Description

Broadridge Financial Solutions, Inc (BR) possessed many of the hallmarks a value investor looks for in a spin off when it was separated from Automatic Data Processing (ADP) in March 2007. It was very small relative to its parent, implying likely forced selling by ADP holders, management had invented the proxy distribution industry it monopolized, and a potential SEC/NYSE regulatory change provided Broadridge with a hidden potential windfall and a commensurate way for management to sandbag earnings.  Almost 5 years later, it is clear management disappointingly embarked on a strategy of consistent misallocation of capital, and the company faces yet another regulatory change, this time with outcomes ranging from mildly negative to catastrophic.  I recommend shorting Broadridge.  For a detailed description of the business operations see my 2007 write-up. 

Capital (mis)allocation

To frame the discussion, I begin with part of Broadridge’s corporate history.  In FYE 2005, BR (then part of ADP) bought Bank of America’s U.S. Clearing and BrokerDealer Services business to the Clearing and Outsourcing Segment.  The purchase price was $344mm, making it the largest transaction in company’s history.  In the five years from 2005 through 2009, Clearing and Outsourcing lost $21mm, $25mm, $12mm, $5mm, and $9mm respectively ($72mm in total loses).  In November 2009, after failing to make a single annual profit, management threw in the towel and sold the clearing business to Penson Worldwide, Inc in November 2009 for $35.2mm, roughly 1/10 of its initial purchase price. 

It is possible that the clearing business was a one-off bad deal and management is now schooled in the art of the shrewd purchase.  That belief is a prerequisite for investors as Broadridge has spent over $500mm on “tuck-in” acquisitions since its spin including purchasing Access Data in May 2009 for $45.2mm, City Networks in June 2010 for $37.7, New River in August 2010 for $77.6mm, and Forefield, Inc in December 2010 for $18.3mm.  Broadridge has not disclosed financial information for these acquisitions, but I believe they are cash flow negative in the aggregate; if not, it would imply Broadridge’s legacy businesses are declining rapidly. Broadridge also purchased Matrix Financial Solutions in January 2011 for $197.6. Matrix generates approximately $80mm in revenues and is projected to be $11.5mm accretive to cash earnings FYE 2012 implying a purchase price of 2.5x revenue and 17.4x cash flow.  These are not cheap multiples by my ruler.  Even more recently, Broadridge bought Paladyne Systems in September 2011 for $78mm, a business with $30mm in run rate revenue expected to be dilutive to EBIT in 2012. 

Shortly after its spin, Broadridge reported a FYE 2007 EPS of $1.42.  By FYE 2011, EPS had declined to $1.38 (analyst consensus for FYE 2012 is $1.46).  Simply put, the company is generating essentially the same earnings per share despite half a billion in acquisitions. 

You can think of Broadridge as a utility in which the managment team is constantly trying to purchase growth in unregulated businesses by spending free cash flow from the low-growth regulated businesses.

Skin in the game?

If management purchased stock on the open market alongside investors, I would not view Broadridge’s acquisition strategy with such a jaundiced eye.  However, insider’s trading activity paints a picture of a management team allergic to its own stock.  Co-founder John Hogan sells stock as fast as he receives it, divesting 157,000 shares since 2008 leaving him with a paltry outright owned 20,000 shares.  He has never purchased a share since the spin.  The same applies to CEO Rich Daly, who has exercised and sold 240,000 shares without purchasing any while CFO Dan Sheldon has exercised and sold 100,000 shares since the spin, also without purchasing any.  If management’s ownership appears substantial in the proxy it is simply a matter of very large annual stock grants.  Daly and Sheldon have been granted over 1.7 million and 450,000 options respectively since the spin.  After repeated prodding by shareholders from the day Broadridge began regular way trading, management finally engaged a stock repurchase program, a move I typically applaud.  However, according to Daly’s shareholder letter, valuation is not what drives repurchases.  Rather, Daly writes, “We intend to buy back our shares to offset any equity compensation dilution and evaluate other buyback opportunities when cash is available.” A review of the numbers shows that 40% of the share repurchases are to offset management’s grants.  To put figures to it, $535mm has spent on buying back 26 million shares yet fully diluted shares have only declined 15 million from 142 million to 127million, meaning 11mm new shares have flowed to management.  As of September 2011, there are still an additional 13.5 million options and 2.7 million RSUs outstanding.  Management treats its stock grants as a cash machine and uses a company buyback program to make the dilution less obvious.

