Automatic Data Processing (ADP) Is Undervalued: Pershing Square

Pershing Square sees an upside potential in Automatic Data Processing (NASDAQ:ADP), a $51-billion market cap payroll processing giant. The hedge fund has been fighting to get three seats on ADP’s board and play a role in boosting the company’s performance. But there is strong resistance from the ADP’s management side, which had rejected the fund’s performance plan and its board nominees. In its Q3 investor letter, Pershing Square discussed the payroll processing giant, calling ADP “a classic investment”.

Let’s take a look at the fund’s comments.

ADP is a simple, predictable, free-cash-flow generative business that has significantly underperformed its potential. As a conservatively financed, high-quality business in a sector with substantial positive growth, we believe it has modest downside. If it is able to achieve its potential, we believe it offers substantial upside.

ADP’s significant underperformance is largely in its Employer Services segment (~2/3 of profit). Employer Services’ underperformance is best demonstrated by its (1) poor operating efficiency and subpar margins of 19%, and (2) declining organic growth of 2%-3% for FY 2018, with much of the revenue weakness due to the company’s lack of a competitive offering in the enterprise segment which serves large companies. Our detailed due diligence revealed the company’s underperformance and outlined a path to drive meaningfully improved performance. With a transformation focused on operational efficiency and technology leadership, we believe that ADP can accelerate growth to 7% or more, in-line with, or better, than industry growth rates, while increasing margins from 19% to 35%.

We have taken an active approach to our investment in the company to highlight the opportunity to drive significant value for all stakeholders. While we strongly preferred to work collaboratively with ADP’s board and management to unlock the company’s potential, as we have successfully done in nearly all of our prior active investments, they were unwilling to do so. Consequently, we were forced to run a proxy contest to highlight ADP’s underperformance and potential for improvement to help effectuate the necessary change.

Proxy contests are tools that activist investors use to effect change at public companies. While we were not successful in gaining seats on ADP’s board this election cycle, our campaign over the past few months has informed ADP shareholders, the board, and management about the potential opportunities that exist to create significant shareholder value.

Our efforts to inform the shareholder base about the company’s underperformance relative to its potential were embraced broadly and garnered substantial minority support for our candidacy on the board. Compared with the ADP incumbent director with the fewest votes, Mr. Eric Fast, we received 31% of the FOR votes – thus nearly a third of shareholders supported us. This 31% does not include shareholders who withheld against Mr. Fast on the recommendation of ISS as its suggested mechanism for facilitating my election to the board. Including these votes, 45% of shareholders either directly supported my candidacy to the board or withheld against Mr. Fast to facilitate my election to the Board. Just 55% of shares voted supported the entire incumbent board slate. Had ADP been willing to use a universal proxy card for this election, we would have likely received one or more seats on the board.

We received substantial minority support no matter how the votes are counted. Putting aside the percentage outcome, we believe that the substantial majority of shareholders who did not support us were convinced that the message we delivered was heard “loud and clear” by the company. These shareholders were willing to give the board and management another year to demonstrate progress on the opportunities that we had identified.

We and other shareholders will be focused on ensuring that ADP achieves its substantial potential, and will hold the board and management accountable for its commitments to investors. While these undertakings represent just a fraction of ADP’s full potential, they are now the floor for prospective performance. ADP’s performance will have to improve significantly to meet these commitments.

ADP’s shareholders are now fully informed about the opportunity for improvement, and the current board and management will need to announce a credible plan to improve performance. If they do so, we and other shareholders will be happy. If management fails to deliver, we will be focused on next year’s annual meeting. The dynamic we have created by the proxy contest sets up a favorable risk-reward ratio for ADP shareholders. It is a quintessential example of how shareholder activism is supposed to work.

ADP currently trades at an approximately 12% to 15% premium to its unaffected price prior to our rapid accumulation of ADP shares and market rumors of our investment. While the current stock price likely reflects some value for potential corporate tax reform, the market is also anticipating that ADP will make some progress improving its performance. We believe the dynamic created by the proxy contest will lead to substantially improved performance at the company, and, as a result we believe the stock remains undervalued. ADP is also potentially a large beneficiary of corporate tax reform as a reduction in US tax rates will boost ADP’s earnings and its market value by as much as 20%.

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Automatic Data Processing (NASDAQ:ADP) describes itself as the “largest provider of HR services in North America, Europe, Latin America and the Pacific Rim”. The company has a market cap of around $52 billion, a P/E ratio of 29.70, and a dividend yield of 2.15%.

ADP shares have been performing well so far this year. The stock has gained 13.85% since the beginning of the year. Meanwhile, ADP has surged 19.14% during the last 12 months.

Besides Pershing Square, other hedge funds and active managers also see a value in ADP. There are 44 funds in Insider Monkey’s database with bullish positions in the payroll processing giant.