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

All right. Good afternoon, everybody. Thanks for sticking with us. This is Tien-Tsin Huang. I cover the payments, processors and IT services sector at JPMorgan, and really pleased to have with us ADP back at the event. With us from ADP, we've got Danyal Hussain, who many of you know, does a great job at Investor Relations at ADP and always enjoy chatting with -- Danny's always super helpful. So what we wanted to do was just go through a list of questions in a fireside chat format if that's all right, Danny, and then we'll take some questions from the audience to the extent that we have any. Just hit the -- see some already. Just hit the Ask a Question section at the website, and I'll do my best to hit those. But again, a lot of these questions, hopefully, we'll address the questions on the top of everyone's minds. So Danny, thanks for being here again.

Yes. Thanks for having me, Tien-Tsin. Happy to be here.

And it's good to see you. So we'll spend about 20, 30 minutes, if that's all right. So let's dig right into the quarter. I know it's not that far away. It was clearly a big upside surprise, both to our expectations, and I would say, your expectations as well, given what you guided. You want to call out for us maybe the top 2 or 3 areas that drove the outperformance and then what might be sustainable or not?

Yes. Happy to, Tien-Tsin. You're not the only one who, by the way, has told us that we've got a good poker face. So that wasn't by design. We didn't intend to take an exceedingly conservative stance, but in retrospect, obviously, we're very happy with the results. So starting from the top of the P&L and going down, we did see outperformance from a number of categories. Bookings, as everybody knows, is critical to the ADP narrative. And we were more than happy to see that accelerate from the Q4 trough to a 2% growth and a record Q1 level for our ES sales. So that was driven by a number of factors. I'm sure we'll get into that in more detail. That contributed a little bit to the revenue upside. But really, the bigger contributor to our revenue upside came from better retention than we had forecasted. I think this is one of the more surprising bits of information to come through in the quarter is that bankruptcies and out-of-business losses, contrary to being elevated in the quarter like we had expected, those were actually down on a year-on-year basis, which, in this environment, was definitely counterintuitive. So that contributed nicely to our revenue performance. On top of that, something that we don't talk as much about in an ordinary quarter because it's usually fairly quiet is some of our volume-based businesses. So we do things like recruitment, outsourcing. We have a card business. We do wage garnishment payments for our clients. And so all of those together, they can be relatively quick to accelerate or decelerate. And in Q4, we did see a relatively significant decline, not surprising given the freeze in client activity. And that just came back quite a bit faster than we had expected in Q1. So those 3 factors together contributed to the better revenue. And as we had -- and coached a lot of the investment community over the past few months, the revenue losses that we were anticipating were expected to come in high decremental margins because we intended to keep most of the service and implementation organizations intact. And so without much cost to offset, those revenues were going to cause a pretty substantial hit to margins. Instead, because the revenues ended up a lot better than we had expected at down only 1%, ultimately, we let that flow straight to the bottom line. So margins ended up likewise being much stronger than expected. And on top of that, not just stronger revenue but actually better expense management helped contribute. So Kathleen has led the charge there. She's our CFO, and we kept a very tight line on expenses throughout the organization. We talked about our transformation initiatives and driving a little bit of additional expense benefit in the quarter, above and beyond our expectations starting the year. So that helped a little bit. We managed headcount, I think, pretty effectively in the quarter as well. So you tie it all together, and we had outsized performance on the top line, some better expense management and all of that driving better earnings growth than we had anticipated.

That's a good summary. So let's hone in on the bookings piece, right? So that's always an important factor for the stock. That was way better than what anyone had expected, again, poker face aside. How much of that was just adapting to a virtual model versus maybe some pent-up demand or pull-forward perhaps from future quarters as everybody was motivated to sell? Can you walk us through maybe the top 2 or 3 factors that maybe drove the upside from your analysis?

Yes. For sure. I think the short answer is there was probably sum of all of those as a contribution to our outsized performance relative to expectations. We were broadly pleased with the ability for our sales force to go out and sell more effectively in a purely virtual environment. And in the initial weeks, there was an adjustment period. We went through, of course, the process to adequately train and make sure that sales force was as effective as possible in selling in a virtual environment. So you've got training programs that we have for our inside sales force that we were able to parlay into our field sales force. They obviously translated that into an effective piece of momentum in the overall business. And then on top of that, what we saw and what we had expected is that the actual client behavior showed signs of improvement. And so the biggest single factor to the bookings decline in Q4 and the subsequent acceleration is the overall level of activity. So our clients in Q4 were taking, generally speaking, fewer meetings. In many cases, especially if they were in harder-hit industries, for them, it's just not a priority. And so they would put something like an HCM decision off into the future. Fast forward 3 months, we saw a lot more activity from our clients and prospects. So that was obviously a great sign, and then you compound that with the fact that our sales force has gotten more effective at selling in a virtual environment. And together, that drove a much better outcome than we had anticipated. When you break the results down by business, there were some additional one-off factors that contributed, some of which we might not see persist later into the year but others that we think might. So as examples, we called out our multinational business as having done exceptionally well in the quarter. You just look at the volume of sales that they were able to generate. And yes, there was a little bit of potential of pent-up demand in that regard. Some deals that we expected to close in Q4 were pushed into the first quarter, but it's fairly small in magnitude when you compare it to the overall U.S. performance. Likewise, in the downmarket, we talked about new business formations as actually contributing in some ways to our downmarket sales. Along the same vein, we don't expect those higher levels of new business formations to necessarily persist over the coming quarters. But that said, we did see strong momentum elsewhere in the business. And so that fundamental change in how clients are more willing to engage and our sales force's ability to operate in a virtual environment, all of that remains with us as we move forward. And so we're optimistic about the rest of the year.

