Why We Remain Positive On ADP

by Trefis Team
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ADP (NASDAQ:ADP) has had a good start to its fiscal 2018. While the company’s fiscal 2017 performance was mostly in line with its guidance and market expectations, its stock reached an all-time-high of more than $120 per share after the release of the results, as investor Bill Ackman bought a large stake in the company. Though the market corrected itself a bit over the last few weeks, the company’s stock is still trading 4% higher than its price at the beginning of the year. Accordingly, we believe that the company has strong growth prospects that are reflected in its current valuation. We have a price estimate of $107 per share for ADP, which is in line with its current stock price. Below we talk about the key growth factors that will drive ADP’s value in the coming years.

See Our Complete Analysis For ADP Here

Source: Google Finance

PEO Services To Boost Top-Line Growth

With the growing preference of businesses to outsource their HR services, ADP’s revenue from its PEO services have grown at around 14.5% annually over the last five years. However, ADP’s overall revenue has increased at a rate of roughly 7% annually during the same period. Consequently, the proportion of PEO services in the company’s total revenue has gone up from less than 20% in 2012 to almost 28% in 2017. Since the global market for HR outsourcing is estimated to expand at a compound annual growth rate (CAGR) of around 12.7% between 2016 and 2020, we expect ADP’s revenue from its PEO services to continue to grow in double digits over the rest of the decade.

Further, with the implementation of the Affordable Care Act (ACA), the adoption of ADP’s products catering to the regulation has been increasing significantly, driving up its client base.  This is because large employers (+1,000 employees), many of whom were unprepared for the implementation of the regulation, are now choosing providers such as ADP to help them implement ACA solutions for their employees. As a result, ADP has seen a sharp rise in the demand for its PEO services, which is evidenced by the 9% annual rise in its worksite employees over the last two years. Assuming the ACA is not repealed in the near term, this is likely to continue. Given the rising demand for PEO services, we forecast ADP’s total worksite employees to increase to over 740,000 employees by 2024. Based on company guidance, we expect ADP’s PEO services revenue to grow by 11% to 13% in the current fiscal year.

Payroll Processing Will Continue To Be The Core Business

While ADP’s PEO services business has driven much of the top line growth in the last few years, payroll processing continues to be its core business, contributing the largest portion of its top-line. The company’s revenue from its payroll processing services have grown at a steady rate of 5% annually over the last five years, driven by stable growth in the number of clients served by the company, and an annual rise in client fees. Although the share of the division in terms of ADP’s total revenue has dropped from 75% in 2012 to about 69% in 2017, it accounts for almost 65% of the company’s total valuation, according to our estimates.

With a large and growing customer base and a high retention rate of clients of (over 90%), the company is in a strong position to generate sustained revenue growth in this segment. Based on the company’s guidance, we estimate ADP’s total number of payroll processing clients to continue to grow consistently at a CAGR of 2% and reach 740,000 clients by 2024. Moreover, if the company continues to increase its fee per client in line with industry standards, its average implied fee per payroll client could grow from a little over $13,000 per client in 2017 to almost $16,000 per client in 2024. As a result, net revenues from the Payroll division would grow at a CAGR of 5% through our forecast period.

In addition to the steady growth, ADP’s payroll processing business generates a higher EBITDA margin compared to its PEO services. The company’s operating margin from payroll processing has increased from 20% in 2012 to around 24% in 2017, while the operating margin for its PEO services has remained stagnant at 12% over the last five years. Thus, we figure that the growth in the company’s Payroll division is likely to trickle down to its operating profits much faster than its PEO services. As a result, we expect the sustained growth in ADP’s core business to boost its bottom line going forward and drive the company’s future value.

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