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Merger Drain

Plus, Frederick's of Hollywood wants more cleavage, less leverage; software termination fees add to merger costs; judicial guidance on E-mail snooping; and more.
CFO Staff, CFO Magazine
September 1, 2001

MERGER DRAIN

Most everyone knows that consolidation-related IT savings rarely live up to the premerger hype. Once touted as a benefit of mergers, the integration of information technology systems and the elimination of duplicate ones often costs more than it saves in the short term. Add one more IT cost to the merger money pit: Lawyers say companies have failed to notice early-termination fees linked to software licenses. "Multi-billion-dollar merger deals can carry $10 million worth of software license termination fees," says Rob Kiesel, an attorney with Schulte Roth & Zabel, in New York. "And smaller deals often carry proportionate penalties."

In general, software vendors restrict transfer of assignment, so merger partners cannot shift their licenses to a new parent company to avoid triggering termination clauses. As a result, companies are left with few alternatives save to pay the fees. Due diligence isn't even enough. The payout is usually the aggregate fees of thousands of small IT contracts, making it virtually impossible to review all the nonmaterial pacts before the merger is approved. Flexible contracts are one answer, but they carry higher up-front costs. -- Marie Leone

CFO IN SHINING ARMOR

Fixing Frederick's

Want more proof that turnarounds are more challenging in this economy than they were during the last recession? Consider the task facing Craig Boucher, interim CFO at Frederick's of Hollywood. (Boucher is on loan from Irvine, Calif.-based Crossroads LLC.)

Not only is he fixing a highly leveraged balance sheet, he's also got to firm up the company's business plan and operations.

Saddled with $44 million in debt from a 1997 leveraged buyout, the lingerie retailer's fortunes declined when it experimented with a more upmarket image and committed the cardinal sin of limiting the trademark décolletage on its catalog covers. "Cleavage is the Holy Grail," says Boucher of his adopted company, which has been in Chapter 11 since July 2000.

All interim CFOs establish a relentless grip on cash, but Boucher also worries about fixing IT, upgrading shabby stores, and retooling the Web site. Among the tasks he helped to tackle was a study of Frederick's retail operation. Because some malls refuse to accept the racy retailer, "stores were opened haphazardly," says Boucher. The stores also suffered from a pattern of deferred maintenance, which was blamed for a drop in sales that took Frederick's from its onetime peak in the catalog business of $70 million in 1997 to $30 million last year. "The stores were buoying the company, yet they were being neglected," he asserts. Even worse, there was no coordination between store and catalog, as the same items were assigned separate inventory and SKU numbers. "They were buying the same stuff from different vendors."

Boucher even took a strong interest in the company's Web site, which was, he says, "big on bells and whistles, but low on functionality." Like most turnaround specialists, he has a low opinion of the failed dot-coms that litter the current landscape, but he was keen to come to this demoiselle's distress. "Frederick's is a very innovative company," says Boucher. "It introduced black lingerie from France in 1945. It sold the first bikini in the U.S. And in 1981, it brought the thong from Brazil." What dot-com can claim that kind of cultural impact? --Tim Reason

THE SEC OFFICE of the Chief Accountant seeks candidates to fill four accounting fellow positions. The two-year terms begin June 2002.

TREASURY ALERT

Plugging Another Loophole

Timing is everything, especially when it comes to taxes. So the Internal Revenue Service wants to tighten the leeway corporate treasurers enjoy when they "pick and choose" the tax treatment of contingent, nonperiodic notional principal contracts (NPCs).

Typically swaps that tie payments to movements of a specific index, NPCs fall outside IRS rules for derivatives taxation. This makes them the perfect vehicle for turning capital losses, which are amortized over a certain number of years, into ordinary losses, which are deducted in their entirety--or vice versa, depending on which saves the most taxes in any given period.

Without IRS guidance, treasurers can choose among several treatments of NPCs so as to produce a desired tax result. At least that's the case for now.

The IRS, well aware that treasurers can easily "whipsaw" the government with this flexibility, plans to codify and regulate the timing and characterization of nonperiodic payments, as well as those for other financial instruments, just as soon as it figures out how. According to the July Internal Revenue Bulletin, "The existing rules for various financial instruments are so inconsistent with each other...that it is difficult to decide which set of existing rules should be followed."

