2023-05-24 15:35:05 ET
Summary
- With barely a 2% increase from the same time last year, ADP's stock performance has been largely stable over the last years.
- The company was trading noticeably expensively in recent years, with an average ten-year PE of 29.
- Even with a guided EBIT growth of 10% to 12% and the lacking performance over the last year, the company remains too expensive in my opinion.
Over the past year, Automatic Data Processing, Inc.'s ( ADP ) stock performance has shown limited growth, registering a marginal increase of only 2% compared to the previous year. This, with the combination of ADP's high ten-year average PE of 29 and the expected EBIT growth of 10% to 12% for the next years, poses the question if the company's fundamentals have outrun the valuation over the last year, which would mean an undervaluation right now and might therefore be an attractive entry point.
Business
In the human resources sector, Automatic Data Processing, which was founded in 1949, is well-known for offering complete payroll services, talent management, HR management, benefits administration, and time and attendance solutions. ADP has a global presence and enjoys the trust of over 860,000 enterprises in 140 nations, serving a diverse range of clients from small businesses to big corporations. The corporation primarily engages in two business sectors:
- Employer Services: This segment provides a wide range of technology-based human capital management and human resources business process outsourcing solutions. These include tax and compliance services, payroll services, benefits administration, talent management, HR management, time and attendance solutions, and insurance services.
- Professional Employer Organization Services: Small and mid-sized firms can get outsourcing options for employee administration from ADP's PEO division. Services including risk management, payroll, benefits management, and human resources are included.
Businesses of ADP (marketscreener.com)
Geographically, the US accounts for about 88% of ADP's business. The remainder is virtually split between Canada and Europe.
SWOT Analysis
To better appreciate ADP's business model and its opportunities and risks, let's conduct a detailed SWOT analysis:
Strengths:
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Market Leadership and Brand Reputation: With its extensive background in the HR and payroll industries, ADP has built a solid brand image. Because it is the market leader, it can take advantage of economies of scale and erect a high barrier to entry for potential rivals.
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Comprehensive Suite of Services: ADP provides a wide range of services covering various HR responsibilities. It can meet a range of client needs thanks to its broad portfolio, which increases customer retention and opens up the potential for cross-selling.
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Technological Innovation: ADP has a competitive advantage thanks to its continued investments in innovation, notably in cloud-based services and data analytics. As a result, the firm is able to provide effective, scalable, and adaptable services to satisfy the changing needs of enterprises.
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Strong Financial Performance: The company's excellent financial position, as seen by its consistent revenue growth, robust cash flow, and strong balance sheet, allows it to make investments in growth projects and survive market fluctuations.
Weaknesses:
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Dependence on the US Market: Despite having a presence elsewhere, ADP nevertheless gets a sizable chunk of its income from the United States. Because of its concentration, it may be more susceptible to changes in American regulation and the economy.
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Complexities in Integrating Acquisitions: Acquisitions are a common part of ADP's growth strategy, although they can pose difficult integration problems. These can affect the business's operations and financial success if they are not properly managed.
Opportunities:
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Increasing Outsourcing of HR Functions: ADP will benefit as more companies look to outsource their HR duties so they can concentrate on their core capabilities. It may increase its share of this expanding industry by utilizing its extensive offerings and technological prowess.
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Expansion into Emerging Markets: ADP has numerous potential for growth in emerging markets. ADP may benefit from this trend as these regions' businesses develop and their demand for expert HR services rises.
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Advancements in Technology: The HR sector may undergo a further transformation as a result of technological developments like artificial intelligence, machine learning, and data analytics. ADP can boost customer happiness, accelerate growth, and improve service delivery by keeping on the cutting edge of these trends.
Threats:
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Regulatory Changes: Regulations for the HR sector are strict and frequently updated. ADP's operations may be impacted and its expenses may rise as a result of changes in tax laws, labor legislation, and health care regulations.
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Intense Competition: The HR sector is extremely competitive, with both long-standing players and recent entrants providing comparable services. The pricing power and market share of ADP may be under pressure from this competition.
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Cybersecurity Threats: ADP faces substantial cybersecurity concerns due to the sensitive nature of the data it processes. A data leak might seriously harm the company's finances and reputation.
