This Overpriced Wide-Moat Firm May Be Losing Its Edge

As the largest provider of payroll services in the United States, Automatic Data Processing should continue to benefit from the evolving and increasingly complex relationship between businesses and their employees. But in the medium term, we see challenges.

ADP currently enjoys a wide moat thanks to traditionally high switching costs. The incremental investment required to add a new customer or an employee to a platform is small, which in recent years has resulted in high incremental returns and margins for ADP. In general, employers will pay a flat service fee and then additional fees for every employee added to the system.

Though ADP possesses multiple structural benefits, we view its moat trend as negative as a result of lower switching costs and a decreasing cost advantage. ADP's legacy technology platform is the result of years of acquisitions that weren't fully integrated and is seemingly cobbled together using antiquated systems--some from the 1980s. ADP's technology has likely contributed to its client retention issues, as younger, more tech-savvy companies in the space--such as Workforce, Ultimate Software, Intuit, and Namely--pose a significant technological threat. Going forward, we expect ADP's margins to be challenged by significant reinvestment needs and an aging technology platform.

In addition, the company has seen competition from Paycom and Paylocity, which appear to offer superior customer service. Clients are increasingly defecting over customer service issues. ADP's competitors have client service teams; ADP, meanwhile, has disparate teams using different systems that often don't communicate or work together to address client issues. While ADP has been working to integrate these functions, we believe it will take years of increased spending to properly address.

Given its challenges, we think that ADP is highly overvalued today, trading around a 40% premium to our fair value estimate.