|Shares Out. (in M):||432||P/E||0||0|
|Market Cap (in $M):||65,508||P/FCF||0||0|
|Net Debt (in $M):||296||EBIT||0||0|
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Automatic Data Processing (ADP) is best known for payroll and related tax processing, but also provides broader “beyond payroll” human capital management (HCM) and human resource outsourcing (HRO) applications and services to customers of all sizes around the globe. As with most stocks, ADP’s share price has been rising during the time we wrote this up for VIC. Despite the run, we believe it is still a compelling value at current levels. This is not the type of stock to double or triple your money overnight, but it should conservatively provide ~9-15% annualized returns for many years with highly recurring revenue, good margin and growth opportunities and virtually no balance sheet risk.
ADP segments its business into Employer Services (ES) and Professional Employer Organization (PEO). ES has the lion’s share with 86% of LTM adj. segment revenue and 83% of LTM adj. segment profit. Per the 10K:
Employer Services. Our Employer Services segment serves clients ranging from single-employee small businesses to large enterprises with tens of thousands of employees around the world, offering a comprehensive range of technology-based HCM solutions, including our strategic, cloud-based platforms, and HRO (other than PEO) solutions. These solutions address critical client needs and include: Payroll Services, Benefits Administration, Talent Management, HR Management, Workforce Management, Compliance Services, Insurance Services and Retirement Services.
Professional Employer Organization. Our PEO business, called ADP TotalSource®, provides clients with comprehensive employment administration outsourcing solutions through a relationship in which employees who work for a client (referred to as “worksite employees”) are co-employed by us and the client.
A quick note on PEO: The idea behind the PEO is to give smaller companies access to a larger company’s healthcare and other benefits, without the need to staff a large HR department. Note they include HRO solutions related to PEO in the PEO segment. PEO is only offered in the U.S.
ADP’s mix of ES business is approximately 20% small (1-49 employees, “down-market”), 40% midsize (50-999 employees, “midmarket”), 20% large/enterprise (over 1,000 employees, “upmarket”) and 20% multi-national/international (ADP offers in-country and multi-country solutions in 140 countries, with Canada and Europe being the biggest international markets). Key competitors in down-market are Paychex and Paycor, in midmarket are Paycom, Paylocity, Ceridian and Ultimate, in upmarket are Ultimate, Workday, Oracle and SAP and in international are Oracle, SAP, NGA and P&I.
ADP’s business is attractive primarily because its revenue is largely recurring and diversified across industries, it produces high margins (~31% LTM adj. EBITDA margins after removing zero-margin pass-through revenues included in PEO) and high returns on capital with low capex, has a strong balance sheet and is the leader in its core payroll processing markets. The business is also growing. From 2014-2019, ADP grew EPS by 13% per year, including 16% growth in 2019, on revenue growth of around 5%. Prior to the virus, management expected to grow EPS by 16-19% per year from 2019-2021 on revenue growth of 7-9%.
The recurring or “sticky” nature of revenue primarily relates to the fact that ADP’s services are mission-critical (messing up payroll or tax is no bueno), low cost and frequently imbedded in customer’s systems making them difficult to switch out. Management estimates that client retention is approximately 11 years in ES and six years in PEO, with little variation from period to period. ADP is considered the “gold standard” for payroll and tax; HR department employees do not take reputational risk by choosing ADP for these applications.
The main competitive advantages in this industry seem to lie around (in no particular order):
Having the most local and global scale (cost advantages, distribution reach, ability to invest in innovations, etc.)
Having a reputation for consistency and accuracy
Having the best technology
Having the best compliance
Having the most data
Having the best local country expertise (knowledge of regs)
ADP seems to check almost all these boxes, with technology the main area for concern (we will return to this shortly). These characteristics have led to high returns on investment.
With 810k clients, ADP is the scale player in many of its core markets, including most notably payroll services. For instance, ADP paid ~26 million workers in the U.S. in 2019, or about one out of every six, and ~15 million workers outside the U.S. A 2018 report from Deloitte indicates ADP’s North American market share in payroll exceeding 40% in companies with more than 20k employees and 30% in companies with less than 20k employees. Notably, ADP is the dominant player in the attractive mid-market. ADP is also the largest U.S. PEO certified by the IRS, with 12,500 clients and 562k worksite employees in the U.S. in 2019.
