2023-04-20 10:41:24 ET
Summary
- ADP's strong performance indicators and digital transformation efforts position the company well for growth.
- Market concerns around ADP's PEO business and macroeconomic uncertainty warrant close examination.
- ADP's financial stability and attractive valuation make it a compelling investment opportunity.
As the macroeconomic environment remains dynamic and uncertain, we explore the investment thesis for Automatic Data Processing ( ADP ), a company exhibiting robust performance and growth potential in the face of such challenges. In this article, we will delve into ADP's strong pays-per-control growth, new bookings, and high Employee Services retention, as well as the opportunities presented by their digital transformation efforts and product modernization. We will also discuss potential concerns surrounding ADP's PEO business and the broader macroeconomic environment, and assess the company's financial stability and valuation.
FYQ3 and 2023 Setup
Our view is that the macro environment remains resilient, with no significant broad-based macro impact on ADP. However, the macro environment is dynamic, so we will eagerly await management's commentary during the upcoming earnings call. In addition to macro, there are also many companies-specific topics we hope management will provide more color on during the next earnings call.
We believe that the company's strong pays-per-control growth, healthy new bookings, and high Employee Services retention are evidence of its robust performance. Employers' reluctance to cut staff amid the current labor shortage has further contributed to the stability of the market. Though there has been a slight uptick in bankruptcies in the lower end of the market, these levels align with pre-COVID figures, reinforcing our confidence in the resilience of the macro environment.
We think that ADP's considerable efforts in modernizing its product portfolio have positioned the company well for growth. By rebuilding products, updating user interfaces, and better leveraging cloud technologies, ADP has successfully increased its focus on innovation. We are particularly optimistic about the potential of the new tax & payroll calculation engine, upmarket products, and NextGen HCM. These advances should enable ADP to compete more effectively, especially in the mid-market segment, and result in higher NPS scores, benefiting new bookings and gross retention.
In our opinion, the softness in ADP's PEO business during F2Q can be attributed to the cyclical nature of insurance and a challenging comparison to pandemic-driven inertia. Nevertheless, we remain confident in the value proposition of PEO for SMBs. With various levers at their disposal, ADP's management has the potential to improve bookings capture. Moreover, as PEO customers transition to WorkforceNow, we anticipate a continued increase in the average PEO customer size.
We also believe that digital transformation offers ample opportunities for ADP to enhance operating efficiencies, particularly in service. The new calculation engine should contribute to this by reducing service requests through enhanced ease-of-use. Additionally, AI/ML-powered programs should enable the sales force to better target, approach, and pitch to potential customers.
Under the leadership of new CEO Ms. Black, we expect ADP to enter a new phase of evolution, one that requires even more rapid innovation due to the fast-paced changes in the world of work and the need for further organizational modernization. We are optimistic about her ability to maintain continuity while also emphasizing key investment areas to preserve ADP's attractive growth and profitability balance.
Lastly, while M&A opportunities are regularly considered, we agree with ADP's management on maintaining discipline regarding valuation and deal size. The company's focus on smaller tuck-in deals indicates that M&A is an option, albeit not a top priority.
Concerns: PEO and Macro
We believe the market is concerned about the performance of ADP's Professional Employer Organization business, as evidenced by the recent lighter-than-expected F2Q results and the subsequent downward revision of the FY guide. This apprehension is primarily attributed to softer PEO retention rates, which can be partially explained by macroeconomic uncertainty and the above-average drag resulting from medical benefits price increases.
Macroeconomic uncertainty is another top-of-mind topic for investors, in our view. The US labor market exhibited signs of gradual weakening as it added 236,000 jobs in March, a reduced figure compared to the upwardly revised 326,000 jobs in February and 504,000 in January. This slowdown may be attributed to the effects of the Federal Reserve's interest rate increases on the economy. The March figures were also 3,000 lower than the 239,000 anticipated by economists, suggesting a less robust job market in the world's largest economy. Sectors such as leisure, hospitality, and healthcare witnessed fewer job additions, while government and professional services continued to grow at similar rates to previous months.
The cooling labor demand is further supported by the decline in job openings and the upward trend in jobless claims. The Bureau of Labor Statistics' Job Openings and Labor Turnover Survey indicates that employers are slowing the pace of hiring. Furthermore, ADP reported that private employers added 145,000 jobs in March, a decrease from the 261,000 jobs added in February. This information suggests that while the labor market is still growing, its momentum is diminishing from the highs experienced over the last two years.
As ADP faces potential headwinds from a weakening demand environment, management has expressed confidence in its ability to protect margins. Our research indicates that ADP has a range of options to manage costs effectively. Labor, being the company's largest expense item, offers significant flexibility if the company chooses to join other tech companies in pruning headcount. Additionally, ADP has the option to adjust lower-return or longer-payback internal investment programs as necessary.
Financial & Valuation
Our analysis of ADP demonstrates the company's impressive financial stability and growth prospects. Over the past few years, ADP has consistently posted solid revenue growth, even amidst the challenges posed by the COVID-19 pandemic. From FY16 to FY19, ADP's revenue grew at a CAGR of 7.0%, showcasing its resilience in the face of economic headwinds. Despite the pandemic, the company still managed to grow by 2.9% in FY20 and 2.8% in FY21.
In FY22, ADP rebounded with a robust 9.9% revenue growth, reaching $16.5B. We expect the company to continue its strong performance in FY23, with consensus estimates projecting 8.5% growth to $17.9B. Growth is anticipated to moderate to a more normalized rate of 6.6% in the next fiscal year, aligning with the company's reputation as a stable growth enterprise.
Furthermore, ADP has consistently protected and expanded its operating margins. FY23 is expected to witness an operating margin expansion to 24.8%, up from 23.5% in FY22. The company is on track to achieve a new record of 25.4% operating margin in FY24.
EPS are also projected to grow substantially, with FY23 EPS expected to increase by 16% to $8.12 and FY24 EPS predicted to grow by 11% to $8.99. Currently trading at 24.5x forward 12-month consensus EPS, ADP is at the lower end of its 5-year range. Historically, excluding the COVID shock, ADP has traded between 22 and 35x.
Relative to the S&P 500, ADP is trading at a 35% premium, which is also towards the lower end of its 5-year range. The company typically trades at a premium of between 20% and 80%. Based on our research and analysis, we believe that ADP shares offer good value, considering its proven track record of stable growth and margin expansion.
Conclusion
Our analysis suggests that ADP presents a promising investment opportunity, given its resilience in the face of an uncertain macroeconomic environment and its ongoing digital transformation efforts. The company's strong performance indicators, modernized product portfolio, and focus on innovation are poised to drive growth and improve operating efficiencies. While there are concerns regarding ADP's PEO business and broader macroeconomic uncertainty, we believe that the company's solid financials and attractive valuation provide a strong foundation for potential investors. As ADP continues to evolve under the leadership of its new CEO, Ms. Black, we remain optimistic about the company's ability to maintain a balance between growth and profitability, as well as its potential to capitalize on emerging opportunities in the rapidly changing world of work.
For further details see:
Automatic Data Processing's Resilience And Digital Transformation