CHAPTER 15 Excavating Value Post-Audit

The IR audit almost always leads to a more refined definition and, more

often than not, positions a company to maximize the equity valuation at

any given time. From this reality, IR should always dig deeper and use its

capital markets expertise to excavate, craft, and position the new story.

EXCAVATING THE STORY: EXAMPLES

The following is the story of a real company (with a fictional name) that realized

the importance of excavating the story.

Uncovering the Pearls

Nightingale Inc., a health care company, had a common story. The management

team was running the company with a well-developed long-term strategy,

but they didn’t know how to connect with Wall Street. For eight quarters

in a row, their stock had gone down right after their conference call.

IR became involved to help them hone in on their story and deliver it in

a professional manner to the right constituents on The Street. The IR audit

revealed that Nightingale had a big short position, and the short sellers were

there for good reason. The negatives were apparent right away, already factored

into the low stock price.

First, the company was using its cash to finance its customers, a move

Wall Street never likes because it is a perceived high risk distraction from the

core business. Management announced that they were dismantling this financing

arm of the business.

Second, the company had a customer that was responsible for a majority

of its sales, but this customer was a division of a much bigger pharmap5

ceutical company, which was spinning it off to shareholders. The Street had

predicted this to be a negative, but management knew that it would now be

a larger part of this smaller company, strengthening Nightingale’s powerbase

in the relationship.

Third, The Street had always viewed one of the company’s product lines

as too specialized with no growth opportunities. Though the market was

highly fragmented, Nightingale was the biggest manufacturer of this product

and demand was growing annually, representing one-fifth of the company’s

total revenue. IR recommended adding this narrative to its story, explaining

that Nightingale was the industry leader in a growing market.

Fourth, Nightingale had acquired a business with a good product and a

bad management team. Short sellers specifically thought it was a terrible

business headed right down the drain. During the IR audit, management was

asked why they bought the business. The CEO said it was a good product,

just badly managed. The company had decided not to talk about this new division

on its conference calls because though they were working to stabilize

the business, it wasn’t meeting its numbers. In the meantime, when Nightingale

marketed the product to some of its customers, they discovered it was

desired by some of the biggest players in the industry.

The IR audit uncovered a whole new story for Nightingale. By redefining

the company, management took control of its destiny, improved its credibility

with The Street, increased its stock price and valuation, and erased the

time drain, anxiety, and pressure of handling things poorly.

The moral of the story: a company can never assume that Wall Street

fully understands its business. In order to uncover potential value, IR professionals

must conduct the audit and look for the gems that analysts and

buy-siders are looking for.

The next story shows a sample of valuation factors that may provide IR

with an opportunity to uncover real value to increase perceived value and

the stock price.

Define the Business: A Diversification Case Study

Picture a company that thought it had its definition right, but The Street really

didn’t understand the business. Zippa! is a popular apparel brand that

started with a trendy, seasonal product and was identified by analysts as a

company that generally sold its wares through one retailer. However, Zippa!

had spent several years diversifying into other products, other brand names,

and other distributors. Yet, when the retailer with which they’d initially been

identified began to perform poorly, so did Zippa!’s stock price, even though, by that time, the retailer represented only 10 percent of sales. What the market

somehow missed was the increasing diversity in all aspects of Zippa!’s

business.

An absolute must in buying and owning stocks for the long run is to balance

one’s portfolio with a diverse basket of assets. Portfolio managers do

this every day to generate consistent returns and balance risk. The first step

with Zippa! was an IR audit that focused on the numbers, as they never lie.

The business actually was very well diversified, which minimized risk in

four different areas of the company.

Brands: Zippa! had over a dozen brands, yet only two were well-known

and highlighted by the company. Putting numbers behind these brands, IR

noted that seven years ago, the two popular brands made up 95 percent of

sales, as compared to the current contribution of 65 percent.

