ADP Exposure Increased

I last reviewed Automatic Data Processing (ADP) in my October 31, 2022 post at which time Q1 results and the revised FY2023 outlook had just been released. Based on my analysis I deemed ADP to be slightly overvalued.

On January 25, ADP released Q2 and YTD2023 results and provided an update to its FY2023 outlook.

Despite headlines of a recession in 2023, ADP's management remains committed to its FY2023 outlook. While minor adjustments have been made to some targets, FY2023 diluted EPS AND adjusted diluted EPS growth outlooks remain unchanged at 15% - 17% of FY2022 results.

Business Overview

Please review my October 31, 2022 post.

Financial Review

Q2 and YTD2023 Results

ADP's Q2 2023 results are reflected in this Form 8-K and the accompanying earnings presentation; the Q2 2023 Form 10-Q is not yet available as I compose this post.

I provided ADP's Q1 2023 financial highlights for comparison.

ADP's CAPEX requirements are well below those of capital-intensive industries. This is a strong advantage when it comes to generating Free Cash Flow (FCF).

ADP's FY2012 - FY2022 FCF (in Billions of $) is $1.661, $1.342, $1.518, $1.639, $1.511, $1.655, $2.044, $2.122, $2.410, $2.587, and $2.925. YTD2023 FCF is ~$1.52B.

FY2023 Outlook

The following is ADP's current and prior FY2023 outlook.

Clients Funds Investment Strategy

A comprehensive overview of ADP's Clients Funds Investment Strategy is found in Note 4 in ADP's FY2022 Form 10-K starting on page 62 of 95.

The purpose of ADP’s Client Funds Extended Investment Strategy is to generate income from significant client fund balances. When deemed prudent, ADP will further enhance its investment returns by investing long and borrowing short to take advantage of the yield spread.

This strategy is structured to allow ADP to average its way through an interest rate cycle by laddering the maturities of investments out to 5 years (in the case of the extended portfolio) and out to 10 years (in the case of the long portfolio). This investment strategy is supported by ADP's short-term financing arrangements necessary to satisfy short-term funding requirements relating to client funds obligations.

While client funds interest revenue was up in Q2, the increase was a bit lighter than expected. Management attributes this to a slight pullback in yields from where they were 3 months ago when the prior outlook was provided.

The mid and the long rates have come down following the release of previous guidance. Even though short-term rates have increased, some of ADP's short-term borrowing costs have increased in its commercial paper program. The reason the client fund interest forecast is revised slightly lower is to reflect these increased borrowing rates and the softening of deposit interest rates in the mid and the longer term.

ADP is also lowering its client funds interest growth from 4% - 6% to 4% - 5%. This is primarily because of changes to assumptions around average wage related to worker mix, tax rates, and the impact of the lapping of the payroll tax deferral.

This is what ADP provided when it released Q1 2023 results.

Risk Assessment

There is no change to ADP's senior unsecured domestic long-term debt credit ratings from the time of my last review.

• Moody's: Aa3
• S&P Global: AA-
• Fitch: AA-

The outlook assigned by all 3 rating agencies is 'stable'.

All ratings are in the bottom tier of the upper medium-grade investment-grade category. They define ADP as having a very strong capacity to meet its financial commitments and differ from the highest-rated companies only to a small degree. 

These ratings satisfy my conservative investment preferences.

Dividends and Share Repurchases

Dividends and Dividend Yield

ADP distributed its 4th regular quarterly $1.04/share dividend on October 1, 2022. Looking at ADP's dividend history, I expected a quarterly dividend distribution at the beginning of January 2023 in the ~$1.09 - ~$1.11 range. This would have resulted in a ~1.8% dividend yield based on ADP's ~$242.65 share price at the time.

I could not have been further off the mark. ADP increased its quarterly dividend to $1.25!

The next quarterly dividend distribution will be at the beginning of April. Using my ~$225 purchase price, the dividend yield is ~2.22%.

Share Repurchases

The FY2012 - FY2022 weighted average share outstanding (in millions rounded) is 492, 487, 483, 476, 459, 450, 443, 438, 433, 428 and 421.

