A Forensic Accountant's Winners and Losers from Pending Litigation

by: SA Eli Hoffmann

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. (NYSE:WWE) shares are down 13.4% since May. But lawsuits against software publisher THQ Inc. (THQI) and JAKKS Pacific Inc. (NASDAQ:JAKK) could give WWE a 14-22% increase in earnings; the company derives almost 25% of its revenue from licensing.
  • MasterCard Inc. (NYSE:MA) faces anti-trust suits from American Express Company (NYSE: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. (NYSE: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.'
  • Gavel 26 03 2007
  • Qualcomm Inc. (NASDAQ:QCOM) shares are down 20% since May, largely over an overreaction to its ongoing lawsuit with Nokia Corp. (NYSE: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. (NASDAQ:INTC) failed to preserve key documents and now faces pressure from Advanced Micro Devices Inc. (NYSE:AMD); the investigation into Dell Inc.'s (NASDAQ:DELL) accounting practices may be more serious than they're letting on; Steve Jobs may yet be forced to leave Apple Computer Inc. (NASDAQ: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 RunAnalysts Remain Mostly Negative On MastercardQualcomm Given Analyst Boost On Legal Prospects Versus NokiaMerrill: Intel's More Interested In Crushing AMD Than Improving Margins