Wall Street Relationship Has Been Rocky for Company

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The people of Wall Street can be a fickle crowd to please.

Relations between a publicly held company and its followers in the investment banking world are complicated. Competing agendas can turn them into a many-sided tug-of-war.

The investment banks are vying with each other for the company’s underwriting business, constantly pitching new deal ideas.

On the other side, the companies want access to capital that will help them grow profitably plus they want to attract the most prestigious banking firms to manage their offerings so institutional investors will become interested in the stock.

Then there are the analysts, who know that a favorable opinion can steer business to their firms. Some have been known to use their positions as bully pulpits to prod companies they cover into strategies or corporate governance policies that make it easier for them to recommend a stock.

That’s certainly been the case with Jakks Pacific, where at least two recent analyst reports have discussed management’s need to rebuild its “credibility.”

At Jakks, a number of corporate governance issues, mostly related to executive pay (see story page 20), long have been of concern to analysts who consider the issue a major stumbling block for the firm.

“They would like to improve the relationship with Wall Street but they are very focused on growing their business,” said Brett Hendrickson, director of research at B. Riley & Co. “That’s a polite way of saying Wall Street hasn’t been a big priority for them.” He rates Jakks a “hold.”

In July, the wedge between Jakks and Wall Street deepened after the company revised downward its revenue projections for 2002. The revision came only two months after Jakks and selling insiders raised $60 million in a secondary offering of stock to the public.

The original revenue forecast was made in February, after the annual Toy Fair trade show in New York. It called for revenue of $360 million to $380 million. Jakks reiterated the guidance in April, a month before the secondary offering, but then scaled back the range to $310 million to $330 million on July 22.

Feeling ‘duped’

In the offering, Jakks raised nearly $50 million for the company, and nearly $9 million for selling shareholders, including Chairman and Chief Executive Jack Friedman and President and Chief Operating Officer Stephen Berman.

Since the offering was completed, at $17.75 a share, Jakks’ stock has fallen to around $11.

“Most institutions would lose a lot of confidence in the company given that a stock offering was just done two months before,” said Bob DeLean, a Morgan Keegan analyst who lowered his rating on Jakks to “underperform” on July 23. “I think many institutions might feel duped, given the timing.”

Currently, seven Wall Street analysts follow Jakks Pacific. Four rate the company buy or strong buy, two rate it hold. DeLean’s “underperform” is a version of a sell rating. Of the four buys, three are from analysts whose firms underwrote the recent secondary offering.

Even supportive analysts are pressuring the company to revise its pay structure, which rewards Jakks’ management for increasing pre-tax profit, instead of earnings per share.

Concerns over such issues “could translate into worries surrounding Jakks’ quality of earnings if shareholders do not feel that enough of the increase in revenues is falling down to the bottom line,” said Bear Stearns & Co. analyst Joseph Yurman, who rated Jakks an initial “attractive” in early June. His firm led the secondary offering in May.

Jakks’ rapid growth through acquisition “makes year-over-year comparisons more difficult and less valuable, as organic sales growth can be masked by acquired companies’ contributions,” Yurman added.

The criticism clearly has vexed Jakks executives. Chief Financial Officer Joel Bennett, the firm’s chief contact with Wall Street, said Jakks has hired an outside consultant to review pay policies. He expects a proposal from the consultant within the next 30 to 45 days that would “align the interests of Jack (Friedman) and Stephen (Berman) with the rest of shareholders.”

Yet Bennett contends that his company is being victimized by outside events, such as Salomon Smith Barney analyst Jack Grubman’s recent resignation under fire for his role in steering investment banking business to the firm. “In the days of Grubman, it pays for (analysts) to be more critical. It demonstrates their objectivity,” he said.

Jakks’ strides in diversifying its revenue base, keeping little debt on hand and weathering an economic downturn have “got to be worth something,” Bennett said. But he doesn’t hold much hope that any changes the firm makes will cause the stock price now trading at a lowly 9 times earnings to instantly rebound. “When the loans (to top executives) get paid off and they change the (compensation) structure, we’ll see what happens,” he said. “I guess they’ll find something else at that point.”

