CHAPTER 14 The IR Audit

The Street is looking for an investment opportunity, and the group that positions

and communicates that opportunity is investor relations. Before

any interaction between The Street and the company can occur, though, a

company must define its current position and future plans. This is the definition

stage of IR and it starts with the IR audit.

The IR audit is the first step in self-realization for companies and the

first step in honing their peer group. The audit stems from the valuation

methodology Wall Street professionals use, and the goal is to undertake the

same exercise as the folks who will be buying or publishing on the company’s

stock.

In the audit, IR should

Review disclosures and analyze financials

Interview senior management

Identify comparables

Determine relative valuation

Get capital markets feedback

Gather industry intelligence

To best position any company in the context of other companies

around them, IR must understand all it can about the company and its philosophy,

determine relative value, and collect salient information and outside

perspectives. Then, once the company has drawn up as much knowledge

and intelligence as it can, IR takes the final step of the definition stage

and excavates, crafts, and positions the value story.

The following are steps for the IR audit, regardless of the size of the

company and regardless of whether IR is handled internally, externally, or a

combination thereof.

STEP ONE: REVIEW DISCLOSURES, ANALYZE

FINANCIALS

Definition begins with superior knowledge of the company. Even the most

entrenched IRO should begin by reviewing all company disclosures and releases,

including historical filings, company reports, and news coverage, as

well as past and current financials. Among these resources are:

The last 10-K: This gives the best and most detailed view of the business.

IR should look for competitive advantages, barriers to entry, consistency of

performance, the business model, historic margins, historic sales, and EPS

performance. Additionally, by surveying recent transactions, mergers or acquisitions,

and debt repayment or share repurchases, IR can see if management

has historically created value in the base business.

The last two 10-Qs: This gives significant quarterly information since

the 10-K filing. The 10-Q is not as thorough as the 10-K but gives a great

update on the business, particularly in the MD&A (management discussion

and analysis) section. Also, the income statement, the balance sheet, and the

cash flow statement are all on display in the 10-Q, and all the year-over-year

comparisons are laid out for the investing public. IR should review the Qs for

all of the above items to gauge sequential and year-over-year performance.

The last two earnings releases: IR is looking for content and style here.

Specifically, is it formatted correctly (not too long or too short, not full of

unnecessary quotes) and written properly (simple yet informative, not looking

as if a legal team wrote it or an accountant wrote it)? Are the appropriate

metrics highlighted in a way that is easy for Wall Street to digest? Additionally,

IR should check what time of day it was released. Companies

should schedule both the release and the conference call after market hours.

As we discuss in the Delivery section, timing of the release and conference

call is critical to minimizing risk.

Stock chart: The historical stock performance should be studied for an

idea of how the price has reacted to earnings over time. It should also be

studied for an idea of where the stock is during the definition stage. Is the

stock at a 52-week high or low? Somewhere in the middle? The recent price

and current valuation play a large part in determining the strategy when it

comes to the delivery stage.

The board of directors: IR should also know who’s who and look for

any recognizable names. A high-profile former CEO or someone known on

Wall Street for previous successes is a great point to highlight to the world.

Following the review comes the interview.

STEP TWO: INTERVIEW SENIOR MANAGEMENT

IR can only go so far on SEC disclosures and press releases. Management

has to fill in the blanks and talk about strategy. The IRO and/or outside IR

counsel should sit down with management and learn the executives’ philosophy

on business and the current and future plans for the company.

In addition to gaining valuable information, these interviews help IR

gauge the executive’s capacity for dealing with analysts and portfolio managers

and can play into the decision about who will talk to The Street and

when. The content of the interview should be as follows:

Ask both the easy and tough questions. The latter is important to understand

how the CEO reacts under pressure. Also, the CEO would

rather field a tough question from a team member rather than from a

portfolio manager when he’s unprepared.

Methodically go through the top line and the drivers of the business. If

the company has several business units, IR needs to go through the top

line of each.

Discern management’s thoughts on its competitive advantages and barriers

to entry—first-mover advantage, patents, experience, and relationships

of the sales force.

Discuss marketing, market share, and advertising. Do those expenditures

translate to the bottom line? Does the business respond to promotions?

How has the company taken market share from competitors and

under what circumstances?

