By Stephanie Crane
We at Standard & Poor's Equity Research Services believe Automatic Data Processing (ADP; recent price, $42) represents a good way to play the momentum we see from increasing employment and an accelerating push by corporations to outsource nonstrategic operations associated with employees, such as payroll, health and retirement benefits, as well as recruitment and hiring.
Information technology outsourcing has traditionally been a defensive sector relative to other IT areas, in our view. We believe recent trends in the economy -- notably improving employment statistics, a more solid investment landscape, and rising interest rates -- should benefit ADP, particularly since they're potential catalysts to top-line growth and improved margins. We also expect to see ADP benefit from a growing shift into business-process outsourcing, as it leverages several strategic partnerships, including one with SAP (SAP; 4 STARS, buy; $41).
Our 5 STARS (strong buy) recommendation on the shares is based on valuation, as well as several potential catalysts, including expected improvement in the job market, which we see aiding payroll providers such as ADP in 2005.
Roseland (N.J.)-based ADP is the largest global provider of services related to human-resources outsourcing, payroll, tax filing, and benefits administration. ADP provides a broad range of data-processing services in four business segments: employer, brokerage, dealer, and claims. It serves over 550,000 clients and between 45 million and 50 million employees. The company processes the paychecks of nearly 30 million workers worldwide.
Its employer-services division, which accounted for 62% of revenues in fiscal 2004 (ended June), provides payroll, human-resource, benefits-administration, time and attendance, and tax filing and reporting services to more than 460,000 clients in North America, Europe, Australia, Asia, and Brazil. ADP TotalSource is the third-largest professional employer organization in the U.S., providing outsourced services to clients, including payroll, human resources, benefits and workers' compensation.
Brokerage services (21% of revenues) include securities processing, desktop productivity applications, and investor-communications services to the financial-services industry. The company is the largest provider of securities-processing services in North America. ADP handled an average of 1.4 million trades per day in fiscal 2004, 7% greater than the level of fiscal 2003. It also processed more than 850 million shareholder mailings.
ADP's dealer-services unit (11%) provides transaction systems, data products, and professional services to automobile and truck dealers and manufacturers worldwide. Claims services (5%) offers a broad line of products to help clients accurately estimate auto damage, bodily injury, and property claims.
ADP acquired several businesses in fiscal 2004 at an aggregate total cost of $270 million. Recent significant acquisitions include the U.S. clearing and broker-dealer services divisions of Bank of America and the 401(k) retirement services record-keeping business of Scudder Investments. ADP plans to continue making strategic acquisitions to spur growth.
During 2004, the employment landscape greatly improved, in our view, with nonfarm payrolls increasing by 2.2 million, the bulk of which was added from March through May. The year ended with unemployment stable at 5.4% and an additional 157,000 jobs added in December. In 2005, we expect to see the Bush Administration focus on adding 1.2 million more jobs. We believe that should benefit payroll providers, and especially ADP, which has the majority share of this fragmented market.
Furthermore, we expect the White House to implement a plan to lower employee-related costs including health care. We believe any effort to highlight cost-reduction efforts related to employee expenses will benefit payroll-solution providers such as ADP by raising their profile.
In our opinion, employment's growth in 2004 and its expected increase in 2005, coupled with increases in staff costs, should serve as significant catalysts for adoption of ADP's human-resource and employee-benefits services. These are designed to enable businesses to minimize the back-office costs associated with employees, while at the same time reap gains from productivity and efficiencies.
The human-resources market, estimated to increase 11%, compounded annually, by 2008, according to researcher IDC, remains fragmented, which we believe should offer ADP significant opportunity for market-share gains. The outfit has the largest share of this market, roughly 7%, trailed by Mercer (4%), Hewitt (3%), and Fidelity (3%). By Stephanie Crane
In the U.S., the employer-services/human-resources market is based on 149 million employees. The international arena offers 195 million to 200 million employees. In total, the revenue opportunity in America ranges from $45 billion to $60 billion, with an additional $20 billion to $25 billion opportunity from globally. Of the U.S. pie, 25% to 30% of the targeted opportunity comes from small businesses. The midsize market accounts for the largest opportunity, ranging from 45% to 50%. Large companies make up another 25%.
ADP's employer-services offerings are increasingly value-added, in our view, as well as diversified, which we think should enable it to expand its share of the payroll-processing market. New business is increasing in double digits, and client retention remains strong.
The outfit has also diversified its client base within the four key markets: Small businesses (from 1 to 49 employees) make up 16% of employer-services revenue. Major accounts (midsize companies of 50 to 999 employees) make up 32%, and national accounts (1,000-plus) 23%. International makes up 14% of segment sales. ADP has recently seen increased momentum from small concerns as well as the midsize segment, which helped boost new business by 19% in the fiscal 2004fourth quarter and 6% for the full year.
Business-process outsourcing (or BPO, a market expected to grow over 20% by 2008, according to IDC) has become a logical offshoot for human-resource-services providers. Given ADP's strength as a provider of human-resources and payroll services, we see its efforts to build a presence in BPO as very positive, leveraging benefits from solid margins with little upfront investment. The company already has 20 clients in the U.S. related to BPO. In May, ADP partnered with SAP, combining its human-resources BPO offerings with SAP's application platform on a global basis.
We see revenues increasing 5.7% in fiscal 2005, to $8.2 billion, compared with 8.5% growth in fiscal 2004. We expect quarterly revenue and earnings growth to accelerate in the second half of the year, on favorable comparisons for interest rates (which should increase the return to ADP on funds held for clients) and corporate investment spending, along with a moderate recovery in employer, dealer, and brokerage services.
We expect the employer-services segment to grow in the high single digits, aided by recent acquisitions, strong customer-retention rates, and upward trending payroll data. Brokerage-services revenue is likely to increase in the mid-single digits, with 9% growth in transaction processing and 3% in investor communications. Dealer and claims-service revenues should each rise in the mid-single digits.
DOING THE MATH.
We think that operating margins will widen in fiscal 2005, benefiting from $170 million in investments to internal operations -- including sales-force compensation, facility exit costs, and product-maintenance costs -- made in fiscal 2004 to glean greater operating efficiencies. We also expect pricing to stabilize further into 2005, and see a benefit to margins from a shift towards more value-added solutions. As such, we anticipate operating margins will reach 25% in fiscal 2005, compared with 22.5% in fiscal 2004. We see fiscal 2005 operating EPS increasing 17%, to $1.82, from $1.56 in fiscal 2004.
Our fiscal 2005 Standard and Poor's Core Earnings estimate is $1.58, vs. our operating EPS estimate of $1.82. The 13% difference reflects estimated stock option and pension expense. In fiscal 2004, ADP's S&P Core EPS was $1.38, an 11.5% difference from operating EPS of $1.56.
The stock is trading at a discount to our 12-month target price of $54. Our target price is based on our discounted cash-flow analysis and additional relative multiple analyses (including enterprise value to sales) based on a peer group of companies.
WHERE THE RISKS LIE.
We believe the shares deserve a premium valuation to peers, based on our view of ADP's market-share leadership, healthy balance sheet with $1.1 billion in cash and securities in 2004, and strong cash-flow generation.
Risks to our recommendation and target price stem from competition in the BPO market, which could pressure pricing and profit margins downward. A weaker-than-anticipated increase in the nonfarm payroll in 2005, coupled with slower adoption of solutions aimed at the payroll market, could stymie top-line growth.
Analyst Crane follows IT outsourcing stocks for Standard & Poor's Equity Research Services