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

All right. Good morning. Should we...

Good morning.

Good morning. I'm Steven Wald, one of the payment analysts here at Morgan Stanley. This morning, I'm joined by Kathleen Winters, CFO of ADP. Thanks for being with us, Kathleen.

Thanks. Good to be here.

So before I start, a couple of housekeeping notes, reading a disclosure here. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. [Operator Instructions]

So maybe just a quick way to start off here, Kathleen, is to get a sort of 2-minute overview for those who aren't as familiar with the ADP story of how the business model generally works and sort of how you've been navigating through the pandemic so far this year.

Sure. Thanks, Steve. Yes, just a couple of seconds here on ADP and business model. As some of you may know, we're a global HCM software and service provider. We serve clients of all sizes actually from small businesses with a handful of employees to large global enterprises. We're global. We operate in 140 countries. We very much have been focusing on a multiyear journey that we've been going through to simplify and transform and update our product suite and portfolio. So that's been a big focus for us over the last several years and will continue to be a focus. And I'm sure we'll talk a little bit about that. In terms of how we've been navigating through calendar 2020 in the COVID crisis, look, it's been a very challenging year for everybody, companies and individuals. It's been challenging across the board. It's amazing to think we're in month 12, the last month of calendar 2020. And I think we're all probably grateful that, that's finally here, so we can turn a quarter -- a corner, if you will. What we've seen and how we've been navigating, look, we've obviously had a global economic slowdown which has resulted in a steep decline in employment metrics and employment numbers which, of course, impacts us heavily. We saw that steep decline with -- and I'll use some U.S. unemployment numbers. But we saw that go from pre-COVID U.S. unemployment at 3.8%, then we saw it deteriorate to about 13% in our Q4 of fiscal year '20. And we've since seen a fairly substantial amount of recovery, but not quite to pre-COVID levels, for sure, with the October unemployment metrics being at 6.9%. So still quite a ways to go. So how have we been navigating through all that because we do see -- we've had that, as I said, very steep deterioration in the employment metrics and still quite some uncertainty ahead in our view, right? As you look at various parts of the economy, still in partial shutdowns dealing with the pandemic. You see small businesses continuing to have challenges and struggles and uncertainty, particularly with regard to how much stimulus there will be going forward, if any, at all. Large enterprises, you see various large companies with employment reductions. So there's a fair amount of uncertainty in recovery that we're still looking at. Various sectors of the global economy, in terms of travel and restaurants, still a lot of struggle and challenges out there in particular sectors. How we've been navigating through that and what those challenges mean for us? Look, just like all companies, this has been a significant disruption for us impacting our fiscal year '20 and our fiscal year '21. We reacted, I think, pretty well, actually quite nimbly. We were able to move our entire workforce, our 58,000 employee workforce around the globe to a work-from-home environment, like many companies have to do. And we did that really without skipping a beat. Now I don't say that to imply that there wasn't a lot of effort and work and hard work by people around the company to make that happen, but we made it happen. We moved those 58,000 people without skipping a beat on client service. In fact, one of the things we did, and I'm sure we'll talk about the importance of client service in our business model, but one of the things we did is we saw the need and the demand and spike in client service requests, and we've reallocated a number of our employees, our resources to the client service area so that we could meet those needs, which we believe, in the long term, is critically important to continuously meet those client service needs. So I would say the other thing that we made a particular point of focusing on during this time period is really looking hard at our approach to investment. And while some companies have been in a position where they've needed to pull back on investment during this recession, we're fortunate enough that we've got a very strong business model, high degree of recurring revenue, very high retention rates, highly cash-generative model. And so we're fortunate that we're able to continue to support that investment. And we have not pulled back in terms of investment in the critical areas of our sales and distribution and our product portfolio. So we're really happy to be able to do that. The other thing I would say is in terms of how we've been navigating and managing through this time, as I mentioned at the beginning of my comments, we've been doing a lot of transformation. And that transformation is around our product portfolio as well as our cost infrastructure. All of that transformation work continues. We have not slowed down on that at all. The projects that we have in flight continue. In fact, we're pushing even harder to make them go as fast as we can. And we're working very hard at continuing to develop a pipeline of additional transformation projects. So I'll pause there. That's a little bit about kind of how we've been navigating through and thinking about managing through the current environment.

