Why Pershing Square's ADP Thesis Should Be Taken Seriously

Aug. 25, 2017 7:38 PM ET24 comments

by: Tom Webster

Summary

ADP is using pass through income from their PEO business to manipulate numbers.

ADP's complicated and antiquated back end is preventing ADP from operating more
efficiently.

The focus on meeting incremental growth goals and consistent dividend payments
led management to miss opportunities to create greater margins.

Offering high touch service does not position ADP well for a cloud and tech based
future.

Insular management has led to little perspective from outside the company.

Source: Pershing Square presentation, ADP: The Time is Now (page 5)

Background:

ADP CEO Carlos Rodriguez joined CNBC to discuss Bill Ackman's request to extend the
nomination deadline for ADP's board. After initially requesting a 30-45 day extension, he
said that he actually would only need an extension of a week. Rodriguez said Ackman's
request was similar to that of a spoiled brat in school, asking for an extension on an
assignment. Love or hate Ackman, his investment thesis should be taken seriously. Many
are quick to point out his failures, for example, Valeant (NYSE:VRX) or Macy's (NYSE:M).
Some have also deemed his ongoing battle with Herbalife (NYSE:HLF) a total failure. In
the case of Herbal Life, I think Ackman has shown the true spirit of activist investing, other
may have a different opinion on this. Before passing judgment on Pershing Square's
thesis, investors should weigh Ackman's losses and wins. You cannot overlook the
brilliance of his work with General Growth Properties (NYSE:GGP) and Canadian Pacific
(NYSE:CP). The interaction between Automatic Data Processing and Pershing has many
parallels to Ackman's interaction with Canadian Pacific. One major difference is ADP's
markedly better share performance in comparison to CP's. You can draw your own
conclusions based on Ackman's track record. Let move on and examine the main points
from Pershing Square's 3 hour, 167 slide presentation, which can be found at
ADPascending.com.
Source: Pershing Square presentation, ADP: The Time is Now (page 6)

As I move through the most important slides and points made, I will provide some of the
commentaries from Pershing's presentation. Any paragraph labeled with Pershing, is
providing a brief summation of what was mentioned in the investor presentation. It is
important for me to give background on these slides before weighing in myself.

Pershing: One thing to note is the margin of ES or employer services as this number
along with a few questions about ADP's disclosure are the crux of Ackman's thesis. This
level of margin is referred to by Pershing as adjusted net operating profit margin. I feel that
this truly is a more accurate representation of the margin for their ES business and
working the numbers to present it at the 31% level along with consistent dividend
payments has kept investors from asking questions.

I agree that this is a more accurate representation of the margin for their ES business and
ADP working the numbers to present it at the 31% level has kept investors from asking
more questions.

Source: Pershing Square presentation, ADP: The Time is Now (page 51)
Pershing: ES drives 87% of ADP's revenue and this is where it seems they have been
lacking in profit margin. As human capital management (HCM) has incorporated more and
more technology, these are numbers that shareholder would like to see expanding. PEO is
also pivotal to Ackman's thesis as Pershing Square feels that pass-throughs within this
business segment have been used to manipulate earnings.

While PEO is only 9% of their business, I think that this is still a bit of trickery by
management. Booking this using a fixed number of 4.5% Rates are not even near this
level so I do have questions as to why management would knowingly use a number that is
incorrect. If they see no problem overstating their float at 4.5% then they should tread
lightly in their accusations against Ackman, saying he has some of his numbers wrong.

Source: Pershing Square presentation, ADP: The Time is Now (page 8)

Pershing: Pershing Square made it clear, they feel that executives are more concerned
with meeting their incentives through incremental growth each year rather than exploring
options that trade short term gains for long term benefits. Accusations of insularity and
short term focus are likely the reason that CEO Carlos Rodriguez was so quick to snap
back at Ackman.
Anytime you raise questions about the integrity of a C-Suite, you are going to get a strong
and immediate response. I believe that the questions Ackman has raised are actually valid
and this is part of what prompted a response from Rodriguez containing a personal attack
on Ackman. I have questions about the way Rodriguez responded to accusations of ADP
manipulating their financials. Rodriguez made an appearance on Mad Money with Jim
Cramer to address Pershing Square's presentation.

