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ADP: A HIGH-QUALITY
INVESTMENT OPPORTUNITY
Automatic Data Processing (ADP) is a global provider of business outsourcing solutions, offering a wide range of human resource, payroll, and tax and benefits administration services. We recently included the share in our global equity portfolios – in our view, ADP is a top-quality business with a strong market position and excellent long-term growth prospects.
ADP is very well diversified in a wide range of value-added services to employers and businesses in the following divisions:
ADP stock is trading at premium valuation levels due to its strong market positioning, excellent growth prospects and exemplary capital allocation history. We recently embraced the opportunity to invest in this high-quality company at fair value at levels below US$240.
ADP is a market leader when it comes to payroll processing for large businesses. Given few other comparable payroll-processing options, it is unlikely that large clients will abandon ADP. As per company disclosures, management believes the business services one out of every six employees in the US. Anecdotal evidence (from speaking to various clients) suggests that payroll processing is not a function a chief financial officer tends to change very often, mostly due to:
We believe that the client retention ratio of more than 90% over the past five years will be maintained by ADP, and therefore don’t foresee much change to consensus forecasts that a steady retention ratio will be maintained in the future. During its last financial year, the company experienced average retention rates of over 97%.
ADP is a well-run business with very attractive returns on capital and a highly cash-generative business model due to low capital expenditures, a very sticky client base, and economies of scale unmatched by rivals due to its size and industry-entrenched position. Free cash flow conversion is impressive, with a rate consistently above 100% versus net income. Cash flow returns significantly exceed the cost of capital.
In our view, the price-earnings derating of the stock (when the price drops due to anticipated earnings decline without an actual fall in earnings) over the past three years offered an attractive entry point for us to add the name. Historically, ADP has traded at a range of 20 to 30 times forward earnings expectations. When we invested, forward earnings expectations were at 22 times, and we believed the valuation was attractive for the quality of the business we were acquiring.
Return on invested capital is a key metric for us to determine the quality of a company. In this regard, ADP is an exceptional business, measuring above 40% over many years.
No business can operate without encountering a few headwinds. In the case of ADP, the company 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.
ADP does enjoy a few dynamics that enable it to maintain high returns on capital. Among these, we expect that increased regulatory complexity, tight labour markets and growing adoption of hybrid work will underpin strong demand for ADP’s solutions, supporting a 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. We’re confident that despite competitive challenges, these factors will enable ADP to continue providing strong shareholder returns over time.
We constantly challenge the norm. Our investment process is a thorough and diligent one.
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