ADP injects life into human resources

​​​​​​No one pays much attention to HR systems until they go wrong. Tax codes, timesheets and retirement plans are about as exciting as Christmas 2020 proved to be, and are tempting to ignore.

Automatic Data Processing (US:ADP) allows workers to do just that, by providing employers with slick HR solutions. The American behemoth, which started above an ice cream shop in 1949, now serves 920,000 clients worldwide and manages 38m people's paychecks. It also serves (and pays) its shareholders, offering rich returns and reliable growth prospects.

Client fees are ADP’s main source of revenue. However, under its payroll service, the group also makes a sizeable chunk of interest on funds it holds for employers. Meanwhile, it enters co-employment relationships with certain businesses as part of its growing “professional employer organisation” (PEO) offer.

Recurring revenues and long-term client relationships underpin the group’s business model: ADP’s employer services arm retains clients for around 13 years, and its PEO division keeps hold of them for seven. Moreover, the group’s gargantuan size means no single client accounts for more than 2 per cent of revenues, meaning it is well-placed to withstand macroeconomic turbulence.  

Nevertheless, investors such as Polen Capital Management feared that pandemic-fuelled unemployment, combined with lower interest rates, might hit profits.

Such concerns, which resulted in Polen selling out of ADP, were not unfounded. In the year ended 30 June 2021, interest on funds held for clients fell to $422m (£318m), down $123m on the previous year. In total, revenue growth from employee services reached just 1 per cent in 2021 and earnings growth stalled altogether.

However, the PEO business, which accounts for about a third of income, enjoyed a 7 per cent revenue rise, while earnings before income taxes leapt by 18 per cent. And there are more opportunities as the world edges back towards normality. ADP has released a “return to workplace” dashboard for example, that uses data analytics and surveys to monitor workforce trends and track the vaccination status of staff. 

It is only when you look at ADP’s long-term performance, though, that its true value shines through. Its sales and profits have risen steadily over the past decade, and return on capital employed (ROCE) stands at a whopping 37.3 per cent. 

The group also features on the S&P 500’s 2021 "dividend aristocrat" list, which groups companies that have increased their dividends for at least 25 consecutive years. ADP makes this benchmark look rather unambitious, having boosted its dividends for the past 47. The group is also buying back shares to bolster EPS growth, with 8.2m shares repurchased in 2021. Consensus forecasts now expect EPS to reach $8.39 by June 2024.

There are a couple of less positive trends emerging. While still extremely high, ADP’s ROCE figure has dipped over the past couple of years, as has its capital turnover, which measures how effectively a company is spending money to produce sales. This shouldn’t necessarily worry shareholders. The group has upped its investment in systems development and programming, spending over $1bn in 2021 on the development of new products, maintenance, and new software and licenses. It’s possible that these investments have yet to bear fruit and have temporarily flattened returns.

That said, it is worth keeping an eye on ADP’s transformation programme. The group predicts that its customers will increasingly value data insights, including those derived from artificial intelligence and machine learning. The future might also be shaped by new privacy requirements and data protection rules, which could result in "significant costs" to the business and amendments to existing practices. 

ADP is robust, so such risks are unlikely to prove calamitous. Gradual adoption of new regulation – itself a form of economic moat for large companies – will struggle to rival the effects of a global pandemic, or the 2008 financial crisis. The group is priced at 32 times forecast earnings, which looks cheaper than some of its peers, and the first quarter of its new fiscal year has got off to a promising start. Automatic data processing may sound mundane, but ADP looks like an exciting opportunity for investors. 

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