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Reg FD has changed the way companies serve up information, leading to plenty of tension between CFOs and analysts.
Kate O'Sullivan, CFO Magazine
July 1, 2006
Carol DiRaimo was fed up. Last February, the head of investor relations for Applebee's International began an earnings call by urging analysts to stop hounding the restaurant chain's franchisees for confidential information. Callers were frequently "rude and disruptive," complained DiRaimo, even badgering restaurant managers at their homes. They used deceit to pry sales and trend data from unwitting employees — claiming to be Applebee's employees, or market researchers, or students working on a paper. Some offered to pay for the information.
DiRaimo noted that employees who disclosed such data were in danger of losing their jobs. And she concluded her reprimand by saying that the analysts' tactics violated "the spirit, if not the letter, of Reg FD."
Regulation Fair Disclosure, of course, is the 2000 law that prohibits companies from selectively disclosing material nonpublic information about their business to analysts and stockholders. But analysts have no liability under the law — although bribing people to give information could lead to fraud charges, and trading on information gained through misrepresentation or bribery could constitute insider trading, notes Tom Murphy, a partner at McDermott Will & Emery.
Moreover, calling or visiting a franchise's locations to gather information is standard practice for some analysts — "channel checking," in their parlance. Surveying customers and employees is "just good old-fashioned research," says Jonathan Boersma, director of standards of practice at the CFA Institute.
Arguably, though, Reg FD has caused analysts to become even more zealous in their pursuit of corporate information. The elimination of selective disclosure has put a higher premium on other types of primary research, like channel checking, as analysts strive to distinguish their work. "You've got commoditized information out there now that everybody has access to," says Louis Thompson, president and CEO of the National Investor Relations Institute (NIRI). "Analysts are scrambling for little bits and pieces of proprietary information."
Meanwhile, buy-side research is growing, driven in part by hedge funds, whose number has risen significantly over the past few years. Many funds are known for their aggressive — and in some cases legally dubious — research tactics (see "The Booming Buy Side" at the end of this article).
Chris Morris, CFO of CEC Entertainment and a former colleague of DiRaimo's, has seen his share of enterprising analysts. CEC operates the Chuck E. Cheese's chain of pizza and arcade venues. "Where I believe [analysts] cross the line is when they start to interrogate our employees," says Morris. "If they call 200 or 300 store managers and ask for sales information, that is just a systematic way of potentially obtaining material nonpublic information."
Restaurant chains aren't the only subjects of aggressive research. At medical-device maker Kensey Nash Corp., CFO Wendy DiCicco says analysts frequently call doctors to ask questions about the company's products. "What is aggravating is we'll get a call from a doctor who says, 'This guy has called me four times.' We can't stop the analysts from calling, and it turns into a negative thing between us and the doctor," she says. DiCicco adds that analysts will also visit trade shows to try to get information from Kensey Nash salespeople. "If a new guy is working at our trade-show booth and he tells an analyst that we're expecting approval on something tomorrow, and we haven't announced that, we have a problem."
Struggling for Relevance
True, many CFOs consider channel checks a routine part of being a public company. "Our analysts are in our stores all the time," says Michael Kramer, CFO of apparel retailer Abercrombie & Fitch. "You can't get anything by them. The minute something goes on markdown, they know about it." Kramer claims he has no problem with the practice. "We're always open to hearing what's going on with our stores," he says. "We really don't have anything to hide."
But thanks to Reg FD, companies have become increasingly cautious about how and when to release data. Gone are the days when analysts would send their earnings models to CFOs for review. "There was a time when an analyst might expect a CFO to run through those models line item by line item," says Charles Glovsky, a senior vice president and portfolio manager at Independence Investments, a buy-side investment-management firm owned by City National Corp. "That certainly doesn't happen anymore."
In addition to the restrictions placed on CFO-Wall Street communications by Reg FD, analysts have also had to struggle for relevance since the 2003 global research settlement mandated the separation of research activities from investment-banking business. Many analysts have lost their jobs, with Morgan Stanley one of the latest investment banks to announce layoffs.
CFOs, meanwhile, have seen a well-documented increase in both their workload and their personal liability with the passage of the Sarbanes-Oxley Act in 2002. "I think you're seeing frustration by both parties," says Patrick Hojlo, a former health-care analyst for Credit Suisse who recently left to co-found hedge fund Coeus Capital Management. "Analysts may feel that in years past they got more information from companies, and perhaps that lack of information leads to an inappropriate level of mistrust."
