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In our previous note, we explored investing in stocks after an activist investor has taken a position. The five metrics that can help you evaluate whether the activist will be successful in boosting the stock included the following:
1. Stock is a laggard and/or undervalued.
2. Operating margins have decayed and lag peers.
3. Assets and cash flows are poorly utilized.
4. Undercurrent of grumbling among shareholder base.
5. Company leadership’s credibility relative to the activists’.
In this note, we’ll look at two high-profile current activist campaigns to illustrate these metrics.
ADP and Pershing Square
Pershing Square, led by the controversial Bill Ackman, recently took an 8.3% stake in Automatic Data Processing (NYSE: ADP). The activist wants to put three nominees, including Bill Ackman, on the board of directors and also make changes to the company’s strategy. Pershing Square recently released a 168-page slide deck describing their campaign, which you can find here. So how does this look as a turnaround investment?
On the first metric, stock performance, ADP seems like a weak turnaround candidate. Its shares sell for 28x earnings and 17.1x Ebitda--one of the most expensive stocks among large-cap companies. Perhaps more important, its three-year returns of nearly 50% have doubled the S&P 500’s returns. It is a tough road to convince shareholders that the company has a serious problem when its returns and valuation are indicating the exact opposite.
With Metric #3, asset and cash flow utilization, Pershing Square seems to have little concern with this, as their plans include “no changes in the credit rating, capital structure, dividend policy or client funds investment strategy.” So there is little chance that the activist can use this metric to boost ADP’s returns.
Metric #4 doesn’t seem to be a source of upside, either. Investors don’t think ADP has any major problems with how it is being managed. One possible issue that will have analysts sharpening their pencils, however, is Pershing Square’s comment that management hides lackluster operating performance through “complex accounting.” While unlikely, if it were true investor sentiment could quickly shift against ADP.
ADP’s vulnerability to Pershing Square’s campaign rests with its operating margins (Metric #2), which are about half those of Paychex (Nasdaq: PAYX), a reasonably close peer company. The activist points to issues such as a “bloated cost structure,” stagnant productivity, under-investment in technology and other problems that if corrected could boost ADP’s earnings by 50% and double its stock price in four years. Pershing Square’s numbers and arguments appeared reasonably researched.
The margin shortfall argument might carry a lot more weight if it weren’t for Metric #5: bargaining power. ADP management has a powerful edge here--the impressive shareholder returns provide a naturally strong defense against Pershing Square. Pershing Square’s negotiating power, furthermore, is weak. Their credibility is damaged by its bungled attempt to fix JC Penney along with sizeable losses from its Valeant Pharmaceuticals investment and other campaigns. Institutional investors, whose support Pershing will need in a proxy contest, may be hesitant to back such an outspoken and controversial person like Bill Ackman. Also weakening its credibility--Pershing Square brings little operational expertise. Furthermore, 75% of Pershing Square’s stake is in the form of low-credibility options, not actual shares. Options do not have a vote, and imply a short-term outlook.
Watch to see if ADP’s CEO Carlos Rodriguez inadvertently helps Pershing. His aggressive and sometimes personal stance against Ackman could backfire, as investors could increasingly question why a supposedly secure and capable CEO would engage in a public low-brow spat. Their 68-page rebuttal from their September 12th presentation is available here.
Overall, because of the stock’s strong returns and Ackman’s weak credibility, we would give this activist campaign a low chance of making ADP a successful turnaround investment.
Procter & Gamble and Trian Partners
Trian Partners’ recent interest in Procter & Gamble is more intriguing. The activist firm, led by Nelson Peltz, took a 37.6 million share stake (about 1.5%) in the consumer products company in February 2017, and published a 94-page slide presentation, viewable here, last week outlining their plans.
This campaign has a better chance of producing a favorable stock price outcome. First, P&G stock has been a laggard, gaining only about 12% in the past three years, or about half the S&P 500 return and has also trailed the return of the overall consumer staples sector. While the shares trade at a high valuation, 22.3x earnings and 14x Ebitda, it is in-line with its peer companies.
On Metric #2, operating margins, P&G lags peers by a moderate gap. Trian legitimately claims that prior productivity programs have not delivered meaningful margin improvements, which casts doubt on the company’s current $10 billion cost-cutting program. Perhaps more important, but a bit harder to prove, is Trian’s view that the margins should be a lot wider given all the cost-cutting and investments that P&G has made. Trian’s reasonable points here add strength to their case.
Trian only modestly touches upon Metric #3, asset and cash flow utilization. P&G has few glaring issues with its balance sheet or cash flow utilization. Others have advanced the potential to break-up P&G, which might unlock value but Trian avoids these discussions, for now. Overall, Metric #3 provides a very modest and down-the-road tailwind.
Metric #4 provides a major source of hope for turnaround investors. The market knows something isn’t quite right at P&G. Despite management’s exhortations, the revenue growth and market share trends are disappointing. Although it is difficult to identify a single direct cause, Trian’s claims about weak innovation, low internal accountability, insular management and board, and incentives for producing sub-par profits are likely to strike a chord with investors. While the profit situation is certainly not dire, P&G’s status as a market-wide “core holding” demands better results.
Management’s bargaining power is reasonably strong, but we think Trian narrowly has the upper hand. P&G’s power comes largely from their position as incumbent and their somewhat defensible performance. Peltz, however, has tapped into growing investor frustration, is well-regarded, has strong consumer products company expertise with a good track record and takes a professional approach to influencing companies and shareholders. Further boosting Trian’s likelihood of success in the proxy battle is the modest nature of his proposal: adding a single person (Peltz) to P&G’s 11-person board. His agenda includes more accountability, more outside talent, a better organization structure and other measures to improve the company’s operating performance. He is not advocating for a breakup of the company, replacement of the CEO or other more aggressive moves. Nearly all their 1.5% stake appears to be in common stock. Overall, Trian’s one-step-at-a-time actions increase their likelihood of success, and make it easier for the legions of mutual fund and ETF shareholders to support its campaign.
For turnaround investors, the Trian campaign appears to have a win-win opportunity for investors--either Peltz joins the board and learns enough to re-invigorate P&G, or loses and management must either execute (boosting earnings and the shares) or they will face a more drastic proxy campaign with higher odds of success down the road. We think the P&G campaign could turn out well for shareholders.
Both ADP and Procter & Gamble have proxy meetings in coming months and the run-up to each should be illuminating.
 Returns are price-only.