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

Hello, and welcome to everybody that's joining us here for the Nasdaq Conference and the Automatic Data Processing Systems or ADP's presentation. I am James Faucette, a U.S. payments and fintech analyst from Morgan Stanley. I am very pleased today to be joined by Don McGuire, CFO of the ADP. Also joining us virtually today is the ADP IR team. So Don, in case we get into too much trouble or run into something that we don't know, they're here to help us out. As we get going today, we've got 30 minutes. And I've got basically 45 minutes of prepared questions. But I do want to make sure that we leave time for any of you that are participating via webcast to ask any questions. You can ask your questions. There would be the panel. If you should have a question of a panel or a panel that you can post a question via, and we'll get to your question as we go through the presentation. Also, before I get started, just quickly for any important disclosures from Morgan Stanley, please see morganstanley.com/researchdisclosures. Don, before we get started, any preamble you want to give?

No, James, thank you very much for the invitation. Looking forward to having a discussion this morning.

Well, that's great. So maybe I'll just start at a high level. Most of the conversation, particularly in the U.S. economy has been around labor participation rates, labor shortages in a lot of places that are important, et cetera, as well as kind of what's happening with the level of employment generally. ADP, obviously, you touched a massive portion of the economy as a whole. What are you seeing from that perspective? And is there anything in your history that's prepared you to be able to talk about how we should think about the evolution and development going forward?

No, it's a good question. I think it's a pretty broad question as well. I think it's fair to say that we're still calling it The Great Resignation. I know it's had many names and we're seeing lots of people changing employers, et cetera. But as you know, we do attract an awful lot of data, and we issued the National Employment Report. So we issued several reports over the period of the pandemic. And of course, it's still continuing, I guess, depending on where you are. The severity is mixed. But we did see pretty steep drop-offs across the kind of the low end, the mid-market and the upper end of the market way back. If we look at April '20, the employment levels were down anywhere from 14% in the upmarket and 15% or 16% in the low end of the market. Since then, we've seen some pretty rapid recoveries. So in our ER report, we have said that it looks like the low end of the market, the small business market, is back to about within 2% of prepandemic. The mid-market, a little bit about 4% back -- 4% from its high before we went into the pandemic. In the upmarket, lagging a little bit at minus 6%. And I'm not so sure why that is. I would hypothesize a couple of things, though. I think the smaller the business, the more they just have to get at it and get back to doing what they need to do. And I think that large enterprises often take these kind of jolts, these spikes, if you will, as an opportunity to reassess what they're doing and perhaps some of them have decided that they can do things differently. I'm not sure we'll know, but certainly, I think we're all hoping that employment levels come back to where they were and continue to grow.

And on that point, in terms of the reports, et cetera, it's interesting because you've highlighted the low end of the market, even middle, maybe kind of back or pretty close to pre-pandemic levels. But yet, you still -- we still at least see a lot of headlines around open positions, shortages of labor itself, et cetera. Is that something that you're being able to track? And how well that's being addressed kind of close to real time? And are we in a situation where if we're back to kind of pre-pandemic levels, at least in certain segments, that we're just going to have to live with shortages in those places. Like, for example, I was at a restaurant last night, and they just don't have enough cooks, and their kitchen is really slow, but there's no way to hire perhaps. I don't know.

Yes. I think, James, I think there's a lot going on there. There are some sectors where I think the pandemic gave people the opportunity to assess their lifestyle and what they were doing. And maybe working in a warehouse is better than working in a kitchen. I'm not sure -- I don't know what to say there, but I do think people have the opportunity, and I do think hospitality in particular across many locations -- I am in the London area today, and we're very much seeing the same thing here in the U.K., although some other drivers here with Brexit and the return home of many European workers not coming back. But I think there's a big reassessment of what people are doing. In terms of tracking, we certainly have a couple of businesses of our own by screening and selection business. And the recruitment process outsourcing, the RPO business. And so we certainly do see that there's a lot of activity on screening and selection, meaning people are going into new jobs, and their employers are checking up their backgrounds, and certainly an awful lot of openings and people looking to recruit. What's it going to be like longer term? Hard to say. I think it's likely to come back. I think the composition of the labor market may look a little bit different than it did before. But it does show all signs of looking like it's coming back to closer to where it was before.

