2023-03-12 05:30:13 ET
Summary
- ADP is one of the rare companies that can benefit from a high interest rate environment.
- The company also has strong competitive advantages, and other attractive qualities that we detail.
- Shares are not particularly cheap, but we believe the current valuation to be quite reasonable given the quality of the company.
Most companies are negatively affected by increases in interest rates. Either because they carry a lot of debt and refinancing becomes more expensive, as is the case with the real estate sector ( XLRE ), or because higher interest rates can make their customers less likely to spend, as tends to happen in the retail ( XRT ) and consumer discretionary ( XLY ) sectors. Sectors like industrials ( XLI ) tend to be affected indirectly by the slowdown in the economy brought by the higher rates. Financials ( XLF ) are supposed to benefit from higher rates, but right now they have a giant headwind in the form of the inverted yield curve, plus higher rates usually also cause higher credit defaults. What is left are insurance companies ( IAK ), that benefit from investing the insurance float at higher rates, and companies with special business models. One of these companies with a very special business model is Automatic Data Processing ( ADP ), which has a huge "float" which some people call OTP for "other people's money", that it is allowed to invest for its own benefit before the funds have to be used. ADP calls this money "Funds held for clients" and it is a source of very high margin revenue for the company.
As a reminder, ADP has three main sources of revenue. The main two are called Employer Services and Professional Employer Organization ((PEO)) Services. These two cover most of the things associated with ADP, including a wide range of services related to human capital management. These go from payroll services to human resources management, benefits administration, talent management, HR analytics and reporting, etc. ADP also provides PEO services that allow businesses to outsource HR management, payroll processing, and other related services to ADP. These two are attractive businesses growing at a good pace and with excellent profit margins. Then there is the third source of revenue, Clients Funds Interest, which generates less revenue, but it is extremely high margin. This part of the business should significantly benefit from rising interest rates, especially if they stay high for longer.
Funds held for clients
In its annual report ADP has a section detailing the interest it earns on "Funds held for clients". At its fiscal year end ADP held ~$32.4 billion of Funds held for clients, earning ~1.4% interest. Surprisingly, this was a bit lower than the ~1.5% it earned on the funds the previous year, but as we'll see, ADP's investing strategy means that it takes time for higher interest rates to impact ADP's bottom line.
ADP invests funds held for clients with a strategy that aims to average returns over an interest rate cycle. This is how the company describes it on its annual report, and why it takes time for the company to earn higher returns on this funds after interest rates start increasing:
Our client funds investment strategy is structured to allow us to average our way through an interest rate cycle by laddering the maturities of our investments out to five years (in the case of the extended portfolio) and out to ten years (in the case of the long portfolio). As part of our client funds investment strategy, we use the daily collection of funds from our clients to satisfy other unrelated client funds obligations, rather than liquidating previously-collected client funds that have already been invested in available-for-sale securities. In circumstances where we experience a reduction in employment levels due to a slowdown in the economy, we may make tactical decisions to sell certain securities in order to reduce the size of the funds held for clients to correspond to client funds obligations.
- ADP FY2022 Annual Report
The good news for the company and its shareholders is that if interest rates stay high for a long time, the interest ADP will earn on these funds will increase by a significant amount. Already the company is guiding for the yield on the client funds portfolio to increase to ~2.4% in FY2023 from the previous ~1.4%, that is a massive ~100 bps increase which should generate an additional ~$300 million for the company. ADP is also guiding for the average client funds balances to increase by roughly 4% to 5% further increasing interest earned from client funds.
Competitive Advantages
In addition to benefiting from higher interest rates, we also like that ADP has a strong competitive moat. This is mostly the result of high switching costs for its customers. Once they select ADP to run their payroll or other HR services it can be quite painful and time consuming for a company to switch to another provider. This gives ADP some pricing power, and it benefits as well from its scale advantage that enables the company to provide these services at a lower cost compared to smaller competitors. Still, ADP does have some competition, with its most direct competitor being Paychex ( PAYX ). There is also some overlap with companies such as Workday ( WDAY ) and Oracle ( ORCL ), and some highly motivated startups.
Financials
The competitive moat is reflected in superior financials, including an operating margin close to 20%. Not only is this profit margin considerably higher than your average company, but it has been trending higher as the company benefits from operating leverage as it continues to grow its revenue.