Ask about culture and the principles management attempts to instill in

the company and the employees.

Talk through the expense side of the income statement with both

the CEO and the CFO together. Go through every line and talk about

how these line items, such as Selling, General, & Administrative

(SG&A) expenses, marketing, will increase relative to sales. Try and get

at the operating leverage of the company. If sales go up $5 and the

expenses only go up $1, that’s leverage and a great selling point to

Wall Street.

Interview the CEO and CFO about the balance sheet. How much cash

is on hand? How much net cash does the company generate every quarter,

and what does management plan on doing with it? What’s the historic

return on equity? Does it sit in the bank and earn 1 percent, or is it

reinvested in the business? Is it used to buy a business or repay debt or

repurchase shares? These critical questions will definitely be asked by

the sell- and buy-sides.

The interview process should make the SEC disclosures come to life

and give IR a better idea of the overall company and the competitive landscape.

The interview also allows IR to gauge how solid management will be

when presenting. Can they answer the tough questions? Does the CFO have

the numbers at her fingertips? Is the CEO straightforward or evasive? After

the interview stage, IR might decide that if the CEO hits the road, his lack

of immediacy with the numbers would require that the CFO go along for

every meeting.

THE STAKEHOLDERS

From an overall communications perspective, the opinions of all stakeholders

in the supply chain, including vendors, customers, employees and consumers,

can have a profound effect on the value and morale of the company.

IR must keep tabs on the pulse of these stakeholders, yet gathering this

information is no easy feat. The responsibility of all good corporate communications

leaders is to establish simple, two-way avenues of communications.

For stakeholders such as vendors and customers, IR should work with

the appropriate internal manager to comb through internal or external

communications to obtain their opinions as well as initiate relationships

with specific point people willing to extend honest feedback. Employees

can be reached through newsletters, presentations, and other internal communications,

but employees must also be encouraged and motivated to

upstream opinions to management, rather than leak them to the public.

Frequent management employee question-and-answer sessions can be arranged

and monitored by IR in the same way that IR executes these presentations

for investors.

Information from key stakeholders is invaluable. Management should

incorporate the factors that support their position, or, if it does not like what

it hears, adjust the reality to improve the perception of those in the know.

Hard-core finance or stock junkies who might think this approach is a

little “touchy-feely” should think again. The culture that Sam Walton nurtured

at Wal-Mart made the company a world superpower capable of generating

over $1 billion in revenue per day. The same goes for Bill Gates, who

challenges the best and brightest to maintain a culture that innovates faster

and better than the competition. A solid, open culture enhances value and

creates a long-term, vibrant company. One of the major problems of the

1990s’ stock market bubble was overreaching management teams and their

financial backers being more concerned with building and selling companies

rather than building a long-term, sustainable business and culture.

STEP THREE: IDENTIFY COMPARABLES

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 referred

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 manufacturing,

tend to trade at lower multiples than the historically faster-growth industries,

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 especially

pressing if the company has been locked into the multiple of a slowgrowth

industry when the company is actually thriving. This situation happens

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 different

from another, then that’s an indication that the story might need

refinement.

Companies should make sure they are reaching the appropriate audience,

which means studying comparables that are more in line with their

business and looking closely at operations, sales and service structure, intellectual

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 realize that the landscaping company has a national infrastructure that services

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 similar

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 business

model, IR can consider offering both groups up for comparison. Shuffle

Master Gaming is a company that designs and distributes products to

the casino industry, so their initial comp group is made up of casino equipment

manufacturers. However, their focus on patented technological solutions

and their recurring revenue business model make the company appealing

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 manufacture

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 analysts

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 positioned

with a more appropriate analyst base.

At that point, the IR Audit took hold of the company’s definition, narrowed

it down to electronic transaction processing, and suggested not only

a clarification of the company itself, but also the industry in which it competes.

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 multiple

that correctly corresponds to its business characteristics. Additionally,

a new definition may open the company up to other coverage universes, creating

a reason for more analysts to consider it.

Just a few years ago, one of the largest leisure craft retailers was perceived

more like a manufacturer and consequently received the lower manufacturer’s

multiple instead of a higher retailer multiple. Investors saw risk

in high-ticket items, but management had done an amazing job of generating

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. Fortunately,

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.

