Reversal of Fortunes

A federal-court ruling stalls the IRS drive against abusive tax shelters. Also: finance stars glitter in a FASB film; a surprising haven for CFOs in private equity funds; seeking long-term incentive-pay goals; and more.


The Internal Revenue Service's crackdown on abusive tax shelters lost some momentum in October when a federal judge reversed a 1996 IRS determination and refunded more than $500 million, including five years' worth of interest, to Madison, N.J.-based American Home Products Corp.

The decision, by District Court Judge Paul L. Friedman, in Washington, D.C., held that the tax shelter, originally designed by Merrill Lynch more than 10 years ago and used by AHP in 1990, was legal. He also ruled that the IRS "erred" when it determined that the pharmaceutical company owed the government $226 million in back taxes. Interestingly, earlier this year the IRS chalked up three court victories--over Allied Signal Inc., Colgate- Palmolive Co., and Brunswick Corp.--that labeled the Merrill-designed shelter illegal. If the IRS appeals this most recent decision (notice of appeal is due this month), the case will move to the D.C. Circuit Court, the same venue that handed the IRS its win over Allied Signal.

The shelter in question, which uses a partnership to maximize tax losses on securities transactions, was used by all four companies. But the AHP case has some distinguishing characteristics, says Peter Norton, a New York tax attorney with Baker & McKenzie. Perhaps most significant, he says, is that AHP was able to document that the partnership was set up in a manner consistent with the company's standard business practices. That, says Norton, was enough to convince the court that the partnership was not formed solely for tax purposes, something the other three companies were never able to do.

According to the court documents, Judge Friedman also suggested that the IRS attorney's performance was less than stellar, noting that the agency's star witness--a disgruntled ex-Merrill employee--was discredited during the proceedings.

Norton muses that if the IRS does not seek an appeal, it may be because the Bush Administration contends that tax-shelter abuse is in decline, and that new regulations, such as the registration process, are quelling the misconduct. --Marie Leone

Strictly Show Biz

Can a movie help improve financial reporting? The Financial Accounting Standards Board thinks so. It has released a new 40-minute video that has some of the brightest stars in finance talking up the virtues of proper financial disclosure. At $15 a pop, the video is unlikely to out-gross Harry Potter, but Financially Correct is out to educate, not entertain.

While the message is aimed at nonprofessional investors, a FASB spokeswoman says some accountants and CFOs might benefit from the video's nuts-and- bolts lessons, though she declined to speculate on who exactly FASB has in mind.

The on-screen lessons are offered by none other than Goldman Sachs's Abby Joseph Cohen, former Undersecretary of Commerce for International Trade Jeffrey Garten, Merck CFO Judy Lewent, New York Times chief financial correspondent Floyd Norris, and Warren Buffett of Berkshire Hathaway. While backstage with his makeup artist, the moderator, economist-turned-actor Ben Stein, notes that numbers that lack credibility can be dismissed as mere "spin, rumor, and gossip." Trouble is, Wall Street is as good as Hollywood at make-believe. --Michael O'Loughlin

Going Private

At first glance, the private equity market might not look like a greener employment pasture for finance executives. An analysis by Mercer Management Consulting Inc. of leveraged buyout portfolios shows 50 to 60 percent of private equity funds that invested heavily between 1998 and 2000 would have negative returns if currently marked to market. But poor performance may represent a golden opportunity for financial executives sick of public companies

With portfolio companies underperforming, much of existing management is walking away, leaving a serious skill shortage, particularly in the financial areas. Private equity fund partners often help out during the start-up phase, but with anywhere from 5 to 10 companies to manage, there are limits. "A typical partner doesn't have time to turn around a distressed company," notes Parson Group LLC's Dan Weinfurter. "Just attending the board meetings of all their portfolio companies is a full-time job."

Instead, funds typically look to bring in help--and CFOs top the list. "Financial management is usually the weak link at portfolio companies," says Parthenon Capital CFO Terry Chvisuk. "That's where equity funds spend the most recruiting dollars." But what's the attraction for recruits?

For starters, says Chvisuk, it's often a chance for top-notch controllers to don the CFO title. And there's a payout for guiding a company to a successful exit within a defined time frame. Mercer vice president Neal Pomroy points out that one success often leads to another. "Once you are in the family of some of these active funds, it can be a very rewarding career," he says. Also, "there's a professional rush to be had for a CFO who works in that kind of environment, where the amount of debt puts a premium on speed, execution, and risk-taking," agrees Peter C. Jeton, CFO of Boston- based Heritage Partners Inc., a buyout fund specializing in family-owned businesses.

And for former CFOs of public companies, private equity has an added attraction. "These guys are in seventh heaven not having to deal with analysts and ongoing public reporting," says Chvisuk. --Tim Reason

Dispelling a Myth?

The traditional short-term incentive plan may be destined for the dustbin if an alternative adopted by a handful of companies is successful enough to win more adherents.

The conventional plan limits cash bonuses and links them to annual budgets, with the aim of meeting quarterly objectives. But while it may not fail at that, critics suggest that this type of arrangement also encourages employees to manipulate budgets in ways that hurt long-term performance. In that sense, say some consultants, the idea that bonuses linked to budgets are the best form of short-term incentive pay is actually a myth.

