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

Thanks so much, everyone, for joining us for Evercore ISI's Sixth Annual Payments and FinTech Innovators Forum. I'm David Togut. I lead the payments processors and IT services research team here at Evercore ISI. Delighted to kick off the conference with ADP. Joining us from ADP are Don McGuire, Chief Financial Officer; and Danny Hussain, Head of Investor Relations. Don, Danny, thanks so much for being with us here today.

David, thanks for the opportunity. Good to be here.

Just to kick it off, inflation is top of mind these days. Could you walk us through the impact of inflation on ADP's revenue beginning with pricing and your ability to pass that along to your customers?

Yes. So certainly, lots of conversation about inflation these days, David, and we're certainly paying attention as we should be. Inflation impacts us in a few ways. And I'll give you a couple of ways that it impacts us. Firstly, in our PEO business, our payroll fees or percentage of wages. So as wages go up, our fees go up. So that's, in some ways, a little bit helpful. In the client funds portfolio, certainly as wages increase, that means that we have more client funds on hand in our balances. And of course, those balances can then earn more interest based on interest rates, and we'll talk a little bit about interest rates I think, later on, I expect. And then certainly, the -- in the pricing. So we do have some pricing capability. And of course, we raise our -- have the opportunity to raise our prices with our core installed base, and so we will do that as appropriate. And we, of course, have the opportunity to raise our prices for our -- for the new opportunities, the prospects that we encounter in the marketplace. And of course, I think that we're not alone in this situation. I think the market in general is reacting to inflation. So we expect to be able to do all those things and still maintain our competitiveness as we always have. There are a couple of other ways that inflation can help us a little bit less indirect in the short term. But if inflation persists, it's likely that we'll see interest rates go up a little bit. I think yesterday, we saw the Bank of Canada raised their rate by 25 basis points to 0.5, which is again, first increase since pandemic. Certainly, I think we're going to expect to see more of that coming down the road in the future. And then, of course, in these inflationary times, it's difficult sometimes for companies to find more people so they turn to us to help them as they have attrition and turnover and so we'll help them reduce their costs by outsourcing their payroll and do some of those things on their behalf. And some of that is also complemented by us providing our RPO solutions, our recruitment processing outsourcing and our screening and selection background checking to those new recruits. So that's a handful of the direct and indirect ways that ADP is responding to this higher inflationary environment and how we expect to respond to the marketplace.

Don, appreciate it. Just shifting to cost structure. Could you quantify the impact of inflation there? And related to that, how much of the impact of cost inflation, especially from higher wages, can you offset both with higher prices and with operating leverage in the core business?

Yes. So when we give our -- when we did our Q2 results, our earnings call and we provided some guidance for the balance of the year, we didn't go through and specify or break down that $100 million of expense that we added in and shared that we were going to be impacted by, very little of that actually related to inflation. It was pretty much the minority. Most of that was related, as we shared at the time to staffing up and making sure that we have the implementation and the service resources in place to handle one, the year-end and two, just the recovery in the overall market. So we've done that, and we haven't been that heavily impacted by inflation to date. So we're happy. We're comfortable that higher revenue we're seeing is going to lead us to higher earnings and higher EPS growth. And so we do continue to expect that to happen. As we go forward and look to the future, it's hard to predict. But I would say that we are fortunate to have still very good employee retention numbers. We did a couple of things that we shared with everyone at the earnings call around some kind of interim period wage increases and some interim period kind of performance incentives, if you will, to a broad base of our associates and that seems to have worked. And we are happy with our employee retention. So we don't think we're going to have any shocks, but we think we're going to be able to handle this inflation relatively well. We did -- in terms of inflation and the overall impact, we're all mindful. I'm not making any -- I'm not confirming anything here at the present time, which reappropriate, but we are very mindful of what we share with everybody at Investor Day a 75 basis point improvement per year over the midterm. And I can assure everyone that that's very much in our thinking as we think to our strategic plans and operating plans as we go through the upcoming cycle.

