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Bonds vs. Bombshells

Plus, are REIT spin-offs the right thing to do?; niche insurance policies cover everything from product recalls to turkey stampedes; bankers take a hard line on restructuring charges; and more.
CFO Staff, CFO Magazine
October 1, 2001

Corporate debt is starting to resemble a financial bomb shelter. But instead of stockpiling waxed beans, investment-grade companies are amassing cash from bond offerings to make balance sheets recession-proof.

Prompted by a weak equity market and lower interest rates, corporate issuers beat last year's record $353.2 billion total in just seven months, reports Thomson Financial. Much of the freshly raised capital is either being hoarded or used to pay down bank debt, says Jack Kallis, a senior vice president at State Street Research & Management, in Boston. "Nothing frightens a CFO more than lack of access to the capital markets," quips Kallis, noting that finance chiefs are stockpiling cash based on flashbacks of Q3 1998, when access to the capital markets was cut off.

The flip side: The downturn has made bondholders more active. Those of Covad Communications Group are collecting $283 million in cash through a prenegotiated Chapter 11 filing. Such hefty cash payouts are rare before a company defaults. Of course, investment-grade firms have a lot more leeway than Covad did, at least for the time being.

-- Marie Leone

REIT OR WRONG?

Much Ado about Spin-offs

To spin or not to spin? The question has led to head-scratching at companies with considerable real estate holdings, thanks to a recent decision by the Internal Revenue Service to approve tax-free spin-offs of such property through real estate investment trusts (REITs). McDonald's Corp. had planned to take advantage of the new ruling, but negative reviews from analysts made the fast-food giant think twice. Credit Suisse First Boston analyst Janice Meyer estimates that the rent payments to a REIT, plus the loss of $1.4 billion in rental income from franchisees, would slice up to $5 per share off McDonald's current earnings.

Such prospects have left another potential beneficiary, Wal-Mart Stores Inc., wary of the idea. "Our earnings multiple is in the 30s, so transferring $1 to a REIT gives you less shareholder value than if that dollar stayed in the operating company," says Wal-Mart treasurer Jay Fitzsimmons.

Perhaps. But Lehman Brothers tax analyst Robert Willens sees it differently. "Anytime real estate comprises several hundred million dollars or more of a firm's assets, a REIT spin-off is doable, and even advisable," he says. "It's a way to convert what would have been tax payments into dividends."

In McDonald's case, Willens says, the idea that cash dividends might be unpopular with investors "doesn't move me at all." In fact, he's predicting the comeback of the dividend as ordinary tax rates come down relative to capital gains rates. Willens is somewhat more sympathetic to Wal-Mart's argument, but counters that the improved returns could boost the parent company's multiple enough to outweigh the REIT's lower multiple.

So the jury is still out on whether the tactic will catch on. McDonald's isn't expected to decide before year-end, and other candidates have only begun analyses. Meanwhile, the IRS says it will continue to be vigilant about the business rationale companies cite for their REITs. And even Willens concedes that "the big hurdle will be convincing the IRS that there are other objectives to be accomplished that outweigh the tax issue."

--Alix Nyberg

CUT 'EM LOOSE

Spin-offs lead to better financing decisions, says University of South Carolina researcher and study co-author Eric Powers. Apparently, capital expenditures show greater sensitivity to changes in growth opportunities after a division goes solo.

COUGH IT UP: Health- care benefit costs for small and midsize companies (10 to 999 employees) jumped 9.2% in 2000, says Marsh.

EXPOSING TAX ABUSE

Shelter Fallout

As political footballs go, tax shelters seem to encourage a lot of punting. But that doesn't mean CFOs can just sit back and watch.

To crack down on abuse, the House and Senate are pushing for tax shelter legislation. But the bills are Clinton Administration holdovers, so politicking ensues. Meanwhile, the Treasury Department refuses to support any legislation until department officials figure out whether their first disclosure-rule filing, due last month, produces the intended result--identification of tax abuse. It could just generate a mountain of reporting on legitimate business operations.

Still, Washington's tax players aren't entirely unserious. For one thing, a July 26 Treasury notice shut down a basis shift shelter that helped U.S. entities avoid tax liability by generating and inflating large paper losses through foreign subsidiaries that recorded stock sales as dividends instead of capital gains. The notice also informs shelter promoters of their obligation to register transactions and keep customer lists. It's still too early for Treasury to calculate the amount of unpaid taxes this particular loophole represented, but the sophisticated scheme was used at least 200 times by multiple taxpayers, both individuals and corporations.