Product categories: Zippa! came on the scene selling a certain kind of

apparel that was very popular for teenagers and, at that time, made up 100

percent of its business. This clothing had experienced a decline in appeal,

and The Street was generally a seller of any and all companies associated

with this product. But the fact was that as the company matured, this product

represented only 5 percent of revenues, which made the company much

less vulnerable to the decline in the product’s popularity. Not only that, but

Zippa! makes hundreds of products, all of which contributed significantly to

the revenue stream.

Distribution channel: Zippa!’s product flowed evenly between specialty

retailers, independent retailers, and department stores. It was not, contrary

to Street opinion, dependent on specialty retail and one particular chain.

Putting numbers to these channels showed that there were enough pieces to

the pie and that a decline in any one was not enough to materially hurt the

business.

Geography: The marketplace with which Zippa! had insinuated itself

was more expansive than The Street was aware. Since its genesis the business

had expanded globally, and half of its revenues came from outside the

United States. In other words, the domestic problems in the industry were affecting

other companies much more than they were affecting Zippa!.

Therefore, out of the audit process came the fact that Zippa deserved to

be in a bigger-cap, global comp group. What also came out was that the valuation

gap between Zippa! and these new peers was the result of a lack of

Wall Street understanding with regard to the company’s diversification.

Stay On Core

Another IR audit focused on a client that was operating more like a REIT

(real estate investment trust) than a retailer because they owned much of the

real estate under their stores. The feedback from Wall Street said that this

took focus off their retail business because of the heavy debt load and because

many of their competitors had recently gone bankrupt. A capital markets

perspective told the IR professionals to suggest a series of sale/leaseback

transactions: sell the stores and lease them back, and use the cash from the

transactions to decrease debt, which would shift investor perception. In

other words, the transactions would change their positioning from a real estate

player to a retailer, positioning the company for a better valuation and

a lower cost of capital.

Change the Multiple

IR audits can yield a new way to value a company. To that point, under certain

circumstances IR may want to present the company in a different light.

If it has traditionally been valued by the price-to-earnings method, yet it’s a

capital-intensive business, then earnings may not be the right financial measure.

Rather, cash flow or EBITDA should be used because of interest and

non-cash depreciation expenses.

Companies in capital-intensive businesses, such as the leisure sector,

transportation, and media, incur high levels of depreciation (a noncash expense)

because they own lots of assets. They borrow on bank lines and may

have higher interest expense at any given time relative to their peers. Because

these below-the-operating-line variables can make a P/E comparison less

meaningful, these companies must highlight their cash flow and describe

their results in terms of EBITDA (earnings before interest taxes depreciation

and amortization), deemphasizing earnings to a degree. This encourages analysts

to value the company the following way:

Market Cap plus Long Term Debt Net of Cash divided by EBITDA

This approach better represents the performance that any company can

wring out of its capital structure and doesn’t penalize them for borrowing,

buying, and growing.

In every industry, and sometimes from business to business, the definition

of cash flow can vary. When talking company numbers, management

always needs to walk through the components of an equation and reconcile

those numbers to generally accepted accounting principles.

Separate and Consolidate

The IR audit can also flush out partial ownership in other companies, encouraging

a sum of the parts valuation, which can often result in a valuation

that is higher than the current stock price.

One situation where this may benefit the company is when the business

has some divisions that are more capital intensive than others. In these cases,

the sell- and buy-sides may not look at earnings per share because they are

not an accurate reflection of the true health of the business. Depreciation

and amortization, taxes and interest costs, need to be added back to net income

to more accurately reflect the company’s performance, so analysts and

investors like to look at cash flow or EBITDA.

When some divisions or businesses are capital intensive and others are

not, the IR audit must detail separately the highlights of each divisions. This

may prompt The Street to attach a multiple of EBITDA to the capital-intensive

divisions and a P/E on the rest. Subtracting the debt and dividing by

fully diluted shares outstanding often results in a valuation that is not only

higher, but more realistic than the current stock price.

