2023-06-30 13:10:42 ET
Summary
- Automatic Data Processing appears resilient during economic downturns due to its diversified portfolio and strong financial metrics.
- The current stock price is too high for new investors, however, and so I recommend waiting for a pullback.
- ADP's financials contain manageable long-term debt, impressive return on assets and return on equity, and healthy operating and net margins.
- I recommend waiting for a better entry point, which could occur if a recession happens in the next year. Current investors are advised to hold off on buying more shares.
Investment Thesis
I wanted to take a look at Automatic Data Processing's ( ADP ) financial metrics and how the macroeconomic headwinds might affect the company's outlook. With a slowdown in the economy and a rising unemployment rate, I believe that the company will not be affected by this very much, however, I also do not see potential growth and find the current stock price a little too high for new investors. I would wait for a pullback.
Outlook
I was expecting to see the company’s services suffering during the ’20 pandemic panic, however, it seems like the company still managed to grow slightly during that time. The company’s portfolio of services is very diverse, and it does a great job at making new clients even in tough times like ’20 and ’21.
There has been a lot of talk in the last 6 months about the inevitable economic downturn. This broad-based recession is going to come with an increase in the unemployment rate due to elevated interest rates that will stay elevated for a little bit longer since the Fed is still going to raise interest rates at least two more times . Month after month, we are seeing numbers from the US economy coming in hotter than expected and that is not what Jay Powell is looking for, therefore, anything is still on the table. It seems like the Fed will do anything it can to get inflation down to its target of around 2% which means raising and keeping rates elevated at the cost of a higher unemployment rate.
Back in October of last year, there were a lot of forecasts of unemployment rates reaching around 4.5% by now, which is what the chairman was likely hoping was going to happen and by now rates would start to stabilize. We are still about 1% from that forecast, which means a lot more volatility is still on the table for the stock markets in my view. It seems like a recession is nowhere to be seen yet, and at this rate, I don't think we will see it this year unless the unemployment rate meaningfully ticks up. We’ve only seen a .2% increase since September ’22.
Since ADP is so well diversified across the whole corporate setting, I see little to no hindrance from an economic downturn in the near future. The reason why I think that's the case is because the company managed to grow its revenues every year for at least a decade now, even when the pandemic hit globally. I also think that it will not grow very fast either, because it is already a well-established company in its space and is the leader in the industry. Let’s look at the company’s financials to see how well it is equipped to handle a recession.
Financials
As of the latest quarter, the company had $1.8B in cash against almost $3B in long-term debt. Many people don’t like that companies take on debt for any reason, however, it is not a problem if the debt is manageable, which in the case of ADP, it is very manageable. Interest expense is around $190m per year, which is easily covered by the company’s EBIT. The latest interest coverage ratio, which is as of 9 months ended March 31, ’23 stood at around 23x, which means that EBIT can cover the expense 23 times over. I see no issue with leverage, and it can easily take on more if the company requires it.
The company’s current ratio is acceptable. It’s been hovering around that 1.0 mark for the last 5 years, which means that it can just about cover its short-term obligations if for some reason everyone needed their money right then and there.
Right now, it looks like the company has no liquidity or solvency issues.
In terms of efficiency and profitability, this is where the company truly shines in my opinion. ADP's ROA and ROE are above my minimum thresholds (ROA is at my minimum) and ROE is very impressive. The company buying back its shares helped this metric quite a bit in FY22. It seems that the management can utilize the company's assets and shareholder capital effectively.
The same can be seen in the company’s return on invested capital or ROIC. Even without the latest fiscal year, which was FY22, the company was able to achieve fantastic returns then, averaging around 18% for the last 4 years. Adding FY22 to the mix, it seems that the company’s competitive advantage has increased substantially, and its moat has become even stronger, and I like that about companies. There aren’t that many large competitors that could undercut ADP’s pricing without hurting themselves in the process. This is a very impressive ROIC and not many companies are able to achieve that.
In terms of margins, the company has been holding still for the last 5 years and I don’t think it’s a bad thing. Operating and net margins are very healthy in my opinion and if it keeps these going forward, I wouldn’t be worried about them. I could also see more efficiencies going forward with the advancements of AI/ML tools that will help automate a lot of the work they do.
Overall, it seems that the company is running efficiently and very steadily. Even if we don’t see too much growth coming in the future, these financial metrics tell of a company that is well-operated by the management, is making good profits, and is a leader in the industry. That is a company I would be willing to invest in in the long run, however, we could still overpay for a solid company, so let’s look at what I would be willing to pay for stability in the long run.
Valuation
Looking at the past, the company has been growing predictably, averaging around 7% annually over the last decade. For my base case, I decided to go with that average of 7% CAGR over the next decade because I do not foresee any catalysts that could propel growth to the next level. For the optimistic case, I will add a bit more growth because even though I don't foresee a catalyst, that doesn't mean that there may not be, and I should account for it. I went with around 11% CAGR here, and in the conservative case, I went with 5% CAGR.
In terms of margins, I decided to improve these slightly over the next decade because of the mentioned advancements in AI and ML which will no doubt help companies like ADP to improve efficiencies incrementally over the long run. I decided to improve gross and operating margins by around 200bps or 2% by ’32, which means that every year the company’s net margins will improve by around 30bps or .03%. In FY22, the net margin stood at around 18%, and by '32 it will improve to around 21%, which I think is quite reasonable.
On top of these estimates, I will add a 25% margin of safety just to be even more conservative. With that said, the intrinsic value of ADP with these assumptions is $178.82, implying around 17% downside from the current valuation.
Intrinsic Value showing slight overvaluation (Own Calculations)
Closing Comments
With the above assumptions, which I think are on the conservative side, the company's current share price is slightly elevated and if I was a new investor looking to start a position, the current risk/reward profile is not to my liking. With the potential upcoming macroeconomic headwinds, the volatility in the markets may present a better entry point for patient, long-term investors who are looking to diversify their portfolios.
The company is a solid choice for any portfolio, and I wouldn't lose sleep at night because it likely will not see that many large fluctuations in price. If I was a current investor in the company, I would not buy right now and wait for a pullback to add on any substantial weakness. I could see the share price pulling back more if we do experience a recession in the next year or so and for this reason, I will be staying on the sidelines. I already have set a price alert at lower levels, and I will wait for the company to announce their annual results, which are supposed to come out around the end of July. Until then, I will leave it alone and revisit once I get more information.
For further details see:
Automatic Data Processing: On The Sidelines For Now