Everything We Hear is an Opinion; Everything We See is a Perspective
(Guest Commentary by Rick Konrad – October 22, 2009)
Dear Subscribers and Readers,
Important Note: My business partner and webmaster, Rex, will be in Vietnam for a 10-day trip later this week. As a result, we would not be publishing “full blown” this weekend or next Wednesday. I will, however, author two “ad hoc” commentaries with a more “personal touch” – more specifically, these two commentaries will summarize my deepest fears and concerns about the US and the global economy – and how this may impact our lives going forward. I look forward to sharing my thoughts with you starting this weekend.
Now, let us dive into our mid-week commentary. For those who had wanted to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary. Rick is a regular guest commentator and usually writes for us every third Wednesday of the month. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick will give us his quick perspective on the waning strength of the US economy and US Dollar. In addition, Rick will provide his insights on the North American financial industry, with a specific focus on Broadridge Financial Solutions (BR). Rick believes that BR is compelling in this environment given its stable and recurring businesses (such as proxy distribution and shareholder vote processing), its international exposure, and attractive valuations. Without further ado, following is a biography of Rick:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Brinks Home Security Holdings (CFL)” for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog. You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
Everything we hear is an opinion, not a fact. Everything we see is a perspective, not the truth.
The centrality of the trade-off between risk and return infuses all investment decisions or at least it should. The flow of information from computers, databases and the Internet, so abundant nowadays, has altered communication, calculations, and the way we perceive risk. All of us face a cascade of information containing both fact and fiction. In a world where Twitter and blogs rank equally as sources of information or misinformation as more authentic or at least traditional information sources, it is difficult not to be swept away in a tide of weak reasoning.
Years ago, some philosopher wrote that no man is an island. I think this is a particularly useful quote for investors to think about. After all, in the end, the value of your portfolio is not what somebody tells you is likely to happen over the long run, but rather how much other investors in the collective investment universe are willing to pay you for your assets. So the issue of risk boils down to the uncertainty about the decisions that other human beings are going to make and how we should best respond to those decisions.
I think this is where the issue of perspective comes in. As a Canadian who grew up across from what was at the time of my childhood, a thriving metropolis of Detroit, I gained some perspective of currency fluctuations at a very early age. Crossing the border to buy things in Michigan when the Canadian dollar was strong was innate, rational and sensible. As an investor in the mid 80's, I had a vivid demonstration of the vulnerability of Canadian enterprises getting “picked off” by foreign investors because the asset bargains were irresistible to the rest of the world's investors. Given the US dollar weakness, I think it is very useful to attempt to put yourself into the shoes of the global citizen who holds non-US currency.
As American investors, we do spend an inordinate amount of time agonizing over the downward vortex of the US dollar, a perspective which clearly disturbs many foreign central bankers. Yet, the strength in foreign currencies should and will embolden the rising class of investors in the rest of the world, whether individuals or corporations.
The structural strength in the global economy lies in the emerging market economies. Having experienced hardship through a series of crises in the late 90's, these economies have done what the US has not…paid down debt, increased savings, and built reserves. Perish the thought of the US being an economic locomotive for the next five years…the changes are pervasive, rapid, bewildering, and scary. However, the desire to own assets, especially growing assets with multinational bases will become omnipresent. Yesterday's response to a given set of circumstances may be inappropriate for the evolution that is taking place.
Give yourself the perspective of the global citizen who may be champing at the bit to buy US companies, not unlike the foreign visitors to New York buying apparel at bargain prices.
Many clients and friends have wondered about our stance on financial services. We have been fortunate in trading a number of banks through the first and second quarters but have focused our holdings down to basically two banks at this point, Bank of New York Mellon, (BK) which we like because it is one of the largest global custodians- and hence, it is more dependent on a trust bank model than a traditional bank model. Our favorite bank has been US Bancorp (USB) which reported decent earnings earlier today. A strong capital base and significant fee income have allowed USB to grow while much of the industry is trying to shrink in this downturn. I think some of Richard Davis' comments this morning in the Q&A portion of the conference call were quite enlightening:
“First of all I think that banking in general, because of the higher new bars that will be placed on all of us going forward, namely higher loan loss provisions are likely than they were before the downturn, higher capital requirements are likely and now we are all paying insurance and will for quite some time that in many cases we were actually getting credits for, I think all three of those are natural negative bias toward the ROA and ROE of the long-term banks and the after versus before scenario but I also think that the increasing old fashion banking on spread benefits a yield curve and the flight to quality that banks will have in being able to be the place where our capital is well recognized and we get paid for risk, I think that's a positive bias, so I think net net you can expect banks to go close to maybe slightly under where they were before and this bank was typically in the 21 to 22% ROE, today we are talking about normalized 16 and I think you'll see us between those numbers as things start to settle.”
Fortunately, USB will exhibit ROE's in the future that will likely be head and shoulders above most others, largely because it operates some businesses that require little equity capital. Ditto for BK. But for most banks, especially small community and regional banks, it seems that the quest for mid-teens returns on equity will prove elusive for some time.