Got it. So hopping on the retention side, Danny. With retention, we've heard through the, let's say, all the peers more or less that, right, less switching in general, which makes sense. People are focused on surviving the pandemic. I want to make a case that with outsourcing, there's a greater need to stick with it because of the complexity, right, and everything else. What else could be driving the retention? I know you moved a lot of your clients to a strategic platform on the low or mid-end, for example. And I would argue that maybe that would drive it, too, irrespective of what's going on with pandemic. But do you feel like these elevated levels of retention are here to stay? Could we see it go into another higher level of retention going forward?

Yes. It's -- our perspective this is probably a mixed bag. So some of the benefit that we saw in the quarter relates to the noncontrollable losses. So whether or not companies went out of business, that's the same rate they went out of business last year. That was -- as I mentioned, that was surprisingly positive. In other words, there was a good source of upside for our retention. It's hard to imagine that upside just persisting in perpetuity. So at some point, that will revert back to the mean. But beyond that, the voluntary portion, which is typically most of our losses, that was better, and we think it was for 2 reasons. We wouldn't acknowledge what you described as a naturally high amount of reluctance to switch because you're in the thick of things. There's a lot of complexity, and now it just does not feel like the time if you're running cash rain business for you to switch vendors. And we think we feel the pain and the challenges from that standpoint in the sales process. So it's one of the reasons our productivity is not quite as high as it would be ex-COVID. But the flip side is it seems to be helping the retention. And it's hard to quantify that precisely, but that certainly seems to be one factor. But as you point out, we think what's more important is that our client satisfaction is at all-time highs. And some of that relates to COVID because we were able to stand by our clients and serve them well in this environment. But frankly, this momentum predates COVID, and we were seeing all-time high retention levels in a few of our businesses pre-COVID. We called that out in our second quarter earnings call last year. And so in a world with no COVID, we might have been in a situation where we were still seeing continued momentum and improving retention. That's the part that we're most optimistic about persisting beyond COVID. The rest of it, we would acknowledge there's probably a little bit of noise. For our part, we're trying to take a somewhat conservative approach, at least for the next couple of quarters from the lens of out-of-business losses. So we have factored some of that reverting back to the mean and, in fact, even being elevated. If it doesn't play out, that would obviously be a nice source of upside. But at this point, that's too early to call.

Okay. Good. No, we'll keep nagging you about it as you know on this retention stuff, but that does make sense, Danny. So maybe just to round it out, I know you mentioned the margins and the high decremental margin of the business, just like it's very high incremental in good days. I guess we all sort of underestimated that, right? When you initially guided to the down 300 basis points, you're doing much better than that, 100 to 150 down now expected. I know you're investing. ADP is investing. You're also going through these transformation initiatives and then revenue has gotten better. But talk to us about the visibility that you have now on margins and the priority that you have to preserve margins or to get back to pre-COVID levels. How important is that as we sort of are still fighting through the pandemic, but also reinvesting and then you have the transformation initiatives as well. So I guess, again, a broader question on prioritizing margin here.

Yes. I think in many fronts, we're trying to keep a steady hand through all of this. So investments in things like our sales force and things like R&D, those were making a very steady approach to -- in the downturn. And what that means is it's creating a bit of margin drag if you assume the revenues are in decline. But we're okay with that, and strategically, we believe it's the right thing to do. And we've found a lot of support likewise in our shareholder base with taking that approach. What I think has caused a little bit of confusion is how on the way up, in other words, when revenue is growing, we can have, let's just say, less than 100% incremental margins. But on the way down, we show much more significant decremental margins. And I think the answer to that relates to the time horizon that you're looking at. So as a case in point, if we expected revenues to be under pressure for a period of a couple months or even a couple of quarters, there's really not that much offsetting expense to be taken out for such a short time horizon, because the reality is your capacity needs have not really changed that much if you expect things to accelerate back to where they were in a matter of quarters. And in some of our businesses, like the PEO, yes, we have direct offsetting expenses. But for our ES segment, a lot of the direct revenues don't have a one-for-one offsetting expense. In general, we have almost a semi-fixed and semi-variable expense base. So from that vantage point, we didn't think it made a lot of sense to assume that we were going to be able to take cost out. And now we feel vindicated because now the revenue has come in a lot stronger than expected. We let that drop to the bottom line. And now the outcome has been pretty clear that if that's the case, the margins will come in much stronger than we originally anticipated. And the good news, too, is that we didn't take the approach that we need to invest less or invest more in sales headcount. We took this, again, a very steady hand approach, and now we can stick by that. And to the extent that revenues come in stronger or weaker, ultimately, that's what ends up dictating the margin performance for the year. Then above and beyond that, we're driving those transformation initiatives, which are critical to just providing a supplemental amount of margin expansion, clearly showed some progress this quarter by being able to execute on the digital transformation and the procurement initiatives a little bit faster. So we are getting $25 million extra of benefit for that this year. And that's a lever that, obviously, we'll keep pushing on as well.

