“We fundamentally believe that the cash we generate is our stockholders’ cash. We are committed to investing this capital to produce the greatest returns for our stockholders.” -Rich Daly, Broadridge CEO

Broadridge Financial Solutions (BR) is the most important financial services company you’ve never heard of. While they may not be a household name, every time you vote for corporate directors, place a trade, move cash in or out of your brokerage account, transfer an account between financial institutions or receive an account statement, the likelihood is high that Broadridge made it happen.

It is the rare small company that plays such an outsized and indispensable role in a large industry. The key role it plays is connecting 1,100 banks and brokers, 800 mutual fund families, 6,700 institutional investors, 45,000 global public companies and 140,000,000 individual investment accounts to make sure that financial transactions and client instructions are executed flawlessly. They process trades, manage voting for corporate boards and ballot measures, provide customer communications, and supply data and analytics to their customers. They in effect manage the plumbing that makes the financial markets hum.

A quick glance at the company might lead investors to think there are significant regulation risks given the markets in which the company operates. Instead, Broadridge ends up essentially providing the tools that allow large financial institutions to comply with regulatory requirements.

Broadridge benefits from three key market trends:

Mutualization: the shift of large financial institutions to offload non-differentiated workflows to a common third party.

Digitization: the move away from paper statements and manual trade processing to eDelivery and automated solutions.

Data & Analytic: the trend towards monetizing data assets, which is best enabled by those entities that see the broadest set of data flows.

We believe that Broadridge can leverage its unique vantage point within the industry to drive high-single digit revenue growth and increase margins to achieve low double-digit earnings growth. More importantly, the company’s minimal need to reinvest capital in their business to support their growth means that they are able to achieve this growth even while paying a meaningful dividend and buying back their own shares or investing in smart bolt-on acquisitions.

We are impressed with the degree to which the company takes seriously their responsibility of stewarding shareholder capital as articulated in the quote opening this post. On the topic of acquisitions (the use of shareholder capital where companies often make the most mistakes) the CEO states, “When we choose to use your cash for an acquisition, it is because we believe the acquisition will derive more value for Broadridge than repurchasing our shares.” The company has a stated hurdle of achieving a 20% return on capital deployed on acquisitions, well above the rates of return available to common shareholders if the capital was instead paid out in the form of a dividend. Note too that Daly uses the pronoun “your” (as in shareholder’s) when discussing the capital he is managing.

When seeking companies to add to our portfolios, the most important requirement is the existence of a sustainable “moat” that surrounds the business. Regardless of how cheap a stock might look, we exclusively invest our clients’ money in those businesses, which we believe benefit from significant competitive advantages. Companies that do not have sustainable competitive advantages may thrive for short periods of time, but if they are successful, their success will eventually attract aggressive competition. Without a moat protecting their business activities, success will be short lived as other companies will seek to offer similar items at lower cost or bring to market superior products and solutions.

Broadridge’s moat is based on the significant degree to which their services are built into the very fabric of how their customers operate. With banks and brokerage companies depending on Broadridge to process over $5 trillion a day in equity and fixed income trades, they can’t easily choose to switch to another provider. Despite the mission critical nature of their services, Broadridge’s services make up a tiny slice of the cost structure of their customers. For instance, we calculate that their fixed income trade processing fees work out to approximately 0.00001% of the trade volume they process.

In business service companies, the mix of offering mission critical services that are embedded into customer workflows, but make up a small portion of their customers’ costs is a classic recipe for building a moat. The switching costs for their customers to select another vendor in terms of time, energy and disruption become prohibitive relative to the small impact of any cost savings that might be achieved. Broadridge recognizes this dynamic and matter of factly once stated in an annual report that they “never intend to be the cheapest solution”. Their highly sticky customer relationships have a 98% client revenue retention rate.

