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Monday, March 26, 2007
Long Arm of the Law
By NEIL A. MARTIN
SHARES OF WORLD WRESTLING ENTERTAINMENT have been smacked down 13.4% in the past 10
months, to 15.60, as some of the company's television superstars, including "The Rock," have defected
to Hollywood. But better days could lie ahead for the Stamford, Conn., provider of wrestling-related
products and entertainment (ticker: WWE), especially if it wins several lawsuits filed in recent years
against licensees it alleges have illegally acquired the rights to its name and franchise.
Though World Wrestling has mentioned these suits -- against videogame-software publisher THQI
(THQI) and a joint venture controlled by THQI and toy maker Jakks Pacific (JAKK) -- in its regulatory
filings, you won't hear much about them on the company's quarterly conference calls. That's all the
more reason for investors to turn to Nick Rodelli, an analyst at the Center for Financial Research and
Analysis and head of the forensic-accounting firm's new Legal Edge research service. Rodelli, who joined
CFRA last fall, specializes in dissecting legal "events" likely to influence companies' earnings and shares.
"Litigation has always been out there, but in the wake of Sarbanes-Oxley, legal issues have become
more prevalent," says Rodelli, 34, a former corporate litigator, Securities and Exchange Commission
lawyer and legal analyst for a hedge fund. "More often than not, the shares of companies with
outstanding legal issues are mispriced because they fail to reflect the potential negative or positive
impact of recurring issues. Awareness of mispricing can be the difference between profit and loss for an
investor."
For World Wrestling, which derived almost a fourth of its 2006 revenue from licensing, a win in court
"could provide a significant, recurring boost to financial results, specifically a 14% to 22% increase in
earnings before interest and taxes.
An indication that things are moving in the right direction for
the plaintiff could come within a few months if the company
succeeds in defeating a pending motion to dismiss its federal
racketeering suit against the THQI-Jakks joint venture. "Such
an event may provide the catalyst for investors to begin
reassessing World Wrestling's earnings power, based on
expectations of a higher royalty-income stream from WWE-
branded videogame sales," Rodelli observes.
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CFRA was founded in 1994 by Howard Schilit, a former accounting professor at American University, and
quickly attracted a faithful following on Wall Street by spotlighting questionable accounting and
bookkeeping practices at publicly traded corporations.
Short sellers, in particular, came to rely on the firm's research, which helped expose problems at New
Century Financial (NEWC), Delphi (DFG), Krispy Kreme Doughnuts (KKD) and Shuffle Master
(SHFL), among others. In an admiring profile two years ago, Barron's called CFRA "one of the true
leaders in forensic accounting" ("Super Sleuths1," Feb. 28, 2005).
The legal issues affecting corporations have multiplied in recent years, in part because of greater
regulation, more attention to corporate governance and the growing importance of technology in
numerous businesses. Yet the risks and opportunities inherent in legal decisions are even less
understood by equity analysts and investors than accounting issues.
"We try to provide a real-time perspective on emerging legal and regulatory events," says Richard
Leggett, who succeeded Schilit in 2005 as president and CEO of CFRA. Schilit sold his controlling interest
in the Rockville, Md., firm in 2003 to the venture-finance firm TA Associates, but he remains an adviser
to the company.
Consider MasterCard (MA), the Purchase, N.Y.-based credit-card issuer, which faces not only antitrust
suits brought by American Express (AXP) and Discover, seeking billions of dollars in damages, but
regulatory efforts to reduce fees and encourage more competition. In Rodelli's view, none of the risks
associated with these issues is reflected in MasterCard's shares, which have almost tripled since the
company came public last May and now trade for 108, or 22.5 times consensus 2007 estimates.
"THE MARKET HAS BEEN mesmerized by the great numbers posted by MasterCard since it went
public, but is ignoring the greater threat to its operations from current legal risks," he says.
Rodelli expects these risks to gain more attention in coming
Table: On the Docket2
months as the antitrust suits move toward trial and regulatory
scrutiny of the company's fee structure heats up. Not only
could damages be in the "tens of billions of dollars," he says, but "the market fails to appreciate the
strategic interest of both American Express and Discover in using their strong antitrust claims to gain
long-term advantages in the marketplace, as opposed to a one-time settlement payout."