Great. Well, you've given us a lot to sort of go through there, so thanks for that comprehensive overview. Maybe a good place to start. You talked about a lot of the things you did sort of since March and adjusting to it but -- to the pandemic, but also investments that were already underway and things you were already changing on your business model. But if we sort of look back to the last few quarters' results, it seemed like there was a bit of a bottleneck or a freeze in terms of selling activity. Your bookings obviously declined quite a bit. You pointed to the obvious disruption. I'm curious if you could sort of walk us through, because it was sort of hard to see from the outside, how much of that was driven by the adjustments you had to make as a business to your selling motion versus sort of just the client side, people worried about staying in business, managing costs versus dealing with HCM vendors? Can you sort of talk through what that looked like? How much of it was each? And how that's really changed since March? Obviously, the bookings have come back quite robustly in the latest quarter.

Sure. Yes, it's a critical question. I mean when you think about our business model and some critical metrics, like we are constantly focused on new business bookings -- sales, new business bookings, client retention and level of profitability. So thank you for that kind of question on the new business bookings. Look, what happened with this -- the disruption -- the global disruption -- obviously, huge disruption, right? I mean we've never seen anything like this before with the global economy being so massively disrupted. It was a very rapid and steep decline. So you look at these recessions and downturns, and you try to look at previous recessions to learn from it and to apply, you say, how did we perform last time? What's it going to look like this time? And I think most people feel like and believe, well, this is just different from anything we've seen before in terms of the speed of the decline. And that's what we saw in our Q4 as of June 30 year-end. In our Q4, we saw that very steep decline in new business bookings with companies just kind of, I'll say, kind of hunkering down. There was so much uncertainty during that period of time. For sure, we had a big effort, as I said earlier, kind of moving every one to a virtual environment and a work-from-home environment. So for sure, that had some impact in terms of a kind of temporary or short kind of distraction to get everybody working in that environment. But that was pretty short and pretty minor in comparison to what I would say was the real impact of companies hunkering down. They don't know what's -- at that point in time, they didn't know what was coming. It was just a real impact to clients' and prospects' willingness and ability, I would say, to engage and think about making decisions, whether it's a new venture kind of kicking off and needing to get software in place or a company making a change from one provider to another. There was just this real -- client's ability and willingness to engage was probably the biggest impact here. Quite frankly, with our -- the way our sales force is designed and constructed, pre-COVID, we had a large portion of our sales force, about 1/3 of our sales force, operating what we call as in-house sales. So they were operating in a virtual environment already. So there really wasn't much of a shift for them. They were used to that virtual engagement and the virtual sales cycle. It was really the other, the 2/3 portion, getting them fully up to speed, which I think we did quite well. And you can see that, right, when you look at the Q1 bookings number, seeing the positive sales growth, the positive bookings growth in Q1 which, quite frankly, we were pleasantly surprised that it was that good. As I said earlier, we've looked at prior recessions and how we performed. And my takeaway from studying those prior periods is it's typically choppy during the recovery. And to have the steep decline in Q4 and then a recovery for us right away in Q1 is great. I caution everyone that I do believe it is going to continue to be choppy. So we'll see how it plays out the balance of the year. But the work -- the sales force is fully enabled with all the technology they need to engage virtually to the extent clients are -- and prospects are willing to do it.