Valuation

With a $3bn market value and a $3.4bn total enterprise value, Broadridge trades at 8.8x its 2012E $390mm of EBITDA and 16x adjusted EPS.  Considering Broadridge has spent well over $1bn (1/3 of its TEV) in buybacks and acquisitions to simply keep revenue and earnings flat, these multiples are exceedingly rich.  Its closest comp, DST Systems, trades at a less lofty 7.3x 2012E EBITDA and 12x adjusted EPS.  At those multiples, assuming it achieves its 2012 estimates, Broadridge would trade in the $18-19 range or about 25% lower.  Further, short sellers shouldn’t worry about a leveraged acquisition of Broadridge.  As has been stated by management ad nauseum, customers would reject a non-investment grade Broadridge.  It relies on the brokerage houses of the world to provide its raw material of actual individual or entity stock ownership data for its proxy business and, as reaffirmed on the August 2011 call, “Maintaining an investment grade is not an emotional thing for us. These large transaction that we are talking with clients about right now, without question, the dialogue in their organizations comes up that if they are going to rely on us for mission-critical services, they want to have a high level of confidence in our ability to perform throughout all markets.” 

Gray swan risk

These considerations argue against a long position, but not necessarily for a short position in Broadridge.  The twist of the knife that provides the possibility of asymmetric upside to short sellers is the real threat of new NYSE/SEC regulation.  Again, lets begin with a bit of history.  As detailed in my 2007 write up, Broadridge has a monopoly in US proxy distribution. Consequently, the NYSE, with input from the SEC, governs its pricing.  Broadridge’s Investor Communications segment contributes approximately 70% of its EBIT, of which proxy services represent the majority.  Soon after it spun from ADP in March 2007, the NYSE Proxy Working Group finalized its last fee review by maintaining the status quo on pricing for proxies sent by “snail mail” and further allowing Broadridge to charge an additional market rate (whatever they felt like) for delivering proxies online under new “notice and access” e-proxy regulation.  Broadridge not only dodged a probable price cut, but they were also permitted to charge more for doing less.  It was a big win for the company. 

To my conspiratorial mind, the very reason for ADP’s spin-off of Broadridge was to make it impossible for the NYSE to cut proxy fees. The NYSE could have taken a hatchet to proxy fees without impacting ADP materially, but for newly stand-alone Broadridge, a dramatic price cut would have been irresponsible, especially since the NYSE Proxy Working Group described BR’s service as “critical to the functioning of the corporate governance system for American publicly traded companies.”  

In July of 2010, the SEC made it very clear it wants to revisit Broadridge’s pricing (amongst other changes) with it “Concept Release on the US Proxy System.”  (http://www.sec.gov/rules/concept/2010/34-62495.pdf).  The SEC criticizes the NYSE for not following up on its own recommendations to commission studies to reevaluate fees. The juicy part begins on page 50 in the section titled “Proxy Fee Distribution.”  Some choice quotes include:

• One of the most persistent concerns that has been expressed to the Commision’s staff, particularly by issuers, involves the structure and size of fees charged for the distribution of proxy materials to beneficial owners.
• The Proxy Working Group also recommended that the NYSE should “continue to explore alternative systems…such that a competitive system, with fees set by the free market, could eventually succeed the current system.”
• Several issuers have expressed concerns about these fees associated with the notice and access model…If an issuer elects the “notice-only” delivery option for any or all accounts, that proxy service provider currently charges an “Incremental Fee.”
• We understand that, without a competitive market, there may be a continued need for regulated fees…. One alternative that has been suggested by a commentator is the creation of a central data aggregator that is given the right to collect beneficial owner information from securities intermediaries, but is required to provide that information to any agent designated by the issuer.

The message from the SEC is clear: either fees need to be lowered or Broadridge’s crown jewel asset of sole access to all US broker’s stock ownership information needs to be replaced by a government agency that collects all beneficial stock ownership data and sells into a competitive market of many proxy distributors.  While such outcomes range from bad to worse for Broadridge, neither investors, nor the company, nor the sell-side seem to take it seriously.   Broadridge’s direct response to the issue from its September 2011 call was flagrantly dismissive of the risk as Daly stated, “We're gratified that the New York Stock Exchange and SEC have never had a better understanding of what we do and the value we provide to the proxy process. We're not aware of any proposed rules or legislation that would cause us to anticipate a decline in pricing.  We are excited about our continuing dialogue with both the New York Stock Exchange and the SEC about new areas, where we can add greater value to the communication needs of all shareholders, which would also benefit our shareholders.”  Notwithstanding Daly’s optimism, it is hard to imagine an outcome that is anything but negative for Broadridge.  It appears the regulators now realize and regret giving Broadridge a big windfall with “notice and access” rather than a price cut.   The hundreds of responses to the SEC’s white paper can be accessed here: http://www.sec.gov/comments/s7-14-10/s71410.shtml.  Perhaps the most worthwhile read is the NYSE’s letter, which despite being criticized by the SEC completely agrees with them, stating “…we do not believe that proxy distribution fees should necessarily continue to be specified by SRO rule….we think the concept of a central data aggregator should be further explored.”  A year and half has already lapsed since the SEC launched its proxy salvo, and I have no insight into the ultimate timing of process or, if it even gets to conclusion.  It is simply an overhang that could affect 50-60% of Broadridge’s EBIT in a meaningfully negative way.

Catalyst

• SEC/NYSE US Proxy System regulation
• Continuing poor capital allocation