Fundamentals And Outlook
The company's revenues climbed by 9% to $4.9 billion in the third quarter of this year compared to the same period last year, and there was a 10% growth on an organic constant currency basis. Additionally, net earnings jumped by 12% to $1.0 billion, while adjusted net earnings rose by 13% to the same amount. Earnings before interest and taxes, or adjusted EBIT, climbed by 14% to $1.4 billion, translating to a 110 basis point improvement in adjusted EBIT margin to 27.8% for the quarter. On both a reported and adjusted basis, the company's effective tax rate for the quarter was 23.5%. Adjusted diluted EPS climbed by 14% to $2.52, while diluted earnings per share increased by 14% to $2.51.
The EBIT is generally growing in line or faster than the revenue of the company, this can be attributed to the general growing trend in the EBIT margin over the last years:
Same is true when we take a look at the gross profit margin of ADP:
Outlook
For FY 2023 the company anticipates an 8%-9% increase in revenue. They expect the adjusted EBIT margin to increase by 125 to 150 basis points. It is anticipated that the modified effective tax rate will be around 23%. Adjusted diluted EPS is anticipated to increase within the same range as diluted EPS, with a growth rate of 16% to 17%.
These projections show a more optimistic outlook compared to their previous medium-term guidance . The revised expectations include a revenue growth range of 7% to 8%, adjusted EBIT growth of 10% to 12%, adjusted EPS growth of 11% to 13%, and a total shareholder return of 13% to 15%.
I think the medium-term financial objectives of ADP seem a bit conservative, but as long as the management sticks to these metrics, we have to assume the company grows like anticipated by the management, which in turn means growth should slow down over the next years.
Valuation
ADP is undoubtedly a high-quality corporation, but we still have to determine a reasonable valuation for this company.
The company is currently trading at a forward PE of 26. The company therefore seems slightly undervalued considering the average PE ratio of 29 over the last 10 years.
However, upon examining the PS ratio in comparison to its 10-year average, a different perspective emerges. Additionally, considering the current PEG ratio of 1.7, it appears that the company's valuations seem to be elevated.
To get a better understanding of ADP's current valuation and the possible scenarios of the company, I conducted a Discounted Cash Flow Analysis for a Bear and Bull-Case. The blue cells in the analysis are the assumptions I took to evaluate ADP.
Bear-Case
- Revenue: The revenue was calculated using the low end of management's medium-term guidance for revenue growth of 7%.
- EBIT: Equally, the EBIT was calculated using the 10% EBIT growth stated by the management as the low-end goal.
- Financial Result And Taxes: I averaged the values of the last three years and therefore used -23% to calculate the Net Profit for the years 2023 to 2030.
- Tax Rate: Here I used 22.4%, which is also the average of the last 3 years.
- Free Cash Flow: Using the Tax Rate above, I calculated the EBIAT and afterward tried to determine a suitable EBIAT to FCF ratio. In that case I also averaged out the last three years to address for extraordinary CAPEX and arrived at an EBIAT to FCF metric of 9%.
- WACC: Here I assumed the high end of their latest WACC , which is at 11.3%.
- Perpetuity Growth Rate: The perpetuity growth rate assumed for the analysis is 3.5%.
DCF ADP BEAR-Case (seekingalpha.com; ADP.com)
This Bear-Case gives us a target share price of $151, which indicated that the company is currently overvalued by 30%.
Bull-Case
This time I used more optimistic assumptions, they are once again briefly summarized here:
- Revenue: This time, I used the high end of management mid-term guidance - 8% revenue growth - to calculate the future revenue.
- EBIT: To arrive at suitable EBITs, I used an EBIT growth rate of 12% - once again management's high-end guidance for EBIT growth.
- Financial Result And Taxes: Here I also used the same metric as in the Bear-Case: -23%.
- Tax Rate: I also used 22.4% here as a suitable Tax Rate.
- Free Cash Flow: Using the Tax Rate above, I calculated the EBIAT and afterward tried to determine a suitable EBIAT to FCF ratio. In that case, I used the 9% as above.
- WACC: Here I assumed the more optimistic low end of their latest WACC, which is at 10%.
- Perpetuity Growth Rate: The perpetuity growth rate assumed for the analysis is again at 3.5%.
DCF ADP BULL-Case (seekingalpha.com; ADP.com)
Based on this more optimistic Bull-Case we get a price target of $210. This suggests that the company is currently trading at a fair valuation with the tendency to still being slightly overvalued. This, however, assumes that the company grows as optimistically as assumed by the management.
Conclusion
With being heavily overvalued in the Bear-Case and even slightly overvalued in the Bull-Case, I currently rate the company as a 'Sell'.
However, due to the high quality of the company, I am keen to revise my rating if the valuation is declining or the outlook and therefore the guidance from management is improving.
For further details see:
Automatic Data Processing: Solid Company But Overvalued Right Now