Points of Tension
Aggressive on-the-street research tactics aren't the only point of tension between CFOs and analysts these days. Finance chiefs also report receiving multiple calls on the day before quarterly results are released from analysts hoping to get a read on the quarter based on the CFO's tone of voice. Some have found analysts consistently publishing higher earnings estimates than the company's guidance suggests is feasible, only to slam the company in a report when it fails to hit the higher number. CFOs also field repeated calls on topics they have explicitly said they won't discuss.
"Sometimes they aren't even subtle enough to ask the question different ways," says David McGirr, CFO at Cubist Pharmaceuticals Inc. "They're just trying to wear you down and see if you'll throw up your hands and give them the information."
Analysts aren't thrilled with the current environment, either. Some cite CFOs who hide behind Reg FD to avoid sharing any information. Others bristle at the expectation that an analyst should simply fall into line with the company's public story. Some 41 percent of analysts surveyed by IR magazine reported that companies they cover have retaliated against them in some way after receiving negative coverage in the past year, whether by declining to take their calls, refusing to hear their questions during conference calls, or threatening to take away some other part of the company's business from an analyst's employer.
"Companies want analysts to be an extension of their IR department," says Jonathan Waite, a former restaurant analyst at KeyBanc Capital Markets who also recently left to start a hedge fund, McKay Capital Management, in Las Vegas. "That doesn't really help investors. Investors applaud us for finding out what the management team isn't telling us."
At Altera, a semiconductor maker, tension between management and analysts reached an extreme in 2005. Management stopped taking questions from Tad LaFountain, an analyst for Wells Fargo Securities who had been critical of Altera's share-buyback program. CFO Nathan Sarkisian also reportedly informed a J.P. Morgan Securities analyst that the company planned to cease communication with him. LaFountain announced that he was discontinuing coverage of Altera, and Sarkisian subsequently issued a public apology. Sarkisian has since announced his impending retirement, and the Securities and Exchange Commission has opened a related inquiry.
But what if this prickly environment is exactly what Reg FD was intended to create? "I think FD's goals have been met," says Murphy of McDermott Will & Emery. "The way people conduct themselves and the way they handle inside information has changed a lot." It may not be fun for the parties involved, but skeptical analysts are likely to serve investors much better than those who are currying favor with CFOs in the hopes of winning investment-banking business.
"Ultimately, the investor benefits, because analysts are no longer spoon-fed by companies and they have to do their own work," says Independence's Glovsky. "There's probably more original work being done."
Setting a Strategy
Since, like it or not, the underlying market dynamics are unlikely to change, CFOs need a strategy for managing their interaction with equity researchers. Those finance executives who report pleasant dealings with their analysts credit their own regular, generous disclosure practices, as well as their accessibility, for the relatively stress-free relationships. By sharing significant company data in press releases and on conference calls, CFOs can pave the way for more wide-ranging and satisfying discussions with analysts than if they release the bare minimum, which, under Reg FD, would restrict what they could say going forward.
"We try to be very transparent, for the very reason that when one of my analysts calls me, I want to discuss [his or her] questions," says David Flanery, finance chief at pizza chain Papa John's International Inc. "When the information is out there, I can speak more comprehensively." Flanery also says the company is consistent in its disclosure. For example, Papa John's never talks about future promotions and does not reveal its statistics on the number of transactions at its stores or the average ticket size. (Of course, analysts still ask for this data: "That's the only area where we get pushback," says Flanery.)
Glovsky advocates such an approach. "CFOs should set the rules about when the quiet period begins and ends and what amount of guidance and detail they're going to consistently provide," he says.
McGirr of Cubist stresses the need to treat all analysts equally, regardless of their rating on the stock. "I have a sense that some CFOs struggle with analysts who are not as positive on their [company's] story," he says. "But I see it as one of the great challenges of the job, to take analysts who are neutral or negative and convince them. I'll work years to bring them around." Fielding questions from analysts who are bearish on a stock gives the CFO an opportunity to correct any misunderstandings and to prepare himself to address any potential weaknesses that the analyst highlights. Says McGirr: "I don't take the position that because they don't have a buy on your story, they're wrong."
Regarding channel checks, companies must also take steps to protect information they don't want released inadvertently to analysts or hired researchers. "You need to have systems and policies in place to make sure people are not running off and making selective disclosures," says Murphy. At Papa John's, where independent franchisees run 80 percent of the chain's restaurants, Flanery tells franchisees and store managers to feel free to talk to analysts, but urges them simply to refrain from sharing information they wouldn't share with a competitor.
