Automatic Data Processing, Inc. (NASDAQ:ADP)
ADP reported a strong quarter driven by accelerated bookings growth and positive improvement in revenue retention. EPS increased 16% year-over-year, aided by 8% revenue growth (6% organic) and the reduction of its corporate tax rate. The company announced updated fiscal year 2018 guidance, and now forecasts a faster than expected improvement in margins for Employer Services. We believe the revised forecast is an early indication of potential larger improvements to come.
During our proxy contest with ADP last fall, the company committed to achieving approximately $5.05 of EPS by fiscal year June 2020. Since then, the Company has benefited from a number of extrinsic factors, not due to management actions, which should collectively boost FY 2020 EPS by 20%, or about $1 per share. These positive developments include corporate tax reform, the impact of rising interest rates on ADP’s float income, and the upcoming adoption of a required accounting change (ASC606), which should cause ADP’s earnings to more accurately reflect economic reality. In March, ADP announced an Early Retirement Program which should increase recurring earnings by an additional ~$0.25 or more.
Considered together, these factors should enable ADP to achieve a minimum of ~$6.25+ in EPS by FY 2020, nearly 25% more than the guidance provided by management last September, not including any other initiatives ADP undertakes to improve profitability. As consensus estimates for 2020 are only $5.63 per share, 10% below our minimum base estimate, we do not believe that ADP analysts and investors have fully considered the impact of these factors, which we outline in the table below:
We continue to believe that ADP’s potential is substantially greater than is reflected by its current guidance even when updated for the factors outlined above. Commentary by management on the recent earnings call suggests that management shares this view. On the call, management qualitatively elaborated on a large number of initiatives to improve growth and profitability in addition to its Early Retirement Program including its Service Alignment Initiative, the completion of mid-market migrations onto a single product platform, the roll-out of ADP’s new payroll and tax computation back-end engines, and other undisclosed initiatives. Furthermore, ADP recently promoted an internal executive to the new role of Chief Transformation Officer, and announced its intention to expand its transformation goals to include “additional operational improvement initiatives.”
Pro forma for the completion of mid-market migrations, we estimate that more than 60% of Employer Services revenue is now being generated by its small- and mid-market businesses which run on two next-generation platforms, Run and Workforce Now, which should eventually achieve SaaS (software-as-a-service) margins of more than 40%. ADP’s legacy Enterprise business, which will require product migrations to achieve its potential, generates less than 10% of Employer Services’ revenues according to ADP. We believe that ADP is at an opportune moment in its history to more holistically assess its long-term structural potential, and articulate a plan to realize it.
At ADP’s June 12th Analyst Day, investors are expecting the company to discuss the ongoing business transformation, and to provide investors with an updated outlook for the company which better reflects its potential.
From Bill Ackman (Trades, Portfolio)'s first-quarter 2018 shareholder letter.