Got it. And then just quickly, and we could spend our time talking about the macro, but with the headlines around Omicron variant, et cetera, how -- like, can you give a little bit of insight into what we saw through the Delta wave and how that may have impacted or didn't, the macro and hiring environment and employment environment generally. And was there much variance across different geographies or as it related to policy or response or anything that you could find, like that we should expect?

Yes, certainly, very, very different response rates across the initial wave and then the Delta wave as well. And some places have been quicker to come back than others. I think I would say that there's a little bit of optimism, especially in the -- in "developed countries" that the vaccine rollouts, et cetera, and the booster programs, et cetera, are going to make this wave as -- although people continue to get ill, the reports I read suggest that fewer people are being hospitalized or even if they are hospitalized, fewer people are actually succumbing to the disease, which is good to hear. But once again, I do think things have changed a little bit. The economy seems to be moving and back and on the U.S. market, GDPs returned to pre-pandemic levels. In some countries, it's going back up quickly and making some progress. But it will be interesting. It's hard to speculate. I'm certainly not a scientist, but I think as long as people continue to get their vaccinations and their boosters where they're available, I think our hope is that we'll be able to ride out this next variant even better than the Delta.

Got it. Got it. Well, certainly, that would be encouraging. So let's pivot now to ADP specifically. And coming out of the last earnings, one of the big questions that I'm sure that you've been asked, hopefully, at least 97 times, and that is your record retention levels. Like, you're at very, very high levels right now. How do we think about that moving forward, particularly given the anticipated mix shift toward faster growth, but perhaps lower retention business. Can you kind of walk us through what you're expecting and what your planning is and then the mild markers or the KPIs that you're tracking to see how you're evolving on retention specifically?

Yes, for sure. That's a good question. And we have been making progress on our NPS scores, in particular. I think those NPS scores drive stronger retention rates. And our NPS scores have improved essentially on 2 aspects. One, our product continues to get better. Clients are happier using it; and two, we continue to offer good service. So we have seen retention rates improve across all of our segments, and we shared some of that at the Investor Day a couple of weeks ago. And we continue to move in the right direction there. And by the way, we've been doing that. The business has been moving to SPS, the low end of the market and some of the PEO that we have shared. And so that's happening with the change and the redirection if you will, or the heavier weighting in the lower end of the market. So we have been progressed through that change. That change is continuing. We did also, to be fair, I think we did benefit some from some tailwinds and continue to, although expect some of that to back off. I think people were very leery about changing their providers during the pandemic and all the government programs where you needed some continuity to get through those programs, make your repayments, et cetera. So I think we did have some benefit there, but we don't think that was the primary reason for our improved retention. We really do think it's the initiatives we've had around product and service, et cetera. And specifically, Run Reimagined and some of the UI/UX work that we've been doing, I think those are all contributing to the improved retention rates.

So just on some of those new initiatives and general improvement. Can you talk and provide more detail on how you think about the white space of potential clients? I think that was a term and you started to use it a bit more frequently recently. And of those potential clients, who currently use in-house or legacy ERP solutions, what are their HCM needs? And how can you address those? And what are, I guess, how broad end should we think about that white space potential being for ADP?

Yes. So I think, firstly, it's always important to remember that we're a, give or take, $15 billion and $150 billion market. So there's lots of runway, and there's lots of -- there's still lots out there. I would say that there are still a lot of companies out there or players out there using legacy platforms. And as those legacy platforms got a service or aren't supporting anymore, et cetera, we have opportunities certainly to win share of mid-market there. In addition, there are still an awful lot of regional players in the industry. And by the way, that's true globally. The market is still incredibly fragmented. And so as smaller entities or smaller competitors, et cetera, find it more and more difficult to compete in an environment of a regional and global market, we do think that we have an opportunity to continue to win share and to continue to grow. So there's lots of white space still left, as you said. The other aspect I would add here and from my more recent experience running the international business for a few years, there are -- there's still lots of opportunity in a couple of continents in the world, where the markets are continuing or starting to mature. And so evolving from agrarian or cash economies into more formal economies, where all the governments like to collect taxes, et cetera. And when those things start to occur, certainly, there's more and more opportunity for players like ADP.