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 perspective

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 shareholder

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.

STEP FOUR: DETERMINE RELATIVE VALUE

Once the comparables are chosen, IR must use valuation skills to determine

the company’s relative valuation. Is it overvalued, fairly valued, or undervalued

relative to its peer group? The story that’s ultimately crafted depends

on that answer.

The valuation comparison is a comparison of financials across the company’s

comp group. IROs should construct a spreadsheet of all comps and

their market cap, stock price, last year’s earnings, next year’s earnings estimates

(the analyst consensus), long-term debt, last year’s EBITDA (the consensus),

and next year’s EBITDA. IR should double-check all of the P/E and

EV/EBITDA formulas, and those two columns yield relative valuation. This

comparison chart gives a snapshot of relative value and helps a company see

where—high, low, or in the middle—it trades.

STEP FIVE: GET CAPITAL MARKETS FEEDBACK

After having read up on the history of the company, held interviews with

management, and run a comp analysis that helped to determine the relative

Recently, many gaming companies adapted a valuation argument created

by Daniel Davila, an analyst at Sterne, Agee, & Leach. Mr. Davila

made a credible argument that the best gaming companies should be

compared not only to each other, but also to other entertainment-related

companies like hotels and entertainment conglomerates, both of which,

historically, have traded a premium valuations to the gaming sector.

valuation, IR should figure out the reason for the valuation. The first source

is The Street.

If the company is undervalued, is it because they are terrible communicators

or is it a negative view of management? Is there a perceived competitive

threat?

Wall Street professionals have seen companies come and go. They’ve

witnessed the cycles as those companies either emerge or sputter, grow or

struggle, and are familiar with both success and failure. While most would

argue that no one can ever know a company as well as its management team,

smart CEOs should realize that an outsider’s perspective is sometimes

needed to help the insider see most clearly.

IR should first find out who on the buy-side owns the stock and which

analysts cover it. Then give them a call and start asking questions. Some

portfolio managers and analysts will have time to talk. Perhaps they feel that

management’s compensation is too weighted toward options, the company’s

business is threatened by a new competitor, or the CEO isn’t credible, and

they wouldn’t buy the stock on that basis. Perhaps they ultimately think that

the company is inconsistent with no credibility, routinely overpromising and

underdelivering.

The Analysts

Analysts are the go-to folks for anyone who wants to gather industry and

company-specific knowledge. Although they may not cover every stock in a

given sector, they do know about most of the companies and have a good

idea about their value.

Therefore, a quick phone call or a conversation with the analyst at an

industry conference can help the company’s IR professional form an idea of

how the company’s story is perceived relative to its peers. If an IR professional

has some helpful and specific industry knowledge that he or she can

provide to the analyst, this helps the analyst learn something too. Perhaps

seek out this IR professional and his or her company as a go-to incremental

knowledge or channel check. Over time, this relationship can certainly lead

to better feedback.

STEP SIX: GATHER INDUSTRY INTELLIGENCE

Finally, IR needs to know what the investor community expects from a sector

and the companies in that sector. No matter the valuation method, all

companies are judged relative to other companies. There’s simply no better way to determine how much to pay for a stock. And rarely are two industries

alike. Each has its own competitive issues and dynamics.

The final step in the IR audit, before developing the company story, is

industry intelligence.

History

Any executive, analyst, or investor can attest to the fact that the history of

each industry surfaces incessantly. The stories of who came first, who came

before, what’s been done, and who did it texture the dynamics within the

sectors and are often cited as precedents for evaluation of current actions. If

anyone else, another company or an analyst perhaps, knows these precedents,

the company is best served to have someone inside its walls who

knows these things too.

Current Conditions

In order to gather information on the industry in which the company competes,

IR should collect information from a variety of sources. These include

SEC filings; analyst research reports; conference call transcripts; the industry

trade papers; company communications, such as employee newsletters

and conference and convention minutes; and conversations with consumers,

customers, and vendors.

During this review, understand what the disclosures say about the other

businesses. IR may have discovered, during the review and interview steps of

the IR audit, that her company had rock-solid growth of 20 percent per year

and the same projected going forward. Yet this growth doesn’t seem as impressive

if, after reviewing the filings of the peer group, other companies are

growing at 30 percent, have better balance sheets, and have invested in new

technologies.