Another situation where breaking out operations is helpful is when the

company has ownership in a completely different business, the profitability

of which may not be readily apparent on the income statement. Because

every industry is valued differently, some companies may find that the

earnings or cash flow from some of their subsidiaries may be valued at a

higher multiple than the industry in which they primarily compete. Highlighting

and properly valuing this portion of the earnings can add value to

the stock price.

Blue Chips, a client in the leisure sector, owned 40 percent of a company

in the gaming sector, which trades at a higher multiple than the broader

leisure sector. Management was not highlighting this portion of their financial

results because they did not know to look at, and communicate the

value of, this sector differently from their own.

One of the first and very interesting things anyone would notice when

looking at Blue Chips’ financials would be that its earnings were disproportionately

higher than its revenues. The earnings from this minority ownership

was on Blue Chips’ income statement as equity income, under the equity

method of accounting, and it flowed right down to their operating line.

What investors did not notice, but what IR promoted, was that Blue

Chips’ passive investment was in a sector that investors value very highly.

An IR audit did a valuation of the subsidiary, applied the sector’s average

comparable multiple, and gave a dollar amount to the 40 percent Blue

Chips owned.

deal of debt was built up as Vision View paid for these installations.

The IR audit charted the backlog, revenue, earnings, and debt for Vision

View going back five years. Initially, the company lost money, but as the installations

increased, and particularly when they crossed a certain unit level,

earnings went up and debt went down. The construction of these installations

almost ensured the promise of future revenue for the business, and the

IR audit uncovered the fact that earnings were less important than backlog.

This historical tracking, a precedent of revenue recognition, made the

company’s product cycles more understandable, took some perceived risk out

of this stock, and increased the value, thereby lowering the cost of capital.

FROM DEFINITION TO DELIVERY

Once a company has gleaned definition from the IR audit and rediscovered

the value or growth story it can package to The Street, the company is ready

to deliver that story. In preparing for delivery, management must start with establishing

earnings guidance, the driving force of successful investor relations.

The IR audit almost always leads to a more refined definition and, more

often than not, positions a company to maximize the equity valuation at

any given time. From this reality, IR should always dig deeper and use its

capital markets expertise to excavate, craft, and position the new story.

EXCAVATING THE STORY: EXAMPLES

The following is the story of a real company (with a fictional name) that realized

the importance of excavating the story.

Uncovering the Pearls

Nightingale Inc., a health care company, had a common story. The management

team was running the company with a well-developed long-term strategy,

but they didn’t know how to connect with Wall Street. For eight quarters

in a row, their stock had gone down right after their conference call.

IR became involved to help them hone in on their story and deliver it in

a professional manner to the right constituents on The Street. The IR audit

revealed that Nightingale had a big short position, and the short sellers were

there for good reason. The negatives were apparent right away, already factored

into the low stock price.

First, the company was using its cash to finance its customers, a move

Wall Street never likes because it is a perceived high risk distraction from the

core business. Management announced that they were dismantling this financing

arm of the business.

Second, the company had a customer that was responsible for a majority

of its sales, but this customer was a division of a much bigger pharmap5

ceutical company, which was spinning it off to shareholders. The Street had

predicted this to be a negative, but management knew that it would now be

a larger part of this smaller company, strengthening Nightingale’s powerbase

in the relationship.

Third, The Street had always viewed one of the company’s product lines

as too specialized with no growth opportunities. Though the market was

highly fragmented, Nightingale was the biggest manufacturer of this product

and demand was growing annually, representing one-fifth of the company’s

total revenue. IR recommended adding this narrative to its story, explaining

that Nightingale was the industry leader in a growing market.

Fourth, Nightingale had acquired a business with a good product and a

bad management team. Short sellers specifically thought it was a terrible

business headed right down the drain. During the IR audit, management was

asked why they bought the business. The CEO said it was a good product,

just badly managed. The company had decided not to talk about this new division

on its conference calls because though they were working to stabilize

the business, it wasn’t meeting its numbers. In the meantime, when Nightingale

marketed the product to some of its customers, they discovered it was

desired by some of the biggest players in the industry.

