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This is my first post. All research was done on my own. I used Gemini & GPT to help fact-check and improve writing clarity after my first-draft. I'm looking for other insights the community might have into ADP.
**Overview:**
Been around for 75 years, they handle payroll and HR for most of America. 1 in 6 Americans are paid through ADP, 80% of the Fortune 500 are clients. They specialize in mid-mega companies.
**How they make money:**
Companies pay A PEPM (Per Employee Per Month) subscription fee to use ADP. This means that a business pays a flat-rate fee plus a fee per employee per month. This scales to massive companies as their headcount increases. Employer Services accounts for 67% of their revenue.
ADP also makes the rest of its revenue through PEO Services (Professional Employer Organization). A company can sign up for this and effectively hand off all payroll, taxes, compliance, and employee benefits to ADP. ADP becomes the “Employer of Record”. Small and mid-sized businesses use this PEO service for the pooling effect. Essentially, a small firm can’t get great rates on its own for healthcare, etc., but with economies of scale through ADP, they can get much better rates.
Float: This is the best part of the business. A company might release funds to ADP on a monday and those funds get paid out on Friday. This allows ADP to invest the float, which might not seem like much, but with their scale, this is an incredible part of the business that goes directly to the bottom line. Last year, they made $1.19 Billion in Float (would be about 5.8% of revenue that goes directly to the bottom line).
**Forces work together to create a moat**
They have a few forces working in their favour. First, these large Fortune 500 companies dealing with 20,000+ employees can’t switch to another payroll processor easily. Once a company begins using ADP, it is very hard to leave; they have a 92% retention rate. Second, they have a global compliance “force”. They can pay people in 140 different countries with evolving tax laws. ADP has an army of lawyers and officers that smaller competitors cannot afford. Large companies cannot afford to deal with compliance headaches from small payroll startups. There is a saying, “Nobody gets fired for hiring ADP”. ADP also gets a ton of data on the US Job Market. They offer this data to businesses looking at the job market on “How much does a senior engineer in Seattle make?”
ADP loses low-end clients to startups and Intuit because a small coffee shop doesn’t care about such huge software and the higher cost. The risk is not that they lose them, but that they fail to win new ones.
**“A buoy stays afloat whether the tide comes in or goes out.”**
Not only is the float free money that goes directly to the pre-tax bottom line, but it is also one of the best natural hedges. As interest rates rise, the float earnings will naturally rise; meanwhile, other companies will struggle to grow. As interest rates decline, the float will decrease, but companies’ growth will accelerate and hire more people. The pool of float will increase, but the earnings from the float will shrink a bit. As companies hire more people, the other aspects of ADP will grow to hedge this. This phenomenon is one of the best inflation hedges in the world. Most companies can only hedge against inflation if they can raise prices. But ADP gets a hedge on both Price and Volume. Scenario 1: High Inflation -> Interest Rates Rise -> ADP earns more float. Scenario 2: High Inflation -> Companies give raises -> Float balance grows.
On the other hand, during a recession, ADP has proven to be stable. Other companies will get hit with lower consumer spending. However, ADP doesn’t deal directly with consumers. Companies are much slower to react by firing their workforce. Often, they don’t react and just slow hiring. During the 2008 recession, ADP’s earnings actually grew.
This is one of the best business models I have come across. They have a natural buoy that helps them stay afloat during hard times and gives them a boost to ride the wave during good times.
**Growth**
ADP is not a fast-growing machine. Revenue has a 6.5% 10yr CAGR, and a 5.6% 3yr CAGR. Their gross margin has increased from 43.2% in 2016 to 48.4% LTM. Once accountants get used to the ADP system, they usually recommend it to new clients. Also, monkey-see monkey-do effect: 80% of the Fortune 500 companies use ADP, so when a growing company with aspirations of becoming a Fortune 500 company sees what the top-dogs use, they are likely to follow. Their operating margins % net income margins have increased by 7% over the past 10 yrs as well. You are not buying a growth engine, you are buying an insulated cash machine.
**Financials**
Their ROIC is about 30%, WACC (Cost of Capital) is 7.3%. This means that their spread is 22.7%. Most companies achieve a spread of only 2-5%. For every dollar of capital they invest into the business, they generate a 22.7% return above the cost of that capital. This is pure value creation (insanity). ADP pays negligible stock-based comp and virtually no CapEx. They have a 108% cash conversion. They pay out 4% in shareholder returns (Buybacks + Dividends), which is less than the money they make from their float. ADP essentially generates more cash than it knows what to do with. They have a treasury-adjusted ROE of 14.9% (strong management) and a ROA of 4.7% (barrier to entry). They carry very little debt and have an excellent balance sheet. They have one of the best self-financing machines if they require cash (their float). Management will continue to increase their dividend (50yrs in a row) and buyback shares when appropriate ($6B approved right now). Warren Buffett once said, “I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.” This is a business a fool could run (hopefully it never comes to it).
**A Quick Note on the Inflation Hedge**
Most businesses fight to raise prices to consumers during inflationary periods. ADP has automatic pricing power through revenue streams. During inflationary periods, wages rise, which naturally increases ADP’s revenue (from their payroll volume). The other lever that fights inflation is their float revenue. The Fed typically raises rates to fight inflation, which has a huge impact on ADP’s float revenue. The float revenue flows straight to the pre-tax bottom line. The final inflation advantage is the B2B nature of their mission-critical software. Fortune 500 companies are able to accept a small increased fee on mission-critical payroll software; it ends up being a rounding error for them. In the opinion of many, the current US Debt levels are unsustainable. In order for the US to start paying off this debt, the government will likely want higher inflation levels. I believe that more inflation is around the corner. Even if I am wrong, there is no harm in making this bet; it is a “safe hedge” because we are safer if there is inflation compared to most, yet unaffected if there isn’t. We are buying a great business at a fair price that has multiple safety nets.
Here is a link to my Google Doc file that includes a research section with some math. Target entry price to obtain a 12% IRR over 10 years is somewhere between $212.31-183.16... [Google Doc](https://docs.google.com/document/d/e/2PACX-1vT870QFlcrQ_hQfr45kcosS8-Sh6T_vOUxAWNF9fMoRJNv5rB-YhQ4mn6IXzsoMSeu8JiZVOVESr9LO/pub)