In addition to the disclosures of public competitors, IR should investigate

all stakeholders in the industry, including suppliers, vendors, financiers,

and so on. Trends are always emerging. Consumer behavior patterns, supply

channel efficiencies, government regulations, financing issues, and other topics

that affect every player come up in a sector. IR must have an ear on the

latest and greatest because it helps in defining the company to Wall Street.

Moreover, it can be assumed that the buy- and the sell-sides are also abreast

of these items.

Street Perceptions

Within the sell-side and the buy-side are pods of industry specialists and personalities

who differ as much as the industries themselves. In addition, the expectations, the salient issues, and the valuation techniques vary from one

industry to another.

Especially in the definition stage, IR must help management understand

how The Street is looking not only at the company, but at the sector. An objective

for restaurants is not an expectation in consumer products; a hot

issue in footwear may not even spark a twinkle of recognition in aerospace

and defense; a metric in retail is going to differ from any measure that’s central

to the technology sector.

IR should know how The Street is measuring the industry so that the

relevant topics within the company can be uncovered and highlighted. This

information is unearthed by reviewing the conference call scripts of industry

players and reviewing questions that analysts and portfolio managers ask.

It’s also done by reviewing research reports and monitoring First Call estimates

for an upward or downward bias.

THE RESULT OF THE IR AUDIT

After uncovering all the information it can, determining relative value, and

collecting perspectives, IR should be able to identify if (and why) the stock is

undervalued, overvalued, or fairly valued relative to its peers. For the purposes

of discussion, assume that a company is growing profits at 20 percent

but its stock is near a 52-week low and its multiple is 10x on a P/E basis. The

next step in the definition stage is discovering how to shrink the valuation

gap between the multiple and the company’s growth rate, which just so happens

to be the average multiple of the company’s peer group.

For example, let’s say that from all the information collected, the IR

audit has determined that XYZ Corp. is a terrible communicator. The CEO

doesn’t know when to stop selling, which plays poorly on Wall Street. In addition

to poor communication skills, the buy-side perceives, falsely by the

way, a threat from a new competitor, and finally the company has $40 million

in cash and hasn’t declared a use for it in over two years.

The next step would be to rebuild the story. IR should

Uncover positive value

Counteract any concerns

Correct any misconceptions

Package the company into a carefully crafted message

In the XYZ Corp. example, rebuilding the story would include establishing

conservative guidance that helps management build credibility by achieving self-set earnings estimates over time, developing a presentation

that highlights diversification in the business and shows that the competitive

threat really is insignificant, and encouraging management and the board to

announce a share repurchase authorization to put the balance sheet cash to

work in an accretive manner. These steps, initiated by management and the

IRO, should pay dividends in terms of closing the aforementioned valuation

gap. In all likelihood, Company XYZ’s multiple will expand and close in on

the 20x range, adding tens of millions of value to shareholder wealth.

Another example of an audit to success story is Cinderella Story & Sons,

a fairly new company to the public markets. They had a product that had

penetrated a variety of channels and surfaced into consumer awareness.

They had a good business proposition and a unique operating model, but

The Street was not viewing it enthusiastically. The stock price was down,

and Cinderella didn’t know why.

An IR team conducted an audit that included a review of the disclosures,

interviews with management, identifying the comparables, determining

relative value, getting capital markets feedback, and garnering industry

intelligence.

Once the problems were found, IR addressed them one by one and decided

that Cinderella Story & Sons needed just a few adjustments. The company

reevaluated its profile and changed its tag line to fit into a peer group

that was more in line with the products they offered. This group also traded

at a higher multiple, which the company justified by showing similar growth

drivers that matched the comparables in that group.

IR also recommended that management renew its focus on free cash

flow generation capabilities, their balance sheet, and their investment in

long-term growth initiatives. This repositioned the company as a great value

stock—that is, not growing necessarily, but generating free cash flow, paying

down debt, and carrying a much more attractive risk/reward profile than a

company with a growth multiple.

By conducting an IR audit, companies can set themselves up to rebuild

their story. With a focus on company knowledge, industry intelligence, and

relative valuation, IROs will find that when they are fully informed, they

have the right tools to advise a busy CEO, and the confidence to talk to even

the most sophisticated analyst.

