I added shares of Broadridge Financial Solutions (BR) to the Fat Pitch Financials Port earlier this week. Broadridge is the recent spin-off from ADP (ADP). Shareholders of ADP received one share of BR for every 4 shares of ADP they owned. The spinoff was completed May 30th. There was considerable discussion regarding Broadridge on Value Investing News since then.
Let me now discuss my analysis and rationale for buying Broadridge. First, I believe that Broadridge Financial Solutions will have a sustainable competitive advantage due to the high customer switching costs associated with their integrated security processing and investor communication services. Changing a back office service, such as the ones provided by Broadridge, involve considerable planning and could result in business disruption. Most companies will tend to avoid second guessing their non-core backoffice solutions unless a problem arises.
It appears the highest risk of a customer switching to a different service provider occurs during mergers according to Broadridge statements. There has been quite a bit of consolidation among brokerages over the past few years. However, it has also been my impression that for every merger there seems to always be new firm that pops up afterwards. We recently saw BrownCo and TD Waterhouse merge into E*Trade and TD Ameritrade respectively, but TradeKing, Zecco, and SogoInvest (I’m sure I missed others.) have emerged in their place. In addition, Wells Fargo and Bank of America have ramped up their brokerage services by offering free trading to their banking customers. Given this dynamic market for brokers, expanded international interest in stocks, as well as the constant creation of new funds, Broadridge will have good opportunities for new growth in the future.
The next thing I looked at was Broadridge’s value. For an initial quick and dirty analysis, I used the Graham’s formula to quickly value BR shares. The equation for this formula is:
P = ProjEPS * (8.5 + (2*G)) * (4.4/AAA yield)
I used $180 million for 2007 projected net income based on a recent Broadridge investor presentation (pdf). I divided that 180 by 139 million shares outstanding to get $1.29 in earnings per share projected for 2007 (ProjEPS). Broadridge has provided guidance that their forward outlook is for 10-15% EPS growth. I come up with a more conservative 9% long-term growth rate (G) based on the increase in pro forma earnings per share from 2006 to the low end of the projected 2007 earnings per share. Finally, I adjusted the 4.4 in the equation for the required rate of return to 4.6 to more closely reflect the 10-year Treasury Note rate. The long term AAA yield for corporate bonds is about 5.9%. Using these inputs, I got the following:
(180/139.5)*(8.5+(2*9))*4.6/5.9 = $26.76
Given that shares of BR were trading for about $19.25, I thought there could be a margin of safety in this spinoff opportunity, so I did a bit more research. I ran a few discounted free cash flow models that I wasn’t too confident in but they mostly showed me intrinsic value estimates from between $25 and $55. Therefore, I feel there is a margin of safety here.
There has been a bit of confusion regarding Broadridge’s EV/EBIT ratio on Value Investing News, so I decided to clear up that issue first. I calculated the enterprise value (EV) by taking the current stock quote of $19.25 and multiplying it by 139 million shares. Then I added in $690 million in debt and subtracted out 84.8 million in cash based on the December 31, 2006 pro forma balance sheet. That comes to a $3.28 billion enterprise value. Since 2007 is well underway, I decided to use the average projected 2007 earnings before interest and taxes (EBIT) of $343 million. That gave me a EV/EBIT of 9.6 or an EY of 10.4%. I also calculated a return on capital for 2007 of about 22%, which is much higher than the company’s cost of capital. These fundamentals are very attractive.
My next question was whether institutional investors would dump Broadridge shares. Given that index funds have so much influence in institutional ownership of stocks and ADP is on the S&P 500, there was the potential that the new institutional owners of Broadridge would dump their shares. However, Broadridge has been added to the S&P MidCap 400. I don’t believe the MidCap 400 is as widely held as the S&P 500, so there still might be some selling due to rebalancing. I was hoping that it would not be added to an index so quickly because I wanted the maximum potential spinoff discount resulting from institutional selling. Regardless, shares of Broadridge did face some selling pressure and high volume for its first three days of trading.
It looks like the new management of Broadridge will be highly motivated to boost the value of this stock since they have started receiving generous stock option grants. The CEO, Richard Daly, has already received a large number of stock options. According to this Form 4, Mr. Daly on April 2, 2007 had over 494,140 stock options with average exercise price of $17.89. Mr. Daly will be working real hard to boost the value of this company over the next few years in order to fully reap his rewards.
Some of you might be concerned about the $690 million in debt. A high debt burden is fairly typical with spinoffs. However, this leverage often acts to turbo charge future returns to shareholders. It does add a bit more risk, but spinoffs usually enter a high growth phase that offsets the costs of this capital. In Broadridge’s case, I’m a bit disappointed that the debt did not boost cash holding more. Most of the debt is going to pay off the parent company, ADP.
Finally, I believe the freeing up of Broadridge from ADP’s payroll and human resource focus will allow its management to better focus on fulfilling the needs of its financial clients. It will be interesting to see how Broadridge develops over the coming year. Hopefully, its new focus, independence, and motivation will lead this stock to a profitable future.
Full Disclosure: I own shares in ADP and Broadridge Financial Solutions.