So the IRS is soliciting comments on four suggested taxation methodologies, and inviting original ideas, until late November. "The focus may be on specific products, but it really seems as though the IRS is interested in revamping the tax rules for financial products in general," says William Pomierski, a tax attorney with McDermott, Will & Emery and co-editor of the Journal of Taxation of Financial Products.


In fact, the IRS has talked about releasing new rules on a wider range of tax-planning instruments before it issues new guidelines on the nonperiodic contracts. So you won't see new regulations on NPC's anytime soon.

"The IRS wants rules that don't game the government, but anything more than legislative tweaks would probably require congressional approval," notes Andrea Kramer, a tax attorney and the author of Financial Products: Taxation, Regulation and Design. Still, experts say change is inevitable within a few years. --Alix Nyberg

EMAIL MONITORING

Every Breath They Take?

If you want to rifle through your employees' stored E-mail messages, rest assured that the courts are on your side.

In her opinion in Fraser v. Nationwide Mutual Insurance Co. et al., Judge Anita B. Brody of the U.S. District Court for the Eastern District of Pennsylvania ruled that because the company accessed Richard Fraser's E-mail from the message storage system after it had been read by its intended recipient, it was not in violation of the Electronic Communications Privacy Act (ECPA) of 1986--the law originally written to protect citizens from illegal wiretapping. Intercepting a message before it is read, however, is a violation.

The judge also noted that although Nationwide's retrieval of Fraser's E-mail (which stemmed from a dispute over his noncompany business interests) could be ethically questionable, "it is not legally actionable under the ECPA."

That's good news for companies that regularly shadow employee E- mail, which almost half of all U.S. corporations do. Nearly 47 percent of the companies polled in the American Management Association's 2001 Workplace Monitoring and Surveillance Survey reported that they store and review employee E-mail messages--more than a 300 percent jump from 1997.

The "climate is not favorable for employees," says Thomas Smedinghoff, a partner in the Chicago office of law firm Baker & McKenzie. Even when companies do not warn employees that E-mail is under a watchful eye (Nationwide did), Smedinghoff confirms that employers generally have the right to monitor E-mail for legitimate business purposes.

Companies may have carte blanche to monitor employee E-mail, but workers still have legal recourse if the information gleaned is not used judiciously. That includes, says Smedinghoff, using the information to defame a worker or wrongfully dismiss an employee with a medical condition that is revealed through an E-mail sweep. -- Joan Urdang

E-STAKEOUT

Percentage of U.S. companies that are keeping tabs on employees.

Source: American Management Association

CASH SEVERANCE payments for senior execs dropped by 12%--to 37 weeks--during the past four years, reports Manchester Inc.

DEBTOR'S PRISON?

Too Little Equity May Breed Myopia

Modern finance theory posits that, all things being equal, debt is superior to equity as a source of capital. However, a new study suggests that borrowing can encourage myopic thinking on the part of management.

To be sure, debt carries significant tax benefits, is cheaper than equity, and provides more value to stockholders in a leveraged buyout. But the study's authors--Anil Shivdasani, a vice president with Salomon Smith Barney in New York, and Urs Peyer, an assistant professor of finance at INSEAD, in France--find that a heavy debt load can hurt corporate growth by leading companies to focus too relentlessly on short-term cash flow, thereby losing strategic focus.

Shivdasani explains that if management lacks discipline, a major shift from equity to debt often causes capital to be funneled to projects or business units that generate quick returns. Essentially, adds Peyer, the company begins to manage for short-term cash flow as internal capital is earmarked for debt and interest repayment and long- term investment opportunities are neglected.

The study, "Leverage and Internal Capital Markets: Evidence from Leveraged Recapitalization," was published in the March issue of the Journal of Financial Economics, while the researchers were colleagues at the University of North Carolina at Chapel Hill. They studied 22 U.S. companies that underwent leveraged recapitalization between 1982 and 1994, including USG, Owens Corning, Phillips Petroleum, Texaco, Union Carbide, and Goodyear Tire and Rubber. Examining leveraged recaps allowed the duo to quantify a comparatively "pure" change in leverage, while the 12-year span gave them enough data to chart meaningful postrecap results. On average, the companies in the study had a 17 percent debt-to-total-capital ratio before they leveraged up. That rose to 50 percent after taking on the extra debt. By comparison, the average for their unrecapitalized peers was 21 percent.

