Broadridge Financial Solutions, Inc. (“Broadridge”) was spun off from Automatic Data Processing, Inc. before the NYSE had completed a review of its pricing in its core Investor Communications segment—or perhaps because the NYSE had not completed its review. The transaction’s timing, whether intentional or not, created incentives for management that may have shaped disclosures and contributed to the company’s attractive valuation.

Nowhere in Broadridge’s public filings will you find the word “monopoly” used to describe its market position distributing proxy statements for U.S. issuers, although it would be apt. Nor will you find it explained that because Broadridge is engaged by broker/dealers but paid by issuers to distribute proxy statements to their customers, a “third-party payor” dynamic is created. Management was limited in its ability to discuss just how good its proxy distribution and tabulation business is, because to do so would signal an ability to absorb lower prices while the NYSE was completing its pricing review. Although price reductions would not have been unreasonable, management was also limited in its ability to admit the possibility, because to do so could prove self-fulfilling. Left with an impression of the business that was less than it might have been and an unquantifiable material risk, some investors threw up their hands.

 

Broadridge began trading on a “when-issued” basis on March 22^nd and completed its spin off from Automatic Data Processing, Inc. on March 30, 2007. The NYSE completed its pricing review before July 1^st, and although it is still little known or understood, the NYSE’s new pricing schedule is extremely favorable to Broadridge. In addition, temporary losses from Broadridge’s Clearing & Outsourcing segment mask its profitability, and the absence of a publicly-traded company comparable to the Investor Communications segment and limited sell-side coverage make it more difficult to value. All of these factors may contribute to Broadridge’s attractive valuation of 16.5x FYE June 2008 estimated earnings for a quickly growing business with near-monopolistic market share, third-party payors and low and declining marginal costs that is itself critical to the functioning of the U.S. capital markets. Furthermore, additional value may be realized as the sub-scale Clearing & Outsourcing segment reaches critical mass.

 

The U.S. public markets are built on a clearance and settlement infrastructure that is not well understood, even by active market participants. The proxy processing business, which was essentially invented by Broadridge and its current management team, is properly understood in the context of the unified, national clearance and settlement systems. While concerns have been raised with respect to certain aspects of these systems, such as issues surrounding failure-to-deliver, they are critical to the functioning of U.S. markets, highly efficient and resistant to change.

The Depository Trust & Clearing Corporation (DTCC) is the world’s largest post-trade infrastructure organization. Its subsidiary, the Depository Trust Company (DTC), acts as a central securities depository, so that stock certificates and checks do not need to be physically transferred with each trade, as they were in the 1960s. The DTC holds approximately 85% of all U.S. equities. Stocks are kept in the name of its partnership nominee, Cede & Co. Investors own proportional interests in the shares held by Cede & Co. rather than identifiable shares, and ownership changes are recorded electronically. The other principal DTCC subsidiary, the National Securities Clearing Corporation (NSCC), negates the need to settle each transaction on an individual basis and expedites settlement by allowing multiple trades to be settled by a single net instruction for the movement of securities and cash, greatly reducing the time and capital needed to support trade settlement.

Tracking the voting rights associated with the movement of shares in this system is more complicated than tracking economic interests. This complexity results from the practice of lending shares to short sellers:  the buyer of shares sold short expects voting rights to be attached to those shares. The buyer is the only party with voting rights, in keeping with the idea of “one share, one vote.” Two parties, however—the original owner who lent shares and the buyer of shares sold short—have an economic interest in those shares.

The data needed to compile a shareholder list has to be compiled by the DTC from disparate sources. The DTC’s own records do not include the beneficial owners of shares held in street name; only the individual broker/dealers know the identity of their customers. The broker/dealers hire Broadridge to act as their agent, and Broadridge supplies beneficial ownership data to the DTC. That data, together with additional data from the exchanges and other sources, is used to generate a shareholder list, which is provided to the issuer one day following the record date, for which there is twenty days notice.

Issuers are not given a shareholder list with all of the beneficial ownership attributed; issuers only know the identities of shareholders who did not object to direct communication between themselves and the issuer (called non-objecting beneficial owners, or NOBOs). Objecting beneficial owners (OBOs), constituting approximately 70-80% of all shares, appear on the shareholder list in street name, and direct communication between the issuer and these shareholders is prohibited.

Issuers need an intermediary to communicate with the vast majority of their shareholders, but none of the broker/dealers is set up to distribute investor communications (Merrill Lynch had been in the business, but sold to ADP in 1999). To communicate with their shareholders, then, issuers rely on Broadridge as the broker/dealer’s agent. When proxies, proxy ballots and annual reports are printed, they are sent to Broadridge, who sends them to beneficial owners in the familiar blue polyurethane bag (some are sent to transfer agents who, in turn, send them to shareholders). The same web of intermediaries is used when communications are in electronic, rather than hard copy, form.