A key advantage of scale is the sales force. ADP has 6,500 total sellers (including 1,600 inside sellers and the rest in the field) and over 20k referring partners (for example, CPAs, banks and benefit brokers down-market and midmarket, private equity firms and ERPs upmarket), which are particularly important for attracting smaller clients. They have said that historically around 50% of new business bookings are to existing clients and 50% to new logos, though recently they have been emphasizing new logos and driven that closer to 60%.
Competitive Technology Risk
The knock on ADP is that while it is the big gorilla in payroll and some related products, it is burdened by legacy systems that were built for a different era and largely cobbled together from multiple acquisitions over many years. ADP’s broader HCM offering (beyond payroll and tax) is relatively weak, leading to lower growth and higher costs than some competitors, most of whom are cloud-native and nimbler. Client defections have been most evident in larger clients, with many moving to Ultimate or Workday over the past decade or so. These competitors primarily focus on the broader HCM market rather than payroll and tax specifically (Workday’s big new growth engine is actually outside of HCM as they target CFOs with a finance system).
While these competitors have found a way into the market through the broader HCM platform, they have been much less successful stealing ADP’s core payroll and tax business (with Ultimate as the main exception). These areas are incredibly complex, with constantly changing regulations that vary by locale. They are also mission critical services that employers do not mess with lightly given the importance of getting employee payroll and tax right. Furthermore, the payroll market is not as big in dollar terms as other areas with lower hanging fruit (beyond payroll HCM, analytics). In many cases, larger clients have moved to Workday for HR information systems needs while retaining ADP for payroll and tax. Even so, over time more clients may gain comfort with alternative payroll applications and move away from ADP, buoyed in part by the desire to have one integrated system. Similar risks exist with losing down-market and midmarket customers to the likes of Paycom, Paylocity and Paycor, though these customers have been much stickier to date than the larger enterprise customers. These competitors have far higher growth rates (though off a much lower revenue base), indicating they are taking some share. The potential for ADP to suffer a slow death from its “technology debt” looms as the most serious piece of a bear thesis. The detailed materials put out by Pershing Square in 2017 (https://adpascending.com/) as part of its activist campaign highlight the technology shortcomings in depth and anyone interested should read through those materials.
The greatest risk in the ADP story is also the greatest opportunity. The company has put a great deal of resources behind innovation to transition legacy platforms to the cloud and build out new modern architectures. ADP would appear to have made real progress since Pershing Square’s late 2017 campaign. The company’s steady 90%+ client revenue retention rate indicates it is doing something right:
Management also reports that NPS scores are at all-time highs across most of the businesses.
ADP completed migration of down-market customers to version-less cloud-based platforms in 2015 and mid-market customers in 2018. Nearly all U.S. clients are now in the cloud. Though these platforms are not yet fully integrated into a unified HCM system, they do get clients onto a single cloud product with modules that can be enabled. They also greatly reduced the need for manual processes. These migrations significantly improved retention issues in the midmarket client base (as well as reduced ADP’s costs). ADP now serves over 640k small businesses through RUN, over 70k mid-sized and large business through Workforce Now, over 500 large enterprise businesses through Vantage, and 65k international clients through Globalview, Celergo or Streamline. In fiscal Q3 (March), management said that midmarket Workforce Now client growth had been especially strong, a great sign in ADP’s biggest market.
ADP said they have compounded spending on innovation by 18% from 2011 to 2018 while reducing maintenance spend at a 3% annual clip. Current annual spend on systems development and programming (including capex) is around $1 billion, vastly higher than all its competitors other than Workday. A major initiative has been what it calls the “next gen” platforms in HCM, payroll and tax, which ADP began to roll out in 2019. These platforms are based on a common data model, single or closely linked database and mini-app design. The payroll platform supports workers of all types and enables real-time, transparent, continuous payroll calculations with flexible pay choices and built-in compliance capabilities. The HCM platform is designed to allow clients to personalize their experience based on their needs and is built for dynamic teams. ADP is also trying to leverage its massive HCM dataset (wage, time, location, benchmarking to industry, etc.) through AI applications. Another new offering is ADP Marketplace, where clients can access hundreds of ADP and third-party HCM apps and integrations. This allows clients to pick and choose which applications are the most useful or relevant for their industry or circumstance. Marketplace allows ADP to leverage the innovation of outside HCM developers and its own access to clients, while retaining its position as the system of record for payroll and benefits.