Employees can be trained to recognize and respond to questioners. Applebee's reacted to its channel-checking woes by instructing employees to send all questions to headquarters, and by warning that acceptance of payment for information about the company would result in dismissal. At Kensey Nash, DiCicco says the company gives training sessions to sales employees before every trade show to instruct them how to determine who is an analyst or a competitor and how to handle their questions.
Maureen Wolff-Reid, NIRI chair and president of investor-relations firm Sharon Merrill Associates, urges companies to consider such training for employees who may not realize that they are privy to valuable information. "Companies need to take a much more proactive approach in educating their employees about what someone might find interesting, using real-life examples that are germane to their company," she says. For example, when an analyst is visiting a company, he might ask an employee whether the number of boxes sitting on a loading dock is typical, or more than usual. While this might not seem important to the worker, the answer could give the analyst some sense of the business's momentum.
Ultimately, CFOs must simply be patient. As the Altera hubbub showed, retaliation will only make the angry executive look bad and raise questions as to what the company is trying to hide. With chairman Christopher Cox looking into the issue, the next finance executive to fly off the handle may end up as a test case for the SEC.
"We really focus on our business, and the relationship with the analyst is just secondary," says Abercrombie's Kramer. "If we focus on growing our business, it shouldn't be an issue."
Such good-humored forbearance seems to be the best solution as both CFOs and analysts continue to adjust to the post-FD dynamic. "There has to be mutual understanding between these two parties that things have changed," says Hojlo, the former Credit Suisse analyst. "If you're a CFO, you can't get mad at analysts for uncovering information. And if you're an analyst, you can't get mad at the CFOs because you don't have the information you want from them. Both sides have to respect the added pressures."
Kate O'Sullivan is staff writer at CFO.
Rules of Engagement
The National Investor Relations Institute and the CFA Institute have drawn up guidelines to govern company-analyst interaction and, hopefully, avert future feuds. The guidelines, excerpted below, have been sent to the CEOs of all companies listed on the major exchanges and on the Russell 1,000. — K.O'S.
Analysts, investors, and corporate issuers must not disrupt or threaten to disrupt the free flow of information between each other in an attempt to influence the behavior of those with whom they are communicating .
Corporate issuers must not:
1. Discriminate among recipients of information disclosed by the issuer based on the recipient's prior research, opinions, recommendations, earnings estimates, or conclusions;
2. Restrict, deny, or threaten to deny information or access to company representatives in an attempt to influence the research, recommendations, or actions of the analysts and investment professionals; or
3. Attempt to influence the research...of analysts or investment professionals by exerting pressure through other business relationships
Corporate issuers must provide [qualified persons] access to knowledgeable company officials.... Corporate issuers should establish and adhere to policies that set forth how the company will respond to requests for access and should disclose these policies to analysts and investors upon request.
(From "Analyst/Corporate Issuer Best Practice Guidelines," CFA Institute/NIRI Task Force, 2004)
The Booming Buy Side
As the pressure on sell-side researchers grows, many analysts have moved to the buy side. "A lot of the best and brightest have gone to the buy side," says Louis Thompson, CEO and president of the National Investor Relations Institute (NIRI). Integrity Research Associates LLC predicts that the buy side will double its 2004 research spend by 2009.
Buy-side analysts can be expected to do more of the grass-roots research that some CFOs have decried as overly aggressive. "People who are inclined to get out from behind their desks and who feel most intellectually rewarded by doing their own unique, proprietary research are less likely to stay on the sell-side," says Patrick Hojlo, a former Credit Suisse analyst. While sell-siders spend as much as 65 percent of their time on client service, buy-side analysts can spend 90 to 95 percent of their day researching investment ideas, he says.
Meanwhile, the growing hedge-fund sector has become a big customer of Wall Street's sell-side research groups. According to Scott Barry, managing director of the Equity Research Group at Credit Suisse, commenting at a recent NIRI Web seminar, "There's been a shift more toward servicing the hedge funds." As a result, even sell-side analysts are trying to get out to stores and restaurants in an effort to satisfy the funds' demand for granular, up-to-the-minute data. "They're trying to make a name for themselves," says NIRI chair Maureen Wolff-Reid. "They want to look like they have the inside scoop." — K.O'S.