I have often found it useful to look through the value chain at an industry to see where the significant returns are being made. Though the auto industry for years stood as a testament to poor capital allocation and bad decisions, there were many auto parts suppliers that managed to earn superior returns, not only to the Big 3 (how foolish that term sounds now) but also to most companies. Similarly, many companies that provided outsourcing to the pharmaceutical companies, danced circles around them when it came to improving their profitability at a time that the majors were suffering declining returns.
I feel that way about Broadridge Financial Solutions (BR). Broadridge was spun off as a public company from ADP where it had been ADP's division, “Brokerage Services Business.” At the time of the spin-off, April 2007, the company was $19.70 a share. Back at that time, I had reviewed Broadridge in Value Discipline. From the inception of my positive blog, the stock has advanced only about 14.6% however, this is yeoman performance compared to the S&P's decline of 24.1% over this period. However, in terms of a Euro investor perspective, from the time of the spin to now, the stock is actually down about 2.6%.
BR provides absolutely mission-critical back office outsourced solutions to the financial services industry. It is the clear leader in proxy distribution and shareholder vote processing with over 800 bank or brokerage clients. As Merrill Lynch analyst, James Kissane described it, Broadridge is “the network that connects issuers, brokers, and shareholders in a Street name world.”
Proxy voting, though ignored by many investors due to a feeling of powerlessness will increasingly take center stage. On July 1, 2009, the SEC approved (in a party line 3-2 vote) the NYSE's proposed rule change that eliminates broker discretionary voting in uncontested director elections. The effect of the rule change is that brokers will not be able to cast “uninstructed” votes in any director election. The amended rule will apply to proxy voting for stockholder meetings held on or after January 1, 2010.
How will this impact BR? This change will likely increase the cost of uncontested director elections while companies spend more resources on stockholder communication to successfully reach stockholders who may not be aware of the change in voting procedures and the effect of not returning their proxy. As well, corporate governance will require more attention and advice…the loss of the broker discretionary vote in uncontested elections will likely make achieving a quorum more difficult. The rule change is expected to make it more difficult for companies with “majority voting” provisions to achieve a successful election, particularly for companies with a large retail investor base. Finally, the rule change can also be expected to increase the influence of institutional shareholders and shareholder activist groups in director elections. Hence, I would expect that BR, which processed over 70% of shareholder votes in the US, will have a substantial leg up on its competitors.
The great majority of Broadridge's business are recurring revenue streams, which I had estimated in 2007 at 70% now appear to represent at least 80%. How issuers communicate with shareholders depends on their ability to identify them. The rapid growth in trading made physical exchange of stock certificates an outmoded way to trade. With shares increasingly held in Street name, investor communication became an increasingly important service function which BR mastered.
The investor communications business contributes about 72% of BR's revenues and almost 80% of pre-tax profits.
Securities Processing is about one quarter of revenues. Securities processing revenues are also recurring in nature and protected by longer term contracts with minimums and early termination provisions. This is a more volatile revenue stream because growth is dependent on trading volumes and mix of retail versus institutional and equity versus fixed income. Broadridge can process a wide variety of securities in multi-currencies…some 25% of this revenue stream is international. Many clients who wish to achieve cost savings and efficiency or wish to access better trading technology utilize BR's services. However, the consolidation of the brokerage business has had a negative effect on this business. As clients become inactive, as brokerage firms disappear, there is uncertainty as to the revenue growth and certainly price concessions are starting to appear.
Clearing and Outsourcing is a relatively minor part of the business, constituting only about 5% of revenues. Clearing services is what is termed “settlement,” the exchange of payment between counterparties. This also includes activities such as margin lending and securities lending for shorting. Broadridge offers its services only to small broker/dealers rather than act as a prime broker to hedge funds.
Broadridge generates consistent free cash flows. In fact, the company recently doubled its dividend (not too many examples of that this year) and instituted a share buyback program.
For a $3 billion market cap company, it is currently followed by only three analysts. Return on equity for 2009 (June FY) was 24%.
Please find attached a valuation spreadsheet which outlines three different scenarios for Broadridge. In my view, the most probable, assumes merely 4% compounded growth in free cash flow over the next five years. This suggests an intrinsic value of about $30.50 relative to today's close of $21.50 about 40% upside. The most conservative forecast suggests only 0.55% growth in free cash flows compounded over the next five years. Even under this rather dire forecast, the stock is about 11% undervalued.
Estimates for next June 2010 range between $1.55 and $1.59 up from last year's $1.45, not what I think are heroic estimates for growth. On a trailing twelve month EV/EBITDA basis the stock is less than 7 times. Quite cheap for this cash flow (9.5% FCF yield) and this level of profitability (Street consensus forecast of 27%)
Disclaimer: I, my family, and clients have positions in BK, BR, and USB currently.