Sidoti Search For Growth And Profit

In the spirit of full disclosure from 1995 to 2004 I was an equity analyst, research manager and director of equity research at two different “boutique” brokers. My experience there, particularly with the last one at Adams Harkness in Boston (which was acquired by Canaccord Genuity), greatly informs my analysis with this type of business.

First of all from an industry point of view Sidoti is well known and often summarized as “a place that still covers tons of microcap stocks with research that is a mile wide and an inch deep.” There is basically one senior analyst, Peter Sidoti, and a squadron of relatively young analysts applying some basic research methods to small public companies.

Coverage is concentrated mostly in industrials and consumer discretionary with a decent amount of information technology as shown in the chart here covering research volume during the last 180 days.

There are a handful of terminal problems in the structure of the small brokerage business which I’ll enumerate here. This isn’t about the noble aims and hard work of the people involved – it’s the structure.

1. Clients won’t pay Sidoti more in commissions no matter what they do. They may hold on to what they have today but they will continue to run at $30M in revenues. They can add analysts, add coverage, upgrade their formats but clients will pay them the same amount. It might seem counterintuitive but it’s the way it is.
2. Personnel costs eat up most of the potential for profit. In this case employee compensation and benefits is 73% of revenue. Everyone tries to keep this number down but the better research analysts, salesman and traders are, the more money they command. By going public Sidoti is trying to shift more of this compensation to equity which may then be perceived as worth something.
3. Other costs, even when tightly managed, consume the rest. In the case of Sidoti they generated $825K of net income for 2013. Since revenues won’t grow and costs will be flat to up slightly this net income level more-or-less fixed.
4. One misstep on the trading side could easily eliminate a year of profit and even potentially sink the firm. It’s happened more than a few times, often to small firms. We were working with one that disappeared overnight by getting a agency trade wrong – the resulting error costs exceeded their total equity.
5. Internet-based approaches like Seeking Alpha are beginning to make an actual dent in coverage of smaller capitalization companies. Quality is highly variable but there is a growing portion of “institutional quality” material being generated there that institutions are increasingly paying for.

These types of businesses have historically sold at book value or slightly below. What is called “Member Equity” is $6M for Sidoti. It’s hard to picture this being a public company with a $6M market capitalization. Even if we give them the benefits of more equity-driven compensation getting income up to $1-2M a 10x multiple gets you to $10-20M. Maybe that will be good enough for the management team and the employees.

To make matters worse the IPO is being led by WR Hambrecht who has been fairly radio-silent since their last few deals done in 2007/8. They managed one small IPO in 2013 for a wine company called Truett-Hurst (NASDAQ: THST) where Bill Hambrecht is actually on the board of directors. WRH no longer has distribution or research coverage.  [Again for the purposes of full disclosure we performed some paid advisory services for WRH back in 2007 and 2008. However we have had no business relationship with the company since then.]

Since we suspect Sidoti will try and go public off a strong Q4 and full-year 2014 numbers they have some time to add a co-manager or two. However the ones that will be willing to “go to the right” of WRH are few and far between. Sidoti is on the cover as well which is typical but there are usually other co-managers to provide some remote semblance of independent research coverage.

So what could they do? Sidoti has built a substantial asset. The trick is to leverage it into a business that offers more growth and better economics. This requires some fundamental change which is hard but not impossible. Some potential paths:

1. Go deeper with industry research partnerships. As a firm Sidoti only has resources to be an inch deep if they are going to cover many industries and companies. For example an alliance with a research group like Yole in microelectronics, or Forrester in IT, and others could create a much richer source of industry insights that are grounded in substantial information flow and working knowledge.
2. Build quantitative research tools and a business around them. These can be raw data that can be used to track markets in the industrial sector and also survey-driven products in consumer areas. Economically these products offer the increasing returns to scale that traditional research doesn’t provide in a brokerage model. It’s a proven model.
3. So far the firm as missed the asset management boat but it’s not too late. It would delay the IPO but Sidoti should shift 30-50% of their existing resources into asset management at a stroke. Redefine incentives and compensation across the board to drive the asset management business while continuing to crank out the basic stuff they have long been (and will still largely get paid for). They could double the net income level in the first year and be a credible growth strategy which would lead to a higher valuation.

There’s still time in crafting the roadshow slides and story to figure out how to make the deal seem as attractive as possible. And maybe a $6M market value is all they will seek. If so the deal might get done but it seems like there’s far more opportunity in financial technology and asset management to go after.