So let's talk about some of your new platforms and you kind of alluded to this just now. First, let's talk about your planned platform migration plans in the U.S., and then what about up market and international? Like, what are the specific programs that we should be tracking as investors?

Yes. We made a lot of progress particularly in the U.S. I think we've made a lot of progress in many places, but I'll speak about the U.S. initially here. The move to Run and more recently Run Reimagined and the move to workforce now in the mid-market, really brought a lot of benefits to us. And we've seen our margins improve, and that's the reason for doing these things is to get our focus and put our development dollars and our energies behind fewer products where we can extend the functionality, extend the service to deeper investments. So that has been good for us. We've also learned a lot along the way. It's difficult to approach clients and move them quickly, if they don't know where they're going. Every time you do a migration, you risk starting a buying process. And so you have to be smart about it. You have to execute well. You have to make sure clients are going to get at least what they had before and really see the benefit of the new feature functionality. So we make sure that we've done that. It's taken -- took several years to do that in the U.S. market. And we've been doing that now in more markets. We certainly have more places to go in the U.S. in the upmarket. And so we'll perhaps talk about our next-gen products in the upmarket in a little while. But certainly, we know we're in a different place there right now. We're still developing those products and as we're ready, and we're able to move clients in the upmarket to the next generational products, we will. Internationally, I'm happy to say that we've made lots of progress over my tenure of 15 years I've been out of North America. But I would say that there's still a way to go. We -- perhaps, if you go back 10 years or beyond 10 years -- beyond 10 years back, we likely didn't have as disciplined an approach to growing market share. We did a lot of acquisitions, multiple platforms in single countries, et cetera. We've made significant progress, but I think there's more to do. And as more products like HCM are available in more and more countries, we will continue to make progress there. And just to talk about to frame it a little bit in terms of the pandemic. You can imagine what it was like with all the platforms we have when all the governments around the world started changing all the rules and creating benefits. So we literally had thousands of code changes to make. And maybe would have had several hundred to make as opposed to thousands to make had we had fewer platforms. And so if nothing else, even though that those changes were very successful, if nothing else, it would have made life a lot easier for us and perhaps for our clients.

So was that enough of a headache for ADP and for your clients that it motivates change? Or were you so successful at doing it, that there's a little bit of like, well, we managed 1 of the worst scenarios possible, and we still did okay. You see what I'm saying like you could look at it either way.

No. I think it's -- first of all, we've been working on these migrations, and we're -- prepandemic, and we were doing that for a very good reason, and that reason hasn't changed. It makes a lot of sense to have fewer platforms, getting more focus, make your investment and your products go further for your clients. So that hasn't changed. The 1 thing that remains constant, though, is that some of our clients, our international clients and our upmarket clients tend to have the best retention. And so they're somewhat happy -- to your point, they're somewhat happy with where they are. But -- so you got to make sure that as we get the new products and as we get the new UX and the UI, et cetera, we need to make sure that we bring them along in a journey that improves their retention, improves their satisfaction with us. So it's all about execution. It's all about being careful about how you do that.

Got it. Got it. So you mentioned in passing or said we come back to the next-gen platform. How has your thinking around next-gen HCM changed and -- in recent quarters? And how are you thinking about penetration and potential going forward?

Yes, I don't think our thinking has changed. I think what we're doing is making sure that when we extend and continue to extend our HCM products, particularly in the upmarket, that we've got the implementation resources and we're -- we're well positioned for success, back to my comment earlier, about making sure that we maintain client satisfaction as we go to the next products. There has to be a reason to change. Some of the reasons, real-time calculations, et cetera, there are some very good fundamental reasons that employers and our clients would like to change platforms. And so we need to do that, and we need to bring them along the journey. But to do that, we need to make sure that we're ready to do so. So really no changing in our thinking. But at the same time, just exercising the abundance of caution around our products, which, by the way, are in pretty good shape. And as you know, and we shared a couple of weeks back, we do have a number of clients paying tens of thousands of employees on those products. So we're comfortable and confident with the products. But as -- especially as you get in the upmarket, life is a little bit more complicated. Clients have more demands. We need to make sure that we're fully ready to take them on board.

