Channel Checkers
Here’s a piece written by one of the fellows, Serena Ng, written while she was an intern at The Wall Street Journal.
`Channel Checkers’ Sniff About for Trends
By Serena Ng
8 August 2005
(Copyright (c) 2005, Dow Jones & Company, Inc.)
A FEW WEEKS ago, nine recent business-school graduates and one retired businessman based in eight states set out on one big mouse hunt, collectively visiting more than 70 Chuck E. Cheese’s restaurants across the country.
Along the way they chatted with store managers, noted customer traffic, staff attitudes, and cleanliness of the restaurants, known for their kid parties and games presided over by the eponymous gray mouse. After each stop, the Pizza Ten sent detailed reports of their findings to J.P. Mark, president of Farmhouse Equity Research, in Newport, R.I. Mr. Mark studied their notes and concluded that the chain’s same-stores sales would be flat to slightly lower for the second quarter. He quickly relayed that hunch to his client, a hedge fund that had hired him to check out Chuck E. Cheese’s, owned by CEC Entertainment Inc.
Four days later, on July 26, CEC reported flat second-quarter earnings and a 2.1% drop in same-store sales, which compares business at locations open in the current year’s period to the same time a year earlier. That performance was below Wall Street’s consensus forecast, and it sparked a selloff in the New York Stock Exchange-listed shares of the Irving, Texas, company.
Mr. Mark doesn’t know whether his client acted. But it appears the hedge fund had a Street-beating view of the stock because of the “channel checks” performed by his foot soldiers, who earn $20 to $75 an hour, depending on experience. Mr. Mark hires locally so his researchers don’t need hotel rooms, but he also covers transportation, telephone and other sundries. (The Pizza Ten each also had a $12 per diem for dining at Chuck E. Cheese’s, but most declined that perk.)
Channel checks — collecting data from a company’s customers, suppliers, employees and even rivals to find out how a business is really doing — have always been part of a stock analyst’s duties. But with most Wall Street firms unable or unwilling to devote significant resources to this qualitative and often time-consuming process, a growing number of independent research outfits are making a living out of this niche. The work involves more networking and investigative reporting than analyzing balance sheets and income statements. The channel checkers go out and kick the tires, in the parlance, rather than staying in the office to scan securities filings or call investor relations departments. The idea is to spot a trend before it is widely known.
Money managers — and increasingly, venture-capital and private-equity firms — are turning to independent analysts who can provide such research, hoping for key “data points.” Demand has surged since the Securities and Exchange Commission in 2000 put in place its Regulation Fair Disclosure, which prohibits selective disclosure of material corporate news and led many companies to sharply curtail communications with Wall Street.
“Any Wall Street analyst can build a `discounted cash-flow model’ for valuing stocks, but not many can find massive amounts of raw data and turn that into metrics that can affect a stock’s price,” says Doug Atkin, chief executive of New York-based Majestic Research, a two-year-old independent research firm.
The classic channel checks are conducted on companies with a retail presence — where researchers can walk into stores and talk to employees about the business. While these checks don’t usually generate statistics, they are sometimes the most accurate indicator of a company’s performance.
At the Chuck E. Cheese’s outlets, Mr. Mark says, sentiment from restaurant managers made it clear there would be no upside for the group’s second quarter, and same-store sales would be flat at best. “We didn’t make any prediction or projection per se, but we garnered enough data to know directionally which way the quarter went,” he says. Mr. Mark, formerly director of research at Wells Fargo Securities before starting Farmhouse in 2002, recruits mainly graduate students, M.B.A. degree holders and industry veterans across the country to do his legwork.
Some channel checkers are more sedentary, but still do their jobs differently than their counterparts at the big banks and brokerage firms. They work the phones, but do so to tap into networks of industry contacts, including buyers, suppliers or other middlemen in a subject company’s supply chain. “We trade information with them and promise we won’t quote their names in our reports,” says Jon Gates, director of research of Off The Record Research, a California firm that employs more than 200 “reporters,” channel analysts and data gatherers around the world.
To be sure, channel checks don’t always work, and they are trickier for certain industries with diverse business segments or customer bases, like banks and utilities. And kicking the tires is more accurate than Web surfing, it seems: Earlier this year, an RBC Capital Markets analyst lowered his view on Google Inc. based on channel checks that suggested the Web company’s paid-search business had softened. That wasn’t the case, and the analyst had to revise his forecasts.
“It’s hard to rely solely on channel checks because you can end up with assessments that are way off if you don’t talk to enough people,” says Michael Mayhew, chief executive of Integrity Research Associates, a research consulting and advisory firm in Darien, Conn.
Peter Fenton, chief executive of Detwiler, Mitchell, Fenton & Graves, a technology research provider in Boston, calls channel checks “a piece of the puzzle.” That is why independent researchers often offer only their findings and let the client decide whether to buy or sell the stock, he adds.