In response to Pershing Square's questions about disclosure in recent 10-K and 10-Q
reports, Rodriguez said. "We kind of take offense to the implication that we are, I guess,
playing with numbers or not disclosing information that we should be disclosing". For
someone who immediately went on the offensive, making personal remarks towards
Ackman, I expected an unequivocal denial of any possibility that ADP was choice or
deceptive in their disclosures under current leadership. In this same interview, he went on
to say, "Despite what you might think, we're professionals and we don't take things
personally". Rodriguez does not take things personally, yet he felt the need to refer to
Ackman as a "spoiled brat" for requesting a deadline extension in board nominations.
While he went on to say that this would have required modifications to the company
bylaws, Ackman says that changes could be made that only apply to Pershing Square.
Rodriguez's knee-jerk reaction to Ackman's request for an extension completely
contradicts what he has gone on to say in reference to the situation, as he has tried to
claim he was acting as a professional instead of addressing Ackman's major points with
conciseness and clarity.
Source: Pershing Square presentation, ADP: The Time is Now (page 14)

Pershing: ADP, founded by accountants, has primarily focused on their namesake, data
processing. Today, companies are in need of a suite of HR products, these products are
referred to Beyond Payroll HCM. If you want to be best in class, you must offer a
comprehensive product. If there is a task HR needs to perform, there is likely a product
offered to improve or optimize the execution. It is clear that ADP is the dominant player in
the payroll space, but failing to evolve can lead to major problems in a world where
technology rules.

IBM (NYSE:IBM) is a great example of what can happen if you fail to evolve quickly. They
have experienced a shrinking revenue stream for 21 consecutive quarters. Analysts have
questions about financial engineering that IBM may be using to maintain dividends and
boost numbers. Cloud based start-ups and companies that are focused on newer
technology have steadily taken customers from IBM. Failure to quickly evolve from legacy
business leads to a major bleed out of customers to companies that provide
technologically advanced services.
Source: Pershing Square presentation, ADP: The Time is Now (page 15)

Pershing: ADP understands that they are failing to evolve quickly. To combat this, they
have made many different acquisitions over the years. Failure to create organic growth is
a major issue for ADP and speaks to a lack of action from management. In many cases,
these products are patched together on the back end or as Pershing says, "cobbled
together".

While I know that strategic acquisition can help to accelerate growth and bring better
products to market, it is not necessarily an efficient long term strategy. Constant
acquisitions to keep up with the evolution of HCM Beyond Payroll products has led to a
confusing product structure. A company should strive for a strong culture that creates
organic growth. The only real example of company culture is illustrated by their long-
standing executives, most of whom were promoted from within.
Source: Pershing Square presentation, ADP: The Time is Now (page 18)

Pershing: An overview of ADP's business HCM business, which represents 87% of net
revenue (illustrated on slide 6), show that they have strong competitive positions in three
of their four markets. The Enterprise level, which drives 20% of ES revenue, looks to be
vulnerable to newer players like Ultimate (NASDAQ:ULTI) which have soared in this
space.

