Will Companies Pay for Research? A Pet Toy Maker Says Yes

(Bloomberg) -- With the future of equity research looking shakier than ever, one boutique U.S. firm is betting its turnaround on getting paid by a different customer: the company being covered.

As analyst budgets get slashed amid new regulations designed to reduce conflicts of interest, Peter Sidoti hopes that laying those conflicts out in the open with company-sponsored research can bolster his small-cap focused firm, Sidoti & Co. “The wheels came off” Sidoti’s trading-pays-for-research model about a year ago amid shrinking fees and the rise of passive investing, he said. Bring in new rules requiring direct payment for research, “and all hell breaks loose.”

Three companies -- a strip-club operator, a pet products company and a chipmaker -- pay Sidoti $40,000 a year for coverage by the firm’s 25 analysts. Ultimately, he sees one-third of the stocks his firm covers, now around 300, being paying customers. The sweet spot for research sponsored by companies is those with a market capitalization of under $300 million and which have one or no analysts covering them, Sidoti, the founder and CEO of the firm, said in an interview in New York.

Moody’s, S&P

“We think equity research is heading the same way as debt research,” Sidoti said, drawing a comparison with how debt-rating companies like Moody’s Investors Service and S&P Global Ratings are paid by issuers to produce reports. While this model has also been fraught with conflicts and controversy, especially in the aftermath of the financial crisis, Sidoti sees a new opportunity for the sponsored-research model arising from the European Union’s MiFID II rules.

The regulations, which come into force Jan. 3, are expected to have a worldwide impact on the industry and lead to a dramatic drop in the amount of research consumed, with small-cap coverage potentially the hardest hit. New research models have been springing up, including subscription and company-sponsored models. Still, Quinlan & Associates’s Benjamin Quinlan said that “the removal of bias -- and hence achieving true independence -- is extremely difficult to obtain” in sponsored reports. He expects less than 3-4 percent of so-called independent providers to adopt the model, according to a June study.

Bombshells Bars

Adult entertainment and sports bar company RCI Hospitality Holdings Inc., which pays for Sidoti’s services, said that it is challenging for smaller companies to get quality, independent analyst coverage. “We believe Sidoti has contributed to our overall effort to increase the understanding of our business and financial model,” Eric Langan, RCI’s Chief Executive Officer, said in an email. The company, which operates the Bombshells bar chain, has seen its stock gain 92 percent since Sidoti started coverage. Pet-products company OurPet’s Co. and chipmaker Ixys Corp., which are also paying customers of Sidoti, didn’t respond to multiple requests for comments.

Company-sponsored research is available for free on Sidoti’s website and is identified as such. Sidoti doesn’t provide ratings for these companies, though it does include price targets. The target for RCI Hospitality is $29, implying 23 percent upside to Wednesday’s close. Sidoti’s $20 target on Ixys implies 14 percent upside while the $4 target for OurPet represents a 144 percent upside.

‘Tough Sell’

Sidoti is on the road trying to recruit more companies to cover, though it has been a “tough sell,” with price and the inherent conflict of interest in the model as the main issues he addresses with potential clients. He argues that coverage of smaller companies is “conflicted from day one,” as most sell-side firms that provide research are incentivized by the possibility of future investment banking fees.

Bloomberg Intelligence analyst Sarah Jane Mahmud said that while it is not yet commonplace, there has been an increase in the number of companies commissioning a research provider to produce equity reports as traditional sell-side coverage diminishes. There is also some precedent in Europe, with London-based Edison Investment Research and France’s Natixis SA both charging companies for some research services. Bloomberg LP, the parent of Bloomberg News, has collaborated with Edison on a White Paper about MiFID II.

“As a small-cap public company, the ability to get sell-side research in the traditional way is almost impossible,” OTC Markets’ Jason Paltrowitz, who manages the firm’s corporate services businesses, said in a phone interview. OTC Markets, which runs a platform where investors can trade in mostly tiny stocks, is in a partnership with Sidoti that includes OTC promoting the firm as an equity research provider on its website. In return, Sidoti has waived the fee for providing research on OTC Markets.

After Sidoti and Edison started covering the company, OTC has seen an increase in interest from investors, Paltrowitz said. “We would have nothing if the Sidotis and the Edisons of the world did not cover us.”

To contact the reporters on this story: Beth Mellor in New York at bmellor@bloomberg.net, Esha Dey in New York at edey@bloomberg.net, Felice Maranz in New York at fmaranz@bloomberg.net.

To contact the editors responsible for this story: Arie Shapira at ashapira3@bloomberg.net, Chris Nagi, Morwenna Coniam