Experts say companies would be hard-pressed to justify such moves as having some legitimate economic or business purpose. "Many of these transactions are mere fig leaves that would probably lose if challenged in court," says David Hariton, a tax partner with the law firm of Sullivan & Cromwell, in New York. "The question for CFOs to ask, therefore, is, how vigorously will the Administration oppose these transactions?"

Currently, the penalty for understatement is 20 percent of the tax liability, plus interest. And although interest can add up over the years, the cost tends to be measurable, but not severe. "If the penalties are low and the enforcement is lax," adds Hariton, "it's hard to blame corporations for considering the shelters." --M.L.

PLANTING SEASON

FASB has extended the scope of Statement 143 to include all industrial-plant closings. Firms must fair value an asset- retirement obligation in the period it occurred.

RECAPITALIZATION

An SEC Damper?

Public share prices may be down, but the leveraged-buyout crowd isn't exactly jumping at bargains.

One reason could be new guidance from the SEC on accounting for leveraged recapitalizations. Per Staff Accounting Bulletin 54, if corporate or financial buyers acquire more than 94.9 percent of a company, they have to write up the target's assets to fair market value--commonly called pushdown accounting. For buyout groups hoping to eventually bring the company back to the public market, lower asset values and depreciation charges make for a better IPO road show in the future-- even with FASB's new rules on goodwill. The SEC announcement at the April meeting of the Emerging Issues Task Force, however, could make it more difficult to avoid the step-up in asset values. "I know a lot of people who, if they can't do a recapitalization, won't do the deal," says Mark McDade, transition services partner at PricewaterhouseCoopers.

The trick to qualifying for favorable accounting treatment is to find an independent minority investor--emphasis on independent--to hold at least 5.1 percent of the firm's stock. The SEC has suggested that it will look more closely at the contracts between investors in a buyout group to ensure that the minority investor is in fact not part of a "collaborative group," in which case pushdown accounting would be required.

What constitutes independence? The minority investor cannot have any affiliations with the other investors, can't solicit other parties to invest in the deal, and must be free to exercise its voting rights and sell the shares. It also has to fully participate in the risks as well as rewards of ownership. That means it has to invest on the same terms as other investors, and that its return is in no way guaranteed. It's not unusual for minority investors in leveraged recaps to have their losses limited by put or call options negotiated with the buyout group.

Just what will fly with the SEC? "It's difficult to tell which facts and circumstances will break the camel's back," says McDade. Apparently, buyout artists aren't eager to find out. -- Andrew Osterland

SUMMER RECAP

Recent leveraged recapitalizations by nonfinancials.

Source: Thomson Financial

THE IRS STRIKES OUT: In three separate cases, tax courts upheld a company's right to deduct all corporate-jet- related expenses.

RUNNING WITH THE BEARS

Smoothing the Ride

What bear market? A recent study by actuarial firm Milliman USA shows that the 20 largest companies' defined-benefit pension plans added almost $7 billion in corporate profits to their companies' bottom line during 2000. And they're likely to top that number this year.

These plans didn't beat the 2000 market. In fact, as a group, they lost almost $30 billion--25 percent of their companies' pension surpluses. But Milliman consulting actuary John Ehrhardt estimates that 16 of the 20 firms he studied use deferral and smoothing techniques defined by FAS 87, which allow them to spread pension gains and losses over time.

The result is a pleasant hangover from the bull-market days. Back in 1999, 32 of the 87 Standard & Poor's 100 firms with defined-benefit pension plans actually earned more from their plans than from their operations. For firms that use smoothing, those good times are still rolling.

Companies that chose instead to recognize the fair market value of their pension assets reaped huge rewards, but face sickening earnings hits now that the market has turned. Lucent Technologies, for example, got a huge boost to earnings in 1999 when it switched to a method that more closely aligned returns with actual market value. But its annual report, due out this month, is likely to show the firm is now suffering for that decision.


"Companies that used smoothing had a less drastic but still substantial increase in pension gains [when the market was good]," says Ehrhardt, "and now they are coming down to a soft landing instead of falling off a cliff." By contrast, he says, "companies using market value are riding a roller coaster."

Regardless of method, none of the Fortune 100 firms Ehrhardt reviewed in the preliminary study was in danger of underfunding its pensions. A bigger concern for the CFOs of those firms should be whether the long-term average expected plan return of 9.5 percent is realistic. "Unfortunately, people in this field tend to drive from the rearview mirror," says Ethan Kra, chief actuary at William M. Mercer Inc., "and the last 20 years includes the greatest boom market in history."

