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On Closer Examination

Reform of sell-side research is creating a variety of new headaches for corporations.
Joseph McCafferty, CFO Magazine
May 1, 2003

In the spring of 2000, Bernie Ebbers, president and CEO of WorldCom Inc., called Scott Cleland "the idiot Washington analyst" because Cleland predicted that WorldCom's proposed merger with Sprint would fail. The reference to Washington, D.C., was meant to disparage the analyst by pointing out that he wasn't part of a big Wall Street firm. Today, Cleland wears the insult as a badge of honor.

Now founder and CEO of independent equity research firm Precursor Group Inc., Cleland says it was his distance from Wall Street that enabled him to see WorldCom for the troubled company it was. He was right about the merger, of course, and he was right again in early 2002, when he became the first analyst to predict the downfall of the company, which he called a "dead model walking." "[Precursor] was one of the few to see it, because we didn't have any investment-banking relationship with [WorldCom]," says Cleland, who cofounded the Investorside Research Association, an organization of independent research firms.

Not surprisingly, Cleland has no sympathy for the Wall Street research system he left behind after 10 years as an analyst with, among others, Legg Mason. He says the system has failed investors. "There should be no tears over reforming the false advertising and misrepresentation that has passed for sell-side research for so long."

Right now, sell-side research hovers on the verge of real reform, triggered by New York Attorney General Eliot Spitzer's crusade. Reform proposals are intended to eliminate the conflicts of interest that led sell-side analysts to grant "buy" recommendations and other favors to investment-banking clients they privately derided. As part of a more than $1.4 billion settlement Spitzer brokered with the investment banks over various misdeeds, 10 Wall Street firms, including Merrill Lynch, Credit Suisse First Boston, Smith Barney, and Morgan Stanley, will be required to pay $900 million in "retrospective relief" for investors, $450 million over five years to fund research from independent companies, and another $85 million for educating investors.

The settlement, as well as new rules from the National Association of Securities Dealers, the New York Stock Exchange, and the Securities and Exchange Commission, will also prohibit investment banks from subsidizing their research arms or influencing analysts' pay, and require analysts to disclose relationships with the companies they follow. An additional directive from the SEC will require analysts to certify that their reports reflect their true personal views.



All of this is sure to improve the overall quality and integrity of research, which in the broader scheme is a very good thing for the U.S. financial markets. Yet the blow to the economics of research is real, and at least in the short-term, this means that companies will have to struggle with coverage that is less available, more critical, and sometimes confusing to investors.

Playing Favorites

Part of the problem is that research just doesn't generate investment-banking-scale revenues, so many firms are cutting back on analyst staff. In fact, the number of analysts had been dropping since the end of the boom, when much of the investment-banking business dried up. In the spring of 2000, Thomson First Call, which publishes analysts' earnings estimates and research, carried 28,500 total individual analyst recommendations. Today that number has dropped to 24,500.

Whether provoked by the new reforms or, more likely, concerned about a shrinking pay package, "a bunch of the top analysts have hung up their spurs and moved on," says Samuel Jones, chief investment officer of Trillium Asset Management Corp., a socially responsible investment firm. Neil Blackley, a 20-year industry veteran, is one of them, leaving Merrill Lynch as its top European media analyst. "I've been doing my job ethically for 20 years, and then Eliot Spitzer comes along and all analysts have been put on trial and found guilty," he told the Financial Times in February. Merrill Lynch's top banking and brokerage analyst, Judah Kraushaar, also announced plans to leave.

The loss of analysts means less coverage, especially for small and midsize firms. In 1998, 6,100 companies drew coverage from at least one analyst, according to First Call. That number is down nearly 30 percent, to 4,300. "It's a significant problem for any company that is not in the mainstream or in the S&P 500," says John Webster, managing director of Greenwich Associates, a Greenwich, Connecticut — based financial-services advisory firm. "It impacts the ability of these companies to raise money in the equity markets" because they can't communicate their stories to investors.

Steve Capp, CFO of Pinnacle Entertainment Inc., feels the neglect. The Las Vegas hotel and gaming company, with $514 million in revenue, has difficulty drawing any coverage from sell-side analysts. While he welcomes research reform, he worries that the company will lose the little coverage it gets. "I wouldn't be surprised if I have to be my own sell-side analyst," says Capp. He adds that Pinnacle is taking it upon itself to get its story out to investors. "It's a time-consuming exercise, but CFOs are going to be doing a lot more of it."


Pinnacle is in prestigious company. Tiffany & Co., the venerable New York jeweler, has also lost analysts. Vice president of investor relations Mark Aaron says the company has 15 analysts following it, down from 20 a few years ago. Like Capp, Aaron is taking a do-it-yourself approach. "Our attitude is that we communicate directly with the buy side. We don't wait around."

Aaron coordinates a program that targets large institutional shareholders that hold stocks similar to Tiffany. He says the reaction is usually positive, and sometimes surprised. "People say, 'Wow, you're calling us?'"

Tougher, meaner research Reform has made it more hazardous, although not impossible, for analysts to write rosy reports in exchange for investment-banking services. That's good news for investors, but for company executives, it means less influence on sell-side analysis. "Expect analysts to be more skeptical," says Cleland. "Expect them to be asking tougher questions."

And making tougher recommendations — maybe. Since September, research firms have been required to include in every report the overall percentage of buys, holds, and sells among all the companies they cover, as well as the comparable percentages among their banking clients. "This is a powerful incentive to say what you mean and mean what you say," notes Chuck Hill, director of research at Thomson First Call. He says if you have all "buys" on your clients, "pretty soon people will start to realize what a shill you are."