If MasterCard appears to be the loser, American Express conceivably will benefit from the litigation,
which focuses on the so-called exclusionary rule by which MasterCard effectively sought to prevent
banks that issue its card from issuing AmEx or Discover cards. (The Department of Justice challenged
this rule and won; the American Express and Discover lawsuits piggybacked off the DOJ action.)
Consequently, the two stocks might make for "an excellent pair trade," says Rodelli, with an investor
buying American Express at 16.5 times "07 estimates, and shorting MasterCard. (Shares of MasterCard
have fallen about 2% since CFRA issued its first report Feb. 1, while American Express is roughly flat.)
Paint maker Sherwin-Williams (SHW) also faces potentially significant risks from litigation, says
Rodelli. The threat to Sherwin-Williams comes from a recent ruling by a Rhode Island state judge,
upholding a jury verdict that found the Cleveland company guilty of creating a "public nuisance" and
health threat with its lead paint products, sold many decades ago.
The court also is demanding a statewide cleanup. Although Sherwin-Williams has said that it will appeal
the ruling, other cases against it are pending in Ohio, New Jersey, Wisconsin and California, prompting
fear that lead paint could become "the next asbestos."
The company's shares have held up well in the face of legal threats and decisions, and its operating
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performance has been strong. Sherwin-Williams has rallied more than 52% since mid-July, to 67, and
currently trades for 13.5 times Wall Street's 2008 earnings estimate of $4.98 a share.
The company's valuation "doesn't reflect the significant risk," insists Rodelli. If law firms begin to see
lead-paint litigation as "an attractive return on investment," he adds, today's trickle of cases could turn
into a torrent.
JUST AS INVESTORS ignore legal risk, they sometimes overreact to litigation and miss potential
opportunities in mispriced stocks. That may be happening with Qualcomm (QCOM), a provider of
wireless technology, which is embroiled in legal controversies with Nokia (NOK), Broadcomm (BRCM)
and others.
The disputes center largely on the future division of royalty payments on third-generation, or 3G,
mobile-phone technologies; Nokia has charged that Qualcomm's royalty rates of around 5% are too
high, while Qualcomm has filed patent-infringement claims against Nokia.
The disagreements have weighed heavily on Qualcomm's stock, which peaked at 53 in May, troughed at
33 in August and now trades around 43. But with the shares fetching 24 times expected earnings (minus
cash) -- a valuation near historic lows -- Rodelli argues that there's little downside risk, and substantial
upside if "any positive catalysts" arise on the legal front.
"Nokia already has done its damage to Qualcomm's share price, expending a great deal of its bargaining
leverage in the process," he says. The end result could be a compromise that tilts in Qualcomm's favor.
The Bottom Line LEGAL EDGE, which CFRA launched in January, also has
followed Advanced Micro Devices' (AMD) antitrust suit
against Intel (INTC). Rodelli sees strategic benefits for AMD,
World Wrestling, American Express and
Qualcomm could be helped by court cases. as the litigation overhang could provide the semiconductor
MasterCard and Sherwin-Williams could be company a window of opportunity to establish relationships
hurt. with computer suppliers like Dell (DELL). Moreover, Intel
allegedly failed to preserve key business documents, he says.
Rodelli warned clients early on that a probe of Dell's accounting practices by the SEC could be more
serious than the company initially had indicated. He argued investors were overreacting to a disclosure
by Commerce Bancorp (CBH) of investigations by the Comptroller of the Currency and the Federal
Reserve, which involved charges of "related-party dealings" by the bank's CEO and his wife; they fell
short of "major investigation" status, he said.
He also expressed concern that Steve Jobs might yet be forced to leave Apple (AAPL) because of
ongoing probes into the company's alleged backdating of stock options. And he highlighted how Crocs
(CROX) potentially could beat back knockoffs as a result of a decision involving the footwear maker's
patent-infringement claims before the International Trade Commission.
"THE MARKET TENDS to look at these kinds of legal issues in a binary way: either this or that is going
to happen and, when it does, it's all over," says Rodelli. "The reality is that legal issues are like onions.
You peel away one layer and there's another one below, and another."
Small wonder it often is hard for investors to distinguish good news from bad in matters before the
court. Or that, with companies increasingly incorporating litigation into their business plans, Rodelli's
docket is likely to stay full.
E-mail comments to editors@barrons.com3
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