The paydown was so aggressive at these companies that within three years of the recapitalization, the ratio sank to an average 30 percent. To ensure that the findings were not a "statistical artifact," the researchers also examined company annual reports and press coverage immediately following the recaps. Almost all firms in the sample described measures, such as asset sales and reduction in capital expenditures, designed to improve cash flow, says Shivdasani. Several affirmed that generation of cash flow was a key strategic objective.


To give more weight to the findings, the team tested the market's reaction to companies that managed for short-term cash flow. Using a stock-price-based yardstick--an excess value measure that calculates worth relative to corporate peers--they found that firms focused on short-term cash flow did decidedly worse during the three years following the leveraged recap than companies that managed to satisfy corporate economics.

Critics contend the study paints too broad a picture. Dennis Soter, head of the corporate finance practice of consulting firm Stern Stewart & Co., points out that the problem with many highly leveraged companies is their strategy, not their capital structure. He cites several poststudy cases, including SPX Corp., Equifax, and Ipalco Enterprises, that kept investment strategies intact despite leveraged recaps.

In April 1997, for instance, auto-parts manufacturer SPX completed a $100 million leveraged recap that raised its debt-to-capital ratio from 70 percent to 118 percent. A year later, after passing up smaller acquisition targets--and amid financial meltdowns in Asia, Russia, and Brazil--the junk-rated SPX raised a $1.65 billion loan package through a bank-loan syndication and scooped up $2 billion (in revenues) General Signal, a company twice its size. The move completed SPX's repositioning from an auto-parts supplier to a higher-margin specialty services company--and boosted its prerecap stock price by more than 50 percent.

Looks like the debt-versus-equity debate will go on for at least a little while longer. --M.L.

NEGATIVE REACTION

Company growth rate levels sink after recaps.*

 Overall

Within industry

Capital expenditures-34%-43%
Sales-9%-21%
Asset-14%-21%

*Growth rates calculated from year prior to leveraged

recapitalization through one year after.

Source: "Leverage And Internal Capital Markets" Study, March 2001

EMPLOYERS PREVAIL in 66% of job- discrimination suits in federal court and win nearly half of their appeals, says PlanSponsor.com.

REPORTING PUSH

First Mover Advantage

Battles are won, goes the Civil War­era maxim, by he who "gets there first with the most." The same applies to investor relations, says Mike Coke, CFO of AMB Property Corp.

In 1999, the San Francisco­based real estate investment trust (REIT) reported its results a full month after the close of the first quarter. "Fifty other companies reported earnings that week," notes Coke, including most of his competitors. "I wanted AMB to become the benchmark for the industry." So he pushed the company to report earnings earlier. Much earlier.

Coke dubbed his goal "GE minus one," and tied employee bonuses and vendor incentives to AMB's ability to beat General Electric Co.'s early reporting date by a day. AMB hit that goal in the second quarter of 2000, and this year it has twice reported on the second Monday of the quarter, beating GE by three days.

The result? AMB gets a lot more attention, says Coke. Seventeen analysts cover the company, an increase from 9 in 1999. In addition, the number of analysts and investors listening in on earnings calls has more than tripled, to 140. "It's all the big analysts and investors," says Coke. "And the quality of coverage is a lot broader now."

"It helps me not to have three other calls to cover the same day," agrees institutional investment analyst Jim Sullivan of Green Street Advisors, in Newport Beach, Calif. "The most impressive part is that AMB has shown that its reporting systems are superior to those of the other real estate companies that we follow." But, he adds, "it also sets AMB up as sort of a lightning rod, especially if there is negative news."

That's OK with Coke. "It has probably led to some overanalysis," he concedes, "but I prefer that to no analysis. The worst thing that can happen is to be unimportant."

Another benefit, he says, is that "backroom accounting people now feel that they are part of the success of the business." Releasing numbers in the elite company of GE and others, Coke explains, "gives them something to be proud of."

That's true even when there's bad news, as there was last quarter. Like many REITs, AMB invested overenthusiastically in the tech sector. Once again, though, the company was first with the most, aggressively writing down its investments to zero, a move other REITs were forced to follow. "AMB set the tone," says Sullivan. "It put the onus on other companies to come clean as well." --T.R.


STATE OF THE UNIONS

Will They Love It at Levitz?

Levitz Furniture Co.'s recent victory against organized labor may have lost the war for other companies trying to decertify unions.

