A Forensic Accountant's Winners and Losers from Pending Litigation

Annotated article summary from this weekend's Barron's. Receive all our Barron's summaries by signing up here:

Long Arm of the Law by Neil A. Martin

Summary: Nick Rodelli, analyst at the Center for Financial Research and Analysis, specializes in forensic accounting -- dissecting legal events likely to influence a company's future. He says the risks and opportunities inherent in litigation are poorly understood by equity analysts, and thus present a unique opportunity for investors who can assess when the markets have under- or over-compensated for the impact of litigation. Some examples:

• World Wrestling Entertainment Inc. (WWE) shares are down 13.4% since May. But lawsuits against software publisher THQ Inc. (THQI) and JAKKS Pacific Inc. (JAKK) could give WWE a 14-22% increase in earnings; the company derives almost 25% of its revenue from licensing.
• MasterCard Inc. (MA) faces anti-trust suits from American Express Company (AXP) and Discover over its 'exclusionary rule,' as well as regulatory pressure to reduce fees. The market has failed to take any of the risks into account; the damages could be in the "tens of billions." If MasterCard loses, American Express should benefit. He suggests a pair trade long AXP (16.5x earnings) and short MA (22.5x earnings).
• Sherwin Williams Co. (SHW) -- a recent ruling that found the company guilty of creating a public nuisance and health threat with its lead paints from decades ago, and demands a state-wide (Rhode Island) cleanup. Ohio, New Jersey, Wisconsin and California also have pending lawsuits. The company's 13.5x valuation and a 52% rise in share price since July imply the Street doesn't understand the risk that lead paint could become 'the next asbestos.'

• Qualcomm Inc. (QCOM) shares are down 20% since May, largely over an overreaction to its ongoing lawsuit with Nokia Corp. (NOK) and Broadcom Corp. (BRCM) over royalty payments; they say Qualcomm's 5% rate is too high. At 24x earnings, Qualcomm is near historic lows, leaving little downside risk and substantial upside should anything positive develop in the courts.
• Intel Corp. (INTC) failed to preserve key documents and now faces pressure from Advanced Micro Devices Inc. (AMD); the investigation into Dell Inc.'s (DELL) accounting practices may be more serious than they're letting on; Steve Jobs may yet be forced to leave Apple Computer Inc. (AAPL). On the other hand, investors have sold off Commerce Bancorp Inc. (CBH) shares over a relatively minor investigation.

Related Links: Sherwin Williams' Lead Trial: Once This Cloud is Lifted, the Bull Will Run • Analysts Remain Mostly Negative On Mastercard • Qualcomm Given Analyst Boost On Legal Prospects Versus Nokia • Merrill: Intel's More Interested In Crushing AMD Than Improving Margins