After reviewing corporate disclosures and interviewing management to add depth to the picture, IR can move to the next step in definition: determining the comparable group. To do this, IR should create a spreadsheet with a dozen or more companies, in the same industry or with the same business model, and with a similar market cap. These companies are commonly re- ferred to as comps.
Every sector trades within a given multiple range, usually related to business model characteristics and outlook for profit growth. Traditionally slower-growth industries, such as consumer staples or industrial manufac- turing, tend to trade at lower multiples than the historically faster-growth in- dustries, such as technology and health care.
A company identified with the wrong peer group may be trading at a multiple that actually discounts their true value. This problem is espe- cially pressing if the company has been locked into the multiple of a slow- growth industry when the company is actually thriving. This situation hap- pens for one of two reasons. Either the company has been positioned incorrectly, or the company is relatively unique and the peer group needs to be established.
Identity
Companies that are covered by several analysts should look at each analyst’s coverage universe. If one analyst covers a group of stocks that is much dif- ferent from another, then that’s an indication that the story might need refinement.
Companies should make sure they are reaching the appropriate audi- ence, which means studying comparables that are more in line with their business and looking closely at operations, sales and service structure, intel- lectual protection, size, and so on. The conclusion may initiate a change in the tag line and an overhaul of communications.
A Horse of a Different Color
Though some companies have clear business propositions and fall neatly into peer groups on Wall Street, many do not.
For example, a national landscaping company may be the only one of its kind that’s publicly traded. There aren’t ten publicly traded landscaping companies that IR can analyze to determine relative valuation. Creativity or outside help from Wall Street is needed here. In this example, IR might re-
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alize that the landscaping company has a national infrastructure that serv- ices individual homes, which is similar to that of Rollins, Inc., the parent company of Orkin Pest Control, and also similar to The Brinks Company’s division for household alarms, Brinks Home Security. These companies, presumably of the same size (give or take $100 million in value), are very much alike and have the same capital needs and similar margins—
they are good comparables. Wall Street tends to give these businesses simi- lar multiples.
In other situations, two peer groups are needed. If a company fits well with one group because of its industry, but also another because of its busi- ness model, IR can consider offering both groups up for comparison. Shuf- fle Master Gaming is a company that designs and distributes products to the casino industry, so their initial comp group is made up of casino equip- ment manufacturers. However, their focus on patented technological solu- tions and their recurring revenue business model make the company ap- pealing to buyers of technology stocks, so a second technology comp group might emerge.
It’s simply an exercise in valuing a company two ways with the hope that there might be inefficiency in the marketplace relative to one of those comp groups, leading to a buying opportunity.
Companies with multiple divisions or brands, or ones that both manu- facture and sell items through retail, do not fit so neatly into any box and may be muddled in the mix of a peer group that represents only part of the company’s business. In this instance, IR may want to establish a new peer group altogether, perhaps even defining a whole new industry, and look for companies with similar makeups for comparison. Even more radical, IR may want to suggest a new valuation methodology.
Imagine a company called Spare Change, which had a unique business proposition that was not well defined by The Street. Spare Change provided financial transaction processing services primarily in supermarkets, although The Street didn’t really compare them to similar companies. In fact, the an- alysts who covered Spare Change (see Table 14.1) were an eclectic group and lumped the company into categories that included retailers and general consumer products companies.
These three analysts all spent their time following different companies.
The research universes suggested that Spare Change would be better posi- tioned with a more appropriate analyst base.
At that point, the IR Audit took hold of the company’s definition, nar- rowed it down to electronic transaction processing, and suggested not only a clarification of the company itself, but also the industry in which it com- petes. This instigated a reconsideration of Spare Change’s peer group and
positioned the company for an upward adjustment of its multiple. The new valuation goal was more in line with financial services comparables rather than consumer products like tissue or toothpaste.
A company moves closer to optimal value when it is trading at the mul- tiple that correctly corresponds to its business characteristics. Additionally, a new definition may open the company up to other coverage universes, cre- ating a reason for more analysts to consider it.
Just a few years ago, one of the largest leisure craft retailers was per- ceived more like a manufacturer and consequently received the lower man- ufacturer’s multiple instead of a higher retailer multiple. Investors saw risk in high-ticket items, but management had done an amazing job of generat- ing consistent financial results over time, suggesting that the retail multiple was appropriate. Once discovering The Street’s perception of its business, IR repeatedly communicated the correct retail positioning to investors, backed up by numbers: store-level return on investment and same store sales. For- tunately, the company is now measured against other hard goods retailers, but it didn’t happen overnight.
Another client, a small sports equipment manufacturer, had always been viewed by The Street as competing in a tough industry with low multiples, about an 8 P/E on forward-year earnings. After looking more closely at the business model, IR recognized that this company was not much like the other players in the field, many of which were waning under the weight of their outmoded product offerings or high infrastructure costs. This company had, in fact, evolved beyond its peers and was more of a lifestyle company with a brand name that could easily be leveraged across a host of other products.
Other companies compared better to this firm, and so IR repositioned it into a new group and changed all financial communications accordingly.
This sector traded at triple the multiple of the company’s original sector and positioned the company as relatively undervalued as management built the business.
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TABLE 14.1 Analysts and Companies
Analyst 1 Analyst 2 Analyst 3
Spare Change Spare Change Spare Change
Ediets RMH Teleservices Checkfree Corp
Imax Valuevision GTECH Holdings eFunds
PF Changs Scientific Games Global Payments
Nautilus Danka Business Solutions New Frontier Media
Creating this new comp group was a great new start, and a fresh per- spective for the analysts and their sales forces. If that repositioning exercise had not been undertaken, The Street would have likely continued to define the company in a low-multiple industry. Taking control and redefining its own comp group repositioned the company to significantly increase share- holder value.
Redefining and repositioning both in terms of qualitative presentation and quantitative metrics can add value. Once the appropriate group is established, all communications of the company must relate to the new comparables.