2023-08-17 12:56:48 ET
Summary
- ADP faces significant competition over the next decade which may erode its market share or margins.
- The Core HR market is maturing in the United States which limits ADP's growth prospects.
- ADP is overvalued on a relative basis and significantly overvalued on an intrinsic basis.
Automatic Data Processing ( ADP ) is a clear leader in the HR software industry, but unfortunately, ADP's business is at risk of being disrupted over the next decade. Plus, equity upside is limited by the dwindling growth opportunities for ADP's human capital management ((HCM)) business. Currently, ADP's stock is priced too expensively given its risks, future revenue growth, and margins.
Overview
ADP's management breaks the business down into two segments: Employer Services and PEO. The Employer Services segment encompasses ADP's HCM software which helps businesses with Core HR tasks. Core HR tasks include payroll, time and attendance, employee self-service, etc. This portion of the business makes up 2/3 of ADP's revenue and 4/5 of ADP's EBIT. The PEO segment of ADP's business encompasses the human resource outsourcing portion of ADP's business. This portion of the business is far less important because it makes up 1/5 of ADP's EBIT.
ADP's HCM offering is being threatened
Competition
While ADP's human capital management offering is well-respected within the industry, competitors are threatening to take market share. ADP's product could be falling behind given that it won Next Gen HCM in 2019, Next Gen Pay (part of Core HR) in 2020, DEI in 2021 , and intelligent self-service (part of employee experience) in 2022. ADP's demotion to the DEI and employee experience categories indicates slower innovation than ServiceNow, Workday, PTO Genius, Paychex, and Paycom (who won Core HR in 2021 or 2022). Core HR is the main use case for HCM systems, so it's important that ADP continues to offer an exceptional product - otherwise, in my opinion, they certainly don't deserve their expensive valuation.
HCM Architecture
ERP and HCM systems typically last 8-12 years before their architecture is disrupted. Thanks to the recent AI wave, a new generation of HR software is coming. Current HCM systems sold by vendors such as ADP are legacy in nature because after a company implements one of these systems, they're stuck with workflow and hierarchy decisions. As companies grow and change, these HCM systems must undergo expensive reimplementation.
An HCM system that is built on AI, on the other hand, is more flexible and adapts to an organization as it grows and changes. The emergence of AI HCM systems will seriously threaten ADP's product offering over the next decade.
Scalability
ADP, over the next 10 years, will face slowing revenue growth because the Core HR space is maturing. Currently, North America's Core HR market is crowded and penetrated. Most large companies in the United States have adopted Core HR systems already, whereas adoption among SMEs is lower. ADP's future growth will be dependent on selling to SMEs who have a difficult time affording the solution.
Alternatively, ADP can expand internationally which is notoriously difficult. For example, expanding internationally requires ADP to deal with language barriers and less-friendly business environments. These factors increase expansion costs and decrease the benefits of growth to shareholders.
Q4 earnings
International
Management echoed my view on international expansion, during ADP's Q4 conference call , when the CEO said "Many countries put many of the states that are complex, here in the U.S. to shame." Additionally, management noted that they're taking their product Roll international by introducing it to two countries. However, I'm pessimistic about future growth from international expansion because the CEO said he'd be "surprised if [Roll's international expansion] ultimately makes a dent" in overall bookings.
Guidance
Management guided a 4% increase in PEO revenue for FY2024 after PEO revenue grew double digits in FY2023. The macro backdrop slowing, and tough YoY comparisons due to Q4 being very strong were blamed for the weak guide. Other red flags include PEO margins being projected to drop 20-40bps in FY2024 and Employer Services client revenue retention being projected to drop 50-70bps. These declines were also blamed on macro.
Margin Expectations and Relative Valuation
Employer Services Margin
ADP's incremental margin, which is calculated by dividing the change in EBIT by the change in revenue, averaged 44.01%. Theoretically, ADP's employer services margin will approach 44% if ADP is able to maintain this incremental margin.
Looking at a chart of ADP's employer services margin reveals that margins have been rangebound in the 30-32% range over the past 5 years. Given that software margins are typically 20-25%, assuming margins will approach 40% is somewhat dangerous. My base case is that margins will settle in the 25%-35% range because HCM software switching costs are very high, giving ADP pricing power. However, giving ADP Microsoft-like EBIT margins of 40% seems too generous.
Looking at other publicly traded HCM companies, Paychex is the most profitable. Its 41% EBIT margin should be viewed as a best-case scenario for ADP's HCM business.
PEO Margin
ADP's incremental PEO margin averages about 20%. PEO margins will approach 20% over time if ADP's incremental PEO margin stays constant.
PEO margins have steadily increased over time despite a pullback during COVID.
