2023-08-18 07:48:58 ET
Summary
- Automatic Data Processing gets a hold rating, agreeing with the consensus from analysts & the quant system.
- Positives are the dividend, earnings growth, and capital strength.
- Headwinds are the valuation and share price.
Research Brief
Today's analysis covers a company that seems to be somewhere at the crossroads of several sectors I cover: financial, tech & innovation, managed services.
Automatic Data Processing ( ADP ) recently had its earnings release on July 26th for its fiscal 2023 Q4 , and so we will deep dive into this firm more closely today, a firm often just referred to as "ADP" and probably known most for its payroll services.
However, turns out it is much more than that.
From info on its official website , we can learn the following: over 70 years in business, offer solutions across the spectrum of HR /payroll /talent /tax / benefits administration. $16.5B in revenue (2022), 140 countries, 1MM clients, helps over 40MM workers get paid worldwide, trades on the Nasdaq.
From a personal perspective, I have used ADP's platforms many times as an employee at various enterprises, so I am familiar with the end-user side of things. Today, I get to see the firm from the point of view of an analyst and investor.
Rating Methodology
To get a "holistic" rating score of buy, sell, or hold, I break down my analysis into 5 categories: dividends, share price, valuation, earnings growth, & capital strength.
If I recommend the stock on at least 3 of these categories it gets a hold rating, and at least 4 will give it a buy rating. A score of less than 3 is a sell rating.
Dividends: Recommend
The dividend yield as of Aug. 17th is modest and not anything to consider notable, especially having seen some dividend yields lately over 5%.
In the case of ADP, you do have an upcoming ex-date and steady quarterly payouts, and a dividend of $1.25 per share you can count on.
Notable to mention is the fact that the dividend yield is 27% above the sector average, as per the table below. This makes it highly competitive in my opinion, among its peers of course but not necessarily the market overall.
ADP - dividend yield vs sector avg (Seeking Alpha)
Although not guaranteeing future dividends, the past 5-year growth rate at least can indicate some longer-term proven stability and growth in this category, I think lessening the probability of immediate dividend cuts in the near future.
Also, the following data points to reliable dividend income for investors since 2020, with steady growth in the payout amount per share. Again, another sign of the financial position of this company being strong, since companies often cut dividends or eliminate them if they run into serious problems, in order to preserve capital.
I would definitely recommend this stock in this category.
Share Price: Not Recommended
In this section, I answer whether I think the current share price is a buy opportunity or not, in the most simplified manner possible.
First, I pulled the most recent chart as of the writing of this article, showing the share price in pre-market hours on Aug. 17th of $250.90 (blue line) compared to its 200-day SMA of $230.40 (orange line):
Second, I establish that my holding period for this stock will be 1 year, and that in a year I make the following assumptions: the current SMA will go up 10% and I will sell at a capital gain, but it could also drop 10% and cause an unrealized paper loss, and negative return on capital.
The 1 year holding period includes the quarterly dividend income earned.
The following is the trade scenario, using the current SMA and share price, assuming the SMA will go up 10% in a year and that will be my sell price:
This scenario achieves a total return on capital of 3.01%, which is positive but still below my target of achieving at least a 10% return.
In this second scenario, I established that my maximum risk tolerance is the SMA dropping by 10% below its current value. However, if I buy at the current share price, I could see a negative return of -15.36% in a year, under this simulation. The most I would tolerate is a -10% unrealized loss.
The above simulations may not work for every one of my readers and their portfolio goals, but creates a simplified framework within which to plan for both potential gain and potential loss, and establishing a range.
The above simulations show that the current share price is not a buying opportunity to be recommended. In my further simulations, I determined a price closer to $232 or less would fall within my risk/reward range.
Valuation: Not Recommended
When it comes to this stock's valuation, I cannot say I would recommend it right now. It is overvalued and I will show you why.
Consider official data using two key metrics, the forward P/E ratio and forward P/B ratio, and the valuation story it tells us.
Currently, this stock's almost 28x forward price to earnings is extravagantly high in my opinion, being almost 37% above it sector average which hovers closer to 20x earnings.
ADP - P/E ratio (Seeking Alpha)
Further, with a price to book of almost 21x, it is a whopping 727% above its sector average, a number I didn't think was possible, considering the sector is closer to just 2.5x earnings.
ADP - P/B ratio (Seeking Alpha)
Let's take two of its peers, Paychex ( PAYX ) and Paycom ( PAYC ), and see how they compare to ADP on valuation.
Paychex has a forward price to earnings of around 26.25x, and a price to book around 11.20x. Paycom 's price to earnings is around 49.27x, with a price to book of 10.61x. In this case, Paychex has a better valuation overall than ADP, and both companies have a lower price to book value on a forward basis.
If I was buying this sector, I probably would first look at Paychex then.
Earnings Growth: Recommend
In this category the stock wins my recommendation and here is why.
