Automatic Data Processing - Stock Analysis - July 2020

On July 29th, Automatic Data Processing, Inc. (ADP) released Q4 and FY2020 results and FY2021 guidance and the share price dropped ~6.5% from the previous day’s close.

Although ADP’s business is experiencing headwinds attributed to COVID-19 I have a positive long-term outlook on the company.

Following the share price pullback I acquired additional shares in an account for which I do not disclose details. This account has held ADP shares for ~20 years.

Summary

  • ADP’s share price dropped ~6.5% following the July 29th release of Q4 and FY2020 results and FY2021 guidance.
  • ADP should continue to benefit from the evolving and increasingly complex relationship between businesses and their employees, changes in the US tax code, labor regulation and benefit compliance.
  • ADP’s current dividend yield is higher than it has been in the last 4 years.
  • COVID-19 is putting pressure on ADP’s financial performance but I view ADP’s long-term prospects as attractive.

Introduction

I have owned shares in Automatic Data Processing, Inc. (ADP) for ~20 years and my average cost is currently below $48. Although records from my self-directed broker indicate the value of my ADP investment has almost tripled, this return is grossly understated in that it does not account for the appreciation in value of the Broadridge Financial Solutions, Inc. (BR) and CDK Global, Inc. (CDK) shares I received when these companies were spun off from ADP in 2007 and 2014, respectively.

Furthermore, I have generated additional income from my ADP shares by having occasionally successfully employed the use of a covered call strategy.

In 2017 and 2018 I wrote articles in which I deemed ADP to be richly valued (see here, here and here). In 2019 I wrote a few articles in which I disclosed the use of covered calls.

While I have certainly fared well with my ADP investment, the only additional shares I have acquired over the last several years have been by way of the automatic reinvestment of the quarterly dividend income. That is…until today!

Following the release of ADP’s Q4 2020 and FY2020 results on July 29th, ADP’s share price dropped ~6.5% from the previous day’s close. This certainly caught my attention and based on a quick analysis I decided to add to my ADP position which is in an account for which I do not disclose details.

Business Overview

A comprehensive overview of ADP’s business can be found in Part 1, Item 1 in its 2019 10-K.

While ADP’s business is spread over 810,000 clients in 140 countries and territories giving an investor a reasonable level of comfort that its business is well diversified, a significant percentage of ADP’s business is derived from US based companies or US companies with international operations. In fact, in 2019, ADP disclosed that it paid ~26 million (~1 out of every 6) workers in the United States.

Q4 and FY2020 Financial Results

ADP’s most recent results can be found here, here, and here.

Although ADP reported stronger results relative to FY2019, I fully expected weak Q4 (April – June) results and am surprised ADP’s Q4 performance was not worse than what was reported.

One line item which may draw your attention when you look at the FY2020 Balance Sheet is the $1B increase in short-term debt. These notes are due September 2020 and management expects to issue new debt in the coming weeks or months depending on market conditions. We can expect this amount to move back into long-term debt once this occurs.

FY2021 Outlook

ADP’s FY2021 Outlook can be found on page 3 and 4 of 14.

On the Q4 July 29th conference call with analysts, management indicated:

‘Looking ahead, what we have been encouraged by signs that the economic distress brought about by COVID-19 has started to ease in certain countries and several U.S. states. We are seeing continued or even increasing distress in others. And over the past several weeks, we have seen the pace of employment recovery slow. Accordingly, as we set our expectations for the coming year, we believe that the worst is behind us. But the global economic recovery over the coming quarters will be gradual.’

‘While we believe government stimulus programs have helped many small businesses, we continue to see some companies in an inactive state where they are not paying employees. And we expect continued elevated losses in the early part of fiscal 2021 as restrictions and lower demand in certain industries continue to drive fall out.’

Guidance provided by ADP contemplates the U.S. getting to ~7% unemployment by June 2021. Given that the unemployment rate declined from 14.7% in April to 11.1% in June and that some state and local leaders are frantically reversing state reopenings I think ~7% unemployment by June 2021 is highly ambitious. We regularly hear that the COVID-19 pandemic has reached crisis proportions in the US and conditions are deteriorating quickly in several regions. I would not, therefore, be surprised if ADP lowered guidance in the coming quarters.

Clients Funds Investment Strategy

The purpose of ADP’s Client Funds Portfolio Extended Investment Strategy is to generate income from the 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.

In Q4, ADP temporarily suspended purchases of new securities and reinvestment of maturing securities in this portfolio. These purchases, however, were resumed in early July.

ADP has over $5B in securities maturing in FY2021, yielding on average over 2%, and management expects to reinvest at prevailing yields that are well below that level. As a result, average client funds yield is expected to be down 50 bps to ~1.6% for the year. With this combination of lower balance and yields, management expects interest income on client funds to be $0.39B – $0.4B, down ~$0.15B versus FY2020 and interest income from the extended investment strategy to be $0.43B – $0.44B, down ~$0.125B versus FY2020.

Credit Ratings

Looking at ADP’s current long-term credit ratings we see that Moody’s has rated ADP’s long-term debt Aa3 since August 28, 2015. This is the lowest tier of the High Grade category.

S&P Global has rated ADP AA since April 10, 2014. This rating is one notch higher than that accorded by Moody’s.

I have no issues with ADP’s credit ratings.

Valuation

Management has provided guidance for FY2021 (page 13 of 14) but I think it is extremely challenging to provide guidance in the current environment. I have, therefore, been less stringent in the use of valuation in my decision to acquire additional ADP shares.

With diluted EPS forecast to be in the range of $4.73 – $5.02, we get a forward PE range of 27.3 – 29 on the basis of the current ~$137 share price. In addition, ADP’s adjusted diluted EPS is forecast to be in the range of $4.85 – $5.15 giving us a forward adjusted PE of 26.6 – 28.3.

These valuation levels are certainly not ‘attractive’ but I think that in 5 – 10 years from now I will not have regretted adding to my ADP exposure.

Dividend, Dividend Yield, and Share Repurchases

ADP’s dividend history can be found here and I fully expect ADP will distribute a $0.91/share dividend at the beginning of October. Here is ADP’s dividend history in an easier to read format.

With ADP trading at ~$137, the $3.64 in dividends distributed/to be distributed in 2020 provides investors with a ~2.67% dividend yield – a yield not witnessed since ~2016.

I think ADP will increase its quarterly dividend to at least $0.99/share commencing with the dividend payable at the beginning of January 2021. If my assumption is correct, shareholders would receive ($0.91 (the October 2020 dividend) + ($0.99 x 3)) over the next 4 quarters for a total of $3.88. Using the current ~$137 share price this results in a projected dividend yield of ~2.83%.

In Q3, ADP temporarily suspended its share repurchases as it decided it would be prudent to wait for stabilization of the overall environment. On the Q4 call with analysts, management indicated that it anticipates the resumption of its share repurchase program at some point in FY2021. This, however, is subject to market conditions; guidance includes a slight net share count reduction.

Final Thoughts

I view ADP’s fall from grace with many investors and subsequent share price pullback (a 52 week high of ~$182 in late February 2020) as a temporary opportunity to add to my position.

While COVID-19 is putting pressure on ADP’s financial performance I think the long-term prospects for ADP are in no way diminished.

I fully appreciate that ADP’s share price is susceptible to further weakness and am open to acquiring additional shares in the account which currently has ADP exposure as funds become available for deployment.

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.