Shareholders receive proxies and vote in one of four ways: (i) by completing the paper proxy and returning it to Broadridge, (ii) by telephone with a Broadridge employee, (iii) through the internet, and (iv) by using Broadridge’s proprietary ProxyEdge platform or a competitive platform. Broadridge then tabulates the votes.

Broadridge receives several different fees for distributing investor communications, including fees for each nominee (broker/dealer) with which it interacts on every security, a base fee and a bulk processing fee. It also marks up its postage costs and is paid an incentive fee every time it is able to reduce an issuer’s cost by suppressing a mailing (called an elimination fee). An example of the latter would be Broadridge’s practice of “householding” or eliminating multiple mailings to the same address. Broadridge also receives fees when it tabulates votes through any of the four channels. In each case, the issuer pays the fees to Broadridge, who pays a rebate to the broker/dealers.

The pricing dynamic for proxy processing is extraordinary. Broadridge enjoys a market share of approximately 99% in proxy distribution for shares held in street name (70% for all proxies). The service it offers is, in the NYSE Proxy Working Group’s own words, “critical to the functioning of the corporate governance system for American publicly traded companies,” which rely on an infrastructure that requires an intermediary for data and communication distribution. The entities contracting with Broadridge, the broker/dealers, are not paying its fees; the fees are instead paid by the issuers. The cost to individual issuers is immaterial, so they are less price-sensitive, although fees are large in the aggregate. The NYSE, which determines Broadridge’s pricing in consultation with the company, could act as a check in this structure under NYSE Rule 465; it was, until its IPO, owned by its member firms, including the broker/dealers who receive rebates from Broadridge and who helped design the industry’s fee architecture.

 

Broadridge’s profitability will only be enhanced by the SEC’s recent amendments to the proxy rules, known as “notice and access.” Notice and access removes the requirement for public companies to send automatically a full, hard-copy set of annual meeting and proxy materials by allowing them to deliver instead a “Notice of Internet Availability of Proxy Materials,” and to provide online access to the documents. Companies choosing the option to use this new notice and access delivery model must give shareholders an ability to request a paper copy of the posted materials. Under notice and access, Broadridge will be paid for electronic distribution while it continues to receive elimination fees. The economics of vote tabulation will also improve because its marginal costs for electronic tabulation are near zero while its costs for paper and telephonic tabulation are quite high and its profit margins quite low.

 

Below are statistics regarding recent proxy volumes:

 

 

Securities Processing Solutions (SPS) provides trade processing from order management to clearance and settlement, record keeping for compliance reporting, integrated web based desktop applications, including BPS Advantage, ProVisor and Enterprise Workflow. SPS process approximately 2 million equity and 2 million fixed income trades per day. Many large banks utilize their platforms, including Bank of America and Bear Stearns. Broadridge competes primarily with SunGard Data Systems Inc. and with in-house providers who may acquire Broadridge clients. SPS is a very high margin business (>27% EBIT margins) with very entrenched customers that have been with the company for an average of 10 years. Channel checks indicate that clients rarely leave because of high switching costs; customer losses really only occur when clients are acquired by brokerages with in-house processing. For example, Broadridge is losing TD Waterhouse, which represented $40 million in revenues to SPS, to Ameritrade. Potential new clients may be gained from amongst the 5,000 small bank/brokerages that exist, of whom approximately 10 could generate revenues of $50-80 million.

 

Clearing & Outsourcing was acquired from Bank of America for $360mm in November 2004. Clearing takes over a trade where SPS ends by dealing with the actual exchange of money at settlement. Clearing is a scale business and Broadridge is on its way to achieving break-even scale, which management projects will occur this fiscal year (FYE 6/08). With this business, Broadridge is able to offer a one-stop shop for its processing customers who typically also need trade clearing services. Many of the larger clearing businesses, including Spear Leeds & Kellogg (now Goldman Sachs) and Pershing (The Bank of New York Mellon) are no longer independent. However, Penson Worldwide, which went public in May 2006, is a stand-alone clearing business that provides some insight into scale economies:

 

 

 

Broadridge currently trades at 14x FYE June 2007 estimated earnings of $1.40 and 16.4x FYE June 2008 estimated earnings of $1.18. Note that earnings are expected to decline as a result of previously announced customer losses due to acquisition. While there are no companies directly comparable to Broadridge, most processing companies trade at 20x earnings or higher (e.g., JKHY, BSG, FISV, DST, STT, BK, and IFIN).  Given Broadridge’s monopoly position in its ICS segment and potential new client growth in its SPS, it should at least trade in line with its comparables. There has also been a very healthy acquisition appetite for processing businesses lately including FirstData at 25x forward earnings, Ceridian at 24x forward earnings and Metavante at 22x (before incorporating stand-alone company costs). Additionally, Clearing should be worth at least the $2.50 per share Broadridge paid, which corresponds with JP Morgan’s thesis that Penson is worth 3-3.5x revenue. Putting it all together, Broadridge is worth approximately $26 per share today with a value that should increase as it gains new securities processing customers, achieves scale in clearing, and benefits from new fees and lower marginal costs in investor communications.