However, such companies as SPX Corp. and Briggs & Stratton Corp. have uncapped bonuses and decoupled them from short-term budget goals, instead linking payouts to stock performance. And that, asserts G. Bennett Stewart, a senior partner at the consulting firm Stern Stewart & Co., should discourage employees from gaming the system by, for instance, cutting funds for research and development to hit short-term earnings targets.

SPX, for one, swears by its plan. Chuck Bowman, director of corporate finance at the Muskegon, Mich.-based auto-parts maker, says the company hasn't seen any "sandbagging and negotiating of budgets" since it implemented the plan five years ago. Before that time, he says, bonus games at the company were the rule.

But the jury is still out on its ultimate success. SPX's shares have gained an average of 29.3 percent a year since 1996, compared with only 20.6 percent for the Standard & Poor's midcap index. In contrast, the companies that make up the S&P electronics and components index returned an average of 34.1 percent during the same period. --M.L.

Separation Anxiety

Most CFOs dismiss the notion that goodwill affects the price they're willing to pay in an acquisition. After all, goodwill is a noncash item, and most companies value assets based on discounted cash flow.

Nevertheless, the Financial Accounting Standards Board's new rule concerning goodwill in business combinations is having an impact on deal- making. One provision of FAS 141, as the rule is known, requires the separation and valuation of certain intangible assets from goodwill. The provision requires intangibles with determinable lives, such as patents and backlog, to be amortized over the lifetime of the asset. And the resulting earnings dilution is a definite turnoff, according to Alfred King, vice chairman of consultancy Valuation Research Corp., who says companies are fighting "tooth and nail" to get intangibles grouped with goodwill or classified with indefinite lives so amortization does not apply. He concludes that despite protestations to the contrary, CFOs care as much about EPS as they do about cash flow. "What is becoming crystal clear is that CFOs are vitally concerned about reported earnings," asserts the consultant.

King cites the example of one client that is in the process of completing an acquisition. "They have not closed the deal yet," he says, "but they are already recognizing that the intangibles have a short life. It's giving them heartburn." Although King says that isn't enough to make the buyer back out of the deal, he says it is very likely that the client will seek to negotiate a lower price.

More Than Accounting

Some CFOs concede that earnings dilution is an important consideration. "When you announce an acquisition, you talk to investors about accretion or dilution. An acquisition that includes intangibles would generally be less accretive to earnings," says Mary Kabacinski, CFO of School Specialty Inc., in Greenville, Wis. "If you're sensitive to extreme dilution, that might affect your decision to buy the target." However, she adds that although the dilution effect is a consideration, "it would not influence us one way or another regarding whether we buy a company," because cash flow is most

Martin Headley, CFO and treasurer of Bogart, Ga.-based Roper Industries, agrees. Although Headley says "the amortization of intangibles has little if any impact on our valuation as we are considering the cash returns," he does concede that amortization could be an issue when intangibles are large enough to turn an acquisition that would increase earnings into one that reduces them. "If this were the case for Roper," acknowledges Headley, "this might well have an impact on our valuation conclusions."

Investment bankers appear to support the notion that EPS dilution relating to intangible assets does indeed matter. "Public companies, and even initial public offerings, are often priced by analysts as a multiple of earnings per share, not cash flow," notes Doug Rogers, executive vice president at CBIZ Valuation Counselors. He says that many clients "are asking CBIZ to view acquisitions based on the old allocation rules versus the new rules."

Dealmakers may also want to look more closely at another new accounting rule, FAS 142, which concerns the conditions under which goodwill and other intangible assets must be written down because of impairment. The rule, warn some experts, makes it dicey to pay a high premium for intangibles, especially when market conditions are as volatile as they have been recently. "There's a potential impact on pricing because of the impairment write-down risk in the future," explains Pete Nachtwey, national managing partner for valuation with Deloitte & Touche LLC.  --Craig Schneider

Profit Picture

Impact of new goodwill rules on corporate profits:

  • Goodwill accounts for 83% of intangibles.
  • S&P 500 earnings "at risk" in Q4: 13%.
  • Estimate of benefits to S&P 500 EPS is $4 in 2002, a 7% increase over 2001.
  • Sectors garnering largest earnings benefits: media, telecom, aerospace, services, commodities, capital goods, and diversified.

Source: "No More Foolin' With Poolin'," July 2, 2001, UBS Warburg, New York

Facing the Hook

The use of poison pills to thwart hostile takeovers may be growing, but so is opposition by shareholder activists. In the latest skirmish, the activists won handily. Witness Navistar International, which had been at odds with investors for 10 months over its staunch refusal to rescind its poison- pill provisions.

But the Chicago-based heavy-duty truck maker is far from the only company eyed by leading activist Herbert A. Denton, president of Providence Capital LC. Denton says he expects to target about a dozen companies like Navistar in which, in his estimation, the high takeover costs associated with poison pills protect management from being held accountable for poor performance. Sure, management traditionally says such defense mechanisms are designed to foil a lowball tender offer. But, says Denton, "the best defense is a high stock price." And, he adds, "When there's a discrepancy between the share price and the value of the company, there are things management can do other than take comfort in the pill."

