Contents
Summary
- In early February I recommended a short-term conservative option strategy on the basis that I viewed ADP as being richly valued.
- A comparison of ADP’s current valuation relative to the FY2011 – FY2018 timeframe suggests ADP continues to be overvalued.
- Shares have pulled back from a 52 week high following the recent release of ADP’s Q3 results and I anticipate a further pullback prior to the expiry of the options I previously recommended.
- I present a potential option trade if there is a strong probability shares will close above the $155 strike price and you do not want to have your ADP shares called away.
- An additional bearish option trade is presented if you think ADP will remain overvalued over the short-term.
Introduction
I view Automatic Data Processing (NADAQ: ADP) as a long-term investment. I have, however, mentioned in previous articles that even if I view a company as a long-term investment I have no objection to taking short-term conservative bearish positions by employing conservative option strategies.
In my February 2nd article I wrote that I viewed ADP as richly valued and indicated I would be writing out of the money covered calls to generate additional income. In my February 4th article I provided details of my covered call option trade; ADP was trading at ~$143.63 when I wrote $155 May 17, 2019 covered calls.
I collected $2.15/share meaning my breakeven level is $157.15/share calculated as the $155 strike price plus the $2.15/share option premium (excludes nominal commission).
If you look at ADP’s stock chart subsequent to early February you will see shares have been on an upward trajectory and recently reached ~$165 on April 23rd. Following the release of ADP’s Q3 results on May 1st, however, shares have retraced somewhat; ADP closed at $158.42 on May 2nd.
I am currently slightly underwater on this trade but am of the opinion ADP’s share price will retrace further as we approach the May 17th option expiry.
In this article I present my game plan in the event the share price pullback I anticipate does not materialize prior to expiry. In addition, I provide another short-term and conservative option trade which can be employed if you do not own the underlying shares and agree with my analysis that suggests ADP is overvalued.
Q3 2019 Financial Results and FY2019 Outlook
ADP’s Q3 results can be accessed here.
If you look at the top of the first page of ADP’s Earnings Press releases for recent previous quarters you will see diluted EPS and diluted adjusted EPS guidance have been revised upwards (see here, here, here, and here). There is no denying this is a good trend but let’s have a look at ADP’s valuation on the basis of the most recent guidance.
Valuation
In my February 2nd article I provided the historical data on which I analyzed ADP’s valuation over the past several years. I have streamlined and simplified the presentation of the data and provide it below.
Even though ADP has increased its guidance and its share price has just recently retraced from its recent 52 week high I am still of the opinion that shares are somewhat expensive.
Look at the annual high/low share price over the past several years and look at the PE ratios on the basis of these high/low share prices.
With ADP currently trading at $158.42, the current PE (using diluted EPS guidance) is 30.29 and the current adjusted PE (using adjusted diluted EPS guidance) is 29.12. Both these levels are closer to the ‘high’ of previous fiscal years.
If we scale back ADP’s PE to a still somewhat high 27.5 level we would get a share price of ~$143.83 (using EPS guidance of $5.23) and $149.60 (using adjusted EPS guidance of $5.44).
I don’t know if ADP’s share price will pull back to these levels in this current environment but I think a pullback from the current level to below my $155 strike price is not out of the realm of possibility.
Dividend and Dividend Yield
ADP does not keep current the dividend history on its website. I have, therefore, looked at recent quarterly dividend press releases to obtain the data required for me to calculate ADP’s dividend yield.
If you look at various stock screeners you will see they report ADP’s annual dividend as being $3.16. I reflect the annual dividend as being $3.06. The reason is that ADPs’ quarterly dividends in FY2019 are $0.69, $0.79, $0.79, and $0.79. Stock screeners are using $0.79 for all 4 quarters.
Looking at ADP’s valuation on the basis of dividend yield we see the ADP’s current dividend yield on the basis of the 52 week high is ~1.85% and ~2.51% on the basis of the 52 week low. With ADP trading at $158.42 we get a current dividend yield of ~1.93%. This yield is low relative to historical levels other than ADP’s dividend yield in FY2018 when we use the 52 week high share price.
If ADP’s share price were to drop to ~$147 (roughly the mid-point of the $143.83 and $149.60 reflected in the Valuation section of this article then the $3.06 annual dividend would provide investors with a yield of ~2.08%. Even this dividend yield is low relative to recent historical levels.
Options
Covered Call
Looking at the current price for the May 17, 2019 $155 call I see the Bid/Ask/Last Price are $4.20, $4.60, and $3.56. If I wanted to close out my position I would likely have to pay ~$3.60/share (each contract is for 100 shares) but I only collected $2.15/share so I am down $1.45/share.
I could write a June 21, 2019 $160 covered call in which the current Bid/Ask/Last Price are $3.30, $3.50, and $3.41. If I receive ~$3.30 that would cover the $1.45 I have to lay out to close my existing $155 position.
I could go out further on the calendar but ADP holds its Investor Day on June 12th. In addition, Q4 and FY2019 results and FY2020 guidance will be released early August. I would like to see how shares react following these events, and therefore, I will stick with June options.
Bear Call Spread Option Strategy
If you are in agreement that ADP is richly valued you may wish to consider employing a Bear Call Spread; this strategy is used to profit from a neutral to bearish price action in the underlying stock.
I have mentioned in previous articles, but reiterate here, that this strategy results in you collecting an upfront premium. A comparable strategy would be to use the Bear Put Spread but then you would have to lay out money at the time of the trades.
The trade I propose is:
- Sell $155 June 21, 2019 Call and generate $6.10/share
- Buy $160 June 21, 2019 Call and pay $3.41/share
- Net credit of $2.69/share (excludes nominal commission)
If shares close below $155 at expiry, the holder of the right to buy ADP shares at $155 would let their options expire since they can acquire shares on the open market at a better price. In addition, you would let your right to buy ADP shares at $160 expire. Your maximum profit potential is, therefore, the $2.69/share you collect at the time of the trade.
On the maximum risk front, you stand to lose the most if ADP is trading above $155 at expiry. If ADP is trading at $170, for example, the holder of the Call would have the right to acquire shares from you at $155 meaning you are down $15/share. You, however, have the right to acquire shares at $160 so you are ahead $10/share on these options resulting in a net loss of $5/share. This loss is partially offset by the $2.69/share in net premium you collected at the time of the option trades so your maximum loss is $2.31/share.
Combine the Covered Call AND Bear Call Spread Option Strategies
If you own the underlying ADP shares you may wish to combine both option strategies.
The strategies presented above are separate and distinct but both are predicated on ADP’s share price staging a pullback from the current $158.42. As you can see from above, you maximize your profits if ADP closes below $155 and $160 at expiry. You would receive $3.40/share under the covered call and $2.69/share under the Bear Call Spread for a total profit of $6.09/share.
Your risk on the Covered Call front depends on ADP’s share price. On the Bear Call Spread trade, however, you know your maximum risk exposure at the time you place your trade.
Risks
As always, I encourage you to remember that you can employ options to reduce risk. Some option strategies, however, will increase your risk.
If you wish to employ the conservative option strategies presented in this article I highly encourage you to review this explanation of Covered Calls and this explanation of Bear Call Spreads.
Final Thoughts
Based on my analysis I am of the opinion that ADP shares are richly valued and will retrace to $155 or lower by May 17, 2019.
If ADP’s share price does not retrace to below $155 I will close out my position by writing new calls at a higher strike price.
In addition, depending on what happens between now and May 17th I may also initiate a Bear Call Spread.
An update on my ADP position and trades will be provided in due course.
I hope you enjoyed this post and I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long ADP.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
