2023-05-26 10:31:03 ET
Summary
- Automatic Data Processing, Inc. maintains a solid FY 2023 with its steady revenue growth and margin expansion.
- Its impeccable positioning remains one of its strongholds.
- Macroeconomic volatility may be intense, but market opportunities are on the horizon.
- Dividends are enticing, given the increasing payouts and solid yields.
- The stock price has always seemed expensive, but it is reasonable in many different ways.
Human capital solution ((HCM)) providers are at the forefront of digital and labor market transformation. Despite various headwinds, their demand remains high. They are now a staple for the US economy as businesses and households go online. As such, many companies are reaping the rewards of the market trend. HCM giant, Automatic Data Processing, Inc. (ADP) is no exception. It maintains a robust performance with its solid core operations. It sustains its revenue growth while stabilizing costs and expenses. Even better, it has high liquidity levels, as shown by its stellar Balance Sheet. Cash levels are adequate and increasing, while borrowings are stable. Both accounts show that the company can cover its capacity while covering capital returns. We can see it in its consistent dividend payments and share repurchases. Unsurprisingly, the stock price stays high despite the pullback. It still appears expensive, though, if we compare it to the book value of the company. Even so, the stock price remains fair valued with high investment returns.
Company Performance
It has been quite a while since I first covered Automatic Data Processing, Inc. In between times, the company sustained its growth and expansion. Indeed, HCM solutions remain an economic staple as more businesses adapt to the changing labor market landscape. It remains a market giant and uses its brand reputation to maintain its solid standing. As of today, the company shows promising prospects.
Its FY 2023 remains optimistic with its impeccable performance. Its operating revenue for the third quarter reached $4.93 billion , a 9% year-over-year increase. While the cumulative value for the three quarters was $13.53 billion , 9% higher than in FY 2022. The value was already equivalent to 82% of the full-year revenue in the previous fiscal year. If we use the quarterly average to derive 4Q revenue, it will be $4.51 billion. The full-year value will be $18.04 billion, still a 9% potential increase. Although it only had a single-digit growth in 3Q, we must consider the current size of the company. Indeed, it was impressive to see it sustain its growth despite being huge already. It also showed its decent capacity to expand or at least maintain its size to stabilize revenues. This steady revenue increase can be attributed to various factors.
Operating Revenue (MarketWatch)
First, many businesses have started to adopt hybrid or remote work setups. In a recent study, 55% of US companies have remote work flexibility. Aside from the pandemic, The Great Resignation was one of the driving forces behind it. As many employees jumped ships, 21% said remote work flexibility was one of their considerations. Another study showed that 95% of employers said remote work improved employee retention. Meanwhile, 46% had lower attrition. It was no surprise more businesses have started to give remote work flexibility at various levels. In turn, HCM solutions became more of a staple across the globe. It was easy for the company to attract more clients, given its current market positioning. Although we can hardly quantify this aspect, we know it was instrumental in generating revenues.
Hybrid Companies (Gitnux)
Revenge travel was quite unexpected, but its positive spillovers made sense. Remote and hybrid work increased location and schedule flexibility. The labor market transformation allowed more employees and even employers to relax while working. To sustain the uptrend, businesses have adopted HCM solutions to manage human resources virtually. In a survey, over two-thirds of employees said remote and hybrid work allowed them to travel more often. Meanwhile, 27% said they increased their travel duration. It was consistent with the increasing number of businesses opting to adapt to it. In the same study, 76% of the respondents have remote work flexibility at varying levels.
Remote Work And Travel (hopper) Remote Work (Gitnux)
Another growth driver was the relaxing inflation. When it peaked at 9.1% , many businesses became pessimistic. The consolation was that companies maintained their hybrid and remote work setup. Small business startups remained typical, given the more lenient business transactions. The number of small businesses in the US rose from 32.5 million to 33.2 million . Given the increased number of online businesses, HCM solutions demand increased. Most importantly, inflation started to slow down in 4Q 2022. In 1Q 2023, it decreased faster and landed at 5% . It allowed ADP to set more strategic pricing and improve client retention. The relaxing prices and increased demand led to higher revenues. The fintech revolution is another primary aspect, allowing financial transactions online. In 2022, the number of people no longer using cash reached 41% . It was a consistent increase from 2015 with 24% and 2018 with 29%.
Cash Transactions In The US (Pew Research Center)
But what makes ADP a solid company is its efficient asset management. Inflation helped improve cost and expense management. As such, the increase in the operating cost was relatively flatter at 4%. With that, the operating leverage of the company increased from 30% to 32%. It showed enhanced management of variable costs, making the core operations more scalable. We can see it in the operating margin of the company at 28% versus 26% in 3Q 2022. It was also the highest margin in the given time series. Given this, the company was also at its largest size but most efficient in 3Q 2023.
Operating Margin (MarketWatch)
With regard to its peers, ADP remains one of the largest HCM solutions providers. It appears to have underperformed, given the peer average revenue growth of 20%. Yet, we must understand that given its size, it may be challenging to sustain decent revenue growth. The company was still successful in this aspect. Also, it had higher revenue growth than some of its peers like Paychex ( PAYX ) with 8%. ADP was better than many of its peers in stabilizing costs and expenses. Its operating margin was higher than the peer average of 23%. It was way higher than large peers like Workday ( WDAY ) with -5%. Given this, the company stayed a durable giant in the HCM industry.
Peer Revenue Growth (MarketWatch)
In its 4Q 2023, the company is optimistic with its 8-9% . It is consistent with my estimation discussed earlier. Yet, it must not be complacent as recession fears impact economic confidence among businesses and households. But there are still many opportunities it can seize this fiscal year. We will discuss more external factors and strengths in the following section.
