Bill Ackman, portfolio manager of Pershing Square, certainly draws a lot of attention. He is considered an activist and agitator, however, the reality is that he is a value investor. Ackman has an eagle eye for looking for value in the most unusual of places. In his most recent investor letter, Ackman discussed taking a new position in Automated Data Processing (ADP, Financial). Why did Pershing Square take a position in this company? Ackman writes,
“ADP is a high-quality business that trades at a meaningful discount to its intrinsic value due to the near-term effects of the economic downturn. We view ADP as three separate businesses: (1) a payroll processor that has been impacted by rising unemployment and a spike in the corporate default rate, (2) a client fund account that holds money on behalf of its customers (“float”) which has shown declining earnings as low interest rates and recent wage deflation reduce float balances, and (3) a dealer services business that has been impacted by the unprecedented turmoil facing the U.S. automotive industry. As the U.S. economy stabilizes, we believe the headwinds facing ADP will become tailwinds. Given the operating leverage inherent in ADP’s business model, ADP’s earnings should accelerate as it approaches its normalized earnings potential. ADP’s business has numerous attractive qualities: (1) given the low capital outlays required to run the business, it generates cash flow in excess of reported earnings, (2) its dominant market share and global franchise afford it with meaningful pricing power, (3) it possesses one of the few truly Triple-A balance sheets in the world, (4) the company has additional avenues for growth as it has yet to fully penetrate the global payroll/tax market and has a valuable suite of “beyond payroll” product offerings that it can cross-sell into its existing client base, and (5) it will benefit from higher interest and tax rates (higher taxes lead to greater float balances).
We also respect management’s focus on shareholder value. Over the last four years, ADP has spent about $5 billion repurchasing more than 20% of its outstanding shares and paid more than $2 billion in dividends. The combination of a high quality dominant business, shareholder friendly management, and an attractive price in our experience typically leads to a good investment outcome.”
Company Description
ADP provides various business outsourcing solutions to companies of all sizes in North America, Europe, Latin America and Asia-Pacific. The vast majority of these services are in the areas of payroll and HR services outsourcing. The company has about 46,000 employees and serves roughly 585,000 clients. Most of ADP's services are provided on an outsourced, service bureau basis to clients that retain the company's services for an average of about nine years. ADP is organized into three major business units -- Employer Services (ES), PEO Services (formerly part of ES) and Dealer Services.
Employer Services provides a comprehensive range of services including payroll processing, tax and benefit administration services, HR information, and other HR services to roughly 560k employers globally (83% of ES revenue is generated in the U.S.), making it the largest global provider of payroll services.
PEO (Professional Employer Organization) Services, which is branded ADP TotalSource, provides comprehensive employment administration outsourcing solutions for 193,000 worksite employees at over 4,500 small and medium-sized businesses in the U.S. ADP is also rolling out an ASO (Administrative Services Organization), which is similar to the PEO offering, only without co-employment.
Dealer Services provides computing, data, and professional services to over 25,500 automotive, heavy truck, and power sports dealerships and manufacturers in over 50 countries.
Wide Moat
A number of factors contribute to ADP's wide moat and strong profitability. First, because of the difficulty in switching outsourced human resources processes to another provider, ADP is able to lock clients into its services through long-term contracts. Average client retention is estimated to be longer than 10 years, and this stickiness allows ADP to raise prices with very little resistance. Second, ADP's scale allows it to be price-competitive without feeling margin pressure as it can leverage its large 550,000-member client base to spread out costs associated with its servicing infrastructure. Finally, the firm's strong brand plays a role, as clients are hesitant to entrust their critical HR functions to an unproven competitor. ADP's established competitive position and the industry's minimal capital-reinvestment requirements have enabled the firm to turn 17% of its revenue into free cash flow on average over the past five years.
International Opportunities
It has opened exploratory offices in China and India in an effort to establish a service network once these economies become more mature. The firm is also establishing a strong worldwide network outside emerging markets to better serve large multinational firms seeking to obtain consistent global HR services.
Valuation
With 503 million shares outstanding and stock trading at 39, ADP has almost a $20 billion market capitalization. As mentioned in the Pershing letter, it is one of the few AAA rated companies and has $1.4 billion dollars in cash or approximately $2.85 per share in cash. ADP is expected to generate over $1.3 billion in free cash flow in 2009. It is expected to return over 90% of that cash to shareholders through share purchases and dividends.
