Why Payroll Processing Remains Key For ADP’s Long-Term Growth

ADP (NASDAQ:ADP) has been a dominant player in the human capital management space over the years, with a strong presence in payroll processing and professional employer organization (PEO) services (or HR outsourcing services). The company’s core client base consists of large enterprise clients, with small and medium businesses (SMBs) making up a smaller proportion of the client base. ADP’s PEO services business have driven much of the top line growth in the last few years, but Payroll Processing continues to be the largest revenue segment within the company. ADP has witnessed high single digit revenue growth over the last few years, with Payroll Processing revenues growing at 6% annually to $8.2 billion in fiscal 2016 ended June.

According to our estimates, Payroll Processing makes up over 50% of the company’s valuation, generating roughly 70% of the company’s revenues.  We have an $87 price estimate for ADP’s stock, which is roughly in line with the current market price. ADP’s stock price has fluctuated between $77 and $95 this year. Below we take a look a few growth drivers for the Payroll Processing division and why it forms such a large part of the company’s valuation.

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Revenue Growth From Payroll Processing

ADP is one of the largest providers of payroll information, tax-filing services and organizing pension plans under its Payroll Processing division. Beyond payroll processing, the company provides time and labor management, employee benefits management and retirement administration services to its clients. Payroll processing revenues have grown at a steady 5-6% over the last few years. Growth was driven by a steady 4% increase in the number of clients served by the company, complemented by a consistent 2-3% annual price increase as shown below.

With a large customer base and a high retention rate of clients (over 90%), the company is in a strong position to generate solid revenue growth in this segment. We forecast ADP’s total number of payroll processing clients to continue to increase to over 750,000 clients at a CAGR of over 2% over the next five years.

 

Moreover, if the company continues to increase its fee per client in line with industry standards, its average implied fee per payroll client could increase from under $13,000 per client to almost $15,000 per client. As a result, net revenues from the payroll division could grow at a CAGR of 5% through the forecast period.

 

Payroll Processing: The High Margin Business

ADP’s cash operating expenses for Payroll Processing have increased at a slower rate than revenue growth due to economies of scale. As a result, the adjusted EBITDA margin for the Payroll Processing division has improved from 19.3% in 2011 to over 21% in 2016 as shown below. Comparatively, the fast-growing HR outsourcing business is a capital intensive division. Scaling up that division has led to higher operating expenses due to an increase in the number of worksite employees. Consequently, the company-wide EBITDA margin has compressed by around 150 basis points over the last five years to 21.4%.

We expect the revenue growth in the payroll division to continue to improve the division’s profitability. We forecast the EBITDA margin of the payroll division to improve further to around 23% in the next five years. Additionally, the company is likely to witness strong revenue growth from interest on client funds over the next few years due to the hike in interest rate at the end of last year. Since the operating expenses of the client funds interest segment are fixed in nature, revenue growth directly translates to an improvement in margins. As a result, the company-wide EBITDA could grow at a much faster pace than payroll division EBITDA as shown below.

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