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Morningstar | ADP Off to a Quick Start in Fiscal 2019; Shares Remain Overvalued

Wide-moat Automatic Data Processing got off to a strong start to its fiscal 2019. ADP grew top line revenue by 7.9% from the previous year ahead of our full-year expectations closer to 5%. Revenue net of pass-through expenses (the number that really matters) grew by 11.6%. It would be fair to say that ADP is seeing some exceptional growth. Much of this was driven by ADP’s impressive performance within its PEO business. PEO operating income grew 24% to $145.9 million while segment margins improved 280 basis points. Given this favorable result, management upped its guidance. The company now expect revenue growth to be in a range of 6% to 7%, 1% higher than its previous guidance. We’ll be adjusting our model to reflect this improved near-term outlook, but do not anticipate any material changes to our model. We’ll be maintaining our fair value estimate of $102 per share. Currently, shares are trading at more than 27 times our estimate and nearly a 40% premium to our fair value estimate. Given this, we think the stock is expensive.

Much of the controversy around ADP has centered around its ability to raise margins. During the quarter, ADP’s employer service margins jumped to 27.3%, a year-over-year increase of 260 basis points. Total pretax margins increased 1.1% to 19.5%. If we exclude the impact from pass-through expenses, we calculate ADP generating pretax margins of 24.2%. However, we think this margin increase likely benefited from the previous quarter’s $365.3 million charge related to restructuring initiatives. It appears ADP is benefiting from a temporary reduction in staffing and some pull forward in expenses related to its voluntary retirement program. Management has been transparent about this and fully communicated that this quarter’s margin improvement will not continue the rest of the year. We anticipate that ADP will give back some of these gains during the remainder of the year.

Finally, we found management’s discussion around incentives interesting. CEO, Carlos Rodriguez discussed tweaking incentives that has resulted in “big improvements in the upmarket…But not necessarily yet affecting the numbers.” We don’t know what these incentive changes are, but would guess that sales people were previously incentivized to book sales by fiscal year-end and now are being incentivized to book sales each quarter. This might explain Rodriguez comment a few sentences later discussing how ADP historically has gotten off to a weak start in first quarter. Our only other guess is that ADP is rewarding employees across all departments to share leads with each other. This makes sense, but it would potentially require ADP to pay its employees more, something management would probably like to avoid. In addition, we would think it’s challenging to implement changes this quickly.