ADP Enjoys Sticky Clients and Steady Demand for Mission-Critical HCM Solutions  

Equity Analyst

Emma Williams

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ADP has invested heavily over the past decade to develop public cloud native solutions and consolidate its portfolio of disparate platforms. ADP had successfully migrated most of its small and midsize clients to its strategic platforms as of fiscal 2021 and will be migrating enterprise clients to its new human capital management platform over the coming decade, as well as rolling out its new underlying payroll and tax engines. While we expect platform migrations to ultimately result in higher retention and profitability, the forced migrations will likely create a catalyst for enterprise clients to reassess providers, temporarily hindering both metrics.

ADP faces fierce competitive pressure from nimble upstarts, legacy peers, accounting software, and enterprise resource planning providers. We expect new solutions will allow it to compete more aggressively on functionality, reduce software maintenance costs, and provide scope for greater operating leverage, supporting margin uplift. However, we think increasing competition will result in greater pricing pressure and force ADP to maintain high levels of investment to ensure the functionality of its product offering remains competitive. This investment is in addition to the continued investment in sales and implementation required to roll out new solutions and migrate clients. As such, we expect ADP's price increases will be limited to about 0.5% a year on average, in line with recent growth but below long-term averages, limiting margin expansion potential. 

We expect increased regulatory complexity, tight labor markets, and growing adoption of hybrid work will underpin strong demand for ADP's solutions, supporting greater share of wallet and market share gains in the small and midsize market. This includes greater penetration of the outsourced payroll and human resources model. However, we expect forced platform migrations to hamper ADP's enterprise market share growth over the next decade before gradually recovering as the new platform is adopted in the market. We expect ADP's overall market share to grow modestly for the five years to fiscal 2028, followed by higher growth as platform migrations complete.

Business Strategy & Outlook

ADP has garnered a wide economic moat underpinned by high client switching costs. It also benefits from intangible assets including its brand strength accumulated over several decades, an extensive referral network, and cost advantages due to economies of scale. Despite facing intense competitive pressure and forcing clients to undergo platform migrations from legacy ADP systems, the company has maintained high revenue retention and achieved modest operating margin expansion over the past decade. While we expect returns on invested capital to continue to come under pressure due to elevated investment in software development and client migrations, we are comfortable that ADP will be able to earn maintainable economic profits for at least the next 20 years. 

ADP operates two segments: employer services and the professional employer organization. The employer services segment offers payroll, human capital management solutions, HR outsourcing, insurance, and retirement services. The smaller but faster-growing professional employer organization segment provides HR outsourcing solutions to small and midsize businesses through a co-employment model. PEO clients' employees, referred to as worksite employees, are co-employed by ADP but in practice work for the client. The arrangement allows clients to benefit from ADP's scale to secure competitively priced benefits for their employees.

As with payroll and HCM peers, ADP benefits from high client switching costs. Payroll and HCM software is typically deeply embedded in a business' operations, making it a costly and time intensive process to switch providers. Alongside monetary costs, a business could face operational disruptions and inefficiencies including having to train employees on the new system, integrate the new solution with other software and risk losing data. Despite facing headwinds due to forced client migrations from legacy platforms, ADP's employer services revenue retention has averaged 91% over the decade to 2022, which is reflective of the high switching costs. This compares with competitor Paychex's client retention of 82% who focuses on small businesses and is more exposed to natural attrition, and about 96% for Ceridian (over the five years to fiscal 2022) who focuses on enterprise clients. Retention for ADP's PEO business, which is skewed to small businesses, averaged about 85% over the five years to fiscal 2022. We view this retention rate as robust relative to the retention rates of competitors in the small-business market including Intuit's QuickBooks and Xero of around 80%. In the long run, we expect ADP will continue to invest in software development, client service and user experience to maintain client satisfaction and high retention rates. Maintaining high client retention allows ADP to earn a steady stream of recurring revenue at low marginal cost. 