Great. Maybe just wrapping on inflation. You've highlighted that the March 2022 quarter EBIT margin will decline before growing again in the June quarter given increased hiring of implementation and service personnel plus wage inflation. Can you quantify some of these impacts? And why would you expect to exit FY '22 with a significant margin improvement? What changes in the June quarter versus the March quarter?

Yes. So once again, I spoke just a little bit about us hiring implementation service resources, and we've now layered those in. So I think we're comfortable. I think if you go back to Q3 of last year, we're at a much less certain period of time with respect to how the pandemic was going, COVID, et cetera. And certainly, I think activity levels were somewhat depressed in Q3 of last year. So we are back to something that looks more normal now. We're happy with where we are. And really, we're just -- we're dealing with a grow-over problem from what was kind of a weak overall activity level. And fewer resources in implementation and service at this time last year. So not really a problem just working through the ripples and the step-up, if you will, from where we were last year to where we are now. And if I think about the balance of the year and in Q4, by Q4 of last year, we had pretty much return to a more normal operating environment, and we were substantially staffed. So what the expectations in Q4 of last year and Q4 of this year, I think it's going to be certainly an easier compare. And I think we're confident we're going to be able to deliver on the -- what we've shared with you in terms of guidance. So really just the comparison is the -- was the challenge.

Understood. With half of fiscal '22 left, your fiscal year bookings growth guidance calls for 12% to 16% increase over FY '21, which is still a pretty large range considering there 2 quarters left. Can you talk about the employee services sales cycles, closing rates, level of activity you're seeing is the impact of Omicron fades and speak to overall demand trends?

Yes. So I think it's fair to say that from historical perspective, it start to say that we still have a broader range in our bookings guidance that we've had historically. I think that's appropriate given the challenges we've seen with the pandemic and the various waves we've seen. Just to say that the activity levels continue to be good. So we -- when we did our Q2 earnings call, we said at the time, we haven't really factored in any downside for Omicron because we haven't seen any through the end of the second quarter. So the activity levels continue to be good. And it's fair to say that, as we said, the guidance range has been higher than average. It's certainly less than it was last year at this time. And I think as things normalize, we'll see that range continue to get narrower, of course. But just to reiterate that when we provided guidance, we might have a way to share with everyone that we hadn't factored in any major impact from Omicron because we hadn't experienced any at that time and Omicron is now very much receding.

Understood. One of the main aspects of the pandemic, certainly in -- for ADP and for the HR services industry overall has been really record client revenue retention. You've talked for FY '22 about client revenue retention declining slightly about 40 basis points, which is better than your previous outlook for down 50. But it's still very close to the record FY '21 client revenue retention of 92.2%. Can you talk about the factors that will keep client revenue retention near record levels for this fiscal year as a whole?

Yes. I think we're quite pleased with our client retention. The -- we have hit the highs. And as we shared, we're up 40 basis points from -- for record, which wasn't as much as we thought we'd be off and we shared that. And so the Q2 results we had were also a record, albeit safe FY '21. So we're still in pretty good shape. The drivers, of course, tend to be just service levels, Net Promoter Scores. We've rolled out, we've shared our next gen, our 1 UX of user simplicity, if you will, and we continue to get good feedback. Clients seem to be very happy with what we've put in front of them, and that's very much driving our high retention rates. And so we do expect them coming down a little bit as we've said, because we are seeing a bit of a mix shift towards some of the smaller end of the market, which has more out of businesses, et cetera. But I think it's that combination of service, updated products, one user experience that have helped us maintain these retention levels.

Got it. At ADP's recent Investor Day, you provided medium-term objectives to grow revenue 7%, 8%, driven by 7% to 8% Employer Services bookings growth, stable employer services, client retention, plus high single-digit growth in work-site employees and in client fund interest. If we start with Employer Services bookings growth outlook, what are the key drivers of 7% to 8% growth? And how much market share gain does that assume?