That's really helpful context in terms of what you already sort of had going versus what you had to adjust to. And certainly, it comes up from our side in a lot of questions about comparatively how ADP works, sells and offers its products versus other players in the market. And obviously, you're the broadest range of the service model on the HCM side of things in terms of product offering and go-to-market approach. But a lot of attention over the last several years was paid to sort of the lower touch, as many people call them SaaS platforms in the space. And certainly, as we went into the pandemic, people felt that those were going to be better positioned. I'm curious to hear your thoughts on how ADP's approach is differentiated and resonates today or resonated early on with clients during the pandemic and how you see that dynamic evolving over time, just in general, but also how it's changed as a result of virus conditions?

Yes. Yes. Look, we are a software provider and a service provider. And in short, I would say that's not going to change as a result of the pandemic. Quite frankly, I think our ability to meet clients where they want to be met and being able to meet the range, the broad range of different clients' needs is a great advantage for us. There are some clients that want to have a fully kind of automated kind of no human interaction service model. They want to do -- whatever payroll or HCM changes they need to make, they want to do it from their phone, be able to use the mobile app, which we were first to mobile and quite adept at being able to provide that for clients. Some clients want to do that. Other clients that maybe aren't as willing to engage that way or may have more complex needs or changes or questions or clients that may not have the internal resources or internal expertise want to have that ability to have a different sort of service model. And we provide that, and I expect we'll continue to provide that for the foreseeable future.

Very helpful. Maybe switching a little bit gears in the sort of competitive landscape. If we were to sort of go through each of the segments you serve, being the broadest service model out there between down markets versus the mom-and-pop shops upwards of Fortune 500 companies like Morgan Stanley, you serve all. And that's kind of rare in the space. So I'm kind of curious if you just could walk us through the spectrum of each segment and how you view that from a competitive intensity today as well as a green field opportunity. Obviously, these are not all the same in terms of addressable market and sort of open space for every one to go into.

Yes, you're right, it is -- does really set us aside in terms of the breadth of what we offer and that we really serve all segments of the market, small business, mid-market, large enterprise space. It's -- look, the HCM industry is an attractive space. It's a growing space. And because of that, because of that attractiveness, you'd expect that it would be incredibly competitive. It's been incredibly competitive. It remains incredibly competitive. I don't think that's going to change. So -- but that's fine. That's fine. I mean I think it's great for us to have that level of competition. When I think about what do we need to be good at to win in that competitive space, we need to be great from a sales, from a go-to-market standpoint, and we've talked a bit about that already. We need to be great with product in terms of long-term product strategy and execution from an R&D perspective. And we need to be great at -- with also operations, service and implementation. Because if we wow the clients with our product, but if we're not wowing them from a service perspective, that's not good from a long-term perspective. So we need to be great at all of those things, and we're focused on being great at all of those things. And that applies to each of the market segments; small business, mid-market and upmarket. In small business, we've been doing -- in the down market, we've been doing incredibly well, continuing to grow our client count. You may have heard on our most recent earnings call, we've got over 700,000 clients now on our -- in our small business segment on our RUN product. So a new record for us from a client count perspective. In mid-market, also a very, very competitive space with our Workforce Now product. That's performing quite well. We went through a process to streamline and rationalize the product portfolio in that space. And having done that, we were seeing really, really good momentum pre-COVID. We're seeing great retention right now. In fact, we had record retention in that space both -- actually, both in the downmarket and small business segment and mid-market. In Q1, we had record retention. So doing quite well there. In the upmarket space, as you know, there are some established players there. And we're focused right now on our investment in our Next Gen HCM product, which will help solidify our position in the upmarket space. That will be a kind of a multiyear journey for us as we scale that up, but we're really excited about that. And then just lastly, internationally, I would say it's a fairly fragmented market. We compete with some local and regional providers, but have been seeing very nice growth there as well.