First, the firm had an impressive YoY top line total revenue growth, with revenue nearing $4.5B in their last fiscal quarter.
On the bottom line, it looked good too, with net income achieving YoY growth as well:
Additionally, I like that their YoY adjusted earnings per share saw positive growth as well, another notable data point:
ADP - YoY EPS growth (company quarterly presentation)
Since this was also the end of their fiscal year, I think what sets this company apart is its global diversification, rather than serving just US clients. This global penetration I think will be in its favor.
Consider what the firm said in its earnings deck :
10% ES("employer services") new business bookings growth for FY23 driven by strong Q4 results; $1.9 billion ES bookings for the year. ES retention of 92.2% for FY23 returned to record level, led by US midmarket and international .
I think this firm will continue on a positive earnings trajectory it is currently on, and will meet or beat these figures in the next fiscal quarter.
Capital Strength: Recommend
Here are some key data points pointing to this firm's capital strength, according to their corporate overview :
ADP's credit ratings are AA- / Aa3 / AA from Standard & Poor's® and Moody's® and Fitch, the strongest in the HCM industry.
$3.6B USD returned to shareholders in FY22.
In terms of the recent quarter, it's worth looking at the balance sheet. This is a cash-rich firm, with $2.08B in cash, up from the prior year. It also can boast $50.9B in assets.
On the liability & equity side, you are looking at a drop in total liabilities from last year, to $47.46B, and positive equity of around $3.5B.
I bring up this data because it is evidence of a company clearly in the billion-dollar club, that operates on a vast financial scale.
This is past performance, however, and it is important to make some forward-looking predictions too.
I will echo what the CFO said in the quarterly earnings commentary , shedding positive light on the next fiscal year:
Our fiscal 2024 outlook calls for continuing healthy revenue growth, new business bookings growth, and margin expansion as we continue to deliver on our promise to help our clients and their employees better navigate the complex and ever-changing world of work.
There is not much more to go over in this category, which I think clearly is in a positive direction for this firm.
Rating Score: Neutral/Hold
Today, this stock won in 3 of my rating categories, earning a "hold" rating. This is one of the few times my rating is in line with the entire consensus on a stock, both from analysts and the SA quant system:
ADP - rating consensus (Seeking Alpha)
A hold rating, however, should not be considered a negative, as it could be an opportunity to take advantage of capital gains for those who bought during the April/May price dip.
Risk to my Outlook: Artificial Intelligence
A risk I discovered in researching this stock was one brought up by another analyst, Daniel Wilson, recently in his August 18th article .
According to Wilson:
Thanks to the recent AI wave, a new generation of HR software is coming. Current HCM systems sold by vendors such as ADP are legacy in nature..
The emergence of AI HCM systems will seriously threaten ADP's product offering over the next decade.
This scenario would make my neutral case for this stock somewhat too positive, as it would warrant more of a "sell" rating to take money off the table and get out of this company, due to the eventual risk of competition and "AI" eating up the more traditional legacy providers of HR/payroll solutions.
However, not so fast.
ADP also has had some things cooking in the "AI" space ever since 2022. Consider a Jan. 2022 article by ADP's Julio Hartmann, head of their innovation lab in Brazil.
According to the article:
As an industry leader, ADP looks forward to the future. My team supports innovation through our mantra - always designing for people.
AI helps companies manage their workforce while anticipating changes and preparing their employees for upcoming challenges. Specifically, my team is working on technology that allows companies and employees to navigate a variety of scenarios.
So, I think that although they will competition in this space, which is expected, they will step up to the plate and also score in the artificial intelligence game. This is another reason I think it is just a minor risk, and I think they will adapt to this new reality well, as "AI" does not replace legacy systems per se but rather will automate certain processes and attempt to make them work smarter not harder.
Analysis Wrap-up
Here is a summary of what we discussed in today's analysis:
This stock earned a "hold" rating today, as I am essentially agreeing with both the analyst consensus and the Seeking Alpha quant system.
Positives: dividends, earnings YoY growth, capital strength.
Headwinds: valuation, share price.
Concluding thoughts:
Payroll-focused companies as some of us 1980s kids remember them once, certainly have grown & evolved, and more importantly adapted and innovated.
Today it is simply a matter of a quick login by an employee, a few clicks by a supervisor to approve, and a relatively painless process to get someone paid and also withhold taxes and benefits.
Looking forward, these are firms that could be on your watchlist because they are a critically necessary sector, one that fuels the liquidity of thousands of employees, and therefore the economy as well.
My prediction for their next fiscal quarter is another earnings beat, as they have done in the last 4 quarters, so I would say a 90 - 100% chance of another earnings beat somewhere between $0.02-0.10, so another good reason to "hold" this one if you already got it into at a good price.
ADP - earnings beats (Seeking Alpha)
For further details see:
Automatic Data Processing: Gets Hold Rating As Price And Valuation Soar