Wall Street loves consistency and certainty about the future prospects of any business, and will usually over-reward for certainty. Just look at the market valuation of Automatic Data Processing (ADP) or its cousin Paychex (PAYX). ADP trades at a lofty trailing P/E of more than 40 while PAYX has a P/E of 49! ADP has a record of meeting or beating Street expectations and consistently rising dividends and earnings for more than 40 years. There are very few businesses that can claim a record of no major blimps in their operations for such a long period of time.

The primary business of both companies is the boring and cumbersome task of outsourced payroll processing. Even with the enormous growth both have enjoyed over the years, they have a very small percentage of the entire market for payroll processing. It is a highly fragmented industry with very high switching costs and big barriers to entry.
Due to the lofty valuation of companies like ADP, returns to investors who decide to buy the stock in 2002 and hold it for five years will probably be lackluster. More importantly, there is no Ben Graham margin of safety when buying these stocks. Were there to be a single missed quarter, the stock would tank. It would only take one bad quarter to see a 50 plus percent decline in market cap. In the case of ADP, the disrupter may be a Web-based payroll processor with its entire back office in Bangalore, with customers just printing emailed checks at their site. Such an entity could potentially charge 80 percent less than ADP and still be quite profitable.

A missed quarter seems very unlikely for ADP or PAYX, but one can look at any number of companies that at one point looked invincible and subsequently really left a lot of investors hurting. A good example is Tellabs (TLAB) (Note: The author was an employee of Tellabs from ‘86-‘91). Tellabs was a wonderful company with an exceptional founder and CEO, Mike Birck and a terrific management team and corporate culture. The company really started to hit its stride in the early 1990s with the release of its flagship product, the TITAN 5500. The TITAN 5500 was an optical cross-connect that helped voice and data service providers groom and manage their T1, T3 and OC-X pipes. The product was superior to all others on the market and rapidly gained customer acceptance at a number of blue chip companies including MCI, Sprint, the various RBOCs, various cellular, paging and data service providers. Through the 1990s, Tellabs enjoyed rapid sales growth and was one of the top 10 stocks in all performance from 1991-1999. Sales increased tenfold from under $200 million to more than $2 billion and profitability increased more than twenty fold over that period.

An expert looking at the networking space as late as 1999 could only forecast continued good times ahead for Tellabs. Tellabs had a market cap of more than $30 billion in 1999 against revenues of about $2 billion. Today the company has a market cap of $6 billion — with more than $3 billion in cash and hard assets! Investing in Tellabs in 1999 again had no Ben Graham margin of safety and was a highly risky investment. In addition, being a technology business, Tellabs is more prone to getting disrupted. The experts who saw nothing but good times ahead in 1999 would today not be able to assure us that there will even be a Tellabs in 10 years.

The dichotomy is that seemingly low uncertainty businesses are not necessarily low risk for the investor. ADP and Paychex are high-risk investments at today’s prices — just as Tellabs was in 1999.

The flip side is that when the future in uncertain, Wall Street punishes the company and usually the punishment is really rigorous! Stewart Enterprises (STEI), also mentioned as an example in a previous column, is the second largest company in the “death care” industry worldwide. Stewart has about $700 million in annual revenues and owns about 700 cemeteries and funeral homes in nine countries, with the bulk of them in the United States.

As shown in Figure 2, Stewart was trading at about $2 per share for several months during Q3 and Q4 of 2000. Its historical high was about $28 per share (achieved in 1999). At the time, Stewart had a book value of $8.50 per share. It was thus trading at less than one quarter of book value.

At the time, Stewart’s free cash flow was about $0.72 cents per share. The stock was trading at less than three times cash flow! It was also trading at about one quarter of annual revenue. Like ADP, Stewart has a highly predictable revenue stream. We don’t know who will die in Boise, Idaho in 2006, but any number of life insurance actuaries can tell you with a fair degree of accuracy how many will die in Boise in 2006 — or for that matter any year for the next 10 years. Why was Wall Street pricing Stewart at three times cash flow and ADP at more than 40 times cash flow?

The reason was that Stewart is a leveraged company with a lot of debt. About $500 Million of that debt was coming due in 2002 and there was no clear answer in July 2000 as to how the company was going to pay it. Wall Street assumed the company may have to declare bankruptcy when it defaulted on its debt and tanked the stock to under $2 per share (from $28 per share).

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