That's a super helpful rundown. And I think one of the things that's really helped over time is you guys sort of defining the market and sort of the opportunities and how you're going after each of those opportunities. If I were wanting to take back to before the virus, if we can remember that far, you talked about, at your Innovation Day, an addressable market of about $150 billion. Now obviously, that's not relevant to all your peers. Some of those are not going to be in all the spaces you were in. But you talked about that growing sort of 5% to 6% per year. And then sort of more recently, there's an incremental sort of optimism I'm getting from your and Carlos' tone on the earnings calls in terms of the opportunity coming out of the downturn for you and all players in the market. It seems everyone sees an opportunity here to really expand growth. I'm curious if you could sort of talk through that perspective against your comments today, but also more recently, that it's going to be sort of uneven from here to there. Walk us through how we sort of get from here to there, and the reality that sometimes coming out of a downturn, even if there's incremental opportunity, the first few years are not always the fastest growth years.

Sure. Yes. I mean if you think about the HCM space and what was driving growth pre-COVID, as you said, if anyone can remember back that far, we think about it in terms of a couple of different maybe categories, I'll call it, in terms of what's driving growth. But we think about the way work gets done and the way pay occurs, the way that happens, the way HR functions, the way business gets done and just how technology supports all of that. All of those -- the HCM space was evolving, right, even pre-COVID and driving that growth. I mean we see growth in the mid-single-digit area for the industry, right? So pre-COVID, we're seeing that growth. And then you look at what's happening during COVID and you say, "Well, what's changed for the long term? Has anything changed? Is any of that going to stop?" No. "Does it accelerate even further?" Possibly. I don't know. But you think about it in terms of -- maybe I'll just call out 1 or 2 of the things in those categories that I mentioned. You think about HR and the way HR functions and the need to obviously manage a workforce and engage talent, I think HR functions now having gone through this disruption -- huge, huge disruption that nobody anticipated a global pandemic happening in 2020, right? HR says, "Wow, we've got to be prepared. We're going to have systems and service capability. We're going to be prepared to manage our workforce to ensure we've got engagement. We'll get productivity, to make the changes we need to make in a very seamless way even in an environment of huge disruption because it happens." So if anything, I think the value proposition is even stronger coming out of COVID, post-COVID than it was before. It's hard to measure exactly by how much, but I think it's strengthened. And then you look at technology and you say, "Well, gosh, the technology has to be -- it has to be there. It has to be state of the art. It has to be modern." People, both the users, the buyers, the -- of our software, the employees of each of our clients, they expect a world-class, consumer-grade technology experience. And so again, I think coming out of COVID, if anything, there's stronger demand, greater growth opportunity and a stronger value proposition in terms of what we offer.

That's very helpful and certainly something we'll have to watch for as to see how it translates into the results over time -- near term versus over time. But maybe shifting gears towards the margin. I know that was an area of strength this quarter, another one. And that sort of surprised a number of us to the upside, particularly as you had guided that there could be incremental pressure from a number of sources, particularly top line pressures as a result of ongoing investment in the business. You sort of -- it was an upside surprise. You sort of feel -- sort of sounded generally positive longer term about the margin. But you also cautioned that from here to the next 9 to 12 months, there's going to be some bumps in the road, and that's typically not an even margin across the quarters for your business. So maybe if you could just walk us through, particularly for those of us who are not as close to the story, how you sort of see the next 6, 9, 12 months of margin as well as if we come back to the pre-virus, you were sort of trending into the mid-20s on an adjusted unit basis. Is that still the natural margin for this business? Or do you see that evolving higher or lower over time depending on mix shift or, like you said, the need to invest to give all these offerings to clients going forward?