ADP's human resource outsourcing margins are much higher than other human resource outsourcing companies. In fact, PEO margins are approaching software margin territory which seems unsustainable given the business's characteristics. My base case is that software margins moderate to 15% over time.
Sum of the Parts Valuation
ADP's expected revenue growth of 6-7% (management estimate) is in line with Oracle's, SAP's, and Paychex's consensus two-year revenue growth numbers. This leads me to believe the Employer Services portion of ADP's business should be trading at 15.91x EBIT (the average of the three companies).
I expect ADP's PEO business to trade more expensively than its peer group thanks to stronger revenue growth and higher EBIT margins. Putting a 33% premium on the median EV/EBIT of 19.05x yields a value of 25.34x.
S&P Capital IQ Author's Calculations
The enterprise value (EV) was calculated by multiplying each segment's EBIT by the expected EV/EBIT multiple. TEV is the sum of the EVs from the PEO and Employer Services businesses.
According to the latest 10-K, the "Other" segment includes "corporate overhead charges and expenses that have not been allocated to the reportable segments, including corporate functions, costs related to our transformation office, severance costs, non-recurring gains and losses, the elimination of intercompany transactions, and all other interest income and expense." I dealt with this by allocating 2/3 of the "other" EBIT to Employer Services and 1/3 of the "other" EBIT to PEO (which is in line with the revenue mix).
Intrinsic Valuation
Optimistic Case
Given that ADP looks overvalued in my optimistic case, there is significant asymmetric risk to the downside.
Author's Calculations Author's Calculations
Employer Services Revenue Growth: Management estimates 6-7% growth for Employer Services in FY2024, so I estimate revenue growth of 6.5% in CY2024. Revenue then moves linearly from 6.5% to the risk-free rate (stable growth rate) over 9 years.
Employer Services EBIT Margin: Moves linearly from the LTM EBIT margin to 40%.
PEO Revenue Growth: Management estimates 4% growth for PEO in FY2024, so I have revenue growth of 4% in CY2024. Revenue then returns to its 6-year historical average of 9.56% and then moves linearly toward the risk-free rate (stable growth rate) over 8 years.
PEO EBIT Margin: Move linearly from the LTM EBIT margin to 20%.
Other EBIT Margin: 7-year average.
D&A and CapEx: Analyst estimates as a % of revenue are used for years 1-4; years 5-10 are the average of years 1-4 and LTM.
NWC: 7-year historical % of revenue.
Discount rate #1 (8.19%, used in this valuation): CAPM; Aswath Damodaran's implied ERP of 4.83%; AA credit spread added to the risk-free rate for the cost of debt; 5-year historical beta of 0.83 (I used this one to be more optimistic because when beta decreases, business value increases)
Discount rate #2 (8.85%, used later): CAPM; Aswath Damodaran's implied ERP of 4.83%; AA credit spread added to the risk-free rate for the cost of debt; bottom-up beta, weighted based on EVs from the PEO and Employers Services businesses (my sum of the parts valuation has the EVs used)
Terminal ROIC: Typical software return on invested capital
Terminal RIR: Terminal g (growth) divided by terminal ROIC
Terminal Value: ((Year 10 EBIT*(1-t))*(terminal g)*(1-RIR))/(WACC-g); this is NYU Professor Aswath Damodaran's method
PEO Unlevered Beta
Employer Services Unlevered Beta
Sensitivity Analysis - EBIT Margins
All assumptions are identical to the optimistic case DCF except for the beta and the margins changing. Instead of using a historical beta, I used the bottom-up beta that I calculated in the DCF section (8.85%). None of my scenarios were in the green, indicating significant asymmetric risk to the downside.
Below, I highlighted the range of the most likely outcomes in yellow.
Risks
Although I think that ADP is far too expensive, it's benefiting from a few positive tailwinds. For example, ADP mentioned in its Q4 earnings call that it was able to raise prices without damaging its Net Promoter Score or revenue retention. However, management admitted that they have pricing power because the demand environment was strong. Additionally, management noted in its Q3 earnings that it has focused on retention instead of pricing. Management could hike prices and increase margins in the short term if they wanted. While I expect Employer Services' margin to stay at 30%, management could increase margins in the short term by increasing prices, causing investor excitement and share price appreciation. Additionally, management claimed in Q3 earnings that they're winning more away from their competitors than in past years. If this trend continues, my base case operating margins and revenue growth numbers may be too low.
Conclusion
Overall, ADP is a $170 stock in my eyes. ADP will likely face intense competition in the medium to long term, which should erode margins, and it has limited opportunities to grow revenue in the United States (88% of ADP's revenue comes from the US). Long-term investors should consider holding ADP once it drops below $170.
For further details see:
Automatic Data Processing Is Priced For Perfection