Navistar provoked Denton's ire, and risked a possible lawsuit, because it wouldn't budge even after 83 percent of its shareholders voted in February in favor of a nonbinding resolution to drop the poison-pill measure. "Something is dangerously wrong when an overwhelming majority of shareholders are ignored," says Denton. His two-pronged approach to forcing firms to respond to shareholders includes proposing an amendment to Delaware law that would give investors the power to force a board to rescind its poison pill, and attempting to replace boards of targeted companies with a slate of directors who oppose poison pills. "We'll find a company that wants to take us on in court," crows Denton.

Navistar CFO Bob Lannert says the prospect of doing battle with Denton had nothing to do with the board's decision to remove the poison pill. Rather, it was that Gabelli Asset Management, Navistar's second-largest shareholder with 9.5 percent of shares outstanding, had filed papers to bring the poison- pill issue to a vote again. --Stephen Barr

Open Books

The CFO of USA Networks Inc. has found a way to break free of the dreaded earnings-expectations game with Wall Street. Along with the release of its third-quarter results on October 24, the New York­ based media and commerce company disclosed its internal operating budget--yes, its entire annual plan through 2003, division by division--which prompted CEO Barry Diller to proclaim that USA would no longer participate in the "Kabuki dance" of guiding analysts.

"We think this is a better way of providing information," says CFO Mike Sileck. "We let analysts see our budget, which by definition is our best indicator of future activity, and we stop wasting time and energy on the game."

Most companies come up with internal goals and expectations, "and then water them down and give them out as earnings guidance," asserts Sileck. Observers confirm that executives regularly set the expectations bar low so that earnings exceed the number and garner a positive reaction from Wall Street. "That's a process we've chosen not to participate in," says Sileck.

Analyst Gordon Hodge of Thomas Weisel Partners LLC calls USA's move "very bold and honest" and "the right thing to do," especially since it allows analysts an opportunity to really understand the assumptions embedded in the business plans. "If we're doing our jobs," he says, "we can take the pulse of the marketplace and decide whether those plans can be met."

Sileck expects to field questions from analysts about major events or updates, but in keeping with his general practice, he won't provide interim comment. "Each quarter, we'll release our full results," he explains, "and if we think the balance of the year will be better or worse, then we'll update, just as we do internally."

Other companies may worry that similar budget releases will put useful information in the hands of competitors, notes Hodge, so they won't follow USA's lead. Still, he believes the company is at the forefront of "the disclosure curve." --S.B.

Global Confidence Survey: Desperately Seeking Silver Lining

It's no surprise that confidence in the short-term economy is low. The economic uncertainty that followed the September 11 terrorist attacks still looms over the domestic and global business landscape, casting its shadow on an already sluggish economy. Unemployment figures continue to creep up, while consumer confidence and spending decline. There's been a surge in layoffs and volatility in stock prices. As a result, only 11 percent of U.S. CFOs say they are confident about next year's global prospects, a slight slip from last quarter's vote, and a drop of 56 percentage points from Q4 2000, according to CFO's quarterly Global Confidence Survey.

The survey, which polled finance executives in the United States, Europe, and Asia about regional and global economic issues, found that 71 percent of U.S. CFOs are either concerned or very pessimistic about both the global and domestic economy in the near term. Weighing most on their minds is the economic downturn, a lack of capital, and increased competition. The confidence of Europe's CFOs is also waning, as 56 percent declare they are concerned or very pessimistic about their own short-term economy, compared with 26 percent last quarter. Asia's finance chiefs remain somber about short-term domestic prospects: like last quarter, 86 percent claim to be concerned or pessimistic.

All told, only 13 percent of CFOs from all three continents can muster any optimism or confidence about the near-term regional economies--quite a decline from Q4 2000's 61 percent and last quarter's 22 percent.

One near-term bright spot did emerge from the survey. Sixty-three percent of U.S. CFOs will either increase or maintain their current level of capital spending next quarter, and 70 percent of Europe's CFOs will do the same. However, only 43 percent of Asia's executives will increase or maintain current levels.

The five-year outlook once again is sunny: 74 percent of U.S. CFOs are optimistic or confident about the long-term global economy, while 81 percent give a thumbs-up to the domestic economy. -- M.L.

CFO Global Confidence Survey Results

Attitudes toward global economy in the short term:
 United StatesEuropeAsiaGlobal
Very optimisticn/an/an/an/a
Very pessimistic4%9%19%11%
Attitudes toward own region in the short term:
 United StatesEuropeAsiaGlobal
Very optimisticn/a6%n/a2%
Very pessimistic4%9%30%15%
Attitudes toward global economy in the long term:
 United StatesEuropeAsiaGlobal
Very optimistic4%11%3%6%
Very pessimisticn/a3%3%2%
Capital Spending projections for next quarter
 United StatesEuropeAsiaGlobal
Up by 5+%33%20%6%18%
Up by <5%11%14%9%11%
Down by <5%4%8%3%5%
Down by 5%+33%22%54%37%
No change19%36%28%29%

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