The IR audit uncovered a whole new story for Nightingale. By redefining

the company, management took control of its destiny, improved its credibility

with The Street, increased its stock price and valuation, and erased the

time drain, anxiety, and pressure of handling things poorly.

The moral of the story: a company can never assume that Wall Street

fully understands its business. In order to uncover potential value, IR professionals

must conduct the audit and look for the gems that analysts and

buy-siders are looking for.

The next story shows a sample of valuation factors that may provide IR

with an opportunity to uncover real value to increase perceived value and

the stock price.

Define the Business: A Diversification Case Study

Picture a company that thought it had its definition right, but The Street really

didn’t understand the business. Zippa! is a popular apparel brand that

started with a trendy, seasonal product and was identified by analysts as a

company that generally sold its wares through one retailer. However, Zippa!

had spent several years diversifying into other products, other brand names,

and other distributors. Yet, when the retailer with which they’d initially been

identified began to perform poorly, so did Zippa!’s stock price, even though, by that time, the retailer represented only 10 percent of sales. What the market

somehow missed was the increasing diversity in all aspects of Zippa!’s

business.

An absolute must in buying and owning stocks for the long run is to balance

one’s portfolio with a diverse basket of assets. Portfolio managers do

this every day to generate consistent returns and balance risk. The first step

with Zippa! was an IR audit that focused on the numbers, as they never lie.

The business actually was very well diversified, which minimized risk in

four different areas of the company.

Brands: Zippa! had over a dozen brands, yet only two were well-known

and highlighted by the company. Putting numbers behind these brands, IR

noted that seven years ago, the two popular brands made up 95 percent of

sales, as compared to the current contribution of 65 percent.

Product categories: Zippa! came on the scene selling a certain kind of

apparel that was very popular for teenagers and, at that time, made up 100

percent of its business. This clothing had experienced a decline in appeal,

and The Street was generally a seller of any and all companies associated

with this product. But the fact was that as the company matured, this product

represented only 5 percent of revenues, which made the company much

less vulnerable to the decline in the product’s popularity. Not only that, but

Zippa! makes hundreds of products, all of which contributed significantly to

the revenue stream.

Distribution channel: Zippa!’s product flowed evenly between specialty

retailers, independent retailers, and department stores. It was not, contrary

to Street opinion, dependent on specialty retail and one particular chain.

Putting numbers to these channels showed that there were enough pieces to

the pie and that a decline in any one was not enough to materially hurt the

business.

Geography: The marketplace with which Zippa! had insinuated itself

was more expansive than The Street was aware. Since its genesis the business

had expanded globally, and half of its revenues came from outside the

United States. In other words, the domestic problems in the industry were affecting

other companies much more than they were affecting Zippa!.

Therefore, out of the audit process came the fact that Zippa deserved to

be in a bigger-cap, global comp group. What also came out was that the valuation

gap between Zippa! and these new peers was the result of a lack of

Wall Street understanding with regard to the company’s diversification.

Stay On Core

Another IR audit focused on a client that was operating more like a REIT

(real estate investment trust) than a retailer because they owned much of the

real estate under their stores. The feedback from Wall Street said that this

took focus off their retail business because of the heavy debt load and because

many of their competitors had recently gone bankrupt. A capital markets

perspective told the IR professionals to suggest a series of sale/leaseback

transactions: sell the stores and lease them back, and use the cash from the

transactions to decrease debt, which would shift investor perception. In

other words, the transactions would change their positioning from a real estate

player to a retailer, positioning the company for a better valuation and

a lower cost of capital.

Change the Multiple

IR audits can yield a new way to value a company. To that point, under certain

circumstances IR may want to present the company in a different light.