The Street is looking for an investment opportunity, and the group that positions

and communicates that opportunity is investor relations. Before

any interaction between The Street and the company can occur, though, a

company must define its current position and future plans. This is the definition

stage of IR and it starts with the IR audit.

The IR audit is the first step in self-realization for companies and the

first step in honing their peer group. The audit stems from the valuation

methodology Wall Street professionals use, and the goal is to undertake the

same exercise as the folks who will be buying or publishing on the company’s

stock.

In the audit, IR should

Review disclosures and analyze financials

Interview senior management

Identify comparables

Determine relative valuation

Get capital markets feedback

Gather industry intelligence

To best position any company in the context of other companies

around them, IR must understand all it can about the company and its philosophy,

determine relative value, and collect salient information and outside

perspectives. Then, once the company has drawn up as much knowledge

and intelligence as it can, IR takes the final step of the definition stage

and excavates, crafts, and positions the value story.

The following are steps for the IR audit, regardless of the size of the

company and regardless of whether IR is handled internally, externally, or a

combination thereof.

STEP ONE: REVIEW DISCLOSURES, ANALYZE

FINANCIALS

Definition begins with superior knowledge of the company. Even the most

entrenched IRO should begin by reviewing all company disclosures and releases,

including historical filings, company reports, and news coverage, as

well as past and current financials. Among these resources are:

The last 10-K: This gives the best and most detailed view of the business.

IR should look for competitive advantages, barriers to entry, consistency of

performance, the business model, historic margins, historic sales, and EPS

performance. Additionally, by surveying recent transactions, mergers or acquisitions,

and debt repayment or share repurchases, IR can see if management

has historically created value in the base business.

The last two 10-Qs: This gives significant quarterly information since

the 10-K filing. The 10-Q is not as thorough as the 10-K but gives a great

update on the business, particularly in the MD&A (management discussion

and analysis) section. Also, the income statement, the balance sheet, and the

cash flow statement are all on display in the 10-Q, and all the year-over-year

comparisons are laid out for the investing public. IR should review the Qs for

all of the above items to gauge sequential and year-over-year performance.

The last two earnings releases: IR is looking for content and style here.

Specifically, is it formatted correctly (not too long or too short, not full of

unnecessary quotes) and written properly (simple yet informative, not looking

as if a legal team wrote it or an accountant wrote it)? Are the appropriate

metrics highlighted in a way that is easy for Wall Street to digest? Additionally,

IR should check what time of day it was released. Companies

should schedule both the release and the conference call after market hours.

As we discuss in the Delivery section, timing of the release and conference

call is critical to minimizing risk.

Stock chart: The historical stock performance should be studied for an

idea of how the price has reacted to earnings over time. It should also be

studied for an idea of where the stock is during the definition stage. Is the

stock at a 52-week high or low? Somewhere in the middle? The recent price

and current valuation play a large part in determining the strategy when it

comes to the delivery stage.

The board of directors: IR should also know who’s who and look for

any recognizable names. A high-profile former CEO or someone known on

Wall Street for previous successes is a great point to highlight to the world.

Following the review comes the interview.

STEP TWO: INTERVIEW SENIOR MANAGEMENT

IR can only go so far on SEC disclosures and press releases. Management

has to fill in the blanks and talk about strategy. The IRO and/or outside IR

counsel should sit down with management and learn the executives’ philosophy

on business and the current and future plans for the company.

In addition to gaining valuable information, these interviews help IR

gauge the executive’s capacity for dealing with analysts and portfolio managers

and can play into the decision about who will talk to The Street and

when. The content of the interview should be as follows:

Ask both the easy and tough questions. The latter is important to understand

how the CEO reacts under pressure. Also, the CEO would

rather field a tough question from a team member rather than from a

portfolio manager when he’s unprepared.

Methodically go through the top line and the drivers of the business. If

the company has several business units, IR needs to go through the top

line of each.

Discern management’s thoughts on its competitive advantages and barriers

to entry—first-mover advantage, patents, experience, and relationships

of the sales force.

Discuss marketing, market share, and advertising. Do those expenditures

translate to the bottom line? Does the business respond to promotions?

How has the company taken market share from competitors and

under what circumstances?

