Automatic Data Processing, Inc. (ADP) Earnings Call Transcript & Summary

Good afternoon, investors. My name is Pete Christiansen. I'm on Citi's IT services, payments processors and IT services equity research team along with our fearless leader Ashwin Shirvaikar. This afternoon, we're pleased to have ADP join us. We have CEO, Carlos Rodriguez; CFO, Kathleen Winters; and everybody knows Danyal Hussain, in IR. So with that, why don't we kick it off? Good afternoon. Thank you for joining us.

Thanks for having us.

Great. Wonderful. So Carlos, I think I want to start with rehashing and reviewing some of the things that have happened recently with COVID. But I think more -- we want to spend more time focusing on the longer-term impact COVID may have on the business and how you see the payroll space evolving in general. And then, of course, some interesting -- some thoughts along the way as it relates to elections. So first, I think one of the things that's been apparently clear is that the payroll business, the HR HCM business has gotten a lot more complex in recent months. I was wondering if you could discuss and provide some examples where you feel that ADP has been able to differentiate its client service capabilities in performance in the HR HCM marketplace.

Sure. Thanks. This actually was a good opportunity to do that. It was a very bad thing that has happened for a lot of reasons. And I'm sure we're probably not the only industry, but there are probably select industries that we're able to really show the strength of their value proposition, how they could help clients and, frankly, help society in general because what could be more important than people still getting paid. And we obviously saw very elevated levels of unemployment and a lot of people losing their jobs. But if on top of that, you would have had massive disruption to people's paychecks. It could have been a bad situation. Or frankly, even disruption to tax collections and other things that some of us do in the industry. So I think that's number one that I -- we're very proud that we kind of made it through and we're able to help our clients, our country and also, frankly, many other countries as well where we operate. One of the things that really, I think, stood out is really the difference between what I would call a pure software model and an outsourced model where you're really getting the software, but also with the services, if you will, or the support. And by that, I mean compliance support. And what we saw here, and this is really in every country was governments, as they always do, using employers as instruments of public policy, but we've never seen as the speed with which they did that. And so putting in place, for example, things like tax credits and mandatory requiring clients to provide time off if people were sick, whether or not they had that as a policy or not. So there's a very long list of changes that took place, not just in the United States, but in many countries. They had to be done quickly, right? The government didn't say you can take them until next week and to comply, in most cases. It was, here's a decision you have until Monday or next week to comply or you have to comply immediately. And so when companies find themselves basically in survival mode, which is what they were to then have to worry about all this other stuff and how to accomplish all that stuff was not really a great place to be. So I think that one of the great differentiators and examples of our value proposition is for our clients, that's not something they had to worry about. So when they, for example, had to apply for a PPP loan, which was the program that the government put in place to help small businesses, we had hundreds of thousands of clients who went to our website and basically downloaded the reports that they needed to go to the bank and get their loan. That's very different from having to sit there and figure out how you're going to do that on your own. Not only were you able to get those reports yourself, if you were inclined to do that, but you also were able to contact someone and ask them questions about, well who do I include? And should I be including 12 months' worth of wage data? Is -- does overtime get included? Because these things always sound simple when they are announced by the government. But they never end up being simple from an execution standpoint. So whether it's the PPP loans or the tax credits or the kind of 1,000 to 2,000 regulatory changes, I think that what I would call full-service outsourced model, I think, shined. And that doesn't mean that the software models didn't work because I think in most cases, they did but it helped now create, I think, a little bit of a differentiation between one model versus the other. And we think that medium to longer term, it will be an advantage for us from a marketing and sales standpoint to give people examples of what we were able to do for our clients and what maybe they didn't have available to them if they were not using anyone to help them or if they were using someone that really provided them just a software, but without the support.

That's helpful. One of the things I wanted to chat about was -- and you've mentioned this on previous calls as some of the internal readings that you've been following or ADP has been following. And certainly, we get to see the unemployment data that comes from ADP Research, but also from the government. But I think it's been helpful the color that you've delivered as it relates to some of your internal readings like the job listings, which -- the JOLT data that came out today was very positive. But also things like background checks and clock-in times and all that. Maybe it would be helpful if you can talk about how that has evolved. Maybe in the last couple of months, there's this notion that we've plateaued after many states have reopened. What are your thoughts on how some of those readings have moved recently?