Got it. No, that's good. Like I said, sometimes it takes a crisis to learn these things and to [indiscernible] events to sort of expose some of the learnings around the margins, but that does make sense there, Danny. So maybe to build on the margin stuff a little bit more, I know you and I have debated this a lot, right? As ADP modernizes its technology and its platforms and the potential there to improve margin because of retention and everything else, but just that general concept of ADP modernizing platforms, right, where are you in that journey? And from a competitive standpoint, what do you think is sort of misunderstood or maybe underappreciated when people think about stacking ADP up against some of the SaaS providers? So a lot in that question, I know. I'll let you address it how you want, but sort of a journey to modernization and then where does that put ADP versus some of the, let's call them, the digital-first HCM companies?

Yes. It's an important question, too. And the way I would frame it is that Carlos has taken us on this journey to simplify our overall tech stack. And in doing so, that positions you to have a better product because you can concentrate your R&D efforts on, obviously, fewer platforms and make them more differentiated. But then you can also optimize your service, your implementation around those fewer platforms, so there's margin and also customer service benefits as well. And so we, at this point, have completed that process for over half of our Employer Services segment revenue. And I'm talking specifically about our downmarket businesses, where we use RUN and in our mid-market business, where we use Workforce Now. And then what remains now is the upmarket in the international markets, where we do still have multiple platforms. We feel good about our strategy because we've now proven at least to ourselves and I think also to our shareholders that we can see in this play book the outcome from the downmarket was a resounding success. The mid-market, we were starting to reap those rewards as well. And so we feel comfortable that Next Gen HCM is the platform of choice for the upmarket. A lot of the technical risk is behind us. And so now really, it's just a matter of chopping the wood and implementing those clients, building the service organization around it. And then where that would put us once we complete that process, which will take time, is that we have far fewer platforms, and the benefits of ADP scale then truly come to light. And now in the downmarket and mid-market, years after having completed those migrations, that was the gating factor, we think, to driving some of the improvements in client satisfaction and the market share gains, especially in the downmarket that we've seen. So that's obviously what we're looking to replicate in the upmarket and international. As far as what's, I think, missing from a narrative perspective, I'm not sure that -- that's misunderstood. But what tends to happen is you take any big organization, ADP in particular, we've got this long trailing edge of technology. So we've got super modern technology, our Next Gen HCM, we held nothing back in the development and choice of architecture there. But then we do still have clients on older solutions. And the thing is, from a narrative perspective, depending on your agenda, you can choose to focus on any part of that spectrum. So clearly, we know our competitors will tell their prospects ADP has got legacy technology. But then at the same time, you look at the industry analysts, we're focusing on the things that we put forward that's among our more modern stack, and those get rave reviews. The reality is our business is comprised of all of these. And over time, more and more will get migrated over to that more modern stack. I look forward to the day where some of these older platforms are in our past. But the reality is we have happy clients on them, and so we're taking a meticulous approach to that transition.

Right. Not rushing, right? That's the ADP way. So given that, Danny, does the outsourcing sort of debate with COVID and PPP and the complexity of everything that's going on in the world, right, I mean, can you make a case that outsourcing is -- could see a little bit more in the way of tailwinds coming out of the pandemic than what will be otherwise observed?

I think you could certainly make the case. We know you've made the case, and I think we are trying to make the case to our clients and prospects, too. What -- the piece that gives us evidence that there is something to that narrative is that client satisfaction for those clients is extremely high and has picked up. So our PEO business, we have these HRBPs, business practitioners. They hear firsthand about how grateful the clients are that they don't have to deal with all of this complexity in this environment. So we know that kind of the first derivative impact has been more satisfied clients. Second derivative would be you have higher referenceability because those clients are so happy, they refer you or the PEO model, in general, to somebody else that they know. That will take some time, we think very near term. There are headwinds that right now overcome those tailwinds. But once these headwind abate and once companies feel like they can make decisions the way they would in pre-COVID, that's when we think you would start to really see the benefit of the positioning that we have in that part of the market. So we're optimistic that looking beyond this year, hopefully, the tailwinds with the PEO and other HRO businesses can continue.