Covering the Consumers: Q&A with J.M. Dutton Analyst Jonathan Ziegler

Until late 2002, Jonathan Ziegler, now a J.M. Dutton analyst specializing in consumer products, covered the food and drug retailer sector for Deutsche Bank Securities. Prior to DBS, he had covered the same space with Solomon Brothers (later becoming Salomon Smith Barney and now Citigroup Securities) after establishing his reputation of covering specialty retailers at Sutro & Co. His career as a securities analyst has been largely focused on the west coast having joined the West Coast Research Department of Merrill Lynch in Century City as a special situations analyst. He later joined Sutro, a regional firm in San Francisco also covering special situations. During a three-year period at the Dean Witter Reynolds West Coast Research Department in the mid-80s, his coverage shifted to specialty retailers. Mr. Ziegler holds a B.S. in Economics from the Wharton School of the University of Pennsylvania and an M.B.A. in Finance from Harvard Business School.

How did you get involved in specialty retail?

I started my career as a generalist. I wound up being at Dean Witter Reynolds West Coast research (now Morgan Stanley) as a generalist, and some of my best stock picks that really worked out were retailers. During my period there, they RIF'd an analyst covering the specialty retailers, and they asked me to take it over his group.

What is particularly challenging or interesting about specialty retail?

I feel very fortunate that I wound up in this space because it is exciting, ever-changing, challenging, and innovative. I enjoy both visiting stores and interacting with store employees and customers. It's something that you can bring to a much more personal level than you can in a pure manufacturing company. I also appreciate the visibility in seeing where the tire hits the road.

So there's more "field research" involved?

Yes, and it's tough in one respect. If a company operates 500-1000 stores you're not going to be able to get into all of them. That's the downside. The good news is you can glean an awful lot by visiting stores. You can learn a lot about in-stock additions, customer traffic, cleanliness, merchandising, and you can learn a lot talking to customers, and talking to store managers. So there is significant value-add from in- the- field research with specialty retailers.

You can also see how you react to it, or how your wife reacts to it. That's the Peter Lynch school. The other thing is you begin to understand when you do it long enough about positioning in the marketplace: Are they where the demand is? Are there problems? Are there challenges? There are just a lot of ramifications. Plus, specialty retail as a category is fairly diverse, so it can be very interesting.

How has retail done in this bear market? Has consumer spending (which has been strong relative to corporate spending) propped it up?

I think the answer is yes and no. In the group where I have spent most of my time, the food and drug retailers, most managements have attributed the weakness in same store sales extant to the major curtailment in the consumer spend, and I think, therefore, there has been an impact. The question is -- is that the whole of it or is it just that the country is "over-stored," and increased competition means each store gets a smaller portion of the overall? I think there's a mixture of events. But all things considered, there has been some weakness in sales, and it looks like it's starting to come back a little, and retail is an early sector when the economy comes back. If we have a stronger economy going into the Christmas selling season or even back to school, which is the season we're in now, that could signal an awful lot.

What companies are you looking at?

We're not print yet on the three new small, cap companies I shall be covering, so I would prefer not to discuss them. I'm only in print so far on a company called AdStar (ADST), which is a technology company serving the classified advertising business. They reported today, so I am in conversations with management about their quarter and will have a note out on them.

What do you like about them?

AdStar was an micro cap not being followed by anybody and had a really good story of potential growth. It was in the early stages serving an industry that really needed their service, which is a very powerful, cost-effective service, communicating classified ads, both to printed media as well as to the Web. It's an exciting story. I don't want to comment on their second quarter ahead of my note, but it seems like it's a very well-positioned company with very limited competition.

It doesn't quite fit into specialty retail.

No, it doesn't. While my specialty in recent years has been food and drug retailers, I have covered a range of industries. I would broaden the definition of my expertise to be consumer companies in general.

What are the commonalities of doing research on consumer companies?

You study the consumer. Consumer spending, consumer tastes. The mercurial, and sometimes unpredictable, consumer really is the driver of your business. Consequently, how well the company understands and communicates with the consumer is the principal driver of its business. Where is the company positioned in that consumer niche market? If we're talking micro caps, we're really talking about serving niches, and so you look at how much growth potential there is. That's where the analyst comes in -- trying to uncover all that. That's where the fun is.

Any particular ways you go about valuing companies?

I'm not going to give away any trade secrets. I look at a number of factors, though. Much depends upon the common practice for the particular space you're looking at. The analyst can use discounted cash flows, relative P/E multiples to growth, enterprise value-to-EBITDA. There are a number of valuation parameters but cash flow generation and return-on-invested capital are hugely important. But the real key factor since we're not dealing with dividend-paying stocks is what is today's growth rate and how much do you believe that growth rate is sustainable into the future.

What do you think of the independent research model relative to what you've done in the past?

It's a really great change. I wouldn't be doing it if I weren't really enthusiastic about it. I think Wall Street obviously got tainted by the research-banking debacles in the press of late; thus, the value of independent, dispassionate research has become an exceedingly valuable resource for the investment community. Any report I'll write will have the negatives as well as the positives in it. I am impressed that Dutton was very early in recognizing this need, and, were Dutton a public company, it should fit in very nicely in the emerging growth stock category. I also personally enjoy working with small-cap companies as a change from my focus on large cap in my prior life.

Why?

You are among a smaller, more-select, if not only, group of analysts covering the companies. You generally get closer to top management. Generally, with large-cap companies, senior management is frequently not available to you on a regular basis.

Furthermore, the analyst is entering the scene at a much earlier stage of growth, so you may have a real opportunity to discover a company and be first, which is, quite candidly, where the excitement and challenge is. I had been a value analyst, a contrary investor, and I had been fortunate in that I had picked some names when I was early in finding a company in a turnaround. Well, here I can be early in finding a company in its growth mode.

Is there any single experience that defines you as an analyst?

I'd have to give that some thought. But what comes to the top of my mind is something I just finished saying but is worth highlighting. I found that if you can be early in a turnaround story, if you address the turnaround and have done your homework and believe it has a high potential to pan out, it can be a very rewarding situation for investors. Not only do you get a stock that is at a depressed multiple but you're getting one that has depressed earnings, and if you get both playing out and you're right, you get a double whammy.