Sell-side story

Paul Cordasco looks at the challenges of getting sell-side research coverage.

Paul Cordasco looks at the challenges of getting sell-side research coverage.

In the summer of 2002, Don Stewart was facing a big problem. The CFO of medical-device manufacturer Rita Medical found himself without a single brokerage analyst regularly producing research on his small company. In Wall Street parlance, he had no sell-side coverage. Shortly after Rita Medical went public in 2000, analysts at two of the investment firms that had underwritten the company's IPO - Robertson, Stephens & Company, and Citigroup's Salomon Smith Barney - began producing research. But a little over two years later, the first analyst lost his job when his firm fell victim to the technology-stock meltdown, and the second left for another firm. Many IR programs have traditionally relied on such analysts to help spread their companies' messages to investors. And for smaller companies like Rita, which can often find it difficult to get their messages heard over the market din, these analyst reports and recommendations can play a vital role in their IR programs. IR experts say that analyst coverage provides companies with an imprimatur from a knowledgeable third party. Secondly, many IR programs have also come to rely on sell-side analysts to set up meetings with potential investors - such as mutual-fund managers - as a means of recruiting and contacting new investors. The sudden absence of coverage left Stewart concerned that his small company might struggle to get its story out to the Street. Stewart says that even as headline-grabbing scandals continued to drag sell-side analysts' reputation through the mud in 2002, companies like Rita Medical still needed the recognition that research coverage bestows. "Here's the thing: The sell side has lost a lot of credibility, but even so, it's still not unusual to get the question [from both institutional and small investors], 'Who's covering you?'" explains Stewart. "So even though you feel like laughing at them and saying, 'Hey, you just finished making fun of the analysts and then you ask who's covering me,' you obviously can't do that. And regardless of what people might think or say about the analysts, it just doesn't sound good to answer that question with, 'Nobody.'" Tough battle to regain coverage So Stewart, along with his IR firm Allen & Caron, began what would have seemed like an uphill quest to regain some sell-side coverage. Market conditions had changed dramatically since Rita Medical went public as a hot IPO. Micro-caps (companies with a total market value below $250 million, among the smallest publicly traded companies) that were not yet making money, like Rita, had severely fallen out of favor with investors during the bear market. Yet Stewart hit the road determined to win back coverage. "I made it a major priority," says Stewart. "I went out and hit the road, and made sure to meet with lots of analysts - targeting ones I thought would be the most receptive. And with a little bit of hard work, luck, and skill, I ended up even better off now than I was then." Eventually, the company emerged with four new analysts, including one at Midwestern brokerage giant AG Edwards. "The universal here is that if getting sell-side research coverage is a goal of yours, you have to put the time in to get it," says Matt Clawson, VP at Allen & Caron. "It's often about going out and targeting the sell side and meeting with as many analysts as will meet with you. Oftentimes, that doesn't mean that an analyst will pick up coverage the next week, but it means that maybe you develop a relationship that will turn into something down the road." A three-year bear market and several highly publicized scandals involving sell-side analysts at some major Wall Street firms have made Rita's struggle to maintain consistent coverage a common one for many public companies. The number of public companies on June 1 of this year with sell-side research coverage was 3,615, compared to 4,721 on June 1, 2000 - a drop of 23% in three years, according to data provided to PRWeek by Thomson Financial. Major Wall Street firms have been shedding bodies consistently throughout the bear market, and research analysts - even some high-profile ones - have fallen victim to the pruning. Research seems especially prone to layoffs, as it has been a loss leader for Street institutions for some time. Experts say this is because for years, the Street's chieftains saw their research operations as an indirect revenue generator. An influential sector analyst, like Merrill Lynch's internet wunderkind Henry Blodget, could help a firm win lucrative banking assignments such as underwriting an IPO. This was because of a tacit back-scratching agreement that had investment banks produce research - which was almost always favorable - as a "thank you" to its banking clients. In the past year, securities regulators, led by New York Attorney General Eliot Spitzer, have stepped in to highlight and attempt to end the extensive conflicts of interest of this unspoken agreement. The main concern was that it allowed tainted research to fall into the hands of unsuspecting small investors. Such scrutiny, and a new set of rules designed to separate