My conservative assumptions for ADP's future, including 5% sales growth and 20% net profit margin, indicate limited upside potential over the next 5 years.

Since I wrote my first article on Automatic Data Processing (NASDAQ:ADP) last September, the company has unfortunately underperformed the S&P 500 (SPY). At the time, I thought the shares were fairly valued, but now I have to change my mind and think that the shares are currently overvalued. Even if only slightly.

I also think that the threat of AI is greater than I first thought, which has clouded the outlook for the future a bit.

ADP is a leader in human capital management, providing payroll services to companies large and small. This distinguishes the company from its competitors, some of which specialize in small or large companies.

Due to high switching costs, customer retention is currently 92% in an estimated $150 billion market. And this market is expected to grow 5% to 6% annually, while ADP believes it can exceed this growth rate and achieve a 7% annual revenue growth rate going forward.

In line with current trends, ADP has also embraced the idea of using AI to optimize workflows and create value for clients. For this, they have the ADP Assistant, but also the Next Gen Platform, which connects multiple platforms into one.

Growth opportunities remain in the international business, which currently accounts for only 11% of revenue, and in developing additional areas in companies that currently use the platform only for payroll. Examples include analytics, benefits and data management.

From a balance sheet perspective, ADP is also well positioned as they have an EBIT/interest multiple of 13x and with $2.9 billion in cash, they could pay off the $2.9 billion in long-term debt if they wanted to.

ADP is well ahead of the pack when it comes to the return they earn on their capital, even though Paychex, Inc. (PAYX) and Paycom Software, Inc. (PAYC) also have fantastic ROIC numbers. From a ROIC-WACC spread perspective, ADP has a spread of approximately 42%, assuming a realistic WACC of 9%. This tells us that ADP's management is capable of generating high returns and that the barriers to entry and competitive advantages were in place to protect ADP's earnings.

And despite being the highest quality company in the peer group, ADP still trades at a relatively modest 21x EV/EBIT multiple. Workday, Inc. (WDAY) and Dayforce Inc. (DAY) are currently trading at exorbitant multiples that, I believe, are even too high for the nearly 20% revenue growth they are currently experiencing.

ADP, on the other hand, could trade at a higher multiple than Paychex. But that is more because I think Paychex's multiple is a bit too high right now. Paycom, on the other hand, has already seen a lot of multiple compression as the stock has fallen from its 2021 high of nearly $550 to ~$160 today.

One of my favorite ways to value a stock is with a reverse DCF because it lets you see what the market is pricing in. And in the case of ADP, the market is currently pricing in EPS growth of 12% over the next 10 years.

But in the last 10 years, ADP has only achieved ~11% per year, and I think the competition is stronger today than it was 10 years ago, and therefore I think it will be difficult to achieve the same EPS CAGR and that it will be lower in the future.

ADP's own guidance is for EPS growth of 11%, which is also slightly below the 12% implied, underscoring the fact that the stock is currently slightly overvalued. In my last article, the market had priced in exactly that 11%, which is why I thought the stock was fairly valued at the time.

ADP repurchases 1% of its outstanding shares each year, while SBC is relatively small, resulting in a steady decline in shares outstanding. As the number of shares outstanding continues to decline, so does the amount of money you have to spend each year to buy back 1%, unless the SBC explodes.

This means that more money is available every year to invest in growth, or that the share buybacks can be increased at some point. All thanks to a net income growth rate of about 10% per year over the past 10 years.

Another important part of ADP's capital allocation is its steadily growing dividend, which has increased by nearly 12% annually over the last 10 years. Therefore, I think the stock is attractive for investors who are focused on dividend growth or who are already in the consumption phase because the dividend growth rate is well above the rate of inflation.

I think in the case of ADP, we have to use conservative assumptions because I think the threat of AI could be a big disruption for that industry. Therefore, I believe a sales growth rate of 5% is appropriate, as well as the continued repurchase of 1% of outstanding shares per year.

In terms of net profit margin, I think the 5-year average of about 18% is a reasonable starting point, but I tend to think a 20% margin is more realistic given the potential that AI offers ADP. As an exit multiple, I think it could be 27x in 5 years.

So this would lead to the following outlook over a period of 5 years:

Again, this model, as well as the reverse DCF, shows that I think the stock is currently overvalued. For me personally, a 90% to 100% upside over the next 5 years is the hurdle I use, and at the current share price, I do not see that upside for ADP. For that to happen, the stock would either have to get cheaper or the future outlook would have to get a lot more positive.

The news that Klarna no longer needs Salesforce (CRM) and Workday because of AI could have huge implications for the human capital management sector. In the past, most companies have downplayed the threats posed by AI, saying that AI will make them more efficient and that they will use the technology to improve their own operations.

But the fact that a company as large as Klarna no longer needs two established software providers gives me pause for thought. Should this trend continue, it could lead to strong revenue losses for many companies or even cause whole industries to disappear in the Nirvana.

And of course ADP has a lot of data, and ADP Assists itself is an AI offering, but I think this could be an industry that is going to be very disrupted by AI. Until now, the high cost of switching has always been an argument for maintaining ADP's competitive position, but if AI can be used internally to develop a solution that is close to equivalent, the cost of switching would drop dramatically.

Without the Klarna news, I would have continued to say that the shares are only slightly overvalued, but not far from fair value, but the new threat makes me think that the risk has increased. And I think this new risk should be appropriately priced in, so my outlook has deteriorated a bit, and I think the stock is currently a little too expensive to trade at fair value. That said, ADP is still a fantastic company that just got a strong competitor in AI.