Saturday, September 11, 2010

ADP Investment Thesis / Stock Analysis

ADP is in the business of handling human resource and payroll processing operations for its customers. It is part of the data processing or back room operations outsourcing industry. This industry has been around for some time, and cuts across many industries and business functions. For example: Public listed companies outsource their shareholder and investor relations services to companies like ComputerShare; Financial institutions outsource their banking and payments back room operations to firms like BR, FISV, JKHY, and FIS; and many companies outsource their accounting and back office functions to service providers like WNS and Genpact. Companies can even outsource their payments processing to service providers like TSYS.

ADP's business and competition

ADP handles three main types of business operations: (1) the processing of company payrolls, (2) hiring employees and attaching them to customer companies (the business of being a Professional Employer Organization), and (3) the handling of core business processes of auto dealers.

ADP's 2010 revenue was approximately USD 9b, and its closest competitor PayChex had 2010 revenue of approximately USD 2b. There are a number of other competitors, though none close in size to ADP, such as
ReyRey (Dealership software)

The economics of the outsourcing business

The value proposition of business operations outsourcing is that the outsourcer is somehow able to carry out the outsourced operation better than the company can. This implies two things:
  1. that the process is not a competitive differentiator. Otherwise, the firm would cede its economic position over time.

  2. the process itself must be one subject to an economic effect (such as the "economies of scale", "economies of experience", or "the tragedy of the unregulated commons"), so that by operating the process for many companies, the outsourcer can deliver more value to each individual company than if the individual company were to do it itself. Otherwise, there is no value to outsourcing the business process, unless it is for accounting (expense vs capex, expense vs overhead) presentation or business strategy/focus reasons.

    If follows that if this is the case, then any company that does not subscribe to an outsourcer's services will be disadvantaged compared to similar companies that do use an outsourcer's services. When outsourcing truly adds value, then it almost tautologically creates a self reinforcing feedback loop. Companies who use the pooled services get benefits they otherwise could not obtain on their own, which leads to other companies also joining the pooled services so as not to be disadvantaged, which further leads to even more benefits to pooled members.
We can validate whether an outsourcer is truly creating economic value by reviewing the long term business record and retention ratios of the industry, covering at least 3 contract renewal periods. This will negate the artificial growth in cases where outsourcers do well in the short term (as companies try them out) but where the true long term benefit is elusive. An outsourcing industry and/or an outsourcer that grows and is profitable over the long term suggests evidence that: (1) the process it operates is not a competitive differentiator for its clients, and (2) there are factors that allow it to enjoy economic effects by pooling client operations.

In the case of human resource and payroll outsourcing, the long term record of ADP and PAYX (PayChex) suggests that the operations do indeed add value for their customers. The question for us then is whether this will persist into the future; whether future technology, laws, tastes and zeitgeist will allow the ecological niche that they occupy to continue to exist.

The ecological niche sustaining the PEO and HR payroll outsourcing industry

Over the course of history, changing tastes, technology, demographics, cultures and political economy allow conditions to arise that make room for new types of businesses. These ecological niches come and go over the epochs of history.

ADP's industry was made viable with the arrival of computers, which allow data processing to be subject to the economic effect of economies of scale. Because once a mainframe was purchased, the incremental cost of processing an additional unit of data is marginal. (As compared to pre-computing age, when this data processing was done by people) The high capital investments needed in mainframes, software and data processing technology magnified the economies of scale effect in this business.

The secondary force contributing to this industry's viability was that HR and payroll practices were becoming increasingly standardized across companies, and that for regulatory and other reasons, these processes were becoming increasingly burdensome to operate considering that they did not confer competitive advantage to the company.

This created the ecological niche for PEO and payroll processing companies. ADP and PAYX executed well, and are now the two dominant players in this industry. It is not uncommon for a few firms to dominate in industries that enjoy economies of scale or other economic effects that favor size and/or experience. (Conversely industries such as construction aggregate quarrying, cement manufacturing and flour milling, that do not allow for economies of scale or have products which are not cost effectively transportable, tend to be fragmented and have many small players. Michael Porter's book "Competitive Strategy" discusses this at some length)

Valuation and business prospects of ADP
(aka: How comfortable are we capitalizing the next 20 years of ADP's earnings; and what are those earnings going to look like?)

The need for payroll processing and operating HR processes is eternal. But the earnings quality, ability to earn supernormal profits, and the strength of ADP's business depends on:
(1) The sustainability of the ecological niche in its current form, and
(2) ADP's competitive position within this niche
(3) ADP's prospects for growth

Sustainability of the ecological niche: Whether this ecological niche will continue to exist in its current form depends on:
  1. Whether data processing will continue to be a high capital cost endeavor that enjoys economies of scale. As long as the capital investments needed to achieve the current operating costs that ADP is achieving is relatively high compared to each individual company's operating budget, then the ecological niche will continue to exist in its current form. There are 2 foreseeable threats to this:

    (a) The lower cost of computing, driven by the increasing maturity of distributed systems and middleware, as well as online Cloud Platforms like Amazon EC2 which make it easier for a competitor to start a hosted software/data processing operation without incurring huge upfront capital expenses. This could open the door to a more fragmented industry with many small players, which would erode the competitive advantage that ADP's size confers to it today.

    (b) The structure of the economy changes and the number of SMEs/SMBs decreases meaningfully compared to the number of large enterprises. Large enterprises are more likely to be able to afford the capital investments needed to run their own operations at a scale where they would enjoy economies of scale.

  2. Whether the cost of processing payroll/HR is going to get more complicated and the penalties for lapses more severe. In other words, will there be increasingly complex rules and laws to obey, with increasing costs / penalties for compliance failures or errors in processing. If the rules for HR and payroll processing become simpler, with few penalties / business costs for processing them wrongly, then the cost-benefit of outsourcing this work to a dedicated service provider will become less attractive.
The major megatrends that we know of today, namely (1) the adoption of
Internet technology and the Internet generation mindset, (2) increasing
Oil and Energy prices, (3)
Aging demographics, and (4)
China and India joining the world economy, are unlikely to affect this ecological niche.

Sustainability of its competitive position: ADP's competitive position in the current ecological niche is excellent.In an industry which enjoys economies of scale/experience, being the largest player allows you to operate at the lowest cost and offer the best prices to your customers. And price is likely to be one of the primary deciding factors for ADP's customers, since the processes being outsourced are relatively standardized and not a source of competitive advantage. In this regard, being almost 4 times larger than its next nearest competitor PAYX, ADP has a wide competitive moat.

Where is the growth going to come from: By most estimates, the vast majority of businesses in the United States (and the world) have not yet outsourced their payroll and HR operations. This leaves enormous room for growth, whether or not the macro economy does well.

What can go wrong / How ADP can screw it up

Assuming ecological niche remains as it is, the one thing that could torpedo ADP's earnings stream is if ADP messes up. The fundamental business value that ADP provides is that of cost-effectively handling business processes for businesses. In most cases, it is probable that the most competitive player is the one with lowest cost, and best record of risk mitigation.

The forseeable ways which ADP could stumble and cede business to competitors are:
  1. ADP loses customer data or otherwise fails to deliver its services properly, causing a flight of confidence to other service providers, or
  2. ADP fails to keep up changes in HR / payroll regulations or new business process needs, and allows a competitor to grow by servicing the new requirements, or
  3. ADP's management forgets its source of competitive advantage and allows its cost position or pricing to gradually drip upwards, creating room for a competitor to sneak it and steal its customers.