In the Matter of the Petition of Lowe’s Home Centers, Inc.

In this matter, Dr. Shapiro testified regarding whether the 2.5 percent royalties paid by Lowe’s Companies, Inc. (“LCI”) and Lowe’s Home Centers, Inc. (“LHC”) to LF Corporation (“LF”) for use of Lowe’s trademarks and trade names were arm’s length.

Specifically, Dr. Shapiro critiqued studies prepared by Petitioner’s experts. Arthur Andersen, LLP (“AA”) conducted a series of analyses, using the Comparable Uncontrolled Transactions (“CUT”) method and Comparable Profits Method (“CPM”) to estimate the arm’s length range of royalty rates to be paid to LF. American Appraisal Associates (“AAA”) was retained by Petitioner to prepare a transfer pricing study to determine whether the royalty paid under the license of trademarks by LF to LHC and LCI was within an arm’s length range. AAA also determined the arm’s length royalty rate range using the CUT method and the CPM.

Dr. Shapiro demonstrated that the application of the CUT and CPM by AA and AAA was flawed due to, among other reasons, inconsistent selection of comparables and a lack of comparability between the allegedly comparable agreements/companies and the subject agreements/companies. For example, Dr. Shapiro’s expert witness report points out that AA’s 2002 CPM analysis accepts as a comparable a company, Hechinger Co., that was excluded from AA’s 2000 study because it owns valuable intangibles.

In its decision, the court reviewed Dr. Shapiro’s testimony regarding the AA and AAA reports, noting that:

Dr. Shapiro, in his testimony and report, criticized the AA and AAA royalty rate studies and concluded that LF’s trademarks had little intrinsic value and could be replaced at relatively low cost. He asserted that the AA and AAA CUTs were not comparable to the LHC/LF licensing agreement; the royalties paid by LHC extracted too great a portion of its operating income for the period 1991 through 2000 and prevented LHC from earnings its cost of capital on its tangible and intangible assets; that contrary to the positions of AA and AAA, LHC did own unique and valuable intangible assets, without which the marks owned by LF would be all but worthless; and the CPM analyses ignore the fact that LHC was operating in an industry in transition with few winners (Lowe’s and Home Depot) and many losers. Dr. Shapiro explained that not all excess returns a company may earn are attributable to its trade names. He discussed competitive advantages that earn excess returns and take the form of either cost based advantages or product differentiation. In his report, Dr. Shapiro also discussed barriers to entry by competitors, the ability to innovate, the role of trademarks as a signal to consumers, and the tendency of a trademark to become stale and to require further refreshment.

Dr. Shapiro estimated the weighted average cost of capital (“WACC”) of the Lowe’s consolidated companies for the period from 1991 to 2000. He determined from his estimated computation that Lowe’s residual income was insufficient to pay a royalty of more than .7 percent in 1996 and .8 percent during 1997.

Dr. Shapiro testified that LHC owned unique and valuable intangible assets that included a distribution network, marketing know-how, logistics know-how, assembled workforce, employee goodwill, favorable store locations, economies of scale in purchasing and advertising, good relations with suppliers, and the ability to provide quality service. He did not fix the value of these intangibles. Dr. Shapiro postulates that where a licensor owns a trade name that he licenses to a licensee, who himself owns valuable intangible assets that substantially increase the returns from the use of the trade names, in such case any excess returns earned are attributable both to the assets owned by the licensor as well as those owned by the licensee.
(pp. 31-32)

In the absence of a showing by petitioner that the respective intangibles have a similar profit potential, the CUT method cannot serve to meet petitioner’s burden to overcome the presumption of distortion. The reasoning applies with equal force to the 2002 AA CUT analysis, as well as the 2002 AAA CUT analysis, where no evidence was presented in support of the trademarks of the tested party and those owned by the uncontrolled comparables having a similar profit potential.
(pp. 50-51)

Another area of concern bearing on the reliability of both the 2000 and 2002 AA CPM analyses is the inclusion by AA of Hechinger Co. as one the 11 purported comparable retailers in its 2002 analysis. Hechinger Co. had been excluded as a comparable retailer in the 2000 AA analysis because it owned valuable intangible assets.
(p. 52)

In Dr. Shapiro’s analysis of the M/Bvr (market to book value ratio) of the 11 companies identified in its 2002 CPM study as being comparable to LHC (Finding of Fact “70”), there was data available to Dr. Shapiro on none of the companies for at least one of the three years. This data showed that eight of the nine companies were either in decline over the three years or unable to earn excess returns for one or more of the three years. None of the 11 companies has been shown to be comparable to LHC in terms of sales, number of stores, or geographic markets served. The M/Bvr analysis confirms that at least 8 of the 11 companies were unable to realize or sustain any level of excess returns. In vies of LHC’s continued robust growth in earnings, sales and new store openings, it is abundantly clear that none of the 11 companies selected by AA in its 2002 analyses can be seriously considered, under the CPM of section 1.482-5 of the Treasury Regulations, to be comparable to LHC.
(p. 55)