DeLean, a chief Jakks critic on Wall Street, agrees that it might take some time for the company to regain its credibility, but added that he would take a fresh look if he saw the toymaker making changes in its corporate governance. He also commends Jakks for its stiff upper lip. “They’ve not cut off communications with me,” he said. “Some companies will get really irritated and not talk to you anymore.”

Bennett rejects the idea that the company “sandbagged” the Street with overly optimistic revenue forecasts prior to the May offering. “That would be too obvious,” he said. “The stakes are too high, especially when Jack and Stephen sold in the deal.”

Inventory concerns

While Jakks’ toys have continued to sell well, big retailers such as Wal-Mart Stores Inc. have drastically cut back on their inventory levels. “The initial shock to the pipeline is a reduction in reorders,” Bennett said.

In the give-and-take with Wall Street, Jakks has certain weapons, mainly its choice of investment bankers to lead its public offering.

“As the company matures we receive a higher level of importance to Wall Street, so the investment banking should reflect that,” Bennett said. With a market valuation that recently shot above a half-billion dollars, “we have greater needs than we did when we were a smaller market-cap company. ”

Jakks’ recent history with Bank of America Securities is a case in point.

Bank of America is Jakks’ lead lender on a $50 million credit line, and a previous analyst, William Gibson, had cut the company to a “hold.” Through a reshuffling of coverage assignments earlier this year, Jakks was slated to have been picked up by the firm’s leisure industry analyst, Gary Cooper, who covers Hasbro and Mattel. But despite the company making a presentation at BofA’s last investor conference, Cooper so far has passed on Jakks.

When it came time to put together the May offering, which was led by Bear Stearns, along with U.S. Bancorp Piper Jaffray and Advest, BofA wasn’t one of the underwriters. (Bear Stearns and Piper Jaffray subsequently launched coverage.)

Playing by the New Rules

The recently passed Sarbanes-Oxley Act is the most far-reaching federal crackdown on corporate fraud since the Great Depression. But CEOs, directors and shareholders beware a host of issues, such as whether or not to expense stock options, still remain.

Sarbanes-Oxley has set new guidelines for accounting and fraud, in addition to creating new criminal penalties for rogue executives. More than 130 pages long, the law applies to all domestic and foreign companies that have registered with the Securities and Exchange Commission. The rules are numerous and there are exceptions to most. Some are brand new, others are derived from earlier SEC mandates.

New regulations include:

– A company’s chief executive and chief financial officer must sign off on financial reports. Should that company’s results be restated, both executives are required to give back the year prior’s bonuses and incentive-based pay in addition to all money made through stock sales.

-Companies are barred from giving favorable loans to top executives. This is an issue at Jakks, since the company’s two highest-ranking officers, Jack Friedman and Stephen G. Berman, were given $1.5 million loans in 2000. Since the loans, which carry a 6.5 percent interest rate, were made before the act’s passage, they may continue as long as there are no “material modifications” to the terms.

– Audit committee members cannot be affiliated with the company and are barred from getting paid anything other than director fees. Quarterly and annual reports must now give details about the audit committee’s qualifications.

– Accounting firms are barred from providing certain consulting services to companies they audit; audit partners must be rotated every five years. The SEC has enhanced authority to determine what constitutes generally accepted accounting principles (GAAP).

A new five-member board, the Public Company Accounting Oversight Board, will be created. Its members will be appointed by the SEC, which oversees the PCAOB.

In addition, material off balance sheet transactions and obligations must now be disclosed, and all pro-forma numbers must be reconciled with GAAP. Transactions involving management and directors must be disclosed.

Executives and directors who break the law can expect harsher penalties. Sarbanes-Oxley creates a new federal felony for securities fraud and increases the maximum jail sentence for corporate criminals to 10 years. The sentence for other crimes, such as pension, mail and wire fraud, has also been increased. New rules to protect whistleblowers were also included.

Finally, Sarbanes-Oxley makes it easier for the SEC to bar individuals from serving as an officer or director of a company. It will have authority to freeze payments to executives under investigation.

Conor Dougherty

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