analysts from having any involvement in the investment-banking process, has led Wall Street firms to rethink the resources committed to this loss leader. Coverage of blue chips falls In February, Goldman Sachs laid off six research analysts, leading to its suspension of coverage of 50 companies, including some widely followed blue chips like AOL Time Warner and Disney. Such a move would have been unthinkable during the days of the 1990s bull market, but are part of a new reality where even some of America's largest corporations are losing analysts. "The role of sell side will continue to wane. Economically there's no other way it can go," says Lou Thompson, CEO of NIRI. The problem appears to be more acute for smaller companies like Rita Medical, where attaining and maintaining coverage was tough even when the stock market was strong. (The largest companies still boast a small army of analysts. Coca-Cola and IBM currently have coverage by 16 and 20 analysts, respectively.) Nevertheless, while most experts concede that having some sell-side coverage is better than none, they say the new research environment makes it necessary for IR programs to adapt, and for many to stop relying on the analyst community as a crutch. These experts say that companies need to be proactive about telling their stories directly to institutional investors, known as the "buy side." "We are not telling our clients to not go and pursue research coverage," says Jeff Corbin, managing partner at KCSA. "But we're telling them to be realistic. I think now if the company wants to get its story out and reach new shareholders, it has to spend more time on its own reaching out to the buy side." Some corporate IR professionals say that they have done just that in recent months to cushion the blow of losing much of their coverage. "Basically, when you have 24 analysts covering you, you get a lot of exposure." says Steve Eschbach, head of IR for alternative energy firm FuelCell Energy. "When that shrinks down to eight [as was the case with FuelCell], you do more outreach to the institutions directly." Eschbach enlisted an IR firm to help him target institutional investors. He says the effort paid off, and he's now in contact with 24 separate large investors that he says have showed interest in his company. "I contact them on a regular basis to make sure they're current on our corporate developments," he explains. "So now we are actually talking to the people who have the investment discretion." Other companies that have had proactive IR programs in place for years say the loss of some of sell-side analysts was cushioned for them by the already strong relationships they had cultivated with the buy side. These IR pros say that while sell-side coverage is important, it should never have been an excuse for not having a strong relationship with the buy side. "We really haven't had much of a negative impact from having less coverage," says John Kristoff, director of IR and global communications at ATM manufacturer Diebold, which lost three research analysts during the bear market, and is now down to four. "It makes it a little more difficult because you have to tell the story more often because you're working more directly with buy-side [institutional investor] analysts. But at the same time, your story is not being filtered." ----- Paying for research Companies with little or no sell-side research coverage have taken some drastic steps to insure that third-party research on their company is available to investors. Perhaps, the most controversial measure is to pay one of a handful of small boutiques to produce investment research. Yet the conflicts in paying an outsider to produce investment research on your company are obvious, and therefore seem to put the research's value in doubt. "Our opinion is that paid-for research doesn't necessarily carry much credibility [with investors]," says Jeff Corbin, managing partner at KCSA. Nevertheless, some companies have chosen to go down this road as a last resort. While it does not endorse this practice, NIRI has released guidelines for companies to follow for so-called "Paid-For Research Reports." The best-practices standards read in part, "Such reports should contain factual research conducted by a qualified analyst, and should avoid the expression of opinions about the company's prospects and must not contain a recommendation that one should acquire the stock. Moreover, it is essential that it be fully disclosed in the research report itself that the company commissioned or paid for the research directly or indirectly. Failure to make such a disclosure could be a violation of federal securities laws." NIRI CEO Lou Thompson says companies must tread lightly when paying for research on themselves. "Even though we have laid out standards for paid-for research, I'd say our thought process here is evolving," says Thompson. "Right now, companies have to be very careful with this. For instance, what happens when this research falls into the hands of retail brokers [who often deal with smaller, less savvy investors]? Will they always divulge to their client that this research has been paid for by the company? There could be some big problems here."

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