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Jan 31, 2004

Off the radar

Some companies are dealing with dwindling sell-side coverage

Drinking a potion that makes the hero invisible has always been a successful crowd-pleaser for movie characters. But when companies become imperceptible, audiences are less entertained. And that's essentially what's happening to a number of small to mid-cap companies as sell-side coverage dwindles or - in some cases - dries up completely.

Analyst coverage has been falling for several years but took a dramatic turn for the worse after major Wall Street firms came under fire over conflicts of interest between their investment banking and research arms in 2003. Sell-side coverage for US companies has dropped 27 percent during the past four years, according to Reuters Research. And Thomson Financial estimates that the average number of analysts covering small-cap firms decreased 11 percent in the first nine months of 2003.

One reason for this decreased coverage is the number of layoffs at major sell-side firms. As research departments shrink, so does the number of companies receiving coverage - because there are fewer people to provide it. After slashing the number of analysts on its payroll, the Smith Barney unit of Citigroup dropped coverage of 117 firms in nine industries last spring, for example.

While lesser-known small to mid-cap companies are particularly vulnerable to losing (or never gaining) coverage, even some S&P 500 firms with smaller market caps barely register in analyst reports. One such firm is Deluxe, which typically trades more than 300,000 shares a day and is covered by just one analyst at boutique firm Dougherty and Company. A few years ago, there were around half a dozen analysts covering Deluxe's stock, according to Stu Alexander, vice president of IR at the firm. He expects Northland Securities, another boutique company, to pick up coverage in the near future.

Stellar performers, albeit with smaller market caps, are also under-covered. For example, South Jersey Industries, which recently posted its fifth straight year of record earnings, is followed by only three analysts, each of whom works for a small firm.

Stephen Clark, treasurer and head of IR at South Jersey, is actively courting more coverage - but he's not holding his breath. Instead, he's pursuing other ways of getting attention from the buy side, like participating in investor luncheons and sending out annual reports through the Wall Street Journal and Barron's. 'Anything we can do to put our name in front of people, we do,' he says.

Dealing with rejection

While Clark laments the fact that South Jersey Industries is no longer followed by seven or eight analysts, as was true three years ago, he's not convinced that sell-side research holds the privileged place it once did. 'It's probably fair to say the sway that sell-side analysts had in the marketplace is somewhat diminished from what it was two or three years ago,' he observes.

For some companies, the coverage crunch seems too serious a problem to be overcome. Associated Estates Realty, an apartment real estate investment trust based in Richmond Heights, Ohio, cancelled several earnings calls and webcasts in 2003 after coverage diminished to a single analyst at Legg Mason. The drop was dramatic given that the company had around seven analysts covering it in the not-too-distant past, claims Barbara Hasenstab, the company's vice president of investor relations and corporate communications.

Before Sarbanes-Oxley, Hasenstab feared that attracting new coverage would be tough without an investment banking deal. Now she's convinced that the company's size and performance exclude it from analyst consideration. 'You have to have a pretty compelling story and be larger than $135 mn to get the coverage,' she says. Rather than courting analysts, the company is working on improving its operations and overall story.

For other companies, loss of sell-side attention is less of a hindrance from an IR point of view. Alexander believes that Deluxe's S&P 500 stature helps maintain the firm's visibility. It also helps that he has been practicing IR there for 25 years and thus has long-standing relationships with the company's institutional investors. Alexander's main drive for building sell-side interest is so that he can direct journalists to a reliable third party for further information about the company. In other words, sell-side coverage isn't his gateway to the buy side, and this is increasingly the case among IROs working in companies of various market cap sizes.

As a matter of principle, Alexander does stay in touch with analysts who once covered the company, but he's philosophical about Deluxe's spotty coverage. Because Deluxe is one of only two public check-printing companies, it doesn't fall into an easy niche for analysts. 'Most companies are looking to reduce coverage rather than add it,' explains Alexander. 'So without a catalyst, there's probably not a great likelihood that we are going to see a major New York brokerage pick us up.'

Even those companies gaining coverage - and Regal Entertainment Group counts itself among these lucky few - feel the fall-out from Wall Street's many woes. Donald De Laria, Regal's vice president of investor relations, says the company has picked up coverage since its IPO on May 9, 2002. However, he's noticed that budget cuts among sell-side firms have resulted in a dearth of industry conferences, which he views as one of the more effective ways to disseminate the company's story to a broad audience. 'Increasingly, firms are thinking long and hard about whether to host an industry conference,' De Laria says. 'And that's been bad news for us.'

Developing a thick skin is a necessity for practicing IR at a small cap nowadays. Companies like South Jersey Industries aren't rocked by an analyst brush-off. Clark notes that most analysts who have dropped coverage have been apologetic and very courteous. He keeps their names on his IR mailing list so they will continue to be updated on company news. 'The last thing you're going to do is take any of this personally,' he says. 'You haven't just broken up with your steady girlfriend of the last five years. This is a business transaction. And if circumstances change, the analysts will be back.'