I find this slide to be very representative of ADP's current situation. At every level, there
are many strong competing companies eager to take ADP's clients. They should be very
focused on the Enterprise level, where they do offer a great product in Vantage, but they
are also offering multiple other products. This is a space where I believe they should look
closely at Ultimate and Workday and see why they have found so much success with their
new technology.
Source: Pershing Square presentation, ADP: The Time is Now (page 21)

Pershing also made claims that ADP looks to be losing market share. Carlos Rodriguez
addressed this claim on CNBC, stating that Pershing failed to realize that the March 2009
number included stand-alone clients. The 2017 number is in reference to payroll
customers and does not include stand-alone clients. Rodriguez went on to say, "So our
client count has not gone down from 5,000 to 2,500. In fact, it's about slightly up to
modestly up depending on your perspective." This is a misunderstanding that could have
been clarified had ADP and Ackman agreed to go over the presentation in a private
meeting, instead the two sides were at odds when it became clear ADP would fight to
retain their current board. Even if these are two different numbers and one reflects stand-
alone plus pay roll clients, Rodriguez still gives a nebulous response in reference to their
client growth.

This is a misunderstanding that could have been clarified had ADP and Ackman agreed to
go over the presentation in a private meeting, instead the two sides were at odds when it
became clear ADP would fight to retain their current board. Even if these are two different
numbers and one reflects stand-alone plus pay roll clients, I feel that Rodriguez still gave
a nebulous response in reference to their client growth.
Source: Pershing Square presentation, ADP: The Time is Now (page 21)

Under the assumption that Rodriguez's statement in regard to where the difference in
these two numbers comes from is true, this down trending line does not actually illustrate
ADP's client growth. If instead, they have remained flat from 2009 to 2017, this chart still
shows the rapid growth of Ultimate and Workday in this space. In order for both of these
companies to gain this much traction, it is clear they are offering different or superior
products than ADP. Since 2011, Ultimate has only spent a total of $590 million dollars on
r&d yet the continue to grow at an impressive pace.
Source: Pershing Square presentation, ADP: The Time is Now (page 103)

Pershing: The slide above represents the difference in spending between ADP and their
competitors. Ultimate has managed to grow revenue quickly, yet they are spending much
less than ADP on r&d. As a younger company, growth may come easier, but they are on
pace to reach more than $2 billion dollars of revenue by 2022. If Ultimate can maintain
their trajectory, there is no question they will cut into ADP's client base.

I understand that as a younger company, growth may come easier, but they are on pace
to reach more than $2 billion dollars of revenue by 2022. If Ultimate can maintain their
trajectory, there is no question they will cut into ADP's client base. That being said, ADP
still have a huge advantage over these companies. With major r&d spending and capex in
the short term, they will continue to dominate their competitors in the long term.
Source: Pershing Square presentation, ADP: The Time is Now (page 34)

Pershing: The above slide illustrates an important takeaway from Pershing Square's
thesis. ADP prides themselves on their high touch business model. Lee Cooperman, a
former board member, spoke up, saying that Ackman should reconsider his decision to
seek board seats. Cooperman's warning actually points to one of ADP's largest problems.
A High touch business does not lead to maximized margins. While it is clear one of ADP's
strengths is their customer service, it is not an efficient way to keep clients happy. If ADP
were to offer more updated and functional products, they would not need such a high
headcount for customer service. This is not to say that ADP customers are unhappy, they
are just being serviced in an antiquated manner.

Today, products that are intuitive and efficient are preferable. As a millennial, I can speak
to this point. Younger people want products that offer suggested solutions and
troubleshooting videos in place of having to reach out to someone from customer service
in a call center. ADP should do everything in their power to keep their customers happy,
but I know first hand that younger generations do not prefer high touch service.
While they pride themselves on their business model, I believe they are positioning
themselves for failure with younger clients are less likely to appreciate interaction with
customer service. Whether or not you agree with a move away from human interaction,
there is no question that it is inefficient to continue providing superior service through
headcount and not explore the effects that better products have on the need for customer
service.

Source: Pershing Square presentation, ADP: The Time is Now (page 54)

Pershing: The chart above illustrates how high the headcount at ADP is and why their
competitors have stronger margins. When factoring out the PEO pass-throughs, ADP is
generating $161 dollars per employee, while major competitors like Ultimate and Workday
generate well over $200 dollars. ADP should be able to reach comparable numbers if they
can improve their technology.