• FY2019 - ADP purchased ~6.5 million shares at an average price per share of $143.02.
• FY2020 - ADP purchased ~6.2 million shares at an average price per share of $160.61.
• FY2021 - ADP purchased ~8.2 million shares at an average price per share of $170.04.
  
• FY2022 - ADP purchased ~9.2 million shares at an average price per share of $214.40.

In the first half of FY2023, ADP repurchased $553.5 million of its common stock. The diluted weighted average shares outstanding (in millions) in Q2 2023 is 416.2.

Valuation

ADP's diluted PE ratio in the FY2012 - FY2022 is 20.41, 28.25, 26.22, 28.33, 30.77, 29.74, 33.79, 31.40, 30.59, 39.02, and 33.08.

When I wrote my October 31, 2022 post, ADP forecasted diluted EPS AND adjusted diluted EPS growth of 15% - 17% growth. Using FY2022's $7.00 diluted EPS and $7.01 adjusted diluted EPS and this growth range, I expected FY2023 diluted and adjusted diluted EPS of ~$8.06 - ~$8.20. With shares trading at $242.65, the forward diluted and forward adjusted diluted PE ratios were ~29.6 - ~30.1.

In addition, the forward-adjusted diluted PE levels based on broker estimates were:

• FY2023 - 19 brokers - mean of $8.11 and low/high of $7.92 - $8.23. Using the mean estimate, the forward adjusted diluted PE is ~30 and ~29.5 if I use $8.23.
• FY2024 - 18 brokers - mean of $9.00 and low/high of $8.25 - $9.25. Using the mean estimate, the forward adjusted diluted PE is ~27 and ~26.2 if I use $9.25.
• FY2025 - 8 brokers - mean of $10.12 and low/high of $9.65 - $10.36. Using the mean estimate, the forward adjusted diluted PE is ~24 and ~23.4 if I use $10.36.

With no change to management's FY2023 diluted EPS AND adjusted diluted EPS growth outlook, the forward adjusted diluted PE range is ~27.4 - ~28 based on my January 25 ~$225 purchase price.

I anticipate minor revisions to current broker estimates over the coming days. For now, however, ADP's forward adjusted diluted PE levels are:

• FY2023 - 18 brokers - mean of $8.11 and low/high of $7.96 - $8.23. Using the mean estimate, the forward adjusted diluted PE is ~27.7 and ~27.3 if I use $8.23.
• FY2024 - 18 brokers - mean of $8.97 and low/high of $8.25 - $9.32. Using the mean estimate, the forward adjusted diluted PE is ~25.1 and ~24.1 if I use $9.32.
• FY2025 - 9 brokers - mean of $10.02 and low/high of $9.67 - $10.50. Using the mean estimate, the forward adjusted diluted PE is ~22.5 and ~21.4 if I use $10.50.

Final Thoughts

I considered ADP's valuation to be elevated when I last wrote about ADP. Mr. Market, however, felt otherwise and the share price marched higher touching a ~$275 52-week high at the beginning of December. Subsequently, the share price has steadily pulled back.

On January 25 I added additional shares at ~$225 in a retirement account where most of my ADP exposure is held; I do not disclose retirement account details. This explains why ADP was my 15th largest holding when I completed my Mid 2022 Investment Holdings Review yet I only reflect 100 shares in the FFJ Portfolio.

Some investors may consider the current valuation to be elevated. My experience as a 17+ year shareholder suggests otherwise with ADP's diluted PE rarely falling below the mid-20s during this timeframe.

I am looking to increase my exposure to great companies that appear to have temporarily fallen out of favour. While there is a risk of a mild recession in 2023, ADP sees no sign of a significant slowdown and its FY2023 outlook remains unchanged except for minor changes to certain targets. I, therefore, think investors have overreacted following the January 25 earnings release. Should I be wrong and ADP's valuation further improves, I will most likely add to my exposure.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long ADP.

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your own research and due diligence. Consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.