M&A has also improved ADP’s product offering, with the company having spent around $800 million over the last five years. To name a few:
WorkMarket targets gig economy workers (a market management estimates to be as much as a third as big as the W-2 market by employee count).
Global Cash Card provides real-time pay capabilities in-between pay periods and allows workers to manage all sources of pay together in one spot. It works especially well with WorkMarket.
Wisely offers a network-branded payroll card and digital account where employers can pay employees and employees can access payroll funds immediately.
While none of these are large enough to move the needle right now, they all represent bets on the future of payroll and HR that help build ADP’s momentum in modern technology and services.
Operating leverage from sales growth coupled with the move to more modern technology and other cost savings initiatives have led to significant margin improvement. Adj. EBITDA margins reached 31% in the LTM through March 2020 vs. only 23% in 2014. Price increases do not seem to have played a material role in this margin improvement. Prior to the virus, management expected another 200-300 bps of margin expansion by 2021. This seems imminently achievable given the opportunities to reduce costs as they shift to more modern technology offerings and reduce bloat and other corporate inefficiency. Sales force productivity should also improve as the offering gets better.
Prior to the virus, management expected longer-term revenue growth of 5-6% in ES (mainly driven by 10-12% new business bookings offset by 6-7% client losses) and 11-14% in PEO (mainly driven by 9-11% growth in worksite employees). Both are consistent with recent history (with ES growth comprised of low single-digit growth in payroll and double-digit growth in beyond payroll HCM applications), as well as in-line with market growth. Seller headcount, seller productivity and new products and services are the primary drivers of revenue growth.
HRO is growing faster than HCM as more internal HR departments look to outsource due to increasingly complex regulatory changes in areas like healthcare, tax, family paid leave, discrimination, etc. The market is large and under-penetrated. For instance, ADP has over 700k ES clients and only 25k HRO clients, suggesting single digit penetration into the company’s own customer base. Management says they get 4-5x uplift in revenue per client from HRO for non-PEO customers as compared to processing alone (for PEO customers the uplift is 10-12x). Overall ADP believes that the PEO industry has only penetrated around 15% of the addressable base. Penetration of the core payroll function itself suggests opportunity, particularly overseas (see 2018 Deloitte study for more on this). Multinational payroll is another growth area, where ADP claims it is growing at twice the 9% market rate, as is international more generally (in fiscal 2019, 87% of reported revenue was in the U.S.).
In terms of risks, we’ve already mentioned the biggest one longer-term, which is around younger and faster-growing competitors taking market share. The biggest short-term risk is around COVID, which will clearly impact payrolls and hence payroll processing revenue in the near-term, and potentially longer if the recovery is drawn out. Here are some key figures:
ADP reported ES new business bookings down 9% in fiscal Q3 due to a rapid decline in March. Management expects new business bookings to decline more than 50% in fiscal Q4.
ADP saw pays per control (a measure of same-customer employee growth) down double digits with an expectation for fiscal Q4 (June) down mid-teens. Not surprisingly, down-market clients are hit the hardest. ADP’s revenue is generally a blend of base fees and fixed fees per transaction (e.g., number of payees or payrolls processed), so the impact of pays per control on revenue is not one-for-one. As a rule of thumb, they expect ES revenue to decline about 25 bps for every 100 bps change in pays per control. This speaks again to the strength of the recurring revenue model as all else equal an increase from 5% to 25% unemployment would reduce ES revenue by only 5% (the bigger hit would come from clients simply going out of business, where the revenue disappears). In PEO, ADP earns revenue as a percent of gross payroll processed, so that segment will be more impacted by higher layoffs, work hour reductions and furloughs (though underlying revenue growth trends are stronger in this segment which will help offset). The average client in PEO has 45 employees, so while they aren’t large, they also aren’t the smallest and most at risk businesses (ADP tends to avoid clients with under 10 employees).