Again, I think this perfectly illustrates where the problem is. ADP is not a bad company,
they are the most dominant in this space and they have been for some time. This is why I
am skeptical of commentary from management. There is no reason that ADP should not
be able to post similar numbers to their competitors. This is likely a result of too many
employees and inefficient technology.
Source: Pershing Square presentation, ADP: The Time is Now (page 86)

Pershing: ADP is in a business that's focus has shifted towards technology. Why should a
tech company have such a large footprint? One of the very positive takeaways from this
office structure is that ADP owns roughly 40% of this office space. As technological
breakthroughs occur and more intuitive products are made, some of this real estate can
be leased or sold, creating a new revenue stream for the company. This is a major
opportunity for ADP and it is something that they should be pursuing.

I completely agree with the point made by Pershing Square. Moving forward, companies
will have to adjust to prosper in a world that depends on technology and online services.
This same thing is happening in the retail space. If a retail company owns many of their
stores, often times it is more logical to move more products online and lease their store
spaces to generate more revenue. Why should ADP be missing out on this opportunity?
Source: Pershing Square presentation, ADP: The Time is Now (page 92)

Pershing: Another important point raised in the presentation relates again to the legacy
products that ADP is using. Dinosaur languages like COBOL make it very difficult to attract
talented younger programmers. By using older languages, ADP is failing to create an
environment that can attract the best young programmers.

I feel that this will cause major problems for ADP. Younger people have no idea how to
use these languages. At what point are they going to transition to more modern languages
that are being used at startups and in classrooms. If you do not have young and
innovative minds in your office, you are likely to miss out on opportunities for improvement
and efficiency.
Source: Pershing Square presentation, ADP: The Time is Now (page 116)

On a quantitative level, I cannot speak to exactly what kind of savings will be created by
attracting the best programmers. From a qualitative standpoint, there is no question that
hiring talented young programmers will result in better products while helping to position
ADP for future success and growth.
Source: Pershing Square presentation, ADP: The Time is Now (page 114)

Despite what Rodriguez has said, it does seem that ADP has an insular management. I
am not saying that promoting from within is negative, in fact in many cases it leads to very
competent management who know their industry inside and out. There is only one
member of senior executive management that has spent less than 10 years with ADP.
This can lead to complacency as everyone has a similar understanding and view of the
business. Having someone with an entirely different perspective can be illuminating. After
spending a lot of time within the same company, it is only human nature to become
inherently biased and view things through your own lens. If Rodriguez claims that they do
not have an insular culture, why then are they not offering one board seat to someone that
owns 8.3% of their shares.