So let's talk about -- pivot a little bit towards the kind of the consumer and kind of the employees. Obviously, your engagement directly is with employers. That's who award you business, et cetera. But I think last year, you processed something like 70 million W2s in the U.S., like an incredible amount of -- incredible number in proportion of the economy. But can you elaborate a little bit on the consumer data opportunity within Data Solutions? I mean, you're touching so many consumers and having a lot of real tracking ability there. Like, what are the opportunity sets which we should be mindful of?

Yes, there are a lot of opportunities there, and we do have access to a significant amount of data. So we're broken into kind of 3 buckets, if you would. I think that the first 1 is just HR analytics and benchmarking. So back to the difficulties employers are having hiring people. If you need to hire a forklift driver in Dallas, we likely have the information of what forklift drivers in Dallas make. So you know what you need to do, you know what questions you should be asking about what you should be offering to win somebody over, because that's likely what the competition is offering. So we think we have that kind of data. HR analytics, turnover rates, how do your turnover rates compare to turnover rates of similar companies in your industry across geographies with the challenges of finding workers, what's the demographic situation of your employees, when are folks expected to retire or you're going to have a spike in retirement, et cetera. So there's lots of things around HR Analytics. The other area, I think, that's important is that just the employment verification, income verification. So we're making it easier for employees and employers to request information from us to independently assert or attest to their employment and their income levels, so they can apply for mortgages, buy a car, et cetera, and get loans. So I think those are some of the key areas that we see. The third one is a little bit -- we haven't really got as far along as we'd like to, but we think there's a big opportunity in. That's retailers and real estate firms and even governments looking for information around certain groups. We have an awful lot of information. We do know how much -- many people on street in this town earn and how close they are to the nearest shopping mall, shopping center, et cetera. So we do have some pretty valuable information that's available. All anonymised, of course, or permissioned. But certainly, we have some very, very good insight.

So just as a reminder to those that are on the webcast, if you do want to submit a question, we've got about 8, 9 minutes left here. I'm pleased to do so, and we'll try to get to those. But I want to talk a little bit about margins. And there are some other things we can talk about around new products, et cetera, but profitability obviously has been central to ADP for a very long time. And that leads to capital returns, et cetera. And so I want to touch on margins and capital allocation and make sure we get to those topics in the last few minutes. So how much of the medium-term margin outlook that you gave recently is being driven by operating leverage? And what are the other moving pieces? And I guess, as part of that, how do you think about operating leverage in PEO versus ES? So kind of break down your margin targets that you've set out, how you get there, and what the key components are.

Sure. So we do see a significant amount of our margin improvements coming from driving incremental revenue. So as revenue increases, we have a significant amount of operating leverage. If an employer adds 3% or 4% more employees, that's really not a significant amount of effort for us, but it certainly is incremental revenue, and a significant amount of that is incremental margin that falls through to the bottom line. So it's all very good for us. So we continue to see progress there. So as clients grow, and as we grow more share, we will continue to see margin improvements. The other area is our digital transformations. So we've had digital transformations going on for sometime. Those savings we've seen from some of those initiatives continue to improve our margins even through pandemic times. We were offsetting some of the challenges that we're seeing from decline in pays per control, et cetera. So it contributed significantly to the overall margins. And then if we look to the PEO business, the PEO business has good margin and because of the way we report, we do need to include the 0-margin pass-throughs in the revenue. But if you pull that out, it's fair to say that we do have pretty good margins in the PEO business around the 40% range. And -- but it's fair to say that it is a more service-heavy operation than ES is. So margins are noticeably lower in that segment than they are in the ES segment.

Got it. And then we're already going to give you credit that you're going to get your medium-term margins. That's going to be no problem because ADP, you guys always get it done. But what about longer term? Is it like, are the medium-term margin targets that you're setting, is that a good long-term model as well? Or do you think there's incremental opportunity beyond that?

