ADP Is Slightly Overvalued

In my July 29, 2022 Automatic Data Processing (ADP) post, I conclude that a share price pullback to the mid $220 range was not unreasonable once the euphoria waned following the release of ADP's strong FY2022 results and FY2023 outlook.

ADP's share price rose after that post. In mid-August, however, the share price commenced a pullback and eventually fell to the mid $220s in late September to mid-October. I would have added to my ADP exposure but as noted in recent posts, the purchase of a second home put a dent in my liquidity.

Now, ADP has just released its Q1 2023 results and revised FY2023 guidance and the share price is ~$242.65. I, therefore, revisit ADP to determine if its valuation is sufficiently appealing to acquire shares.

Business Overview

ADP has invested heavily over the past decade to develop public cloud solutions and consolidate multiple platforms.

It faces competitive pressure from ERP providers, accounting software, smaller but more nimble upstarts, and legacy peers. However, ADP's new solutions should enable it to compete on functionality and lower software maintenance costs.

Nevertheless, increasing competitive pressure will likely require ADP to maintain high levels of investment to ensure its product offerings remain competitive.

The following are excellent sources of information to gain a good understanding of ADP's business.

• ADP's website;
• Part 1, Item 1 in ADP's FY2022 Form 10-K; and
• ADP Investor Presentation - August 2022.

Financial Review

Q1 2023 Results

ADP's Q1 2023 results are reflected in this Form 8-K and the accompanying earnings presentation; the Q1 2023 Form 10-Q is not yet available.

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.

FY2023 Outlook

The following reflects ADP's current FY2023 outlook and outlook when it released Q4 and FY2022 results at the end of July 2022.

Management's growth outlook assumes a deceleration in growth in Q2 and very little growth in the second half of FY2023.

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.

The following reflects ADP's current FY2023 Client Funds Investment Strategy outlook versus that when it released Q4 and FY2022 results.

ADP's client funds short portfolio should continue to benefit as the Federal Funds rate increases over the balance of FY2023.

The new investments in the client-extended and loan portfolios are now expected to yield ~4.3%.

ADP now expects the average yield on its client funds portfolio to be 2.4% in FY2023. This is about 20 bps higher than the prior outlook.

Expectations are for client funds balances to grow 4% - 6% and for client funds interest revenue to increase to $0.79B - $0.81B in FY2023; this is a ~$70 million increase from the prior outlook. Partially offsetting this revenue upside, however, is higher short-term borrowing costs associated with the client funds extended strategy. With higher expected commercial paper and reverse repo rates over the remainder of the current fiscal year, the net impact from the client fund's extended strategy is expected to be ~$0.72B - ~$0.74B which is a $45 million increase from the prior outlook.

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 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 obligors only to a small degree. 

These ratings satisfy my conservative investment preferences.

Dividends and Share Repurchases

Dividends and Dividend Yield

When I last acquired shares at ~$197.50 on January 26, 2022, the $1.04 quarterly dividend yielded ~2.1%.

ADP distributed its 4th regular quarterly $1.04/share dividend on October 1, 2022. Looking at ADP's dividend history, we can expect the next quarterly dividend distribution at the beginning of January 2023 to be declared relatively soon.

I anticipate a $0.05 - $0.07/share dividend increase. If this materializes, the new ~$1.09 - ~$1.11 quarterly dividend would yield ~1.8% based on the current ~$242.65 share price.

At the time of my prior review, ADP's share price was ~$239.50 and the $1.04 quarterly dividend yielded ~1.75%.

Share Repurchases

The FY2012 - FY2022 weighted average share outstanding (in millions) 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 Q1 2023, ADP spent ~$0.333B and lowered the diluted weighted average shares outstanding to 416.9 from 421.1 in FY2022.

Valuation

ADP's diluted PE ratio in the FY2012 - FY2021 timeframe is 20.41, 28.25, 26.22, 28.33, 30.77, 29.74, 33.79, 31.40, 30.59, and 39.02.

When I wrote my July 29, 2020 post, ADP's diluted EPS forecast was $4.73 - $5.02. With shares trading at ~$137, the forward PE range was ~27.3 – ~29. In addition, ADP’s adjusted diluted EPS forecast was $4.85 - $5.15 giving us a forward adjusted PE of ~26.6 – ~28.3.

At the time of my January 27, 2022 post, I viewed ADP's valuation to be reasonable and disclosed the purchase of 100 shares at ~$197.50 on January 26, 2022 in one of the 'Side' accounts in the FFJ Portfolio.

Management's FY2022 adjusted diluted EPS guidance called for a 12 - 14% increase from the $6.02 reported in FY2021. Using the current ~$197.50 share price and adjusted diluted EPS guidance of ~$6.74 - ~$6.86, the forward adjusted diluted PE range was ~28.8 - ~29.3.

Using the brokers' forward-adjusted diluted EPS estimates reflected on the two online trading platforms I use, the forward-adjusted diluted PE levels were:

• FY2022 - 19 brokers - mean of $6.81 and low/high of $6.72 - $6.91. Using the mean estimate, the forward adjusted diluted PE is ~29 and ~28.6 if I use $6.91.
• FY2023 - 19 brokers - mean of $7.55 and low/high of $7.25 - $7.85. Using the mean estimate, the forward adjusted diluted PE is ~26.2 and ~25.2 if I use $7.85.
• FY2024 - 10 brokers - mean of $8.43 and low/high of $8.11 - $8.60. Using the mean estimate, the forward adjusted diluted PE is ~23.4 and ~23 if I use $8.60.

When I wrote my July 29, 2022 post, ADP had recently reported $7.00 and $7.01 of diluted EPS and adjusted diluted EPS for FY2022. Using the current ~$234.80 share price, the diluted PE and adjusted diluted PE were ~33.5.

Now, the FY2023 outlook is for diluted EPS growth of 15% - 17% and adjusted diluted EPS growth of 15% - 17%. Using the 16% mid-point of the projected growth rates and the $7.00 diluted EPS and $7.01 in adjusted diluted EPS results in FY2022, we can expect FY2023 diluted and adjusted diluted EPS of ~$8.12. With shares trading at $242.65, the forward diluted and forward adjusted diluted PE ratios are ~30.

The forward-adjusted diluted PE levels using the broker estimates reflected on the two online trading platforms I use 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.

I view ADP to be slightly overvalued. A ~$230 (or lower) share price is the level at which I recommend buying.

Final Thoughts

I hold the vast majority of my ADP shares in a retirement account for which I do not disclose details. This explains why ADP was my 15th largest holding when I completed my Mid 2022 Investment Holdings Review even though I only reflect 100 shares as being held in the FFJ Portfolio.

I have always been drawn to this company because it benefits from high client switching costs. Payroll and human capital management (HCM) software are typically deeply embedded in a business's operations. In addition to the monetary costs of switching service providers, a business could face operational disruptions and inefficiencies such as:

• having to train employees on a new system;
• the integration of a new solution with other software, and
• the risk of data loss.

A growing number of influential Corporate America executives are sounding the alarm over the state of various major economies (especially the US). If you have not yet started to dial back risk then now is a good time to do so; focus solely on high-quality companies such as ADP.

Having said this, ADP's outlook assumes a deceleration in growth in Q2 and very little growth in the second half of FY2023. It is not unreasonable to expect ADP to hit a 'rough patch' in 2023 at which time you may wish to load up on ADP.

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.