ADP holds sustainable pricing power in its core payroll business given the lack of concentration in its client base (at the end of FY2009 ADP had 540,000 ES clients with no single client representing more than 2% of revenue).
While the typical 2% annual price increase could be more difficult to achieve in FY2009 and FY2010 (ADP has guided to a price increase of slightly less than 1% in FY2010) due to unprecedented challenges in the macro economy and labor market, ADP’s leading payroll brand and sizable scale advantage should allow the company to achieve modest price increases on its client base over the course of an economic cycle for the foreseeable future. ADP’s diversified client base coupled with its sustainable pricing advantage makes the company’s revenue and earnings profile among the most stable and visible.
The current market multiple is not justified. After all, as shown on the table below, ADP is trading in line with the market but has stronger profitability and balance sheet. Over time, this disparity will disappear when the labor market stabilizes and the growth accelerates.
Current Guidance
ADP provided FY10 guidance that is slightly lower than Street expectations. The company is guiding for an overall revenue decline of 1% to 4% and EPS in the range of $2.29 to $2.39 (flat to -4%). The company’s guidance does not contemplate any additional share buybacks. By segment, ADP’s guidance is as follows:
Employer Services is expected to post a top-line revenue decline of 1% to 3%
Pays per control are anticipated to decline 5% to 6%. Additionally, ADP anticipates client retention to be flat to down 1%. ADP does not contemplate any margin expansion.
PEO revenue is anticipated to be flat to up 4% relative to our prior estimate of +5%. Pre-tax margins are expected to be flat.
Dealer is expected to decline 4% to 8%, relative to our prior -5% estimate. No margin expansion is expected. ADP is assuming a 3.8% average interest rate earned on its client fund portfolio for FY10 with a client fund balance decline of 4% to 6%.
Risks
1. 16% of ADP's revenue base is tied to the volatile auto industry through its dealer services division. The reported collapse of the deal for Penske to purchase GM's Saturn brand is now expected to result in the closure of 350 Saturn dealers. ADP has previously estimated that Saturn contributes $20-$30 million of annual revenue to the $1.3 billion Dealer segment. This should reduce ADP EPS by approximately one cent per share on an annual basis.
2. The firm has a large amount of overlapping services and divisions, which could cause confusion and inefficiencies.
“ADP is a high-quality business that trades at a meaningful discount to its intrinsic value due to the near-term effects of the economic downturn. We view ADP as three separate businesses: (1) a payroll processor that has been impacted by rising unemployment and a spike in the corporate default rate, (2) a client fund account that holds money on behalf of its customers (“float”) which has shown declining earnings as low interest rates and recent wage deflation reduce float balances, and (3) a dealer services business that has been impacted by the unprecedented turmoil facing the U.S. automotive industry. As the U.S. economy stabilizes, we believe the headwinds facing ADP will become tailwinds. Given the operating leverage inherent in ADP’s business model, ADP’s earnings should accelerate as it approaches its normalized earnings potential. ADP’s business has numerous attractive qualities: (1) given the low capital outlays required to run the business, it generates cash flow in excess of reported earnings, (2) its dominant market share and global franchise afford it with meaningful pricing power, (3) it possesses one of the few truly Triple-A balance sheets in the world, (4) the company has additional avenues for growth as it has yet to fully penetrate the global payroll/tax market and has a valuable suite of “beyond payroll” product offerings that it can cross-sell into its existing client base, and (5) it will benefit from higher interest and tax rates (higher taxes lead to greater float balances).
We also respect management’s focus on shareholder value. Over the last four years, ADP has spent about $5 billion repurchasing more than 20% of its outstanding shares and paid more than $2 billion in dividends. The combination of a high quality dominant business, shareholder friendly management, and an attractive price in our experience typically leads to a good investment outcome.”
Company Description
ADP provides various business outsourcing solutions to companies of all sizes in North America, Europe, Latin America and Asia-Pacific. The vast majority of these services are in the areas of payroll and HR services outsourcing. The company has about 46,000 employees and serves roughly 585,000 clients. Most of ADP's services are provided on an outsourced, service bureau basis to clients that retain the company's services for an average of about nine years. ADP is organized into three major business units -- Employer Services (ES), PEO Services (formerly part of ES) and Dealer Services.
Employer Services provides a comprehensive range of services including payroll processing, tax and benefit administration services, HR information, and other HR services to roughly 560k employers globally (83% of ES revenue is generated in the U.S.), making it the largest global provider of payroll services.