I think longer term, if we're going beyond 4 years or so, I would say that we'll continue to -- we'll certainly continue to grow the top line. We'll continue to grow share. So I do think that we'll continue to see the biggest driver, which is increased revenue, continue to drive our margins. Certainly, beyond 3, 4 years out, we're going to see increased digitization. We're always mindful of saying, though, and I think I need to reiterate here that, we do see ourselves a little bit differently than some of the pure SaaS players. Even though we know product is important and easy self-use is important, et cetera, what we do offer that's different from some of the pure SaaS players is if you have a problem with your payroll or filing your taxes with the ERS, you can call us and we can help you. Because some of the pure players, they can't do that. They can tell you how to fix the bug or they'll take a ticket on the bug, but they won't really offer you any assistance in getting your payroll or getting your tax filed, et cetera. So we do differentiate there. But I think as we go out and much further down the road, I think we're going to see more use of AI and whatnot, and things will get done faster and more efficiently. And I expect -- fully expect that ADP will continue to take advantage of those initiatives, just like we took advantage of the introduction of Mainframes way back when, I think we've been very successful adopting to and adapting to new technologies.

So let's talk about capital allocation. Can you kind of recap for us kind of the capital allocation prioritization of ADP? And where does M&A sit within that, particularly given the level of competition in the space?

Yes. So maybe I'll just -- I'll start with the slide we showed or just recap the slide. I think over the horizon from 2010, we returned about $24 billion back to shareholders through share buybacks and dividends. And of course, we've just announced our 47th consecutive year of increased dividends, which puts us in a rather elite group, I think, we'll get -- we'll get past 50. That's for sure. So we're looking -- very much looking forward to the days in the future or the years in the future to do that. When it comes to M&A, back to a comment I made earlier about a little bit of our perhaps less than disciplined approach 10, 20 years back, I think we bought a lot of market share. We got into a lot of countries, and we didn't really do a good job of making sure that we were bringing things together in a way that maximized our coverage with efficiency. And so as I -- as we speak now, I think what we're really looking at is what I would determine or what I would describe as tuck-ins. So there are some geographies. There are some countries in the world with very big populations, where we are yet to be present on the ground. So we certainly continue to assess some of those opportunities. And then we have some tuck-ins around some product offers that we think we can take advantage of. Without doing huge acquisitions, I don't think that's something that we're terribly interested in.

So let's circle back and to wrap up here to where we started in the constrained labor market. How is the constrained labor market impacting ADP's own operations? And in particular, how do you look to attract and retain talent, particularly those with in-demand skills like UX, UI? You talked about your own initiatives there, especially given the competition from the newer HCM peers and players that are trying to be in the market today.

Yes. No, that's a good question. And certainly, we're not immune to some of the challenges with -- in the labor markets these days. I will tell you, though, that we finished the first quarter with significantly more employees than we finished year-end with to fuel our growth and support our growth. So we have been able to hire successfully and add employees to the business. I think we've got a few benefits. One, I think we're a good company to work for. We're a good employer. And specifically around some of the technology challenges that people are having, we do have a number of development centers around the world. So certainly, given the virtual environment that we're working in, we do have the ability to hire technology people in Brazil or India or Canada or the U.K. or India or China. So we do have a footprint that allows us to go beyond the local markets, if you will, and through some governance and some local infrastructure, able to direct people to work on projects that may be outside the geography of their current residence. So those are some of the things we're doing to get ahead or stay ahead of the challenges that are out there and specifically in the technology sector. And so far, we seem to be -- we seem to be making our way.

So just on that point, is there other opportunities? You talked about acquisitions that you had done to gain share or enter new geographies and you want to be disciplined about that, especially given the immigration challenges. But should you be looking to do kind of acquire hires of technology shops, et cetera, to gain some of that skill and talent set in new technology areas? And is that something that you've done in the past?

I think we've made a few acquisitions and the technology has come with it. I think that the recent 1 that we did in international, Celergo. They had some good technology. It wasn't so much the technology they were using, it was the application they developed specifically. So -- and I'm not so sure we should be buying applications just to get access to people, who understand the technology, but certainly, we should be looking to make sure that if we do, do acquisitions, that the technology that comes with it is up-to-date, modern and brings with it a skill set and the people that come with the acquisition, make sure they can continue to contribute on the acquisition itself, and hopefully, more broadly across the rest of ADP's products.

Don, that's all the time we have. We really appreciate you spending time with us today at Nasdaq Investor Conference. Fingers crossed that we'll be able to do this in person next year, and hope things go well in your current travels.

Thanks, Jim.

Thank you very much. Bye.