Automatic Data Processing: Slowing Growth Profile Makes Shares Unattractive (NASDAQ:ADP)

Shares of Automatic Data Processing (NASDAQ:ADP) were crushed on Wednesday, falling about 10%, as investors digested a mixed earnings report. With a 25x forward multiple, there was simply little room for error, and when you drill down into the report, it becomes clearer that ADP is not nearly as much of a growth company as it may first appear. Ultimately, its profit growth is highly dependent on interest rates, which is not a bad thing, but given where other interest rate-driven businesses trade, ADP stock just seems very expensive. Even after this decline, I would sell shares.

In the company’s fiscal first quarter, it earned $2.08 in adjusted EPS, beating consensus by $0.06 while revenue was essentially in-line at $4.5 billion, 7% higher than last year. EPS rose by 12%. It did so even as earnings before interest and taxes rose by just 7% to $1.09 billion aided by 10bps of margin expansion. This 5% EPS outperformance was partially due to share repurchases. ADP bought back $250 million of stock, and its share count fell by 1% over the past year.

However, most of the EPS outperformance was due to a 160bp drop in the tax rate to 21.3%. Tax rates can fluctuate quarter to quarter and are ultimately a lower quality driver of earnings than top-line growth, especially as management is guiding to a 23% tax rate for the full year.

Drilling into segment results, employer services saw 9% revenue growth to $3.05 billion and 220bps of margin expansion. “Pays per control” (same-company employment growth) rose by 2%. Essentially, the average customer had 2% more employees than last year, helping to drive revenue growth. Additionally, client fund balances were up 6%.

Customers deposits money with ADP to make payroll every two weeks. As those balances build before being paid to employees, ADP earns interest. This has made it a major beneficiary of higher interest rates. The yield on this ~$34 billion rose to 2.6%, up from 1.9% last year. Because these accounts are transactional and short-dated, ADP earns less than Fed funds (~5.3%) as the deposits are not particularly valuable to the banks, but its rate is correlated with short-term rates. I will discuss client funds’ impact on P&L more below.

Overall, it kept operating guidance largely unchanged for this segment with similar revenue and new business growth. The one exception is slightly wider margins, but this is primarily tied to earning a higher interest rate on client funds as will be seen in ADP’s consolidated guidance.

PEO services was the laggard with just 3% revenue growth to $1.47 billion, and margins contracted 90bp to 15.1% due to increased reserves for workers’ compensation and higher selling expenses. PEO is essentially when a business is outsourcing employment functions to ADP who then not only processes payroll, but handles HR administration, benefits, workers’ compensation etc. Essentially, it allows small and medium sized businesses to focus on running the business while ADP manages all the aspect of handling employee issues. ADP & the business essentially function as co-employers as workers do tasks at the business but have pay and benefits handled directly thru ADP. Average employees thru this service rose by 2% to 717,000

Due to the weaker first quarter, management was forced to trim both revenue and margin guidance.

Overall, this was a mixed first quarter. Earnings beat, but taxes drove the beat. Employee services results were solid, primarily due to higher interest rates. Its PEO business is seeing margin pressure and was forced to trim potential revenue growth expectations as the selling environment has become more difficult. ADP maintained guidance for 10-12% EPS growth, but only due to client fund balances. Client fund revenue is expected to be $35 million higher thanks to a 10bp higher interest rate as rate cuts appear less likely. This is offsetting weakness at PEO to leave guidance flat.

Ultimately though, earnings ADP get via contracts with customers, at both employer services and PEO, are more valuable than interest income. Investors value certain cash flows more highly than uncertain ones. Long-term contracts provide that recurring cash flow that can be modelled out for years. Conversely, ADP has no control over rates. Unexpected events could cause the Federal Reserve to raise or lower rates quickly and shift the economics of client funds dramatically.

Now, I do not intend to be overly critical of the business, essentially getting funds from customers, which you hold and get to earn interest on, is quite a good, low-risk business. However given the volatility inherent in interest rates, those earnings are deserving of a lower earnings multiple than ADP’s non-interest income.

The challenge is that ADP is only able to post double-digit EPS growth because of higher interest income; the rest of the business is growing slowly. In Q1, pre-tax profits were up $82 million to $1.092 billion. Interest on funds for clients rose by $61 million. Interest accounts for less than 20% of pre-tax profits but about 75% of profit growth. Pre-tax Profit growth ex-interest rose by just 2.4% to $890 million.

A 20+x multiple for an underlying business growing low to mid-single digits this year is extremely expensive. This is especially the case as client funds interest income growth will likely slow during and after 2024. The Fed is almost certainly not going to keep raising rates as quickly as it has; it expects to cut rates twice next year in fact. Even if it does not cut rates and holds them, client funds interest rate will level off and not continue to increase with growth driven just by balances, which will be tied to client and employment growth.

If anything, the picture for employment growth is one of deceleration. ADP is seeing 2% same-store employment growth, which is in-line with the national average in Q3. While we may not see outright employment declines, assuming no recession, the trend is clearly towards slower employment growth.

This is partly due to the fact that there are few potential workers left to employ. The prime-age (25-54) employment to population ratio is now above pre-COVID levels and close to highs seen in the 1990s. Even if employers wanted 5% headcount growth, they likely could not achieve this given the small remaining number potential workers. Just given the macro environment, growth is likely to be slow for ADP.

Now, ADP does have a pristine balance sheet. It has just $3 billion of long-term debt. This would make it seem like ADP could borrow more to increase share buybacks and reduce the share count more aggressively than 1%. However, it needs to maintain pristine credit as its customers are entrusting it with cash to make payroll. Its balance sheet strength is a competitive advantage to win customers and be able to earn as much as it does on client funds. As such, I would expect ADP to keep its current capital allocation mix.

Over the next twelve months, ADP should be able to earn $9-$9.20 a share with about 40-50% of that growth coming from higher rates, meaning it is about a 5% grower ex-rates. As we think beyond the next twelve months, growth will likely slow to that 5% rate, or if rates actually are cut by the Fed as forecast and client funds becomes a detractor, growth could be slower than that.

At 23x earnings, ADP screens as very expensive given the likelihood of meaningfully slowing growth. I would rather own a business like Chubb (CB), which has also benefitted from higher rates, but trades at 11x earnings. Of course, there are more risks to insurance than payroll processing, but given how interest rates are the underlying source of profit growth, the valuation disconnect is striking. Chubb also buys bonds of several years’ maturities, locking in elevated rates for longer than ADP can, mitigating the near-term earnings risk of lower rates. I would value ADP’s noninterest income at 20x, given its recurring nature, and with slow growth, even that multiple may be generous. Given where banks and insurers trade, interest income should be valued at 10-12x. That argues for a blended multiple of 16-17x or about $160/share.

Even after its fall, ADP’s stock is too expensive, and as these results force investors to do a harder think on its medium-term growth prospects and the source of its profit growth, I would expect shares to continue falling. I recommend selling.