But without pressure from auditors, few companies are likely to lower their expected rate of return. For a plan with $40 billion in assets, a 2 percentage point reduction in the estimated return on assets would create an annual reduction in pension income of $800 million, says Ehrhardt. "What CFO is going to propose doing that? "

Meanwhile, many smaller companies are in danger of falling below funding levels required by the Internal Revenue Service and Pension Benefit Guaranty Corp., says Milliman consulting actuary Jeffrey Kamenir. Plan liabilities are based in part on a mandated interest rate calculated from 30-year Treasury rates, which have been falling steadily. "Really bad stock performance could be the killer on top of lower Treasury rates," says Kamenir. As a result, he says, many companies had to make additional contributions by mid-September or change their asset method to smoothing. Like smoothing for accounting purposes, that for funding allows shortfalls to be made up over time. But beware--the IRS gives automatic approval to asset-method changes only once every five years. "The 2001 investment year is turning out to be really bad, too, so companies that exhaust their smoothing-method option this year may have to put in contributions next year," says Kamenir. --Tim Reason

LET THE GOOD TIMES ROLL

A sampling of companies that used smoothing.

Expected return on pension assetsActual return on pension assetsPension income as reported
Exxon Mobil726208  263
General Motors7,666634(270)
Ford Motor3,281979188
General Electric3,7541,2871,744
Citigroup757102  29
Enron7541(10)
IBM 3,9021,395  896
AT&T1,821995767
Verizon Comm4,6861,2942,328
Philip Morris799(350)290
Bank of America813(135)118
SBC Comm.3,149951,145
Texaco136(41)(22)
Duke Energy24447(3)
Chevron418110125
American Int'l Group 3817(35)
Merck267(196)(116)
WorldCom493624
McKesson HBOC37136
Conoco76(29)(19)


Source: Milliman Usa

MASS LAYOFFS--those of 50 or more workers for at least 31 days--rose 7% from last quarter, to 1,911, reports the Labor Department.

INSURANCE

A Niche for All Hazards

Move over, Lloyd's of London. The broker, renowned for offering oddball policies such as one that compensates a company should two or more workers win the U.K. national lottery and resign, isn't the only company offering niche coverage. These days, advanced intelligence-gathering technology and new target-marketing techniques allow insurers to offer reasonable premiums for tailored programs that cover everything from turkey stampedes to automobile parts.

Niche insurance isn't new, says Rick Lindsey, president and CEO of Chicago-based Prime Insurance Syndicate Inc.; rather, it's a response to an economic cycle. "Claims go up as the economy goes down," says Lindsey, who notes that more claims are filed against corporations when the economy slows. What is new is the increased interest in specialty insurance by small and midsize companies. That's why Prime offers corporate policies for as low as $500 a year. One of the company's more unusual policies: poultry insurance, which includes coverage specifically for turkeys. The birds have a tendency to stampede when spooked, resulting in a significant loss of assets.

One of the newest players in the niche market is Detroit-based Goss LLC, a joint venture comprising The Goss Group Inc., Marsh Inc., and GMAC Insurance Group. Goss deals exclusively with the needs of the automotive-supply industry, including environmental liability, design liability, and consequential damages insurance, as well as product recalls. The venture originally was to target tier-one suppliers ($100 million to more than $2 billion in sales), says president and CEO Greg Goss. However, tier-two ($50 million to $100 million) and tier-three ($10 million to $50 million) suppliers are also revved-up about the insurance. --Joan Urdang

STOCKING UP

Total pay for board members at the top 200 U.S. companies averaged a record $138,747 in 2000, up 4% from the previous year, reports Pearl Meyer & Partners.

RESTRUCTURING CHARGES

When Worlds Collide

Restructuring charges evidently mean different things to different people. Equity analysts view these charges as one-time events that should be disengaged from earnings to create a picture of how a company's ongoing operations are performing. Credit analysts and lenders have a different perspective. Focused on cash flow, lenders, for example, scrutinize rather than isolate charges to ferret out cash portions that choke cash flow.

Witness the practical consequences of such scrutiny in the extreme example of Lucent Technologies. In late July, CEO Henry Schacht unveiled an ambitious new plan aimed at reducing annual operating expenses by $2 billion and boosting working capital by $1 billion. But bankers placed caps on restructuring charges written into a February credit facility, essentially tying the CEO's hands.

"The notion of putting a limit on the restructuring charge is unusual," says Bob Konefal, managing director of the telecom practice for Moody's Investors Service. "But it wasn't unexpected."

In negotiating the limit, the banks looked at the implications for cash flow of what was included in the charge. According to Lucent, financial covenants included bank limits on the firm's overambitious vendor financing portfolio as well as hefty severance payouts and lease payoffs resulting from facility closings.