Ask about culture and the principles management attempts to instill in

the company and the employees.

Talk through the expense side of the income statement with both

the CEO and the CFO together. Go through every line and talk about

how these line items, such as Selling, General, & Administrative

(SG&A) expenses, marketing, will increase relative to sales. Try and get

at the operating leverage of the company. If sales go up $5 and the

expenses only go up $1, that’s leverage and a great selling point to

Wall Street.

Interview the CEO and CFO about the balance sheet. How much cash

is on hand? How much net cash does the company generate every quarter,

and what does management plan on doing with it? What’s the historic

return on equity? Does it sit in the bank and earn 1 percent, or is it

reinvested in the business? Is it used to buy a business or repay debt or

repurchase shares? These critical questions will definitely be asked by

the sell- and buy-sides.

The interview process should make the SEC disclosures come to life

and give IR a better idea of the overall company and the competitive landscape.

The interview also allows IR to gauge how solid management will be

when presenting. Can they answer the tough questions? Does the CFO have

the numbers at her fingertips? Is the CEO straightforward or evasive? After

the interview stage, IR might decide that if the CEO hits the road, his lack

of immediacy with the numbers would require that the CFO go along for

every meeting.

THE STAKEHOLDERS

From an overall communications perspective, the opinions of all stakeholders

in the supply chain, including vendors, customers, employees and consumers,

can have a profound effect on the value and morale of the company.

IR must keep tabs on the pulse of these stakeholders, yet gathering this

information is no easy feat. The responsibility of all good corporate communications

leaders is to establish simple, two-way avenues of communications.

For stakeholders such as vendors and customers, IR should work with

the appropriate internal manager to comb through internal or external

communications to obtain their opinions as well as initiate relationships

with specific point people willing to extend honest feedback. Employees

can be reached through newsletters, presentations, and other internal communications,

but employees must also be encouraged and motivated to

upstream opinions to management, rather than leak them to the public.

Frequent management employee question-and-answer sessions can be arranged

and monitored by IR in the same way that IR executes these presentations

for investors.

Information from key stakeholders is invaluable. Management should

incorporate the factors that support their position, or, if it does not like what

it hears, adjust the reality to improve the perception of those in the know.

Hard-core finance or stock junkies who might think this approach is a

little “touchy-feely” should think again. The culture that Sam Walton nurtured

at Wal-Mart made the company a world superpower capable of generating

over $1 billion in revenue per day. The same goes for Bill Gates, who

challenges the best and brightest to maintain a culture that innovates faster

and better than the competition. A solid, open culture enhances value and

creates a long-term, vibrant company. One of the major problems of the

1990s’ stock market bubble was overreaching management teams and their

financial backers being more concerned with building and selling companies

rather than building a long-term, sustainable business and culture.

STEP THREE: IDENTIFY COMPARABLES

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 referred

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 manufacturing,

tend to trade at lower multiples than the historically faster-growth industries,

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 especially

pressing if the company has been locked into the multiple of a slowgrowth

industry when the company is actually thriving. This situation happens

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 different

from another, then that’s an indication that the story might need

refinement.

Companies should make sure they are reaching the appropriate audience,

which means studying comparables that are more in line with their

business and looking closely at operations, sales and service structure, intellectual

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 realize that the landscaping company has a national infrastructure that services

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 similar

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 business

model, IR can consider offering both groups up for comparison. Shuffle

Master Gaming is a company that designs and distributes products to

the casino industry, so their initial comp group is made up of casino equipment

manufacturers. However, their focus on patented technological solutions

and their recurring revenue business model make the company appealing

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 manufacture

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 analysts

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 positioned

with a more appropriate analyst base.

At that point, the IR Audit took hold of the company’s definition, narrowed

it down to electronic transaction processing, and suggested not only

a clarification of the company itself, but also the industry in which it competes.

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 multiple

that correctly corresponds to its business characteristics. Additionally,

a new definition may open the company up to other coverage universes, creating

a reason for more analysts to consider it.

Just a few years ago, one of the largest leisure craft retailers was perceived

more like a manufacturer and consequently received the lower manufacturer’s

multiple instead of a higher retailer multiple. Investors saw risk

in high-ticket items, but management had done an amazing job of generating

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. Fortunately,

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.

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 perspective

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 shareholder

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.

