Dealer Services – ADP Spin Off Analysis

You probably know ADP as the payroll people, especially if you live in the US. You probably have some experience with them and might have even seen their jobs numbers. If you checked out their website you would see the following, “ADP services 620,000 organizations in more than 125 countries, including more than 90 FORTUNE 100 companies use at least one of ADP’s services.” It’s clearly a large, mature company that processes payroll and performs HR type services. For the most part you are right. That’s their bread and butter. The interesting part is that they also have side businesses that they grow to become large institutions and then either sell or spin off. The reason they emphasize the dealerships is because 16% of their revenues come from dealer services, which include dealer specific ERP systems and marketing services. That is the business they are currently planning to spin off. This isn’t a new tactic for ADP. In 2007 they spun off their financial services division, which is now Broadridge Financial Solutions, Inc. (BR) and sold their travel services. Based on the incentive program, the desire to spin off these entities appears to be less a focus on the core competency than a desire to improve margins. For that reason, the expectation is the spin off will occur by next June 30th and potentially in the next few months.

ADP operates three disclosed segments: Employer Services, Professional Employer Services (PEO), and Dealer Services. Employer Services is what ADP is known for. It also expanded related services to smaller entities as PEO. Dealer Services, thanks to the new disclosures, can be broken down into three segments: Automotive Retail Solutions North America, Automotive Retail Solutions International, and Digital Marketing Solutions. To analyze these entities, the most recent SEC filings were used in each case. That means the last year a record was reported, which is three years after the date for segment income, was used with the thought that information would account for acquisitions, reorganizations, error, etc. Therefore the later amounts should be the most accurate information available. Additionally, the spin off has not yet  been reconciled to the segment data previously provided. To adjust amounts for agreement with the previous audited submission, the Other category was adjusted accordingly.

Revenue (mil): 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003
Employer Services 7,914 7,389 6,878 6,535 6,379  6,228 5,816 5,163 4,700 4,872 4,393
PEO 1,973 1,771 1,544 1,317 1,186 1,061 885 704 577 478 462
Dealer Services 1,814 1,661 1,514 1,248 1,242 1,302 1,281 1,098 937 900 814
-Automotive Retail Solutions North America 1,207 1,115 1,025
-Automotive Retail Solutions International 315 303 299
-Digital Marketing Solutions 310 263 225
-Other (18) (20) 15
Other (391) (205) (103) (172) 32 144 (182) (128) (126) (79) (135)
Total 11,310 10,616 9,833 8,928 8,838 8,734 7,800 6,836 6,088 6,170 5,535

As a whole the company’s revenue grew at approximately 7% a year. You can see the downturn in the economy and jobs in 2008 and 2009, which makes sense as employers lay off people and stop hiring. This was partially offset by the growth in small to medium size business offering in PEO and to a lesser degree Dealer Services growth. Dealer Services had a severe drop in growth during the economic downturn. At first glance, Dealer Services appears that 2011 started a higher growth level, but per their disclosures it would been only 3% as opposed to 21% reported if not for acquisitions. The primary acquisition was Cobalt, who is the base of their Digital Marketing Solutions (Digital) segment. If you look at the overall operating margin, you see a solid 17% margin with higher averages. The margin requirements for the executive incentive program is pretty clear here in keeping margins high. The segment raising margins is the Employer Services segment at 27% margin for both the prior year and average. PEO has lower margins as one would expect to win smaller businesses, which have less money to use. PEO has consistently maintained 10% margins. Dealer Services currently has the same margins as ADP as a whole. It has maintained margins at that level even through the economic downturn. You will notice the overall margin has decreased as PEO and Dealer Services gained in percentage contribution to operating margin, which is being asserted as part of why management wants to spinoff Dealer Services. The split between Dealer Services from ADP if looked at from an overall perspective will have no impact on margins, but as you can see from the split out values, margins will increase as Employer Services will be a greater percentage of operating profit.

OI % 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003
Employer Services 27% 26% 27% 27% 28% 26% 24% 24% 24% 20% 24%
PEO 10% 10% 9% 10% 10% 10% 9% 8% 7% N/A N/A
Dealer Services 19% 17% 15% 16% 17% 17% 16% 15% 16% 16% 17%
-Automotive Retail Solutions North America 26% 24% 24%
-Automotive Retail Solutions International 10% 6% 9%
-Digital Marketing Solutions 9% 5% 4%
-Other 211% 95% -304%
Other 179% 198% 382% 122% -590% -164% 45% 88% 51% -370% -327%
Total 17% 19% 18% 21% 21% 19% 21% 20% 20% 23% 30%

Within Dealer Services, we have a thin slice of financial data with only three years of data. This is most likely strategically selected as to not report prior to the acquisition of Cobalt as the large driver of revenue growth is Digital at 18% growth. This growth is followed by North America at 8% growth and maintaining a 25% operating margin. The smaller segments have lower operating margins. International increased in margins to 10% and Digital increased margins to 9%. Dealer Services will most likely see margins decrease as Digital continued growth puts downward pressure on the company’s margins.

