Thursday, December 13, 2012

ADP Research and Analysis

You may say I’m a dreamer but I’m not the only one. Stockholders in Automatic Data Processing (NASDAQ: ADP) also believe in the idea that the US economy is headed for a protracted increase in employment that will improve its top line. The investment thesis behind buying ADP is the idea that margins will subsequently expand as the company is leveraged to an upswing in the economy. It has been that way in the past, but I’m not convinced that this time it is going to be the same.

ADP’s Q1 Earnings

As implied above ADP is the sort of stock that is going to benefit from an improvement in employment gains. As such, current employment gains are actually not far off previous recoveries, but the problem is that the job losses incurred in the recession were far in excess of the norm. By my calculations, the US has not even recovered 50% of the jobs lost in the recession. This isn’t great news for the economy, but it’s not so bad for firms like ADP.

All of which could easily lead an investor to conclude that ADP’s metrics should be evaluated with the view that there is protracted growth to come. In other words, if it is doing okay right now and its evaluation is cheap, then how about its prospects for margin expansion and growth going forward? As ADP outlined in the conference call, a 1% increase in pay per control positively impacts revenues by about $20 million, and this marginal increase tends to drop straight into the bottom line. ADP is geared to a recovery in the jobs market.

Current conditions are actually pretty good for ADP.  It recorded 15% worldwide new growth in business services and professional employer organization (PEO) services in the quarter. This helped translate into 5% and 13% organic growth respectively in these segments. Understandably, ADP seems to be arguing that the election plus the upcoming ‘fiscal cliff’ may mean that these growth rates are unsustainable going forward. Therefore its guidance of 5-7% revenue growth for the year might end up being too conservative.

So it sounds good, and ADP is a good way to get a leveraged growth kicker (from the chance of an improved economy next year) into your portfolio. Right?

Previous Performance and Competitive Threats

The answer to the last question has to be a ‘maybe’ at best.

First, let’s have a look at previous revenue and pre-tax margins across the economic cycle.

The fact is that ADP wasn’t really able to expand reported margins much during the strong years leading into 2007. It was really a story of double digit revenue growth from 2005-07, and with growth in single digits for this year and forecast for next year too, it doesn’t really imply (at least from a historical basis) that margins will expand much. Moreover, recent acquisitions have actually reduced margins.

Second, this time it is different.  This time around there is a revolution happening in cloud computing and software as a service (SaaS) based solutions, which threatens the industry. These changes are being reflected in the investment patterns of major companies in the HR space. Oracle (NASDAQ: ORCL) buys cloud based HR solution company Taleo. SAP buys human capital management SaaS based company SuccessFactors. Most recently, IBM (NYSE: IBM) buys HR on-demand software company Kenexa.  Spot the pattern here?

The fact is that all these acquisitions give these giants the capability to bundle add-on employment services to their SaaS based offerings. What investors need to understand about the new SaaS based world is that it is much easier for companies to interact and market add-on services to their existing customer base. This doesn’t mean that the old fashioned principle of winning by offering a more competitive offering doesn’t apply, but what it does mean is that more competition will be encouraged. Now, given that ADP already has stern competition in payroll from the likes of Paychex (NASDAQ: PAYX) and to a lesser extent Equifax, this is hardly good news.  It’s hard to see that growth in ADP’s PEO division (where many of its hopes are being pinned) won’t be affected by increased competition.

Cloud Based Cannibalization?

Moreover, a company like Intuit (NASDAQ: INTU) has the capability to convince its SMB customers to go with its ‘do it yourself’ SaaS based payroll solutions.  This is a key point because as ADP expands its own cloud based solution, it will create a ‘market buzz’ around SaaS solutions. Not only does this threaten to cannibalize (probably a good thing) its own sales, it creates some awareness for its rivals who are offering a similar service, and Intuit is very strong in the SMB market with other tax and accounting solutions.

The Bottom Line

I confess it’s a bit of a tough call here. It seems a bit harsh to conclude that ADP is not a geared play on a continued recovery, and I’m sure it will do well given that scenario.  On the other hand, investing is largely about being a bit of a coward and anticipating business risk. The heavyweights are moving into the HR and human capital management market, and although Oracle, SAP and IBM are not likely to focus on the SMB market in a big way, the possibility still exists. As for Intuit, it is actively looking to expand its products and revenue streams. In conclusion, there might be better ways to chase an ‘employment growth play’ than buying ADP.

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