The competitive moat is also reflected in impressive returns on capital employed, which have been trending higher. This tells us that the competitive moat is strong and getting stronger, otherwise the company would not be able to increase the returns it gets on the capital it employs.
Growth
ADP has been a very consistent grower, delivering ~6% average quarterly y/y growth in the last five years, despite experiencing significant headwind during the worst of the Covid crisis. For FY2023 ADP is guiding for revenue to grow between 8% and 9%, which we find quite attractive and impressive given ADP's scale.
Earnings have been growing faster than revenue, as the company delivers operating leverage. This should continue this year, as ADP is guiding for the adjusted diluted EPS to grow between 15% to 17%. We don't know that many companies of this size that can deliver this level of earnings growth and with a similar consistency.
Balance Sheet
ADP has an extremely strong balance sheet, with very low leverage, and significant cash and short term investments that provide a lot of liquidity. This gives the company a lot of optionality, including being able to seize an acquisition opportunity should it present itself. It should also help investors sleep better at night knowing that the company is quite solid.
Guidance
The slide below summarizes guidance from the company for FY2023. We already talked about the key elements, such as revenue being guided to grow 8% to 9% y/y and adj. diluted EPS by 15% to 17%. Another key indicator is the yield the company is expected to generate from client funds, which is expected to increase by ~100 bps. We believe the high interest rate environment will continue to be a tailwind for the company for some time. As we already discussed, given the company's investment strategy it takes time for it to benefit from the rising interest rates.
Valuation
With so many positive attributes it is not surprising that ADP trades at a relatively high valuation. Still, the valuation has come down recently, and shares now trade with a price/earnings ratio close to the ten year average.
ADP is also well liked by many dividend growth investors, as it has a history of rapidly raising its dividend. As can be seen below, in the past ten years it has more than doubled. The current dividend yield is currently a modest ~2.3%, but investors should also consider that the company returns significant amounts to shareholders in the form of share repurchases. In fact in FY2022 the company returned more through buybacks that through dividends, paying ~$1.7 billion in dividends and spending ~$2 billion in share repurchases. This allowed the company to buy back ~9.2 million shares, or an average of roughly $217 per share. The net common payout yield, which combines the dividend yield and the buyback yield, is also show below.
Based on our estimates for future earnings we calculate a net present value for the future earnings stream of ~$171 per share. This is ~20% lower compared to where shares are currently trading, leading us to believe that shares are slightly overvalued. Of course small changes in the assumptions or in the discount rate can have a significant impact in the estimated net present value. We believe shares are currently priced to deliver roughly 8% to 9% for long term investors.
EPS | Discounted @ 10% | |
FY 23E | 8.11 | 7.37 |
FY 24E | 8.96 | 6.70 |
FY 25E | 9.94 | 6.09 |
FY 26E | 10.83 | 6.12 |
FY 27E | 11.81 | 6.17 |
FY 28E | 12.87 | 6.12 |
FY 29E | 14.03 | 6.06 |
FY 30E | 15.29 | 6.01 |
FY 31E | 16.67 | 5.95 |
FY 32E | 18.17 | 5.90 |
FY 33E | 19.81 | 5.84 |
Terminal Value @ 3% terminal growth | 325.17 | 103.61 |
NPV | $171.94 |
Risks
While we view ADP as a very stable and solid company, it of course still has a good amount of risk. It is constantly under attack from competitors trying to take market share from it, including from nimble startups looking to disrupt it. There is also significant regulatory risk, as the company has to comply with many laws and regulations in its line of business, some of which can be changed in ways that negatively affect its growth or profitability.
Conclusion
We believe ADP is a company that can add interesting diversification to a portfolio, especially given that it is one of the rare companies that can benefit from a high interest rate environment. Guidance for FY2023 is quite good, with the company expecting significant revenue and profit growth, and with the interest earned from funds held for clients increasing in a very meaningful way. While shares are not particularly cheap, we would argue they have a reasonable valuation, and as such we are initiating coverage with a 'Buy' rating. While there are risks to consider, we believe ADP is an above average quality company, with a very solid balance sheet and attractive profit margins. What's more, ADP pays a good dividend that it has been increasing, while at the same time repurchasing shares. This is definitely a company worthy of investor's consideration.
For further details see:
Automatic Data Processing Should Benefit From Higher Interest Rates And Shares Are Reasonably Valued