2023-09-20 15:40:45 ET
Summary
- ADP is a high-quality company with strong growth opportunities and excellent capital allocation.
- The company's focus on long-term growth makes it an attractive investment for long-term investors.
- ADP's competitive advantages, loyal customer base, and strong balance sheet contribute to its potential for double-digit annual returns.
Thesis
Automatic Data Processing ( ADP ) is one of the highest quality companies out there while still being fairly valued compared to other companies of similar caliber. The company's growth opportunities and capital allocation are incredibly strong I believe because the management team does a great job of thinking long term.
For long-term investors, the present share price is a good opportunity to buy a company that is likely to generate double-digit annual returns.
ADP's Capital Allocation
Companies with high returns on capital that exceed expectations are among the best long-term investments. And ADP traditionally had a strong ROIC that was 20%+ and they still managed to increase it. They may not be able to maintain recent levels, but even if they only generate 25% ROIC over the next 10 years, shareholders will benefit greatly.
ADP has increased its dividend for 48 years while targeting 7%-8% revenue growth going forward and plans to buy back 1% of its shares each year. The combination of these three factors will work well together. Especially when the ROIC-WACC spread is as wide as it is. By my calculation, ADP has a WACC of around 9% to 10%, which would give them a spread of 45% today. And even if ROIC falls, they still have a double-digit spread, which shows that management is top notch in terms of capital allocation and getting strong returns on their capital. Management teams of that quality are very rare.
Automatic Data Processing's Growth Opportunities
ADP, the global leader in HCM, sees a $150 billion TAM with the market growing at 5-6% annually. And the plan for ADP is to grow organically through international expansion into Europe and Asia, and to expand across regions and products. However, in small countries where it would not make sense to establish a presence, they also buy partners, as they did in Sweden and South Africa. But major M&A activities are not planned because they do not want to buy revenues, as they said at the Citi Global Conference. If they find something that fits they would do the acquisitions but they seem to have enough organic opportunities.
Generative AI combined with ADP's data provides them with powerful capabilities and valuable insights across industries and sectors. ADP can automate and simplify workflows while meeting the needs of its more than 1 million clients . A lot of people see AI as a threat to ADP, but I think it's more of an opportunity that will benefit them in the long run because they've shown over the last couple of decades that they can adapt to new environments.
With a 92% customer retention rate, it is clear that they have loyal customers who value their products and that switching costs are high, which is a strong competitive advantage. The complexity and regulations in many areas make their outsourcing segment particularly interesting for SMBs. And this market is currently underpenetrated, so there are growth opportunities.
Peer Comparison
What we can clearly see is that ADP is the best capital allocator among its peers. They just outperformed the competition in terms of return on capital and especially return on equity. And since shareholder returns follow returns on capital in the long run, ADP will most likely be the best bet, even though they have slightly worse margins than their two strong competitors, Paychex (PAYX) and Paycom (PAYC). Of course, the high ROE can be explained by higher leverage, but since ROC shows how a company would do with more capital, it still shows their superior capital allocation skills in my view, even when we take debt into account, as ROC does.
Compared to Paychex and Paycom, which are more asset-light, ADP's debt position looks quite high . But Ceridian (CDAY) and Workday (WDAY) have similar total debt at $1.25 billion and $3.27 billion, respectively. However, ADP's debt position is not a concern as they can easily service it as we will see in a later chapter on the balance sheet.
Reverse DCF for ADP
I really like the reverse DCF to see if a stock price is justified and if the company can achieve the growth rates going forward. The assumptions for ADP's reverse DCF are adjusted diluted EPS of $8.23 for fiscal year '23 and a 10% hurdle for the discount rate.
For ADP to be fairly valued, it needs to grow EPS by 13% per year. Their 10-year CAGR is 11.04% , so they are a little below that, but because of the strong growth opportunities going forward, I think it can be argued that they could achieve the 13%.
ADP itself is forecasting EPS growth of 11% to 13%, so the stock is at the high end of that. But if ADP were to buy back more shares than planned (1% per year), EPS could be even higher than 13%. As a result, I believe that double-digit annual returns are very possible at this price. 13% to 15% would also likely beat the S&P 500 total return by a wide margin.
ADP's Valuation
Historically over the last 10 years, ADP's current valuation of 21x EV / EBIT is not really expensive, but neither is it cheap. Given their growth potential and the quality of their business, I think this is a fair valuation with plenty of room for future shareholder returns. Of course, I would prefer to buy at a multiple below 15x, but I cannot see ADP falling that low, and if it does, I am very interested in buying if it is due to a temporary problem or the general market environment that has made this opportunity possible.
Compared to their competitors, their multiple is the second lowest after Paychex, even though they are the highest quality of this peer group. And I think the EV/EBIT multiple is the best way to value a company, because depreciation and amortization should be included, because they are real costs. So I prefer EV / EBIT instead of the often used EV / EBITDA multiple.
ADP's Balance Sheet
Also, I think the downside is pretty protected with ADP as their balance sheet is rock solid . For the balance sheet, I have a rule that I only buy companies where total debt is no more than 4x Net Income, and ADP's Net Income of $3.4 billion is against $3.5 billion in total debt, so it's almost 1x. So very safe in my opinion. Plus, they have $2 billion in cash and cash equivalents. So the debt can be easily serviced and there is no big risk because of the seemingly high debt.
Their free cash flow CAGR of 11.76% over the past 10 years also gives them plenty of room to return cash to shareholders and even more safety. So if ADP wanted to, they could pay down all of their debt as fast as they want, if we look at their FCFs above, but I think they are using debt strategically to improve returns on capital.
Risks
ADP could potentially be threatened by technological advances, but almost every company faces this risk. And with their long track record, they have survived many of these threats in the past. Their knowledge and high customer retention rate speak to the stickiness of their business model, creating high barriers to entry for competitors.
Conclusion
ADP's management compensation is strongly aligned with shareholders' interests. Furthermore, the company is focused on the long term outlook of the business, while having high customer loyalty and plenty of growth opportunities. Their competitive advantages and strong balance sheet are other strengths. So all in all, I think there is a high probability of double-digit annualized returns going forward at this price. However, every dip is helpful in getting even better returns. A price in the low 200s, as we saw earlier this year, looks like a perfect buying opportunity today.
For further details see:
Automatic Data Processing: Fairly Valued With Strong Growth Opportunities