Equity analysts generally don't focus on such charges, because they're not indicative of a company's fundamental operating performance. Yet banks are tightening loan covenants for many troubled firms, so more of these supposed one-time events may bear closer scrutiny. Loan Pricing Corp., which tracks trends in loan covenants, reports that the debt-to-EBITDA ratio is 3.2x for the first half of 2001, compared with 3.5x for 2000. Lucent won more wiggle room in August, when bankers agreed to loosen the $4 billion cap they had imposed on its restructuring charges. But while that cleared the way for Lucent to write off an additional $9.7 billion, the firm has been delayed in spinning off Agere, its optical components subsidiary, until it meets other restrictions. -- A.N.

LET'S MAKE A DEAL

To spin off Agere, bankers are requiring Lucent to:

Source: Lucent Technologies

EXCHANGE RATE: Telecom costs rank as a Top 5 corporate expense, up from number 10 a decade ago, according to QuantumShift.

WEATHER DERIVATIVES

Climate Control

Rough game on the back nine? Late for a meeting? Lousy earnings report? Blame it on the weather. Last quarter, Deere & Co., Six Flags Inc., and The TJX Cos. all pointed fingers at Mother Nature when their numbers came up short.


But they and other companies may not be able to use weather conditions to excuse poor performance much longer, if
derivatives used by energy companies, agribusinesses, and others with direct exposure to the elements keep growing more sophisticated. Eventually, even companies with indirect exposure may be able to lay off weather risk.

"If you can articulate the financial impact of weather data measurements on your business, you can cover a portion of that risk," insists Scott Mathews of Jersey City, N.J.-based derivatives broker United Weather, which has been advocating that view to analysts.

Maybe. But foul weather may continue to be fair game for CFOs as long as analysts don't criticize them for failing to prepare for rainy days. "Weather derivatives are still an immature product, so I'm not going to build them into my models," notes Lehman Brothers analyst Richard Gross. While Gross concedes that weather derivatives are somewhat material to the stock price, he says, "you can't come to grips with how to analyze them on an individual company basis, because a lot of the use is internalized."

Others contend the use of weather derivatives will remain limited simply because product or geographical diversification serves many firms as a natural hedge. Perhaps, responds, Mike Grover, manager of weather risk for Minneapolis-based Cargill Inc., but such diversification is rarely a perfect offset. Two years ago, Cargill formed a team to hedge internal weather risks and offer weather derivatives to its customers. "The company has a diverse array of businesses, most of which have weather risk," explains Grover. For example, Cargill's sales of de-icing salt are hedged against a combination of temperature and precipitation. But Grover won't say much more about the hedges, for fear of disclosing competitive advantages. (Cargill is a private firm, so it needn't worry about the analysts' response.)

Grover's reticence is not the only indication that the forecast looks bright for weather derivatives: a spokesperson for Goldman Sachs says the investment bank plans to start trading them this fall. --T.R.

COMPUTER PRIVACY

This Means You

Bob Knowles's company destroyed 130 tons of computer hardware between January and July, and it's on track to smelt 300 additional tons by year's end--more than tripling last year's mark. The CEO of Denver-based Technology Recycling attributes the dramatic rise in its business volume to new privacy laws, particularly the Gramm-Leach- Bliley Act (GLB), which requires companies to obliterate consumer financial data from computers that are earmarked for the trash.

Under GLB, which went into effect in June, companies that collect nonpublic personal information (NPI)--Social Security numbers, credit information, banking data--from consumers must comply with the law's privacy provisions, says Thomas M. Regan, an attorney with Cozen O'Connor, in Philadelphia. The provisions direct companies to protect NPI from the consumers' cradle to the grave, and to notify them of the companies' privacy policy.

At first glance, GLB might seem to apply only to banks and other traditional financial institutions. Yet the law's definition of a financial institution is so broad, notes Regan, that it covers any company that gathers such personal information, including retailers that issue credit cards, auto dealerships, tax-preparation professionals, real estate appraisers, search firms, and personal check-printing services. But, adds Bob Knowles, "many executives don't know that the law affects them."

The penalties for noncompliance are harsh, says Daniel Langin, an attorney based in Overland Park, Kans., if only because it represents a breach of fiduciary duty. He estimates that fines for board members could reach $10,000 a day once government audits commence. At least six federal agencies help enforce GLB, including the SEC, the FTC, and the Office of the Comptroller of the Currency.

The fallout may not end there, warns Knowles, as violators could be denied access to Small Business Administration loans or see their liability insurance voided. -- M.L.

OFFSHORE WINS: The IRS awarded a $33.6 million Web-site redesign contract to Accenture, based in the tax haven of Bermuda.




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