount of debt following poor business investments and lavish spending, and then hid the debt from their balance sheet using complicated accounting transactions.  When smart analysts and journalists started poking at how they really made money, the schemes started to unravel, the true debts became due, they ran out of cash, and the company quickly collapsed like a house of cards.  As we used to say where I worked, “Cash is king” – at the end of the day, it all comes down to how much cash you have to manage your business for an extended period of time.

The leadership at Enron conducted a massive fraud, pocketing tens of millions of dollars in personal gains, and some of them went to prison.  They misled investors, customers, and employees on an enormous scale.  They were the textbook definition of “con artists” – they told their investors and Wall Street analysts what they wanted to hear, gaining their “confidence” and never looked back while they reaped the personal financial windfall.

Why Are We Talking About Enron?

Throughout all of the conversations and debate of “re-opening” the economy/country the last several weeks, I keep thinking of the phrase “consumer confidence.”  The strength of an economy is largely built on the strength of consumer sentiment, much like the strength of an individual stock is built on the confidence of an investor in that stock.  If consumers feel confident in their financial strength (current assets compared to their debt, future income potential, job security), they will be more likely to spend their money.  If consumers spend money, companies generate revenue, which allows them to invest in new products and services and create jobs.  Think of it as an economic flywheel.  When one of the components breaks, the whole system can collapse.

It’s been fascinating to see the dramatic difference in how the pandemic has affected some industries compared to others.  Certain industries (grocery and pharmacy stores, online retail, consumer products) have thrived, while others (clothing retail, airlines, hotels, entertainment) are struggling and some are hanging on for dear life.  I also think there will be a second wave of troubled industries to come (commercial real estate comes to mind).  As I mentioned a few weeks ago, those companies who are best positioned from a cash / liquidity standpoint will be able to weather the storm the longest until customers are confident enough to come back. 

So, what does that look like?  It’s interesting to me that “confidence” plays out in two ways here.  Usually, it means consumers are confident they can afford to make a purchase – a new car, a new house, sign a new lease, buy new furniture.  Recovering from a pandemic, we have added a new definition of “confident” – when customers will be confident that it is safe to shop at malls, go to restaurants / bars, fly on an airplane, go on a cruise, attend a large sporting event / concert. 

I’ve been encouraged by government officials who are taking a thoughtful approach to reopening, looking at the data week to week, planning for multiple phases at once, and most importantly – speaking in a candid and transparent manner.  As I have said before, when I hear a government official say the phrase, “we don’t know the answer to that” when responding to a question, or “we need to think through some options”, they have a lot of credibility in my mind because they are being honest.  I also like seeing the acknowledgment of feedback from constituents and flexibility in modifications to re-opening plans, as more information is gathered.  The data is moving fast and we are in the ultimate state of unknown – trying to do 20/20 hindsight finger-pointing will not be helpful.  The governors are in tough positions – they have to balance the safety of their citizens with the demands from business owners to let them open up and go back to work.  These are the competing interests in trying to manage both a health crisis and a financial crisis at the same time.  I don’t understand governors who are establishing policies that last for another three months – just think how much has changed in the last three months.   To me, it’s best to have multiple contingency plans based on a certain set of scenarios, and when you get to the execution date, you implement the best plan based on the scenario at that time.

The point of all of this is simple – the consumers will determine the success of the economy, based on how they feel.  Most importantly, it will be a gradual return – there is no light switch you can flip and turn things back to the way they used to be.  And it’s going to take some time.  While I worry about the impacts on the economy, we’ve only been at this for eight weeks, and there are significant financial safety nets that have been put in place.  Yes, they may not be enough, but hopefully there will be more assistance to come to those most in need.  We always hear about how the country came together during World War II to fight a common enemy and everyone pitched in to do their part.  This country fought World War II for four years.  Admittedly, I need to learn more about that time in our country’s history.  I just found a book about the home front during World War II that is next on my list to read.

Back to my point.  As a government leader, you can set guidance, regulations, and do your best to enforce them, hopefully using common sense and scientific data as you do so.  You can’t just give up because it’s hard or you’re bored.  You can’t command the economy “re-opened” by fiat, and tell citizens to take back their states and expect it to be successful.  It may help the financial crisis short-term, but it could be very detrimental to the health crisis, both short-term and long-term, which will further set back the economy.  Like the Enron example, you can’t just tell people to be confident in what you are selling them and expect them to buy it…..unless, of course, you are nothing but a con artist.

This Week’s Moment of Happiness

This was a tough week for me personally, starting to worry about all of our plans this year slipping away.  But I’m coping as best as we all can these days.  I can neither confirm nor deny that I may have developed an unhealthy emotional attachment to Ben & Jerry’s ice cream.  As I have said before, I am not a trained mental health professional, so I won’t try to self-diagnose.  And please don’t judge – we’re all coping in our own ways.  Moving right along…..

No, my moment of happiness this week was not related to ice cream.  The Lollapalooza music festival recently started posting videos of performances from older festivals.  This week, they live streamed the 2011 performance of Foo Fighters and it was fantastic to watch.  Quick diversion – is anyone else getting really tired of the somber and maudlin music in commercials these days?  We get it – we’re all in this together, you’re with us, yadda yadda yadda, but can we get some happier music?  Even some of the live stream events from musicians seem to be following the same path of sad songs.  So, I was glad to distract myself for two hours watching one of my favorite bands play some loud f*cking rock music at a concert held during a simpler time.  It was an excellent performance all around – these guys bring it every night and I am glad I had the opportunity to see them at Fenway two years ago.

Related to this moment was an essay that the band’s lead singer and founder, Dave Grohl, wrote for The Atlantic this week.  It’s titled “The Day the Live Concert Returns”, with the subtitle, “I don’t know when it will be safe to sing arm in arm at the top of our lungs. But we will do it again, because we have to.”  In the essay, he talks about how much the band misses playing for its fans and the joy he has experienced in his life seeing live music and a surreal experience where Bruce Springsteen was at one of his shows and complimented him on the performance.  You can read the article here.

I am always inspired by musicians who are genuine when they talk about playing live – you can tell when they mean it and are not just going through the motions.  In the band’s film Back and Forth, Grohl talked about the excitement, nervousness and honor he felt when the band was asked to play in front of 85,000 fans at Wembley Stadium, and during a point in the concert, you can tell that he was overwhelmed by emotion.  You can see the clip from the film here.  Grohl recognizes he is lucky to have experienced the success in his music career and he wants to get back out there to reward the loyalty of his fans.  I think he’s one of the rare celebrities who “gets it.”  One last great Grohl anecdote – check out this story he told on the James Corden Show – it’s only a few minutes long and you won’t regret it.

That’s all for this week.  I’m going to steer back into my lane next week and give a Summer Movie Preview.  It might be only 250 words – nah, I’m just kidding.  There’s plenty of action going on in the movie industry and there are some great movies on the way very soon – we just may need to get a little creative to see some of them.  Thanks again for reading and if you want to subscribe to be notified of future posts, you can subscribe here.