Automated Data Processing Stock: Don’t Underestimate the AI ​​Threat (NASDAQ:ADP)

ADP investment thesis

Since I wrote my first article on Automatic data processing (NASDAQ: ADP) last September, the company unfortunately underperformed the S&P 500 ( SPY ). to at the time I thought the stock was fairly valued, but now I have to change my mind and believe the stock is currently overvalued. Even if only a little.

I also think the AI ​​threat is bigger than we first thought, which has clouded the outlook a bit for the future.

A quick overview of automatic data processing

ADP is a leader in human capital management, providing payroll services to companies large and small. This distinguishes the company from its competitors, some of whom specialize in small or large companies.

Due to high switching costs, customer retention is currently 92% in an estimated $150 billion market. And this market is expected to grow 5% to 6% annually, while ADP believes it can exceed this growth rate and achieve an annual revenue growth rate of 7% in the future.

In line with current trends, ADP has also embraced the idea of ​​using AI to optimize workflows and create value for customers. For this, they have ADP Assistant, but also Next Gen Platform, which connects several platforms into one.

Growth opportunities remain in international business, which currently accounts for only 11% of revenue, and in developing additional areas in companies that currently use the platform only for payroll. Examples include analytics, benefits, and data management.

From a balance sheet perspective, ADP is also well positioned as it has a 13x EBIT/interest multiple and with $2.9 billion in cash, it could pay down $2.9 billion in long-term debt if it wanted to .

Peer comparison

ADP is way ahead of the pack when it comes to the return they earn on their capital, even though Paychex, Inc. (PAYX) and Paycom Software, Inc. (PAYC) also have fantastic ROIC numbers. From a ROIC-WACC spread perspective, ADP has a spread of about 42%, assuming a realistic WACC of 9%. This tells us that ADP’s management is capable of generating high profits and that barriers to entry and competitive advantages were in place to protect ADP’s earnings.

And despite being the highest-quality company in its peer group, ADP still trades at a relatively modest 21x EV/EBIT multiple. Workday, Inc. (WDAY) and Dayforce Inc. (DAY) is currently trading at exorbitant multiples that I believe are even too high for the nearly 20% revenue growth it is currently experiencing.

ADP, on the other hand, could trade at a higher multiple than Paychex. But that’s more because I think Paychex’s multiple is a bit too high right now. Paycom, on the other hand, has already seen a lot of multiple compression as the stock has fallen from its 2021 high of nearly $550 to ~$160 today.

Inverse DCF

One of my favorite ways to value a stock is with an inverse DCF because it allows you to see what the market is pricing in. And in ADP’s case, the market is currently pricing in 12% EPS growth over the next 10 years.

But in the last 10 years ADP has only achieved ~11% per year and I think the competition is stronger today than 10 years ago and therefore I think it will be difficult to get the same EPS CAGR and it will be lower in future.

ADP’s own guidance is for EPS growth of 11%, which is also slightly below the implied 12%, underscoring that the stock is currently slightly overvalued. In my last article, the market was priced right at that 11%, which is why I thought the stock was fairly valued at the time.

Allocation of ADP capital

ADP buys back 1% of its outstanding shares each year, while SBC’s is relatively small, leading to a steady decline in outstanding shares. As the number of shares outstanding continues to decline, so does the amount of money you have to spend each year to redeem 1%, unless SBC blows up.

This means that more money is available each year to invest in growth or that share buybacks can be increased at some point. All thanks to a net income growth rate of about 10% per year over the last 10 years.

Another important part of ADP’s capital allocation is its steadily growing dividend, which has grown nearly 12% annually over the past 10 years. Therefore, I think the stock is attractive to investors who are focused on dividend growth or who are already in the consumption phase because the dividend growth rate is well above the rate of inflation.

ASSESSMENT

I think in the case of ADP, we have to use conservative assumptions because I think the threat of AI could be a big disruption to that industry. Therefore, I believe a sales growth rate of 5% is appropriate, as well as continuous buyback of 1% of outstanding shares per year.

In terms of net profit margin, I think the 5 year average of around 18% is a reasonable starting point, but I tend to think a 20% margin is more realistic given the potential that AI offers ADP . As an exit multiple, I think it could be 27 times over 5 years.

So this would lead to the following outlook over a 5 year period:

Click to enlarge

Again, this pattern, as well as the inverse DCF, shows that I believe the stock is currently overvalued. For me personally, a 90% to 100% upside over the next 5 years is the hurdle I use, and at the current share price, I don’t see that upside for ADP. For this to happen, stocks would either have to get cheaper or the future outlook would have to become much more positive.

risks

The news that Klarna no longer needs Salesforce (mRCC) and Workday due to artificial intelligence could have huge implications for the human capital management sector. In the past, most companies downplayed the threats posed by AI, saying that AI would make them more efficient and that they would use the technology to improve their own operations.

But the fact that a company as large as Klarna no longer needs two established software providers gives me pause for thought. If this trend continues, it could lead to severe revenue losses for many companies or even entire industries disappearing into Nirvana.

And of course ADP has a lot of data, and ADP Assists itself is an AI offering, but I think this could be an industry that’s going to be very disrupted by AI. Until now, the high cost of switching has always been an argument for maintaining ADP’s competitive position, but if AI can be used in-house to develop a solution that is nearly equivalent, the cost of switching would drop dramatically.

Conclusion

Without the Klarna news, I would have continued to say that the stock is only slightly overvalued but not far from fair value, but the new threat makes me think the risk has increased. And I think this new risk should be properly priced, so my outlook has deteriorated a little bit and I think the stock is currently a little too expensive to trade at fair value. That said, ADP is still a fantastic company that just got a strong competitor in AI.