* represents less than 1%

Name of Beneficial Owner Amount and nature of Percent

beneficial ownership

Ellen R. Alemany 16,799 *

Mark D. Benjamin 113,822 *

Peter Bisson 3,707 *

Richard T. Clark 18,750 *

Eric C. Fast 32,558 *

Edward B. Flynn 88,237 *

Linda R. Gooden 28,988 *

Michael P. Gregoire 8,236 *

R. Glenn Hubbard 38,592 *

John P. Jones 55,996 *

Dermot J. O'Brien 53,285 *

William J. Ready 2,693 *

Carlos A. Rodriguez 178,117 *

Jan Siegmund 142,045 *

Sandra S. Wijnberg 1,079 *

BlackRock, Inc. 27,999,497 6.10%

The Vanguard Group, Inc. 30,095,522 6.52%

Directors and executive officers as a group 25 persons, 1,136,857 *

including those directors and executive officers named above

Pershing Square, L.P. 5,143,921 1.2%

Pershing Square II, L.P. 216,356 0.0%

Pershing Square International, Ltd. 6,276,957 1.4%

Pershing Square Holdings, Ltd. 11,366,204 2.6%

Pershing Square VI Master, L.P. 13,800,237 3.1%

Pershing Square Capital Management, L.P. 36,803,675 8.3%

PS Management GP, LLC 36,803,675 8.3%

William A. Ackman 36,803,675 8.3%

Veronic M. Hagen 0

V. Paul Unruh 0
Source: Data from SEC filings

It seems outlandish to deny a board seat to someone who owns 8.3% of your shares.
Especially considering that directors and executive officers as a group. own less than 1%
of shares. How can Rodriguez say there is no insularity and he does not get personally
offended, yet deny a board seat to someone who owns 200x more shares than him and
has had great success in past activist campaigns. Someone with this large of a stake
clearly has the best interests of the company in mind. It seems that Rodriguez is taking
actions to preserve his position at the company. Rodriguez's actions are completely
understandable but do not be fooled by what he is saying. Actions speak louder than
words and denying an 8.3% shareholder a board seat points to an insular culture.

Source: Pershing Square presentation, ADP: The Time is Now (page 127)

Pershing: Finally, let's take a look at the key financial model assumptions that Pershing
Square has come up with. Under the transformation model assumptions, Pershing
believes that ADP can reach an EPS of $8.70. In the status quo scenario, EPS will reach
$5.90 by 2022. The status quo takes into consideration commentary from management
and 2017 guidance issued by ADP, while the transformation model assumes that ADP can
work on the many issues that Pershing touched on in this lengthy presentation.
Even if Pershing was wrong in some of their assumptions because they were not able to
privately meet with ADP, Ackman raises some very strong points. There is a difference of
$2.80 in EPS between the two models. If Pershing came to some of their conclusion due
to misunderstanding, there is still likely major room for improvement to ADP's business,
revenue, and margins. ADP was not convincing in their response to the presentation,
issuing a brief statement 2 hours after its conclusion. They claimed that they are not
"resting on their laurels". Past performance is not indicative of future results. ADP has an
extremely impressive dividend record and recent stock performance. Despite this, they
actually are resting on their laurels. Rather than addressing the many points raised by
Ackman, the CEO has resorted to name-calling. The Chairman of the Board, John Jones,
was unwilling to take a call from some of the previous CEO's Ackman has worked with.
This includes Seifi Ghasemi, the CEO of Air Products. It is clear that ADP is not actually
open to change or outside perspective and they are much more interested in preserving
their current leadership. Sometimes it takes an entirely different and outside perspective to
see things from a new angle. If ADP fails to address some of the questions that have been
raised, they will find themselves losing their competitive advantage. If instead, they show
urgency and a willingness to improve their technology, they will be able to leverage their
current competitive advantage to ensure even stronger performance in the future. Right
now, it seems that Rodriguez and ADP will ignore the well-researched points raised by
Ackman because a few of his numbers may have been incorrect. Rodriguez can keep
comparing his own returns to those of Pershing Square, in which case, he is ironically the
one acting like a spoiled brat.
Source: Pershing Square presentation, ADP: The Time is Now (page 139)

As of today (8/25/17), There is a major potential that this situational will result in a proxy
fight. The two sides have finally agreed to meet on September 5th. Personally, I think it is
unlikely that they are able to settle their differences and come to an agreement. Either
way, I believe that this will all have a positive effect on ADP's future. Even if you do not
agree with Ackman and the way he approached this situation, as an activist his goal to
gain board seats and implement a plan, not make friends. If he gains these board seats,
either through a proxy fight or an agreement with ADP, I believe that it will result in great
changes for ADP. If he does not end up gaining these boards seats, ADP will still be
forced to respond to concerns that are raised. Either way, they are likely to make some
changes or come out with answers as to how they are dressing some of the points made
in Pershing Square's presentation. As this continues to shake out, investors can look to
make an entry into ADP as there seems to be a ton of room for revenue and margin
growth at the company.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any
positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving
compensation for it (other than from Seeking Alpha). I have no business relationship with
any company whose stock is mentioned in this article.