Automatic Data Processing (NASDAQ: ADP), with a market capitalization of about $26.6 billion, is the largest global provider of payroll, human resources, tax filing, data processing, and benefits outsourcing services. The company has a commanding position in the large company segment of the payroll processing industry but also counts small and medium sized business among its more than 570,000 clients. The company’s principal competition comes from Paychex (NASDAQ: PAYX), with a market capitalization of about $11.4 billion, which operates in the small and medium-sized business payroll processing space. Ultimate Software (NASDAQ: ULTI), and Insperity (NYSE: NSP) are much smaller players focused on human resources outsourcing and software with relatively less exposure to direct payroll processing services. Ultimate Software has a market capitalization of about $1.8 billion while Insperity’s market capitalization is about $800 million.
By capturing the large company part of the payroll processing market, ADP has created competitive advantages that have led to robust cash flow growth of around 10%, solid operating margins north of 31%, and strong returns on invested capital just under 22% since 2007. The company’s primary competitive advantages are high barriers to entry because a large infrastructure is needed to process a large number of employees; economies of scale once the infrastructure is in place because of its ability to add incremental recurring revenue without material capital expenditures and which leverages fixed infrastructure costs over an ever increasing customer base; high customer switching costs due to the company’s long-term contracts and the difficulty in switching human resources processes to another outsourced provider- average client retention is estimated to be longer than 10 years and revenue is highly recurring in nature; pricing power with customers due to the high switching costs; and a brand image that gives ADP an advantage as it competes for new customers and retains existing ones because clients must trust the entity that conducts its critical payroll and human resource functions.
ADP is fundamentally a play on the U.S. economy and with recent signs of a turnaround in the job market, revenue and earnings growth are poised to improve, taking the share price beyond the estimated current intrinsic value of about $70 per share on a discounted cash flow basis. This estimated value is about 30% above the recent share price of about $54 and reflects assumed growth in free cash flow of about 6% annually which is a sizeable reduction from the approximately 10% annual growth rate in free cash flow since 2007. However, free cash flow has grown by only about 2% since 2002 so a 6% growth assumption is aggressive but warranted given the expected economic recovery and concurrent job growth that ADP can exploit with its competitive advantages.
ADP trades at a multiple to future growth above its smallest peers but well below that of its largest peer. Analysts estimate that ADP’s earnings growth will be about 9.8% which is better than Paychex at about 7.2%, and with a forward price to earnings ratio of about 18x compared to about 19x for Paychex, ADP has a more attractive price to earnings to growth multiple of about 1.8x compared to about 2.6x for Paychex. Insperity has the lowest price to earnings to growth multiple at about 0.81x while Ultimate Software’s price to earnings to growth multiple is about 1.2x. Both of these companies have much higher growth rates as they are growing off much smaller revenue and earnings bases than either ADP or Paychex. I believe that the projected earnings growth rate for ADP at about 9.8% is reasonable given that earnings grew by about 5% for the year ended June 2011 even with the significant drag of weak employment all throughout the year. Furthermore, the company’s competitive advantages will be more fully exploited as the jobs market recovers thus growing the customer base, expanding operating margins, and growing cash flow. Operating margin was only about 31.7% last year compared to a five year average of about 38.5%, leaving significant room for improvement as customers and services offered are added. Operating cash flow, which was only about 17.3% of revenue last compared to an average of about 18.1% since 2007, grew by only about 1.7% last year. This rate of growth is much less than the approximately 7.1% annual rate for the past five years which I anticipate will be closer to the rate going forward. The $70 per share intrinsic value estimate pegs cash flow growth at 6%.
Although the economic outlook and the job market in particular are forecast to be improved in the next two years, their impact will be moderated by low interest rates through 2013 which hurts ADP’s interest income from holding client funds, which has declined to about 6.9% of revenue last year from about 10.4% of revenue in 2007. Declining income from interest on client funds will be a headwind for the company for the foreseeable future but investors should gladly accept this drag on earnings because I firmly believe the company will not be tempted to reach for yield by placing customers’ funds in high risk investments. Such a move might be advantageous to income in the short term but would expose the company to real and permanent value destruction if losses in risky accounts caused harm to a client(s) operations or financial position. The company has never shown an inclination toward such behavior and I doubt it ever would.
ADP has a high current payout ratio of about 55%, which is well above its long term average of about 40%. Paychex’s current payout ratio of about 84% is much higher than its historic average of about 65% but I believe that in both cases it is temporary until earnings growth moves back toward the historical averages for a sustained period of time. ADP should increase dividends annually going forward as it has in the past, but at a slower rate than earnings growth to allow the payout ratio to revert to its mean.
ADP ‘s focus on the large business market allows the company to dominate the niche and enjoy its many competitive advantages, but this strategy does limit ADP’s exposure to the higher growth rates and greater volatility of small and medium sized businesses. Overall, ADP is well positioned to take advantage of the recovery in the jobs market and at its current price of about $54, the shares are a strong buy. Even if cash flow projections do not materialize to the assumed 6% growth rate going forward or are delayed by a downturn in the economy, the shares are fairly valued at the current price and investors can collect a sustainable 2.9% dividend.