The example above describes the company’s Global Technology and Operations Segment, where the company has well over 50% more market share than all of their competitors combined, yet less than 10% of the addressable market for operations outsourcing due to the fact that most of their customers still manage these functions in-house. But the bigger, and even more entrenched, business segment is Investor Communication Solutions, where the company’s flagship offering is their management of the proxy voting process by which shareholders vote for the board of directors, mergers, and other corporate actions for public companies and mutual funds. Have you ever noticed that the ballots you get to vote your proxies all look the same? Those aren’t government forms, they just all happened to be sent to you by Broadridge with the company operating a virtual monopoly.

With Broadridge’s stock trading at a forward PE multiple of 19.5x it is 10%-20% more expensive than the average stock in the S&P 500 and doesn’t look cheap at first glance. But like many of the company’s that make up our portfolio, Broadridge generates returns on invested capital (ROIC) well in excess of the average company. Recently, the company has been earning a rate of return of approximately 50% for every dollar it reinvests in its business. This outstanding level of return dwarfs the 10% return on invested capital that has been the long-term historical average for public companies. Far from being an arcane accounting calculation, ROIC directly influences the amount of cash a company can distribute to shareholders at any given rate of growth.

As a simple example, a debt free company with a 10% ROIC can only distribute half of their earnings to shareholders if they intend to grow at 5% per year. A company with a 50% ROIC, on the other hand, needs to invest so little cash in its business to drive growth that it can distribute 90% of earnings to shareholders while still attaining a 5% growth rate. Since it is the cash a company can distribute to shareholders over the long-term that makes a business valuable, moat-enabled, sustainably high return on investment businesses, like Broadridge, are far more valuable than the average company..

While we do not use the market valuation of peer companies in estimating the intrinsic value of our portfolio holdings, we do note that other technology-enabled business service companies such as ADP (which spun out Broadridge), Paychex, Fiserv, MasterCard, and Equifax have historically commanded PE multiples in the mid-to-high 20s. This is due to the dynamic described above where these companies typically generate very strong free cash flow from competitively insulated business models. In the past, the market seems to have regarded Broadridge as a low-value outsourcing business. But in recent years, Wall Street research has started to group the company with a high-value peer group of technology-enabled business service companies.

Of course, like all companies, Broadridge’s future is not risk-free. Their customers may choose to in-source operational processes, banks that process in-house might acquire Broadridge’s customers, regulation could one day negatively impact them or the company’s acquisition strategy could run off course. But the management team has shown over its long history that they have the skills to navigate these issues.

One emergent threat that could theoretically be existential in nature is the rise of blockchain technology. Known primarily as the software that allows Bitcoin currency to exist, blockchain has far wider uses that primarily center on enabling secure record keeping of transactions without the need for trusted third parties. Acting as a trusted third party in this regard is pretty much exactly what Broadridge’s business model focuses on. So, in theory, blockchain could disrupt the core of their business model. But far from sitting still, Broadridge and many other players in financial markets are coming together to leverage blockchain within their own offerings.

In a recent Wired article titled Why Wall Street is Embracing the Blockchain – Its Biggest Threat, the author describes the way that rather than seeking to block the coming changes, many of the players that could be disrupted by blockchain are actively engaging with the technology and looking for how it can be used to streamline their operations.

On a recent earnings call, an analyst asked CEO Daly about experiments in the country of Estonia to utilize blockchain to manage the proxy voting activities that are so core to Broadridge’s business. Rather than dismissing the threat, Daly illustrated his in-depth knowledge of the Estonian proxy voting process and highlighted the way that his company was, in fact, a leading champion of researching ways to use blockchain within the financial services industry. The key distinction is that Broadridge is a technology-enabled managed services company, not a company that sells software. This means that blockchain might simply become the technology that enables the company’s services rather than being an alternative approach for customers to process transactions and instructions. That being said, we continue to monitor the emergence of blockchain as a potential competitive threat.

The combination of Broadridge’s steady business, deep moat and valuation discount to our estimate of its intrinsic value makes it a good example of the types of businesses in which we seek to invest. It is currently one of our top holdings in client portfolios.

Ensemble Capital’s clients own shares of Broadridge Financial Solutions (BR), MasterCard, Inc (MA) and Paychex, Inc (PAYX).

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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