While ADP's core competency remains payroll administration, the company has expanded its offering to include HCM solutions such as talent and workforce management. As such, ADP now offers an extensive range of payroll and HCM solutions to cater for the full scope of business sizes, including bundled and unbundled software. The solutions range from low-touch artificial intelligence driven apps for micro businesses to full-service payroll and HCM solutions for global businesses with 24/7 client support. Clients can upgrade their software to include these add-on modules, increasing the stickiness of the business. Additionally, ADP's solutions integrate with numerous leading software providers including competitors Workday and Intuit's QuickBooks, as well as approximately 600 third party apps accessible through ADP's app store. Generally, larger clients will pick and choose the best of breed HCM solutions in the market and integrate the offerings together, for example integrate ADP's payroll solution with Workday's enterprise resource planning software. By contrast, smaller clients prefer all in one, bundled solutions and are prime targets for ADP to upsell modules to and increase stickiness; as of fiscal 2020, the average ADP small to midsize business client had two to three modules. ADP's integration capabilities further embed its solutions into a business' operations, increasing switching costs. 

ADP has built a strong reputation over many decades for delivering reliable and compliant solutions for hundreds of thousands of clients, allowing the company to win market share and charge premium pricing. Payroll is a highly sensitive and mission critical operation for all businesses who place high value on reliability, accuracy, compliance, and data security. The potential ramifications for a business from failing to make payroll on time or accurately, being non-compliant with the applicable laws or breaching data security can be severe. We expect ADP has a reputation advantage over smaller, nascent operators who lack a record of performance and can attract new business over these operators. Further, ADP has fostered an extensive distribution network of channel partners including accountants, bank, financial advisors, and benefits brokers who refer clients to ADP. Despite competitors with cloud native solutions offering superior functionality including on-demand pay and continuous payroll, ADP has been able to win market share which we attribute to the strength of their intangible assets. ADP also charges premium pricing for its offering, but we note pricing power has deteriorated in recent years which we attribute to increasing competitive pressures. 

Finally, ADP benefits from a cost advantage stemming from economies of scale, creating an advantage over smaller operators. ADP is a leading provider of payroll and HCM solutions servicing over 1 million clients and paying over 40 million workers worldwide in fiscal 2022. This scale allows ADP to spread its fixed capital investment, namely software maintenance and development, over a larger base affording the company a lower marginal cost relative to smaller operators. On a pre-ASC 606 basis, we estimate smaller, cloud native providers Paylocity and Paycom were paying on average 60% more on software development and programming per client relative to ADP in 2017. Additionally, these providers averaged spending about 45% of underlying revenue on SG&A over the five years to fiscal 2020, compared with 28% for ADP. ADP's cost base is largely driven by volume of clients, while revenue is driven on per employee basis. The incremental cost of adding a new employee to the platform is low and creates material operating leverage for ADP. ADP's cost advantage should improve further over the coming decade because of platform consolidation and improved scale benefits. We expect this superior cost position will provide adequate headway for ADP to combat pricing pressure from competitors and to upsell additional modules to existing clients at a lower cost, increasing the stickiness of the business.

Wide

Economic Moat

Automatic Data Processing

Automatic Data Processing, Inc. engages in the provision of business outsourcing solutions specializing in cloud-based human capital management. It operates through the following business segments: Employer Services, Professional Employer Organization Services, and Other. The Employer Services segment provides clients ranging from single-employee small businesses to large enterprises with tens of thousands of employees around the world, offering a range of human resources outsourcing and technology-based human capital management solutions, including strategic, cloud-based platforms. The Professional Employer Organization Services segment offers small and mid-sized businesses a human resources outsourcing solution through a co-employment mode. The company was founded by Henry Taub in 1949 and is headquartered in Roseland, NJ.

Earnings data Q1 2024

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Automatic Data Processing, Inc. engages in the provision of business outsourcing solutions in cloud-based human capital management. It operates through the following business segments: Employer Services, Professional Employer Organization Services, and Other. The Employer Services segment provides clients from single-employee small businesses to large enterprises offering human resources outsourcing and technology-based human capital management solutions and cloud-based platforms. The Professional Employer Organization Services segment offers small and mid-sized businesses a human resource outsourcing solution through a co-employment mode. The Other segment includes the certain corporate overhead charges and expenses that have not been allocated to the reportable segments. The company was founded by Henry Taub in 1949 and is headquartered in Roseland, NJ.

Automatic Data Processing's adjusted diluted EPS and free cash flow payout ratios easily support a quickly growing dividend. The human capital management company posted impressive results for its fiscal year ended 2023. ADP's interest coverage ratio clocked in above 18 in its most recent fiscal year.

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