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Morningstar | ADP Continues Improvement in 4Q

Wide-moat Automatic Data Processing finished its fiscal 2018 with GAAP revenue growth of 7.6% as the company benefits from improved retention and growing labor markets. Much of the improvement has come from employer services, which expanded segment margins by nearly 200 basis points. However, this margin number excludes the $365 million charge related to the company’s ongoing transformation initiatives. For full-year 2018, we calculate fiscal operational margins of 19.7%, comparable with the previous year. Going forward, we will be looking to see how employer services margins increase after the restructuring charges taken during the quarter. ASC 606 will slow the recognition of some expenses, and adjusting for those items, we anticipate ADP will see revenue growth of around 5% and earnings per share of $5.10-$5.25. Though accounting changes will have an impact on the company’s income statement, we’ve made no material change to our outlook for operating cash flow. We'll be updating our model to reflect full-year results and 2019 guidance but do not anticipate any material changes to our fair value estimate of $96 per share.

Based on the company’s segment numbers, ADP’s margins are headed in the right direction. However, these numbers exclude one-time items resulting from ADP’s transformation initiatives. In addition, we’ll be trying to assess the long-term effectiveness of these cuts. For now these cuts don't appear to have affected employee satisfaction, given that ADP’s Glassdoor employee ratings have modestly improved from the previous year. We find this somewhat impressive considering the ongoing restructuring. Overall, we think this is mildly encouraging. However, we will point out that Paychex, ADP’s closest rival, has achieved better reviews from its employees.

We eagerly await to study how ADP’s margins develop over the next year and will be paying particular attention to operating expense growth each quarter. ADP’s workers’ compensation business will now be included in the presentation of its PEO numbers. Though we agree that this should probably be considered a part of ADP’s PEO business, this may make comparability more challenging, as the segment’s numbers will now include frequent reserves builds and releases.

During the fourth quarter, investors were probably disappointed by the step back in the company’s retention rate. Retention fell 1.2 points after improvements in three of the last four quarters. Management attributed this to the company’s compensation solutions business. Though we’ll be monitoring this number closely, compensations solutions isn’t a part of payroll, the area whose retention will have the largest impact on ADP’s growth. Given that ADP’s retention in payroll remains strong, we’re likely to dismiss this as quarterly noise.