ADP expects client fund balances (comprised of funds that are held for clients for payroll and taxes not yet remitted) to be down low double-digits in fiscal Q4. To the extent the high-grade credit markets implode, there is risk to this float portfolio. The company’s conservative management of the portfolio coupled with Fed actions should mitigate this risk.
For fiscal 2020 management now expects EPS growth of 4-7% over fiscal 2019.
ADP did not give guidance around fiscal 2021 (and withdrew their prior long-term view). However, we can look to Paychex, ADP’s largest domestic competitor for smaller customers, for an indication. Paychex forecast low- to mid-single digit revenue declines and 100-200 bps EBITDA margin reductions in its fiscal year ending June 2021. Paychex expects a return to pre-COVID levels by late fiscal 2021. It’s also notable that Paychex expects fiscal Q4 2020 revenue declines of mid- to high-single digits and a 400 bps decrease in operating margins from prior levels (driven in part because they are keeping more sales, marketing and IT staff in anticipation of a rebound).
On the positive side, clients are seeing the value of a high quality HCM service provider in this environment. The company may see increased outsourcing of payroll and other HR functions, something that Paychex said it is seeing with smaller clients. Furthermore, customers are unlikely to push for price decreases given the mission-critical nature of the service, the cost of switching providers and the relatively immaterial cost of ADP’s services in overall customer cost structures. ADP said that client retention rates were up 50 bps in fiscal Q3 and they expect only a 30-50 bps decline in retention for fiscal 2020. As another data point, we can look to the 2008-2009 financial crisis, when ADP showed solid resilience. ES EBITDA margins were down around 200 bps on a 1% revenue decline in the worst year (fiscal year ending June 2010). PEO revenue and profit grew through this period.
All told, while the COVID crisis will reduce earnings, ADP will stay solidly profitable. The company’s balance sheet is in great shape with $300 million of net debt as of March 2020. There is not a realistic scenario where the balance sheet causes an existential problem even if the COVID downturn is protracted.
Our approach to valuation is simplistic. We assume that EPS suffers for the next two years before recovering to pre-virus levels in year three. After that we assume EPS grows by 12% per year for four years, which is a bit below the 13% rate at which they grew EPS in the five years through fiscal 2019 and well below management’s longer-term high-teens expectations. This works out to a 6.7% EPS CAGR over a seven-year period. We hold dividends constant at the LTM payout ratio, though in reality we expect ADP to pay the current dividend rate even during the trough years. If ADP trades at a 25x P/E in year seven, in line with its median multiple over the last 12 years, it would translate to a 9% IRR from today’s purchase price. If interest rates stay low, we would expect the P/E to move up to around 29x, in line with where ADP traded the last three years. At that multiple, we’d have an 11% IRR. This multiple range is justified given the recurring revenue nature of the business model, ADP’s market position and balance sheet, an improving margin profile and a good industry growth profile.
We consider our EPS growth projection to be conservative. If management can truly execute a major repositioning of the technology, the margins and revenue growth should come out quite a bit higher than our projections. For instance, Pershing Square had estimated 2022 EPS potential of $8.70. Also, the broader economic rebound from COVID could easily prove shorter than what we’ve assumed, with a return to LTM EPS occurring earlier than our modeled year three. If any of these came to pass, we would expect an IRR in the mid-teens or better (Pershing Square pegged value potential at $221-$225 per share by June 2021). ADP bottomed at $110 per share in mid-March (27% below the current price) though quickly rebounded over $130 (15% below the current price). This level provides a reasonable near-term downside case scenario should the COVID crisis take a new turn for the worse.
The information contained herein has been derived from public information believed to be reliable but the information is not guaranteed as to accuracy and does not purport to be a complete analysis of any security, company or industry involved. All data and analysis are unaudited and should not be used as the basis for any investment decisions. Neither the advisor, nor any of its officers, directors, partners, contributors, employees or consultants, accept any liability whatsoever for any direct or consequential loss arising from any use of information in this analysis. The user of the information assumes the entire risk of any use it may make or permit to be made of the information.
Neither the advisor nor any of its employees holds a position with the issuer such as employment, directorship, or consultancy.
The adviser, through a partnership that it advises, holds an investment in the issuer's securities.
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