Automatic Data Processing: AI Technology And A Strong U.S. Labor Market

seekingalpha04-15

Automatic Data Processing benefits from high switching costs and a commitment to innovation, creating a strong competitive advantage.ADP's valuation suggests a potential 10% increase in share price ...

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The share price year to date is up just under 5% against the S&P 500 which is up 9.6%. The company sports strong returns on capital driven by a profitable business model that grows organically. The performance has lagged the S&P500 over the last 5-years but ADP has outperformed competitors such as Workday (WDAY) and Paychex (PAYX). 5-year returns (yahoo finance) The company benefits from high switching costs as their services are often well integrated into Human Resources mission-critical functions, and this allows the company to benefit from good pricing power. Furthermore, ADP's commitment to innovation allows them to keep rolling out updated services and new products that derive more value for clients and create a suite of valuable intangible assets. I believe all of this forms a strong moat over the competition, and my valuation has the share price up 10% from today's price. Background A compensation management system is a piece of software that allows employers to manage pay, bonuses and perks. The growth in the industry has been driven by the IT industry's increased demand for cloud computing, which has allowed businesses to develop well-organized platforms that provide a service at affordable prices. Another driver behind the industry is expanding new businesses that see it ever more important to outsource HR administrative tasks. These businesses like the user-friendliness of the products, and with organizations continuing to implement a hybrid/remote model of work, they need flexible platforms to manage their employees. ADP offers cloud services for Human Resource Management that includes payroll, talent management, and human administration. ADP operates through two business segments, the first, Employer Services (67% of revenues) offers a suite of comprehensive HRO and technology-based solutions aimed at small business to large enterprises. Their second segment, Professional Employer Organizational (PEO) services (33% of revenues), provides businesses with outsourced employment administration benefits that again include payroll, payroll tax and HR guidance. ADP's PEO segment, named TotalSource, is the largest PEO in the US based on the number of worksite employees, and it serves over 16,000 clients and more than 750,000 worksite employees across 50 states. The company's offerings are often well embedded into a company's operations resulting in high switching costs for an organization. This presents itself in the form of having to retrain staff on any new solutions that are introduced, or running the risk of business interruptions. Furthermore, the company's investment into R&D has produced a suite of intangible assets that I believe present a strategic competitive edge. They boasted a client retention rate of 92.2% in their latest fiscal year which is higher than Paychex (82.5%) and close to Workday's 95%. Financials ADP holds the third-largest market share in the industry with trailing revenues of $18.59 billion. They sport a 5-year CAGR of 6.11% which sits towards the median of the industry, driven by organic growth through investments in R&D and the odd acquisition. The HR market is forecast to grow at 12.7% CAGR through to 2030 and I believe ADP is well positioned being one of the largest players in the industry. Profitability in the industry is diverse, ranging from Paychex that has EBIT Margins of over 40% to Manpower Group that has EBIT Margins of 3%. ADP's EBIT Margins are 25.5%, placing it towards the top in the industry, and I can see further expansion from here as the business keeps developing their solutions through investments into R&D. EBIT Margins have expanded over 700 basis points over the last decade driven by good pricing power. EBIT Margins (Seeking Alpha) The company's capital allocation strategy involves paying a dividend yield of 2.1%, investments into R&D and share repurchases. For every dollar of sales ADP repurchase about 10 cents of their shares back, which is way above competitors such as Workday and Paychex. Net Debt to Sales stands at 7.3%. ADP currently has $3 billion in long-term debt with a cash balance of $2 billion, and with the company producing over $1.5 billion in Free Cash Flow they are in a fine position to service any upcoming principals. Latest financials were strong with the company posting revenues of $4.67 billion which beat estimates by $12 million and EPS of $2.13 which beat by $0.03. Total revenues improved 6.3% organically driven by Employer Services that grew 7% and PEO that grew 3%. Adjusted EBIT Margins increased 20 basis points to 24.6% led by Employer Services increasing 170 basis points and PEO increasing 50 basis points. In terms of guidance, ADP expects revenues to register 6-7% growth and adjusted EBIT Margins to expand 60-70 basis points, which is down on their previous target of 60-80 basis points. US Labor Market The unemployment rate declined in March to 3.8%, under forecasts of 3.9%. This is being driven by strong gains in unemployed people finding work and the levels remain low compared to historical standards. Unemployment Rate (Trading Economics) More recently, there was encouraging data in the February JOLTS reports. After a decline over the last few months in the number of job openings, the February data indicates another reasonable month, with of 8.76 million job openings, which is marginally up on January and well above pre-COVID levels. The openings were driven by finance and insurance, state and local government, and arts and entertainment. The strength of the US labor market is an obvious tailwind for ADP Job openings (Trading Economics) Revisions Revenue revisions are broadly flat on where they were 6-months ago. In contrast, Workday and Paychex revenue revisions are down by more than ADP. The same can be said for EPS, they are marginally flat over the last 6-months in comparison to Paychex's that are down. Revenue Revisions (Source: Author's Calculations) Management are confident in the business environment, that is expected to drive a recovery in PEO and presents record backlog across the Employer Services segment. They continue to invest into AI and recently introduced a natural language processor powered by GenAI. This aims to improve HR productivity and decision-making using data. The investments ADP is making into AI indicate the company is actively keeping up with industry dynamics, and I believe this will drive long-term growth for the organization. Valuation Source: Author's Calculations To arrive at my share price target of $268 and an upside of 10% I have EBIT Margins expanding 50 basis points a year and reaching 26% by 2028, driven by the continued automation of their operations and better pricing power as the company keeps investing into new products. The company has a large balance of accrued liabilities, so I have working capital incrementing at 1% of sales and CAPEX of -3.5%. I have also used a P/FCF multiple of 33x (5-year median) and a WACC of 10% (gurufocus). Source: Author's Calculations Risks ADP is exposed to labor market conditions and any contraction in employment could significantly hamper sales growth. Especially as a significant proportion of revenues are accounted for by small businesses. During COVID, smaller businesses received stimulus checks which helped prop up the economy and ADP actually benefitted. ADP are also at risk for cyber incidents, they handle sensitive and personal information that attackers might attempt to reach. Conclusion  ADP is a strong moat, high growth company with a good capital allocation strategy. The company stands to benefit from current tailwinds in the US labor market and is investing into AI technologies. 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