If it has traditionally been valued by the price-to-earnings method, yet it’s a

capital-intensive business, then earnings may not be the right financial measure.

Rather, cash flow or EBITDA should be used because of interest and

non-cash depreciation expenses.

Companies in capital-intensive businesses, such as the leisure sector,

transportation, and media, incur high levels of depreciation (a noncash expense)

because they own lots of assets. They borrow on bank lines and may

have higher interest expense at any given time relative to their peers. Because

these below-the-operating-line variables can make a P/E comparison less

meaningful, these companies must highlight their cash flow and describe

their results in terms of EBITDA (earnings before interest taxes depreciation

and amortization), deemphasizing earnings to a degree. This encourages analysts

to value the company the following way:

Market Cap plus Long Term Debt Net of Cash divided by EBITDA

This approach better represents the performance that any company can

wring out of its capital structure and doesn’t penalize them for borrowing,

buying, and growing.

In every industry, and sometimes from business to business, the definition

of cash flow can vary. When talking company numbers, management

always needs to walk through the components of an equation and reconcile

those numbers to generally accepted accounting principles.

Separate and Consolidate

The IR audit can also flush out partial ownership in other companies, encouraging

a sum of the parts valuation, which can often result in a valuation

that is higher than the current stock price.

One situation where this may benefit the company is when the business

has some divisions that are more capital intensive than others. In these cases,

the sell- and buy-sides may not look at earnings per share because they are

not an accurate reflection of the true health of the business. Depreciation

and amortization, taxes and interest costs, need to be added back to net income

to more accurately reflect the company’s performance, so analysts and

investors like to look at cash flow or EBITDA.

When some divisions or businesses are capital intensive and others are

not, the IR audit must detail separately the highlights of each divisions. This

may prompt The Street to attach a multiple of EBITDA to the capital-intensive

divisions and a P/E on the rest. Subtracting the debt and dividing by

fully diluted shares outstanding often results in a valuation that is not only

higher, but more realistic than the current stock price.

Another situation where breaking out operations is helpful is when the

company has ownership in a completely different business, the profitability

of which may not be readily apparent on the income statement. Because

every industry is valued differently, some companies may find that the

earnings or cash flow from some of their subsidiaries may be valued at a

higher multiple than the industry in which they primarily compete. Highlighting

and properly valuing this portion of the earnings can add value to

the stock price.

Blue Chips, a client in the leisure sector, owned 40 percent of a company

in the gaming sector, which trades at a higher multiple than the broader

leisure sector. Management was not highlighting this portion of their financial

results because they did not know to look at, and communicate the

value of, this sector differently from their own.

One of the first and very interesting things anyone would notice when

looking at Blue Chips’ financials would be that its earnings were disproportionately

higher than its revenues. The earnings from this minority ownership

was on Blue Chips’ income statement as equity income, under the equity

method of accounting, and it flowed right down to their operating line.

What investors did not notice, but what IR promoted, was that Blue

Chips’ passive investment was in a sector that investors value very highly.

An IR audit did a valuation of the subsidiary, applied the sector’s average

comparable multiple, and gave a dollar amount to the 40 percent Blue

Chips owned.

deal of debt was built up as Vision View paid for these installations.

The IR audit charted the backlog, revenue, earnings, and debt for Vision

View going back five years. Initially, the company lost money, but as the installations

increased, and particularly when they crossed a certain unit level,

earnings went up and debt went down. The construction of these installations

almost ensured the promise of future revenue for the business, and the

IR audit uncovered the fact that earnings were less important than backlog.

This historical tracking, a precedent of revenue recognition, made the

company’s product cycles more understandable, took some perceived risk out

of this stock, and increased the value, thereby lowering the cost of capital.

FROM DEFINITION TO DELIVERY

Once a company has gleaned definition from the IR audit and rediscovered

the value or growth story it can package to The Street, the company is ready

to deliver that story. In preparing for delivery, management must start with establishing

earnings guidance, the driving force of successful investor relations.