Okay. So let me go through a few points here. Just I'll work my way to it. There's a lot in that question, David. I'll let me work my way through the -- work to the answer. So I'd say the first thing to talk about here is better product. So having better product, continued innovation in our product, better UX is going to help us have higher win rates. And it's going to help us win more clients, and it's also going to help us continue to upsell additional products into our base. So I guess that would be the first area that we should focus on with respect to our growth. Second is productivity enhancements and not often do we talk about productivity as we talk about revenue growth. But the reality is that over the last couple of years, our sellers have very much learned how to operate more effectively in a virtual environment. And I think we're seeing that translate into more from the same or fewer numbers of people. So we are getting more productivity out of the sellers. And that, of course, is helping with just the average sales productivity per quota carrier. So that's been good for us. Third, and this is a bit new for us. We talked about this a little bit. A couple of people have asked me in the past that we're going to start naming sports stadiums, I think the answer is no. But we have started advertising in areas in Gulf, for example, and other places where we haven't historically done those types of things. So you will see, and you have seen, I'm sure, more ADP presence. And we think continuing to deliver the message into different places is going to help awareness and continue to help us grow. If I was to move on to a fourth area, we do work with a number of various channels through CPAs and banks and brokers, and we do have very much have a group of people who keep those relationships live and active and make sure that there's something in it for the -- all of our partners on the other side. And so I think that mutual win-win environment we have between us and all those channels has really, really helped us with our ability to continue to grow our sales. And then lastly, back to headcount. We do have the opportunity still to grow headcount and grow headcount with that more effective way to sell, I think, is just another opportunity for us to continue to grow the business. And then your -- I think your last part of your question was are we growing market? Are we taking market share? And I think as we shared at Investor Day, we talked about the market growing in the neighborhood of 5% to 6%, and we just talked about 7% to 8% share growth ourselves. So that translates into us taking more share.

Great. Your medium-term guidance also calls for high single-digit growth for PEO average work-site employees. Does that assume significant market share gain as well?

That's -- I think I would say that we expect to grow with the market or better than the market. In terms of our growth rates, as we are the biggest PO today, we'll see how much faster we can grow than the market average. But I think we're pretty confident to say that we expect to continue over the long term to grow at or above the average. And we're doing that in a couple of ways. One, we do have this ability to go out and find new prospects and new opportunities, which we continue to do every day. And then the other thing that we're able to do is we're able to look into using some AI tools and some various things that we think resonate with clients or our current clients who would be better served in a PO environment. We look in at that base of 900,000 clients that we have and see if there are opportunities to move those clients to a different service model where they're better off, and certainly, we'll be happy too. So a couple of ways for us to continue to grow.

Over the last several years, we've been in a pretty significantly declining interest rate environment. It seems like we're at an inflection point right now with the Federal Reserve about to raise interest rates. Chairman Powell yesterday said 25 basis points likely in a couple of weeks. Can you address your high single-digit growth assumption for client fund interest? How much in the guidance is driven by higher interest rates versus wage inflation? And then obviously, underlying growth in pays per control.

Yes. So as we said at Investor Day, and I think as we updated at the last earnings call, the -- we do expect to solidify the 1.4% to 1.5% range, and that's continuing. The markets are still there. We do think and we've heard the defense comments on interest rates. We saw, as I said earlier, the Bank of Canada raised, I believe, it was yesterday, they went up. So we see that coming. There is, of course, opportunity for us as we go forward with that. I think as we've shared the trying to -- it takes a little while to work that in as we position ourselves in longer-term investments, big surges in short-term holdings really is overnight interest rates, which aren't that meaningful for us in the short term. But we do see and we have seen growth in pace, just a number of people we pay and certainly growth in wages. Both of those things will be helpful for us. We have shared some pretty positive pace per control growth through the end of Q2. We think that, that's probably going to be now in the 2% to 3% range. We don't think we're going to see another step up. I think the step-up has happened. Now we're going to see more stable growth. The one area -- if the interest rates, should they arise, will be helpful, of course. The one area that you could say could be a bit of a wildcard, but could take a little bit of time to bed itself in also would be a substantial increase in wages because that, of course, would tick up those balances in a more meaningful way, and that could be helpful to our revenue.

Understood. Looking at your midterm outlook for 10% to 15% growth in EBIT. That assumes 75 basis points of annual adjusted EBIT margin expansion. What do you see as the main tailwinds and headwinds to your EBIT margin expansion forecast?