Well as you said, like we definitely have no shortage of data, right? And I think sifting through the data is helpful and -- but also can be confusing because you really have to, in some cases, get down to the state-by-state level. It wasn't necessarily true in April and maybe early May. But then you did have a divergence, right, of what was happening in terms of state activity, and that divergence wasn't consistent. So you had states that reopened and showed big improvements in employment, particularly in small business, but then had partial closures later in, call it, July, which then caused a plateauing, and in some cases, in a few states, actual declines again in employment based on the data that we have. So it's really all over the map, if you will, once you got out of the trough. But when you take it on balance in the United States at least, the -- what we have seen is a very steep decline, which everyone is aware of. And then a, I would say, a relatively steep recovery in small business, which I think surprised some people. And then a little bit of a lag in terms of some of the decline in layoffs and so forth for midsized and large-sized companies. And then those 2 converging. And in the last, I would say, many weeks have been kind of tracking in a similar direction, which is a gradual slope upward, but I would say, emphasis on gradual. And that doesn't mean that every state is equal, right, because you had some states that were in a slight downward slope and others were in a slight upward slope. You had some that were steep or some of them were shallower, but the average for the United States was what we would call it gradual slope upward, which is then what you see reflected in kind of the macroeconomic unemployment data that you see reported by the government. The difference is, of course, we have it by state. We have it every week. We have it by verticals, by industry. So we just have greater depth of information and data. But that's a general characterization of what happened.

Now how do you see those trends in the various areas that you called out up market, downmarket and then certainly different states? Have you seen the -- your selling trends mirror that image? Or has there been a relationship between the two? So for instance, if downmarket kind of came back up very quickly, did you see your sales activity -- new sales activity pick up in downmarket, for instance, during that period? Or has there been any congruency between the two?

The tricky thing is obviously, I really can't talk about anything other than through the end of the quarter because we haven't made any public statements. So I appreciate you're trying to get it out of me, but I can't really talk about that. But I can tell you that within the quarter, July -- June was better than April, for sure. And certainly, the downmarket was better than the rest in June, if that helps. And then I think we did give some color like Danny maybe can help me, so I don't see anything wrong. But I think at a conference -- when we did our earnings call, we did say that in July, because the earnings call was at the end of July, if I'm not mistaken, sometime at the end of July. And based on our tone and our guidance, I think you would expect that they would have been, at least through that point, a correlation between the GDP growth, the unemployment trends and then bookings and sales and so forth and so on. I mean it's -- I think it's worth asking, it's the right question, but we've never been able to escape, maybe just because of our size, but like if the economy catches something, we catch it too. And likewise, if the economy is on fire, we tend to benefit. And so I think you should expect that we will follow the general macroeconomic conditions subject to, of course, execution being a factor, right? And that's really in our hands. And if we execute well, we'll do better than the competition. And if we don't execute well, we won't. But the backdrop is definitely important.

That's helpful. Now looking longer term, how does ADP see the pandemic influencing the HR HCM marketplace services, but also on the product development side? And do you believe that there will be an impetus to go to more outsourced models as a result of some of the hardships that -- or complexities that people have dealt with in the last couple of months? Do you see that as an eventuality?