Management of Dealer Services is filled with longtime ADP employees. The new CEO has been leading the ADP Dealer Services segment for a number of years and has been an ADP employee since 1975. With the exception of John Holt of Digital, who came with the Cobalt acquisition, the management team is filled with life long ADP personnel. This will most likely result in Dealer Services operating in a similar fashion as ADP. There will likely be a focus on margin, which should improve with the new focus. However, Digital will most likely have downward pressure over the long term if proprietary marketing strategies do not develop as there are few natural barriers to entry. ADP has a history of regular strategic acquisitions to contribute to overall growth rate. This should also be expected as Dealer Services, who was behind the success of the Cobalt acquisition. This could lead to an increase in growth outside of projections from historical data.

There is one area, however, that Dealer Services might change from ADP prior practices that will lead to improved economics of the company. Per ADP’s financial statements, 85% of all revenues originated in North America. This is partially due to the regulatory environment, where the United States and Canada have complex compliance structures for employers. Not all nations have payroll tax and many that do have a simplistic system that does not require outsourcing. This has resulted in a company ignoring international options. This is shown in Andrew Dean’s goals, who is head of International. In the prior year, one of his goals was to create a strategy for Russia and Automaster. He was not rewarded for execution, but to create a plan. The focus has appeared to be on Europe, but only lightly. They claim to have brought in $315 million from 100 countries, which makes it appear to be a discombobulated operation of many tiny businesses, which would require a dramatic increase in compliance issues. A sign this focus will change is based on the disclosure of “Our Market Opportunity,” which lists China and Japan as major opportunities. This could result in International becoming greater or equal to North America operations with the expectation based on the above for similar margins. This is another potential option for growth and higher margins in the new business.

Looking at each of the components competitors for valuation creates interesting results. The closest competitor to Dealer Services is Dealertrack Technologies, Inc. (TRAK). According to Yahoo Finance, Dealertrack has negative income and cash flow from operations. As of July 3, 2014 it was trading at 4.61 times sales and it’s EV/EBITDA was 63.87. The valuation seem insane, but auto sales have been strong and this is the only public company selling marketing and ERP systems to auto dealers. Dealer Services has an estimated 40% of the dealer ERP market with Reynolds and Reynolds having the other 40%. This shows that Dealer Services might sell into a hot market and have valuations that can’t be supported by a discounted cash flow, liquidation or acquisition value. For our valuations purposes, let’s add debt for the spin off. ADP has estimated $700 million to return to itself in the form of a dividend. Let’s estimate that they will issue $900 million in debt to leave Dealer Services with strong working capital. We will have North America with a 7% revenue growth and 26% margin. International will grow at 10% and a 15% margin. Finally, Digital will grow at 20% and a 10% margin. This is approximately $425 million in operating income, which is approximately EBIT. Assuming a one for one share swap and a 10xEV/EBIT then you have 8.82 a share. If you take a ten year bond, and a 20 PE, then you get $8.17. As this is the largest public auto dealer with strong margins, this appears to be relatively conservative. For future calculations, we will estimate it at $8.50.

PEO has several competitors. For comparison, Inspirity, Inc. (NSP), Paychex (PAYX), and TriNet Group, Inc. (TNET) were selected using the trailing twelve months.

 P/S 0.37 6.13 0.92
 P/E 30.17 25.18 161.24
 P/CFO 32.75 19.51 17.87
 OP% 2.37 39.6 3.95
 ROA 4.34 8.29 N/A
 ROE 11.68 35.66 N/A
 EV 582.24 14,400 2,110

TriNet Group is closest in size to PEO and Paychex is closest in terms of services and with a focus of higher margins. TriNet is claiming to increased profits and the future P/E is 20. Using a 25 P/E PEO is valued at $6.71.

Using similar pricing and using the $700M for a stock buyback at current prices, ADP’s remaining services is 73.25. This means the total value is 88.16. This is slightly lower than the current value as of July 3, 2014 and contains the option for stronger international growth than predicted, increased P/E for stronger margins in ADP, and selling into a hot market for Dealer Services. This creates a free option for the upside.

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