STEP FOUR: DETERMINE RELATIVE VALUE

Once the comparables are chosen, IR must use valuation skills to determine

the company’s relative valuation. Is it overvalued, fairly valued, or undervalued

relative to its peer group? The story that’s ultimately crafted depends

on that answer.

The valuation comparison is a comparison of financials across the company’s

comp group. IROs should construct a spreadsheet of all comps and

their market cap, stock price, last year’s earnings, next year’s earnings estimates

(the analyst consensus), long-term debt, last year’s EBITDA (the consensus),

and next year’s EBITDA. IR should double-check all of the P/E and

EV/EBITDA formulas, and those two columns yield relative valuation. This

comparison chart gives a snapshot of relative value and helps a company see

where—high, low, or in the middle—it trades.

STEP FIVE: GET CAPITAL MARKETS FEEDBACK

After having read up on the history of the company, held interviews with

management, and run a comp analysis that helped to determine the relative

Recently, many gaming companies adapted a valuation argument created

by Daniel Davila, an analyst at Sterne, Agee, & Leach. Mr. Davila

made a credible argument that the best gaming companies should be

compared not only to each other, but also to other entertainment-related

companies like hotels and entertainment conglomerates, both of which,

historically, have traded a premium valuations to the gaming sector.

valuation, IR should figure out the reason for the valuation. The first source

is The Street.

If the company is undervalued, is it because they are terrible communicators

or is it a negative view of management? Is there a perceived competitive

threat?

Wall Street professionals have seen companies come and go. They’ve

witnessed the cycles as those companies either emerge or sputter, grow or

struggle, and are familiar with both success and failure. While most would

argue that no one can ever know a company as well as its management team,

smart CEOs should realize that an outsider’s perspective is sometimes

needed to help the insider see most clearly.

IR should first find out who on the buy-side owns the stock and which

analysts cover it. Then give them a call and start asking questions. Some

portfolio managers and analysts will have time to talk. Perhaps they feel that

management’s compensation is too weighted toward options, the company’s

business is threatened by a new competitor, or the CEO isn’t credible, and

they wouldn’t buy the stock on that basis. Perhaps they ultimately think that

the company is inconsistent with no credibility, routinely overpromising and

underdelivering.

The Analysts

Analysts are the go-to folks for anyone who wants to gather industry and

company-specific knowledge. Although they may not cover every stock in a

given sector, they do know about most of the companies and have a good

idea about their value.

Therefore, a quick phone call or a conversation with the analyst at an

industry conference can help the company’s IR professional form an idea of

how the company’s story is perceived relative to its peers. If an IR professional

has some helpful and specific industry knowledge that he or she can

provide to the analyst, this helps the analyst learn something too. Perhaps

seek out this IR professional and his or her company as a go-to incremental

knowledge or channel check. Over time, this relationship can certainly lead

to better feedback.

STEP SIX: GATHER INDUSTRY INTELLIGENCE

Finally, IR needs to know what the investor community expects from a sector

and the companies in that sector. No matter the valuation method, all

companies are judged relative to other companies. There’s simply no better way to determine how much to pay for a stock. And rarely are two industries

alike. Each has its own competitive issues and dynamics.

The final step in the IR audit, before developing the company story, is

industry intelligence.

History

Any executive, analyst, or investor can attest to the fact that the history of

each industry surfaces incessantly. The stories of who came first, who came

before, what’s been done, and who did it texture the dynamics within the

sectors and are often cited as precedents for evaluation of current actions. If

anyone else, another company or an analyst perhaps, knows these precedents,

the company is best served to have someone inside its walls who

knows these things too.

Current Conditions

In order to gather information on the industry in which the company competes,

IR should collect information from a variety of sources. These include

SEC filings; analyst research reports; conference call transcripts; the industry

trade papers; company communications, such as employee newsletters

and conference and convention minutes; and conversations with consumers,

customers, and vendors.

During this review, understand what the disclosures say about the other

businesses. IR may have discovered, during the review and interview steps of

the IR audit, that her company had rock-solid growth of 20 percent per year

and the same projected going forward. Yet this growth doesn’t seem as impressive

if, after reviewing the filings of the peer group, other companies are

growing at 30 percent, have better balance sheets, and have invested in new

technologies.