Yes. So the tailwinds of course, would be revenue growth. As we shared we shared at Investor Day and we shared at the Q2 results that we continue to see revenue growth, we expect revenue growth over the midterm, and that will be positive for us. And of course, a lot of our margin is helped and covered off by that wage growth. And then, of course, we continue to have some discrete expense initiatives. So we do continue to work on things like automation, RPA, providing better self-service tools for, I guess, I would say, 3 parties internally, to our own associates, to our clients and then thirdly, to our clients' employees. So I think we do have lots of -- we have tailwinds for the revenue, and we do have tailwinds from some of the discrete initiatives that I just mentioned. Now for us, given we're a service business, we're not buying a lot of nickel and copper or natural gas. Our inflation watch out is on wages. And so making sure that we can find the right balance of wage increases, automation, et cetera, I think, is going to help us continue to deliver that those 75 basis points that we have shared with the investor community and for our midterm and we're very much focused on those. And of course, just to finish on, we do expect to see some price increases to help us with that as well.

Don, over the last few years, ADP has migrated its smaller business clients, typically under 100 employees per company, the run client base to your new cloud-based platform. Also in mid-market, you've done that with Workforce Now. When we look at your national accounts space, what percentage of the ES clients have migrated to Next Gen HCM from your legacy platform? And what's the time line for this process to be completed?

Yes, we shared at Investor Day and more elaborately. And you remember, we took the time to break out our segments to let people see for the first time, the proportion of national accounts we have or upmarket versus mid-market, et cetera. But at this point in time, it's still a small percentage. It's -- what we're working through is trying to take some very large clients we've had for a very, very long time and trying to make sure that they will experience or have a better experience from start to end, and we're working with them and working through implementation with them to make sure that that's where we arrive. And so that's underway, but it will be some time as we've continued to share before we actually get to where we would like to be and will be with the next gen product. And I would say with one, I think, major exception and that major exception would be that Workforce Now is proving to be a very, very good offer in the lower end of that upmarket space. And we are seeing not only a number of wins of new clients in that space, we are seeing some migrations to that product because it is appropriate for that lower end of the upmarket. So we continue to be happy with where we're going. But it is, as we've shared, it's still very much a journey.

Appreciate that. And then just staying on the Workforce Now product for a minute, you've recently announced that you're going to take that product global. And I know prior to becoming CFO of ADP, you ran the international business. Can you speak specifically to what makes Workforce Now an attractive product for the international markets? And when do you think we'll start to see traction with that strategy?

Just to describe what we're doing there a little bit perhaps more transparently, the Workforce Now is serving that kind of mid-market and lower upper end of the market. And many of those companies, those clients may have operations outside of the U.S. in Canada, for example. Although it's -- we're not talking about the really upmarket clients who are in 100 countries and hundreds of thousands of employees. But we do have the opportunity to extend the capability of Workforce Now into a number of countries. And so we do think that, that's going to be an opportunity even for those mid-market, some of you do know, I mean, I'm Canadian National, and I've started my career at AD Canada and the amount of cross-border integration in terms of where the people who process the payroll sit, they may sit in Canada, they sit in the U.S. They were servicing the North American market. We do have the opportunity to extend that solution to companies who are -- have relatively small amounts or midsized amount of people in various countries. Not to be confused with what we're doing with our GlobalView platform, which is really a market where we have some clients with hundreds of thousands of people on the payroll and they're in multiple, multiple countries. A little bit different, but certainly something that's going to help us be successful or more successful in that mid-market.

Just to pause for a minute, if you have any questions for Don, please do type them into the chat box. You also have the opportunity to raise your hand. So we certainly welcome any questions you have on ADP. I'll keep going, but we'll certainly look for your questions as you have them. In your midterm guidance, Don, can you quantify the expected revenue contribution from some of the newer products in ADP's ecosystem such as Next Gen Payroll, Workforce Management and Next Gen Tax?

