Yesterday Pershing Square Capital Management held a lengthy conference call on its 168-slide deck on Automatic Data Processing (ADP) – the first time it has explained its investment thesis in any detail not only to the public, but to the company itself. As it did so, shares dropped almost 5%; at one point CEO Bill Ackman warned his young analysts of “scaring the shit out of the shareholders.”

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Bill Ackman Pershing Square ADP

The simplest way of explaining the opportunity Pershing Square sees is that margins can expand massively. It argues that earnings per share can reach $8.70 by 2022, compared to management’s projections of $5.90, largely by achieving six-times the margin expansion management is targeting. The presentation has 40 slides on the causes of ADP’s underperformance alone.

Pershing Square plans to do that in a number of ways – recruiting technology experts to help streamline offerings, automating service centers and rationalizing real estate (“this is the slide that really got me excited,” Bill Ackman said of a map of ADP’s property across the U.S., 40% of which is owned, according to the activist). Legacy maintenance spending faces cuts of 50% in the long-term.

An omen is that ADP spinoff CDK Global, a target of several activists including Sachem Head Capital Management’s ex-Pershing Square analyst Scott Ferguson, has achieved impressive margin expansion. “You can learn a lot about a company in my experience by what happens to businesses that get spun out of that company,” Ackman said yesterday.

Pershing Square’s analysis looks more detailed than its work on Valeant Pharmaceuticals International, for example. It is hard to see how ADP can avoid responding to several of the points raised and will have plenty to chew on as it weighs how to respond to the threat of a proxy contest.

In particular, ADP’s board will have to decide whether the skills of Pershing Square’s independent nominees, Veronica Hagen and Paul Unruh, are compelling or whether the contest is merely a wedge to force out CEO Oscar Rodriguez. From the call, it appears to be the latter. Rodriguez himself has taken a tough line, which Pershing Square has sought to portray as the product of misrepresentations, but few boards like being bounced into decisions.

More concerningly, salespeople and support staff will be unsettled by Pershing Square’s criticisms of ADP’s headcount, despite the activist’s claims that they would be empowered by its changes. Compensation changes requested by Ackman might encourage the company to chase growth too aggressively, alienating index funds who dislike such packages (but overwhelmingly approved something similar at CSX earlier this year).

Above all, both sides will need to consider how feasible Pershing Square’s bull case is. A former employee quoted by the activist described ADP’s back-end source code as “duct-tape and bubble gum” in the presentation. Just as at Canadian Pacific Railway, Ackman believes that the doubters are wrong. A major overhaul of people, real estate and code should be less complex than a railroad, but ADP also has lower barriers to entry, as evidenced by growing competition. If ADP is scared of taking a step back to take two forward, it might be with good reason.

A lot is riding on Pershing Square succeeding at ADP – possibly why Rodriguez felt empowered to ratchet up the pressure. Yet a cornered animal can be more dangerous. ADP looks like it could go the distance.

Article by Activist Insight