Yes. I mean, I think the difficult part is going to be how do you prove that, right? Or what's the evidence other than waiting until it happens and then you celebrate after it's happened. But it's hard to point to like is there going to be a government regulation, for example, that says, which I think it would be great if they had one that says, everyone must use ADP or use someone like ADP, so that they're able to pay their taxes and pay their people and so forth, right? We're a critical infrastructure, like we -- I don't know if anybody -- people really are aware of this, but we were deemed in a central business largely because of ADP's efforts in Washington, D.C. In the first few days of the pandemic on a federal level, we were deemed an essential business. And then we also -- by the way, we work with our partners in the industry as well even though they're competitors. Most of the time, at that point, they were a partner. So we have an association, and we all, with us as the leaders, went to our friends in D.C. and told them, we're going to need some support here and some help because the last thing in the world we need is on top of everything else, with unemployment and everything else that's happening, we don't need disruption to the financial system and to people getting paid. And so we got that support, and then we got it because a lot of the states followed the federal advice or federal guidelines. We were deemed an essential service in almost every state as well. Because, again, every state had to publish rules around who was allowed to operate, who wasn't allowed to operate, who could be on the streets, et cetera, et cetera. So for example, as much as we have a very large percentage of our clients taking electronic payments, direct deposit, et cetera, believe it or not, there's still people getting paid by check. And those checks had to be printed, and they had to get on FedEx trucks and they had to get delivered. Otherwise, people aren't going to get paid. And you would have seen that in the front page. So the good news is you didn't hear about that. That's the way we like it because it would have not been a good story if you had heard about thousands of people in whatever state or whatever company that didn't get paid and didn't know where they were going to get the money to pay for their groceries and so forth. So we are -- we're clearly in a central business. Now the question is, can we translate this tailwind in terms of the recognition of how important the services are to a marketing effort, if you will, that will translate into better growth and more revenues for ADP post normalization, if you will, because you also have to have a more normal environment in order to have that kind of a campaign. I think that is definitely our plan. I think it will happen. What is the -- how do I quantify the impact? I can't tell you, but it's better than the alternative, right? Like the -- having someone decided they're going to do a flat tax, would be bad for us. But going through -- because it makes everything simple and like why you need someone to help you with your compliance when everything is kind of simple, when there's -- if there were federal health care, flat tax, like there is a scenario where it's not as great a value proposition. Although there's still a value proposition there, this was the opposite of that, right? This is very compelling to go use an outsourcer like ADP, who not only make sure that the platform you're using is up-to-date with all the regulatory changes, but that there's always someone there also to help you, right? If you don't understand something or you're not sure what to do, right? That additional level of support when it comes to a compliance question, like I have somebody who walked in and they told me that -- hopefully not walked in, but somebody who told me that they're sick. They have COVID. Do I have to give them time off? Yes, you do. Because this regulation was passed by Congress, and I think it was in March that said that you have to -- this is how you do it, and this is the earnings code that you use. And those are the types of conversations we were having. I think you know that we've told everyone is that we had a -- even though our revenues suffered somewhat as a result of the downturn, our level of activity and work with our clients went up. And so that short-term was painful for us, but hopefully created a real value proposition, clarity that will help post pandemic from a client retention standpoint, but also from a new business acquisition standpoint as well.

That's helpful. And then I want to talk a little bit about the recession playbook here. And Kathleen, please feel free to join in. Can you talk about what are some of the components or the levers that you've been able to pull so far? What -- and I know that the outlook that you've presented to the street assumes an exit rate mid- to high upper single-digit unemployment as we exit fiscal '21 for ADP. But can you talk about what would be some data points where you may pivot and decide to change the current short-term strategy given this downturn?

Sure. Do you want me to lead off, Carlos, and then...

Yes. Go ahead.

Okay. Sure. So you had a couple of aspects to the question there. One of which was the downturn playbook or the recession playbook. So let me take that, and then we can go to other aspects of your question as well for sure. Look, we have -- it's funny, spend time planning and talking about your downturn playbook, and my management team knows, we spent time talking about it well before anyone ever uttered the words COVID-19, right? Because it's just good practice to be ready and be prepared for that. And so you have it all planned out, but actually deploying it is when the rubber hits the road, and you've really got to have the fortitude to do it and the readiness to do it. And quite frankly, I think ADP was really very, very ready. The way I have characterized it, and this is both internally and externally, I talked about it in the same way, is that there's tiers to this downturn playbook. And Tier 1 and Tier 2 are the easier tiers, if you will. Tier 1, it's very easy because it's automatic and it's self-adjusting. There are some costs that come out of your cost structure just by function of what's happening and your top line being impacted. So I think sales compensation or other incentive compensation or implementation costs if implementations get pushed out. So that's kind of the self-adjusting piece. Then Tier 2 is the discretionary piece. Still easy, but not really, really easy because you get into a lot of conversations about, well what's really discretionary? What's discretionary in my mind might not be discretionary to the next person, right? So that's where I think we really did a very good job as an organization being really thoughtful and prudent about putting everything on the table to say, let's pull back and let's slow down on those discretionary things. And then lastly, the last bucket is -- the last tier is your long-term investment or your investment. And at ADP, we clearly think about investment with the long term in mind. And our point of view and our thinking is, look, the current environment, while it's difficult, we believe and -- we hope and we believe it's transitory. And so given that, it didn't make sense for us to say we're pulling back on investment, quite the contrary. Because we believe it's transitory, we're saying, we want to continue with the pace of our investment, and we want to invest, continue to invest from a product standpoint, from a sales and distribution standpoint. We want to invest in our associates so that our associates can have the tools they need to support our clients. So that's kind of how we have thought about it in terms of our preparation in advance of COVID, how we deployed it as this all rolled out. And we continue to learn as we go, but I think we have done a nice job in terms of execution on that.