Yes. I think back to the growth rate we have at 7% to 8% versus the industry at 5% to 6%, it's pretty tough to go and quantify each of those individual products or offers that you just described in amongst themselves. But what I can say is that given that we've been chased by our competition for decades now, we do know that to continue to grow, we're going to have to continue to innovate. And I think that's what we've been doing, and that's what's happening, and that's what's allowed us to continue this better than average growth rate. So a little bit difficult perhaps to break them all up independently. But I would say that when you look at our investments in those products and those services and you look at our growth rate, you can see that what we're doing is paying dividends for us, paying dividends for our growth.

Got it. Well, that's a great segue to capital allocation. So with almost 100% of your free cash flow committed to dividends and share repurchase, are you inclined to debt or equity finance a significant acquisition if you have one in the pipeline? And if so, which businesses are you most interested in potentially acquiring?

Yes. So once again, a big question. I think that, firstly, just to talk about doing acquisitions in the first place. We've spent a lot of time over the years in getting ourselves to a simpler place, if you will, with fewer products, less dual maintenance, et cetera. That was -- that came out of the woodwork in spades as we went into the pandemic and the various platforms we had around the world, in particular, in my old space in international, where literally, we had dozens of platforms that have tax updates on the fly, a very difficult area to maintain. So we're very, very focused on making sure that we -- if we choose to do an acquisition, it's an area that extends our reach to some place we're not today, gets us to a solution that would take us longer to build ourselves. But without adding clutter, if you will, to the portfolio. So we're very focused on that. I would say that irrespective of what's happened to the markets in the -- since the beginning of the year -- the calendar year, the drop-off in some of the valuations, valuations tend to still be a little bit high if something is going to be accretive. And we'll see. I mean that's both not only in the public markets, but also in the private equity markets, folks who are interested in selling off and moving on to other things, some of the expectations are still a bit high to be accretive. And then if we think about how we would go about doing the major acquisition, should there be one. I do think that we have lots of opportunity to finance a major acquisition. I think we still got lots of room on our balance sheet. We've got lots of room to increase our debt and still maintain our rating. It is very important for us. As you know, we do borrow money in the commercial paper market several days a year so that we can maintain those longer-term invested float balances and higher interest rates. So we're also always making sure that we don't do anything that would cause us harm on our daily commercial paper rates to make sure that we can still grow and have confidence of the lenders for us to do that. So long story short, we're always looking for something. They're always -- there's always something on somebody's desk, including mine, always something being evaluated, but we'll keep our powder dry until we see the right thing.

Understood. Let me just pause again to see if there are any questions. I'll keep looking in the chat box. If you do have any questions, please type them in there or feel free to raise your hand. Don, as we approach the close of our time this morning, perhaps we can go back to the beginning and come full circle. Given your experience running the international business before coming into the CFO role, are there any specific experiences you had running the international business that you think specifically inform your approach to being CFO of ADP, should we expect ADP to become more global, for example, over the next few years as you evaluate some of the opportunities that you worked on while you're running the international business?

I'd like to think that as I shared earlier, starting my career in Canada and then moving to the U.K. and then off to Asia and then back to Europe. I have had a pretty good vantage point, if you will, of what we do around the globe. Certainly, there are still many, many opportunities in international. I think there's things we can capitalize on. I've spent a number of years getting us to a better place in terms of the number of platforms and more efficiency and improving our margins. And I certainly had lots of help from many, many people along the way, but I think if you go back 2 or 3 years, we didn't spend a lot of time talking about international and earnings calls, et cetera. And I think you're hearing more of that now. So I think some of those perspectives and some of the things that we've done to improve our margins in international and hopefully, in the chair, I'm in now, I can share some of those ideas and thoughts with the rest of the team and see if we can continue to make improvements and continue to be focused on delivering the commitments we shared with everybody at our Investor Day.

Terrific. Well, Don, thanks so much for being with us here today. Greatly appreciate your time and insights, especially dialing in from London. Thanks so much, everybody, for participating in the fireside today with Don. And have a great day and look forward to seeing you throughout the day. Thanks again, Don. Thank you to Danny as well.

Thanks, David. Thanks, everyone.