In addition to the disclosures of public competitors, IR should investigate

all stakeholders in the industry, including suppliers, vendors, financiers,

and so on. Trends are always emerging. Consumer behavior patterns, supply

channel efficiencies, government regulations, financing issues, and other topics

that affect every player come up in a sector. IR must have an ear on the

latest and greatest because it helps in defining the company to Wall Street.

Moreover, it can be assumed that the buy- and the sell-sides are also abreast

of these items.

Street Perceptions

Within the sell-side and the buy-side are pods of industry specialists and personalities

who differ as much as the industries themselves. In addition, the expectations, the salient issues, and the valuation techniques vary from one

industry to another.

Especially in the definition stage, IR must help management understand

how The Street is looking not only at the company, but at the sector. An objective

for restaurants is not an expectation in consumer products; a hot

issue in footwear may not even spark a twinkle of recognition in aerospace

and defense; a metric in retail is going to differ from any measure that’s central

to the technology sector.

IR should know how The Street is measuring the industry so that the

relevant topics within the company can be uncovered and highlighted. This

information is unearthed by reviewing the conference call scripts of industry

players and reviewing questions that analysts and portfolio managers ask.

It’s also done by reviewing research reports and monitoring First Call estimates

for an upward or downward bias.

THE RESULT OF THE IR AUDIT

After uncovering all the information it can, determining relative value, and

collecting perspectives, IR should be able to identify if (and why) the stock is

undervalued, overvalued, or fairly valued relative to its peers. For the purposes

of discussion, assume that a company is growing profits at 20 percent

but its stock is near a 52-week low and its multiple is 10x on a P/E basis. The

next step in the definition stage is discovering how to shrink the valuation

gap between the multiple and the company’s growth rate, which just so happens

to be the average multiple of the company’s peer group.

For example, let’s say that from all the information collected, the IR

audit has determined that XYZ Corp. is a terrible communicator. The CEO

doesn’t know when to stop selling, which plays poorly on Wall Street. In addition

to poor communication skills, the buy-side perceives, falsely by the

way, a threat from a new competitor, and finally the company has $40 million

in cash and hasn’t declared a use for it in over two years.

The next step would be to rebuild the story. IR should

Uncover positive value

Counteract any concerns

Correct any misconceptions

Package the company into a carefully crafted message

In the XYZ Corp. example, rebuilding the story would include establishing

conservative guidance that helps management build credibility by achieving self-set earnings estimates over time, developing a presentation

that highlights diversification in the business and shows that the competitive

threat really is insignificant, and encouraging management and the board to

announce a share repurchase authorization to put the balance sheet cash to

work in an accretive manner. These steps, initiated by management and the

IRO, should pay dividends in terms of closing the aforementioned valuation

gap. In all likelihood, Company XYZ’s multiple will expand and close in on

the 20x range, adding tens of millions of value to shareholder wealth.

Another example of an audit to success story is Cinderella Story & Sons,

a fairly new company to the public markets. They had a product that had

penetrated a variety of channels and surfaced into consumer awareness.

They had a good business proposition and a unique operating model, but

The Street was not viewing it enthusiastically. The stock price was down,

and Cinderella didn’t know why.

An IR team conducted an audit that included a review of the disclosures,

interviews with management, identifying the comparables, determining

relative value, getting capital markets feedback, and garnering industry

intelligence.

Once the problems were found, IR addressed them one by one and decided

that Cinderella Story & Sons needed just a few adjustments. The company

reevaluated its profile and changed its tag line to fit into a peer group

that was more in line with the products they offered. This group also traded

at a higher multiple, which the company justified by showing similar growth

drivers that matched the comparables in that group.

IR also recommended that management renew its focus on free cash

flow generation capabilities, their balance sheet, and their investment in

long-term growth initiatives. This repositioned the company as a great value

stock—that is, not growing necessarily, but generating free cash flow, paying

down debt, and carrying a much more attractive risk/reward profile than a

company with a growth multiple.

By conducting an IR audit, companies can set themselves up to rebuild

their story. With a focus on company knowledge, industry intelligence, and

relative valuation, IROs will find that when they are fully informed, they

have the right tools to advise a busy CEO, and the confidence to talk to even

the most sophisticated analyst.