That's great. So I guess you're not cutting into bone per se. But how do you think about balancing those long-term investments versus your margin profile over the next 12 to 18 months? And do you envision there potentially being delays to some of these investments, where there's a catch-up period? Or do you envision at least under the status quo -- sorry, working from home. The status quo kind of spending levels throughout given where we are with the current state of affairs?

Yes. It's a critical and the age-old question in terms of driving top line growth versus allowing margin expansion, if you will. For sure, we're prioritizing investments so we can drive that long-term growth. So look, from a capital allocation standpoint, we look at every single project that comes forward and we say, what's the business case for this? And does this -- is there a substantiated business case? Do I believe in it? Do I believe that I can get these benefits and that the team can execute on it? And where there's a good business case, and we have confidence that we can execute on it, we're going to continue to put those projects forward and execute on those.

So client funds -- well the interest on client funds obviously hit, but with the interest rate cycle, and it should be a drag for some time. Just a dumb question first. What happens if U.S. rates go negative? What is the game plan there should we see a scenario like that happen?

Well...

Move to another country.

I think if U.S. rates went negative and if you were to believe they were going to stay negative for a long period of time, you'd have to kind of rethink the business model, if you will, of a pricing, if you will, because the business model today is such that we price in a certain way because we have this flow interest, that is part of the model.

And I think the other thing there, too, is back to -- you're never saying never because anything can happen. But like even when rates went negative in Europe is generally in short-term rates. And so we do invest some of our float balances in short-term instruments. But when you get the 3-, 5-year or 10-year, I think the German 10-year went negative, I think once, like maybe for a day or 2. I may be wrong, maybe it was longer. But in the major industrial -- even in the major industrial economies in Western Europe, you have and have had negative rates. But if you go out a little bit further on the -- which is what the government is trying to get you to do, right, is they try to move you out on the curve to take a little bit more risk. I think we feel, we probably -- I think it's right that we would have to be convinced that it's a permanent situation, number one. Number two, we can modify our investment with obviously some caution and some conservatism, like we could go all government bonds, and we could go 30 years if we had to. And just talking about Doomsday scenario, but we don't have to exit the business or make any kind of permanent decisions just because they happened touch-negative for some period of time, I guess, would be the best way to put it. But it's a fair question because it's definitely happened in other parts of the world. So in theory, it could happen here. Luckily, at least right now, it is not a -- it's not considered a policy possibility for the -- at least as stated by the -- from my understanding is that, that's really not a policy that's going to be pursued. And I think the -- not that anyone wants to criticize Europe, but it doesn't feel like it's been a rousing success. And so it doesn't feel like anyone is rushing to copy that or Japan either. So anyway, we feel like this is a typical interest rate cycle, but with extreme in it, right, just because of the speed of the downturn and the magnitude in terms of the drop in rates all the way through all the maturities, all the way up to 10 years. It's pretty incredible, like -- and so there's no question, it's incredible and dramatic. But I would just say there's a few people out there, just to mention, and I don't want to mention any competitors, but like Morgan Stanley would say that there might be some inflation in the offing. And if you look at the breakevens, the inflation breakevens, there's some -- it feels like there may be some people who are starting to play that hand, right, that there might be some inflation down the lot -- maybe not next month or in the next quarter. If that happens, then the Fed will have trouble controlling rates that are 5, 7 and 10 years as much as they'll be able to control. They could, in theory, do some control of the longer term rates, but they'll probably stay focused on the short-term rates. And they would love nothing more than have a very steep yield curve, I think, as long as it doesn't crush the mortgage market. And you know this better than I do, but I wouldn't -- it's not a bet that we're making. I'm a guy that plays at 50-50. It could go the other way. I'm praying for the other direction that yields -- the curve steepens and we get a surprise in the next year or 2, maybe not the next quarter with rates may be moving up a little bit.