During the last several weeks, we sold our stake in ADP (NASDAQ:ADP). Although we expect ADP to continue to do well over time as the company executes on its business transformation, we view the prospective returns from today as more modest because the market is now more accurately pricing in ADP’s prospects for success.
We achieved many of the objectives we established when we initiated our position in ADP. This led to a highly successful investment outcome particularly considering the low-risk and unleveraged nature of ADP’s business. At the time of our exit, approximately two years from the establishment of our position, ADP’s stock price had increased to $167 per share, generating a total shareholder return including dividends of 64%, more than double the S&P’s total return of 30% over the same period.(11) Including the benefit of leverage in the form of long-dated, very-deep-in-the-money call options that were used to finance a portion of this investment, PSH realized returns in excess of the stock return, culminating in an attractive 40% annualized rate of return.
Prior to our investment, ADP was not well understood by the investment community, and garnered little critical attention. While the company participates in an excellent industry and had produced good shareholder returns over time, its performance was well below its structural potential.
While our original approach was to work quietly behind the scenes to achieve our investment objectives, we were quickly forced into a proxy contest which led us to publicly air our concerns and the opportunities we had identified. During the contest, we were able to successfully make the case to shareholders that ADP had the potential to materially improve its competitive position, generate higher revenue growth, and achieve substantially greater efficiency and margins while enhancing the customer experience.
Our activism bore significant fruit. ADP’s investor base emerged from our engagement better educated about the company’s enormous potential. With the support for change from other major shareholders, we were able to catalyze the company to embrace a business transformation. As a direct result of our activism, ADP made commitments to accelerate revenue growth, bolster its competitive position in the Enterprise market, and improve efficiency and margins.
During the past year, management started to execute on these new commitments by accelerating existing efficiency initiatives and embracing new projects to streamline ADP’s business. These initiatives have included: (1) accelerating the development of ADP’s next-generation platforms, (2) broadening and accelerating the company’s Service Alignment Initiative, (3) launching an early retirement program, (4) executing a broad-based workforce optimization effort focused on spans of control and management layers, and (5) launching an accelerated procurement transformation effort aimed at third-party vendors and internal expense management. These projects, along with other smaller initiatives underway, allowed ADP to realize significant margin expansion and earnings growth in the fiscal-year ended June 30, 2019. These initiatives should provide a tailwind for continued operating progress over the coming years. ADP’s business transformation has been accomplished as the company continues to post near-record client retention and accelerated bookings and revenue growth, demonstrating that customers are supportive of the changes.
At the time we invested in ADP, the company was forecasting approximately $3.80 of earnings per share in fiscal-year 2018. Recently, ADP has provided earnings guidance of $6.10 to $6.20 for fiscal-year 2020 (ADP’s fiscal year ends June 30th), and ~$7 per share of earnings in fiscal year 2021, an ~85% increase in earnings per share in three years if ADP meets its projections which historically have been conservative.
Furthermore, we believe that there continues to be a significant opportunity for ADP to execute its ongoing business transformation in the years ahead, and to expand margins and earnings beyond current targets, but best-in-class execution will be required. If ADP meets its 2021 earnings targets, we estimate the stock will generate a low double-digit return from our exit price. While we believe now was the appropriate time to sell our investment in ADP, we wish the company well as it continues its business transformation.
From Bill Ackman (Trades, Portfolio)'s second-quarter 2019 Pershing Square shareholder letter.