Yes. So a lot of questions to address there in terms of margin and profitability. Maybe I'll start with the long-term view and then come back to the shorter term view because, quite frankly, I think the long-term view is very important here. And short term, it's always tough looking at certain metrics, in particular, margin or bookings on a short-term basis, quarterly basis and trying to draw conclusions from that. I caution people from doing that. So from a long-term perspective, look, pre-COVID, we had long-term margin targets of 23.25% to 25.25%. And we were well on our way, in fact, basically at, if you will, the lower end of that range. So we were seeing great momentum there. COVID happened. Obviously, that had an impact on our top line. And that impact is very high margin impact that it had. So think about it as the number of employees for which we're processing pay comes down, the revenues come down. But we're not able to take all of that cost -- an associated amount of cost out, right, because we're still providing, supporting the product, we're still providing the service as we talked about. So while, for sure, there were some cost actions we were able to and did take, it's a very high-margin revenue loss, right? So that obviously has had an impact and set us back from a margin perspective. But when you think about it from a long-term perspective and you think about, well, just like it hurt us on the -- coming down, on the downside, it's going to help us coming up, right, during the recovery. So we're going to -- it's going to depend on what the shape of the recovery looks like, how the employment numbers come back, that will certainly have an impact. But the other thing that's going to have an impact is, remember, I said we did not pause on any of our transformation work, right? All the projects that were in flight continue to be in flight. So everything we're doing, and you know we've got a nice track record here of several years of doing really meaningful, substantial transformation work that has given us profitability improvement and margin expansion. That work continues. So look, I'm optimistic about the future and going forward. And when we have the economic recovery, that, coupled with the continuing transformation work we're doing, I'm optimistic about where we can go. Now in terms of kind of the shorter term view and this year and how that might look, again, quarter-by-quarter, there's lots of puts and takes when you look at a quarter in isolation. I think it's more important to look at the longer term, at least looking at a 1-year period. We feel good about the year in terms of being able to continue the transformation work we've talked about. We've talked about the work we're doing in digital. We've talked about procurement and real estate transformation that we're doing. All of that will continue and will help us. Just a lot depends on what the top line impact is going to be and how that plays out. And if there's a particular quarter where we've got a softer revenue quarter because of various pressures on the top line, that's obviously going to impact us for the quarter on a margin perspective.

Appreciate that. That's super helpful to sort of guide us through. And in the last few minutes, I want to make sure I get to the questions on the web. There are a couple here. I'm going to try and blend them as best I can because they're somewhat similar. Thinking about where ADP differentiates itself and the client retention aspect, how do you sort of see -- I think a lot of people tend to think of the upmarket is probably your safest area of client retention and moat. Where do you think your moat is strongest? And how do you sort of see retention, particularly in some of the areas where people tend to view ADP is more solidified going forward?

Yes. So -- it's a good question. I'm glad you asked it because, as I said earlier, look, sales retention and profitability, it's not a complicated model, right? We've got to do everything we can to focus on constantly maintaining and driving improvement in each of those areas. So from a retention perspective, look, our retention is actually very high, very good retention. To your point, it's strongest in the upmarket. In down market, we do see some churn, if you will, from out of business. But that's -- you always see that in the smaller business segment. We had a bit more of that in Q4 than in normal times because of the pandemic. But actually, in Q1, we didn't see a lot of out-of-business impact. We are a little cautious about that, how that's going to play out during the balance of the year. So we're watching that, and we've reflected that in our guidance with regard to seeing potential out-of-business pressure and, therefore, impact on retention. But we're feeling quite pleased and confident that we've made the decisions, the right decisions for the long term that will drive retention. We've had record retention in small business and mid-market. And we've got strong retention in upmarket as well. So we're pretty optimistic about what we can do there.

Right. Well, we're about to get cut off on time here. But maybe if I can get in the last 30 seconds in a one liner, what's the area of greatest upside that you think investors should be paying attention to for ADP?

Wow, one liner is hard. But I guess what I would say there is, look, there's a reason why ADP has been around for 70 years, right? We know how to win. And we know how to win in good times and in bad. We've got a great business model, as I've said. We're confident in our market position. And we've got great optionality. So I think that's critical for people to understand. We've got that strong business model, strong balance sheet, optionality, ability to invest through the cycle. And that's going to be critical because that positions us extremely well coming out of this.

Great. Well, that's going to take us the time. Kathleen, thank you for joining us.

Thank you very much.