In 1994, the Pleasanton, Calif.-based Levitz refused to negotiate a new contract between the United Food and Commercial Workers (UF&CW) Union and one of its 60 stores. Levitz claimed that under the "good- faith doubt" standard set by the National Labor Relations Board (NLRB) 50 years ago, its unilateral decertification of the union was permissible because the store management received an employee petition-- signed by what it deemed to be a majority of the workers--stating that they no longer wanted to be represented by the UF&CW. When the contract ran out on January 31, 1995, and the store became a nonunion shop, the UF&CW filed charges against Levitz to force recertification.

The NLRB finally ruled in favor of Levitz last March, but also decided that the 1951 doubt standard was fundamentally flawed, because it allowed employers to withdraw recognition from unions that may not have lost majority support. Following a sweeping rewrite of the rules, the new "good-faith reasonable uncertainty" standard requires companies to bear the burden of proof--preferably through a formal election and not a petition--that a union has lost majority support among workers. "The onus to show the loss of support has shifted from the workers to the employer," says Dan Earls, president of UF&CW Local 101.

Companies gained one small concession: The NLRB lifted restrictions on calls for elections, which makes it easier for companies to test an incumbent union's strength. But Kate Bronfenbrenner, director of labor education research at Cornell University, points out that it's never been easy to break a union, and the new rules don't change that. -- J.U.

CORPORATE TAXPAYERS will get a break from Treasury after tax-shelter disclosure regs are modified in time for the September filing.

GLOBAL CONFIDENCE SURVEY

Legends of the Fall

There's a chill in the air, but don't blame it on the approach of autumn. Missed earnings reports, record-setting layoffs, and stock-market and productivity slides have cooled corporate enthusiasm, as only 13 percent of U.S. CFOs registered a vote of confidence in the global economy for the next year: a 53 percent drop from last quarter and an 82 percent fall from Q3 2000. More telling, 53 percent of the U.S. finance chiefs say they are concerned about near-term global prospects, and 56 percent are either concerned or very pessimistic about the domestic prognosis for the same period, according to CFO's quarterly Global Confidence Survey.

The survey, which polls finance executives in the United States, Europe, and Asia about regional and global economic issues, points to a 59 percent decline in global confidence among all respondents compared with last quarter's attitudes about the near term. An especially glum response from Asia's CFOs weighed heavily on the collective confidence. A staggering 86 percent of the Asian executives say they are either concerned or very pessimistic about the global economy during the next year, a 19 percent slip in confidence from last quarter.

Attitudes improve with time. Overall, 72 percent of the CFOs are confident or very optimistic about the global economy during the next five years: that's up from last quarter's 67 percent and closing fast on Q3 2000's 74 percent. When asked about long-term global prospects, Asia's CFOs recorded a 12 percent jump in confidence from last quarter, with 59 percent of them confident about the next half-decade. Seventy-two percent of the U.S. contingent is also confident about the next five years, registering a 14 percent rise in confidence from last quarter, while European CFOs cast the highest vote of self-assurance--78 percent--a 12 percent increase compared with Q2.

Still at the top of CFOs' minds: the economic downturn, attracting and retaining staff, and increasing competition, say the finance executives from three continents. - M.L.

CFO GLOBAL CONFIDENCE SURVEY RESULTS

Attitudes toward global economy in the short term:
United StatesEuropeAsiaGlobal
Very optimistic3n/an/a1%
Confident13%22%n/a14%
Neutral31%43%23%35%
Concerned53%35%73%49%
Very pessimisticn/an/a4%1%
Attitudes toward own region in the next year:
United StatesEuropeAsiaGlobal
Very optimistic3%4%n/a3%
Confident19%24%9%19%
Neutral22%46%5%29%
Concerned53%24%81%46%
Very pessimistic3%2%5%3%
Attitudes toward global economy in the next five years:
United StatesEuropeAsiaGlobal
Very optimistic13%22%n/a14%
Confident59%56%59%58%
Neutral22%20%27%22%
Concerned6%2%14%6%
Very pessimisticn/an/an/an/a
Next-quarter profit predictions compared with 2001:
United StatesEuropeAsiaGlobal
Up by 10%+26%32%14%26%
Up by <10% 13%36%10%23%
Down by <10% 13%9%19%12%
Down by 10% +39%n/a33%20%
No change9%23%24%19%

LOOK OUT: Acquired companies lose 10% of their workers; survivors experience slow wage growth, says The Conference Board.




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