Alternative routes

Clark believes equity research firms operating outside Wall Street often have different priorities and therefore make better prospects for small and mid-cap companies. He's found that analysts at regional and boutique firms are more willing to cover companies with small trading volumes if they have the potential for attractive price performance in the future.

Daniel Fidell, vice president of utility equity research at AG Edwards, is a case in point. He hasn't reduced coverage of small- to mid-cap names as the market has moved toward a growth cycle, although he acknowledges that many other firms have done.

'Sell-side resources have downsized and the remaining analysts are following larger-cap stocks,' Fidell explains. 'What that means is that the other sell-side shops will have to add analysts after the market turns up. When they need to be following these names, they'll be too late.'

AG Edwards is pursuing a different philosophy. 'The small to mid-cap names are where a lot of value has been created and sustained in recent years,' Fidell points out. 'We have no intention of walking away from small caps.'

Along with regional and boutique research, independent research firms are also continuing to cover smaller companies. In fact, one of the three analysts covering South Jersey Industries is Royalist Independent Equity Research, a Houston-based firm founded by former Merrill Lynch energy analyst Donato Eassey. Given the turmoil on Wall Street, Eassey believes that many small and mid-cap names have suffered disproportionately. 'Some of these companies are positioned to outperform and a lot of them have - and will continue to do so,' he maintains.

Eassey says Royalist 'likes covering small names as much as big names' because his firm has no investment banking or consulting clients. 'We want to find value that's genuine so our clients can make money,' he states. 'We make our money from clients if we make money for them. That's it.'

It's no surprise that the few small or mid-cap companies gaining analyst coverage in this tough environment boast absolutely phenomenal results. SanDisk, a Sunnyvale, California-based maker of flash storage card products for digital cameras and cell phones, went from three analysts covering the company to six in the third quarter of 2003. But its year-on-year earnings per share also grew 275 percent in Q3 last year.

SanDisk's senior management wasn't content to let its performance numbers speak for themselves, however. Six months ago, the company created an IR position for Lori Barker to help grow analyst coverage and improve the high-tech firm's visibility. 'In the last five or six months, we've been extremely active with the Street,' says Barker. And yet she's honest enough to admit that solid IR practices alone didn't double the number of analysts covering the company. 'Nowadays, pretty much every company has lost coverage unless it's growing 100 percent,' she concludes.

Build it and they will come
Patricia Gutierrez offers a remedy to staunch the fall-off in sell-side coverage of Latin American companies

It is an undeniable fact that the number of US sell-side analysts covering Latin American companies has been greatly reduced. Banks and other financial institutions have been dramatically downsizing their equity research departments, mostly as a consequence of cost-cutting measures introduced to confront the difficult economic situation of the last few years. Entire research departments have vanished, and those left have significantly reduced the number of stocks they follow.

Although there are several reasons given for these cutbacks in equity research on Latin American companies - from regional considerations to company results - one fundamental cause is lack of investor interest. And, if investors are not interested in the stock, everyone loses, from the sell-side analyst through to the company itself, not to mention brokers and ADR banks (in the case of an ADR listing).

There are, of course, a number of oft-repeated motives for this barely existent investor appetite - such as regional risk, stock market losses and economic recession - but the 'real' reasons are even more simple: bad corporate results and illiquid stocks. And the latter is an all-too familiar problem for a lot of Latin American companies.

However, sell-side analysts point to other reasons that compound the problem of stimulating investors' appetites - namely, poor financial communication policies and dubious corporate governance. All of these factors produce a perfect cocktail to scare away any actual or potential investors.

Effective IR is the solution

The consequences of lack of sell-side coverage are clear: it is simply impossible to reach a wide investor audience without it. Institutions whose investment policies could lead them to consider buying Latin American stocks (particularly in the form of ADRs) might never do so because of lack of information. The same can be said of retail investors - if they don't know about the company and its prospects, how are they going to contemplate the possibility of buying its stock?

Latin American companies need to improve their results and the returns for their shareholders. Investors are naturally interested in good returns on their money as well as in clear and consistent corporate policies in matters such as corporate governance and dividend payouts. But while good returns are fundamental to generating investor interest, they are not enough - there is still more to do.

Financial communications are an inherent part of the strategy, with particular emphasis on investor relations. Communication becomes paramount when the only way for the company to disseminate information is through its own channels. Proactive investor relations that provides a transparent, consistent and continuous flow of strategic, financial and business information and management accessibility is key to establishing credibility and trust, the cornerstones of any investment decision.

Grasp the opportunity

Companies can use all communication channels available: corporate web sites, press and earnings releases, quarterly reports, annual reports, media interviews, inserts in newspapers and sector publications, participation in conferences and other forums, to name but a few.

Those companies that have been assessed by the rating agencies should communicate their ratings because they offer a measure of risk and value of the company and, by extension, its stock.

Experience says that in the middle of every difficulty lies opportunity. This is the time for Latin American companies to create that opportunity by being more proactive. There is an ever-increasing number of communication tools and channels available to companies to help them get their message across and flag up interest among investors. However, good communication should not be seen as a temporary solution. It is important to remember that it is an ongoing process with a long-term horizon requiring consistency and continuity.