PEO (Professional Employer Organization) Services, which is branded ADP TotalSource, provides comprehensive employment administration outsourcing solutions for 193,000 worksite employees at over 4,500 small and medium-sized businesses in the U.S. ADP is also rolling out an ASO (Administrative Services Organization), which is similar to the PEO offering, only without co-employment.
Dealer Services provides computing, data, and professional services to over 25,500 automotive, heavy truck, and power sports dealerships and manufacturers in over 50 countries.
Wide Moat
A number of factors contribute to ADP's wide moat and strong profitability. First, because of the difficulty in switching outsourced human resources processes to another provider, ADP is able to lock clients into its services through long-term contracts. Average client retention is estimated to be longer than 10 years, and this stickiness allows ADP to raise prices with very little resistance. Second, ADP's scale allows it to be price-competitive without feeling margin pressure as it can leverage its large 550,000-member client base to spread out costs associated with its servicing infrastructure. Finally, the firm's strong brand plays a role, as clients are hesitant to entrust their critical HR functions to an unproven competitor. ADP's established competitive position and the industry's minimal capital-reinvestment requirements have enabled the firm to turn 17% of its revenue into free cash flow on average over the past five years.
International Opportunities
It has opened exploratory offices in China and India in an effort to establish a service network once these economies become more mature. The firm is also establishing a strong worldwide network outside emerging markets to better serve large multinational firms seeking to obtain consistent global HR services.
Valuation
With 503 million shares outstanding and stock trading at 39, ADP has almost a $20 billion market capitalization. As mentioned in the Pershing letter, it is one of the few AAA rated companies and has $1.4 billion dollars in cash or approximately $2.85 per share in cash. ADP is expected to generate over $1.3 billion in free cash flow in 2009. It is expected to return over 90% of that cash to shareholders through share purchases and dividends.
ADP holds sustainable pricing power in its core payroll business given the lack of concentration in its client base (at the end of FY2009 ADP had 540,000 ES clients with no single client representing more than 2% of revenue).
While the typical 2% annual price increase could be more difficult to achieve in FY2009 and FY2010 (ADP has guided to a price increase of slightly less than 1% in FY2010) due to unprecedented challenges in the macro economy and labor market, ADP’s leading payroll brand and sizable scale advantage should allow the company to achieve modest price increases on its client base over the course of an economic cycle for the foreseeable future. ADP’s diversified client base coupled with its sustainable pricing advantage makes the company’s revenue and earnings profile among the most stable and visible.
The current market multiple is not justified. After all, as shown on the table below, ADP is trading in line with the market but has stronger profitability and balance sheet. Over time, this disparity will disappear when the labor market stabilizes and the growth accelerates.
ADP | S&P 500 | |
Forward P/E | 16.5 | 16 |
ROC | 24% | 12% |
Operating Margin | 21% | 17% |
L-T Debt to Captial | 1% | 32% |
Cash/Market Cap | 12% | 11% |
Dividend Yied | 3.40% | 2.10% |
Long Term EPS Growth | 12% | 13% |
Current Guidance
ADP provided FY10 guidance that is slightly lower than Street expectations. The company is guiding for an overall revenue decline of 1% to 4% and EPS in the range of $2.29 to $2.39 (flat to -4%). The company’s guidance does not contemplate any additional share buybacks. By segment, ADP’s guidance is as follows:
Employer Services is expected to post a top-line revenue decline of 1% to 3%
Pays per control are anticipated to decline 5% to 6%. Additionally, ADP anticipates client retention to be flat to down 1%. ADP does not contemplate any margin expansion.
PEO revenue is anticipated to be flat to up 4% relative to our prior estimate of +5%. Pre-tax margins are expected to be flat.
Dealer is expected to decline 4% to 8%, relative to our prior -5% estimate. No margin expansion is expected. ADP is assuming a 3.8% average interest rate earned on its client fund portfolio for FY10 with a client fund balance decline of 4% to 6%.
Risks
1. 16% of ADP's revenue base is tied to the volatile auto industry through its dealer services division. The reported collapse of the deal for Penske to purchase GM's Saturn brand is now expected to result in the closure of 350 Saturn dealers. ADP has previously estimated that Saturn contributes $20-$30 million of annual revenue to the $1.3 billion Dealer segment. This should reduce ADP EPS by approximately one cent per share on an annual basis.
2. The firm has a large amount of overlapping services and divisions, which could cause confusion and inefficiencies.
