The Flight of the Sell-Side Analyst

Small-cap and mid-cap companies -- and some large companies, too -- are suffering through a drought of sell-side analyst coverage. The dearth is moving some executives to think about bypassing analysts altogether.

The situation of fewer analyst bodies doing more work can also lead to “analyst churn.” The increased switching of analysts from company to company is the most significant change in investor relations over the past few years, notes Bruce Nolop, CFO of Pitney Bowes Inc. The turnover, he explains, forces the Pitney Bowes investor-relations team to constantly reeducate analysts about the not-so-easily-defined company. A venerable postage-meter manufacturer with a $10 billion market cap, the company has made a recent foray into mailroom services and outsourcing.

In December 2002, 10 sell-side analysts covered Pitney Bowes, Nolop recounts. But by April 2004, that number had dropped to five — three of whom are still new to the company story, having come on board since 2002. That’s left Pitney Bowes with only two veterans, Carol Sabbagah of Lehman Brothers and Shannon Cross, formerly of Merrill Lynch, now with the eponymous Cross Research.

Besides the diminished analyst workforce, Wall Street economics are also spurring shifts in coverage. In effect, the research subsidiaries that employ sell-side analysts aren’t self-sufficient. Investment banks and brokerage houses derive operating profits from investment-banking fees and share-trading commissions, not analyst reports. In the end, sell-side research tends to be a loss leader, bundled for clients along with lucrative services.

Thus, it’s the fees and commissions that “drive analyst coverage,” maintains Reuters’ Kaul, “because that is where the money is.” He contends that many small-cap and mid-cap companies that have great investment potential don’t garner coverage because they don’t represent a substantial source of profit for the firms.

Others agree with Kaul’s assessment. San Francisco-based investor-relations consultant Peter Ausnit, a former sell-side analyst, predicts that over the next decade, sell-side research sponsored by big financial-services firms will increasingly focus on large companies that support Wall Street’s revenue model. Further, analysts tied to big Wall Street firms will soon focus on “only a handful of big-cap stocks that provide sufficient profit margins,” predicts Richard Wayman, president of researchstock.com.

Indeed, the focus seems to be shifting already. Multibillion-dollar behemoths like Comcast Corp., Texas Instruments, and BellSouth Corp., for instance, have dramatically increased coverage since 2002, according to Reuters Research. Each of those companies added 11 new analysts over the period, giving each one the coverage of more than 30 analysts.

For the companies who end up losing what increasingly seems like a zero-sum game, however, the consequences can be severe. Sell-side analysts can provide a smooth passage for a company into the capital markets, supplying an imprimatur for investors seeking guidance about which shares to stock up on. Further, many analysts are aggressive matchmakers, introducing institutional investors to the companies they cover.

Witness the good meeting that analysts have given to FuelCell Energy Inc., a $780 million alternative-energy company based in Danbury, Connecticut. Investor-relations director Steve Eschbach says executives met with more than 65 potential investors during 2003, and equity analysts arranged half of the introductions.

Further, sell-side research can present company deficiencies within a larger company or industry scope. “Sell-side analysts put the bad news in context,” says Nolop of Pitney Bowes, noting that most CFOs appreciate that kind of help when investors are skeptical about management’s perspective.

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