How Automatic Data Processing, Inc. May Remain Solid This Year
As of this writing Automatic Data Processing, Inc. remains a formidable figure in the industry. Its solid market positioning allows it to sustain its growth and margins. Yet, there are risks it must consider amidst interest rate hikes. Higher interest rates may affect the financial leverage of the company. It already has over $3 billion in borrowings. The consideration is that borrowing levels are low or only 5.6% of the total assets. Also, higher interest rates may continue driving the cooling demand across industries. With the looming recession, businesses may think twice about investing and spending. It may lead to lower production, which may affect business operations. Its negative spillovers may affect other areas, even HCM providers. ADP primarily caters to small and mid-sized businesses, which can be more exposed to risks associated with a recession.
On a lighter note, interest rate hikes have started to slow down. From 75 bps, it decreased to 25 bps for two consecutive quarters. Even better, The Fed will likely stop increasing rates. They may stay flat at the current rate, allowing businesses to manage their finances better. The downtrend is logical since inflation continues to relax at 4.9% . If it continues, the company can set more strategic pricing to retain or increase its clients. It can also manage costs and expenses better to maintain margins.
Inflation Rate (Trading Economics) Interest Rate (Trading Economics)
Another primary growth driver is the continued transformation in the labor market. In my previous coverage, I focused on employee preferences. Apparently, even employers have become more open to this possibility. In a survey, over 50% of hiring managers believe hybrid work setups will become a norm. Moreover, 74% of employers plan to implement hybrid work models. It is no surprise that 72% of employers have started to invest in hybrid work technology. These include collaboration tools, virtual meeting software, and other HCM solutions.
The trend in remote and hybrid work is logical as travel demand remains high. A recent study shows that 49% of Americans plan to travel more this year. It may be the highest in Summer with 85% planning to travel more. But either way, a massive portion of the population will either travel more as much as they did in 2022. With that, HCM solutions will be more crucial to effectively managing employees working away from the office. The potential increase in travel frequency is a product of inflation decrease and hybrid work implementation.
But what makes ADP a secure company is its solid financial positioning. Its Balance Sheet shows adequate and increasing cash levels. These are high enough to cover all borrowings maturing this year if it makes a single payment. Also, it can cover three quarterly dividend payments if it incurs net losses. But given its impressive strategies, the company generates returns. The best thing about it is that its core operating income can cover all dividends in a single payment. Its Net Debt/EBITDA Ratio of 0.32x shows that its EBITDA is thrice as much as the total borrowings. We can confirm its adequacy using the Cash Flow Statement. Its Cash Flow From Operations is more than eight times the value of CapEx. Its FCF/Sales Ratio remains high at 27% versus 20% in 3Q 2022. Given this, ADP converts a substantial portion of its sales into free cash. The company maintains the balance between growth and viability with liquidity and sustainability.
Cash And Equivalents And Borrowings (MarketWatch) Cash Flow From Operations And CapEx (MarketWatch)
Stock Price Assessment
The stock price of Automatic Data Processing, Inc. has increased substantially over the years. There has been a pullback since 4Q 2022, but it stays high. At $209.25, the stock price is 0.3% higher than last year's value. Yet, it has already decreased by 8% from my previous coverage. The stock price does not seem to reflect the intrinsic value of the company. Using the PB Ratio, the current BVPS and PB Ratio of the company are 8.93 and 24.46x. If we use the current BVPS and PB Ratio of 21.96x, the target price will be $196.12. Meanwhile, the EV/EBITDA model shows that the stock price is fairly valued with decent upside potential. It gives a target price of ($89.97 B EV - $1.56 Net Debt) / 413,500 shares = $213.81. It is logical, given the improvement of its fundamentals from FY 2022 to 3Q 2023.
Moreover, ADP is a secure dividend stock, given its increasing payouts of $1.25 per share. It has decent yields of 2.31%, way higher than the S&P 500 and NASDAQ average of 1.56% and 1.65%. Even better, it has high earnings to cover it, given the Dividend Payout Ratio of 50%. It does not have to reduce its cash levels because its income is adequate for dividends. It also makes capital returns through share repurchases. In 3Q 2023, it repurchased 1.2 million shares or $800 million. But what makes the stock price reasonable is the investment returns relative to company earnings. If we check the cumulative value of EPS and average stock price increase in 2019, investment returns are high. The cumulative value of EPS is $24.01 while the stock price rose by $54.42. The derived amount shows that for every $1 increase in EPS, the stock price increased by $2.26. It is an important part I failed to consider in my previous coverage. To assess the stock price better, we will use the DCF Model.
FCFF $4,198,000,000
Cash $1,850,000,000
Borrowings $3,410,000,000
Perpetual Growth Rate 4.8%
WACC 9.2%
Common Shares Outstanding 413,500,000
Stock Price $209.55
Derived Value $224.96
The derived value adheres to the supposition of a potential undervaluation. There may be a 7% upside in the next 12-18 months. It is logical, given the continued improvement in its fundamentals. The target price is 2% higher than in my previous coverage. It shows that the stock is now a good bargain.
Bottomline
Automatic Data Processing, Inc. is an HCM solution provider champion amidst market volatility and intense competition. It maintains excellent core operations with its strategic pricing, strong customer base, and efficient asset management. It shows sustainability with its impeccable financial positioning. Cash levels can cover the operating capacity and capital returns, while borrowings are stable and low for the current size. Also, opportunities continue to outweigh market risks. HCM solutions shine while hybrid work, revenge travel, and inflation decrease persist. Moreover, the stock price shows potential undervaluation with decent historical returns and upside potential. The recommendation is that Automatic Data Processing, Inc. is a buy.
For further details see:
Automatic Data Processing: Impeccable Fundamentals With Solid Returns