In February, Morgan Stanley increased the percentage of "sells" it issued from 2 percent to 21 percent. Most firms are noting that they have restructured their rating scale, so that although a company may have gone from a "hold" to a "sell," they don't consider it a downgrade.

The distinction is often lost on investors, says Hill. "They are used to 'hold means sell,' so when they see a 'sell,' they're saying, 'Wow, that company must really be in trouble.'"

Not all research firms have changed their practices in light of stricter standards, Hill adds. In March, almost half of the major brokerage firms listed 15 to 34 percent of their recommendations as "sell." Most of the rest had only 0 to 6 percent "sell" recommendations. Since only some have adopted new recommendation scales, coverage language can be inconsistent. And even though research firms must make the fine-print disclosures of recommendations in "buy, sell, or hold" language, they can still use their proprietary recommendations, such as "accumulate" or "market perform," in the actual research report. "There's a lot of confusion," says Hill. "[Corporate clients] need to do a better job at educating investors about what's going on."

That is, if they can figure it out. Marv Burkett, CFO of Nvidia Corp., is baffled by the varied outlooks held by the analysts that cover the Santa Clara, California — based semiconductor company. "I've noticed a lot of inconsistency in coverage," he says. In fact, of the 20 analysts listed on Yahoo Finance, 4 rate Nvidia a "buy," 8 call it a "hold," and 8 consider it a stock to sell. Either the analysts wildly disagree on the prospects of the company or they have different ideas about what the labels mean.

Most experts expect analysts to dig deeper into the companies they cover. According to Jeffrey Haas, professor of securities law at New York Law School, the new reforms could increase friction between CFOs and analysts. "[Because of Reg FD], CFOs were already hesitant to say anything without a lawyer. Now that analysts can write a truly negative report, CFOs are going to be scrambling to find out who their friends are and who their foes are."

"I welcome the tough questions. That's a good thing," says Tiffany's Aaron. He hopes that reform will encourage analysts to take a longer-term view of the company. And he doesn't see the relationship becoming more adversarial. "I would hope not," he says. "If I stopped talking to everyone who's ever had a downgrade on my stock, eventually I'd have no one to talk to."

One-Stop Shop?
It's not yet clear whether firms will begin spinning out their research businesses completely. Citigroup announced that it has split equity research from its investment-banking business into a new unit under the Smith Barney brand. In March, Credit Suisse First Boston was rumored to be considering launching an independent research firm under the DLJ Research name. It's uncertain if others will follow. "One-stop shopping is still very much in vogue on Wall Street," says Haas.

And as long as the one-stop shop remains, analysts will have conflicts, says Haas. "As long as research still comes out of the same house as investment banking, there will be problems," he maintains. He doesn't think the disclosures about bankers' relationships with their research clients will help much, either. According to Haas, the disclosures will eventually look like boilerplate, and people will begin to ignore them.

Hill agrees that reform might not have a huge impact on the system. "You can issue all the 'thou shalt nots' you want, but investment bankers and analysts are going to talk, and [analysts] are still going to feel that they have to play ball," he argues.

Precursor's Cleland believes that eliminating conflicts of interest will improve research even if some of the big names leave the industry. "The overall quality of research is pathetic to begin with," he argues. "How can it get any worse?" Clearly, independent firms stand to gain. If analysis by the big Wall Street firms remains suspect, investors will turn to other sources, inducing independent research. "The old way just isn't going to work anymore," says Cleland.


Should You Pay for It?
With the increasing difficulty of garnering coverage from sell-side analysts, companies are turning to paid-for research with more regularity. In fact, a February study by the National Investor Relations Institute (NIRI) found that 3 percent of respondents had paid for stock research on their company in the previous two years.

Supporters of paid-for research contend that it provides the same value as traditional research. "If we didn't provide good research, or it didn't have an impact, no one would subscribe," argues John M. Dutton, president of J.M. Dutton & Associates, an El Dorado Hills, California-based firm that produces paid research. Dutton says the firm's compensation structure provides incentive for his analysts to be right, not to bring in business.

NIRI president and CEO Louis M. Thompson Jr. insists that paid-for research can fill the void left by shrinking sell-side coverage. "It can be a useful tool to get to the buy side," he says. But Thompson thinks the industry needs some rules to separate the reputable firms from the hucksters that promote stocks. NIRI's voluntary guidelines for paid research state that the payment should be fully disclosed; the report should be completed by a qualified analyst; and research firms should be paid in cash, not company stock. NIRI also contends that the reports should not contain an actual recommendation to buy or sell the stock. "Where's the credibility in buying a recommendation?" asks Thompson.

But some companies just aren't buying paid research. Steve Capp, CFO of Pinnacle Entertainment Inc., says the Las Vegas hotel and gaming company wouldn't consider going down the paid-for research road, even though it is not getting a lot of attention from analysts these days. "There is still a credibility issue," says Capp. "It sounds a little suspect."

Chuck Hill, director of research at Thomson First Call and a former analyst, alleges that paying for research "could do more harm than good. The connotation is that you are trying to gild the lily," he says. Instead, he advises companies that are struggling to attract analyst coverage to make it easier for analysts to cover them. One way to do that, he says, is to put together a good fact book that has all the data an analyst needs, including honest industry data. "If you demonstrate that you will be helpful in providing tools and industry data, analysts are going to be much more likely to follow you."




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