Automatic Data Processing Stock Analysis: A Wonderful Company. Less Than Wonderful Valuation

Introduction

Automatic Data Processing (NASDAQ: ADP) was founded in 1949. It is a:

• comprehensive global provider of cloud-based Human Capital Management solutions that unite HR, payroll, talent, time, tax and benefits administration
• leader in business outsourcing services, analytics and compliance.

It serves more than 610,000 clients in over 112 countries.

ADP is currently a Dividend Aristocrat which is an exclusive group of companies in which the dividend has increased for at least 25 consecutive years. As recently as November 8, 2016, ADP's board of directors approved a $0.04 increase in the quarterly cash dividend ($0.53/quarter to $0.57/quarter) for an annual rate of $2.28 per share. This increased cash dividend marks the 42nd consecutive year in which ADP has raised its quarterly dividend. The next quarterly dividend will be distributed on January 1, 2017 to shareholders of record at December 9, 2016.

The following analysis has been prepared using ADP's 2016 10-K, Proxy Statement, the Q1 2017 ADP Earnings Call and Webcast presentation on November 2, 2016, and data from Morningstar, Inc.

Q1 Fiscal 2017 Results

On November 2, 2016, ADP highlighted the following 4 key items in its press release:

1. Revenues increased 7% to $2.9 billion for the quarter, 8% on a constant dollar basis.
2. Diluted earnings per share from continuing operations increased 13% to $0.81; adjusted diluted earnings per share from continuing operations increased 26% to $0.86, 26% on a constant dollar basis.
3. Recorded an anticipated pre-tax restructuring charge of $40 million related to the previously announced Service Alignment Initiative.
4. On November 1, 2016, ADP signed an agreement with WageWorks, Inc. to sell its Consolidated Omnibus Reconciliation Act ("COBRA") and Consumer Health Spending Account ("CHSA") businesses for $235 million.
5. ADP acquired 4.0 million shares of its stock for treasury at a cost of $352 million in the quarter.

Fiscal 2017 Outlook

ADP's two reportable business segments are:

• Employer Services (EO)
• Professional Employer Organization Services (PEO)

Revenue

Management's 2017 forecast calls for consolidated revenue to grow 7- 8%.

EO is projected to grow its revenue 4-5%. This business segment offers:

1. Payroll Services
2. Benefits Administration
3. Talent Management
4. HR Management
5. Time and Attendance Management
6. Insurance Services
7. Retirement Services
8. Tax and Compliance Services

Professional Employer Organization Services is projected to grow 14 - 16%. This business segment serves approximately 9,700 clients with comprehensive employment administration outsourcing solutions through a relationship in which employees who work at a client's location are co-employed by ADP and its client.

Margin Expansion

Management expects Adjusted EBIT to increase approximately 50 bps with this increase allocated as follows:

EO: approximately 50 bps; PEO: approximately 75 bps

"Adjusted" results exclude charges related to ADP's Service Alignment Initiative and an anticipated gain on the sale of COBRA and CHSA businesses in fiscal 2017 as well as charges related to workforce optimization, the gain on the sale of a building, and the gain on the sale of the AdvancedMD business during fiscal 2016.

In addition, this includes the projected repurchase of $1-$1.4 Billion of ADP shares.

Worldwide New Bookings

Fiscal 2016 results amounted to $1.75 Billion. This is expected to grow between 4-6 % ($1.82-$1.855 Billion).

U.S. Pays per Control

The "pays per control" metric is one in which ADP measures as the number of employees on its clients' payrolls based on a same-store-sales basis utilizing a representative subset of payrolls ranging from small to large businesses that are reflective of a broad range of U.S. geographic regions.

The target is approximately 2.5% compared to a 2.5% increase in fiscal 2016.

Adjusted Effective Tax Rate

This is expected to drop to 32.7% from 33.3% in fiscal 2016.

Projected Revenue from Client Funds Held on Deposit

• Average Clients Funds Balances are expected to increase 2-4% from $22.4 Billion in fiscal 2016 ($22.85-$23.3 Billion).
• The Yield on the Clients Funds portfolio is projected to remain relative flat at 1.7% which was the yield generated in fiscal 2016.
• Clients Funds Interest Revenue is expected to increase $5-$10 million from $377 million in fiscal 2016. This is a revision from the previous forecast of an increase of up to $5 million.
• The Extended Investment Strategy is expected to have an impact of $5 million compared to $418 million in fiscal 2016. The prior forecast called for flat growth. Under this strategy, ADP continues to include the interest income earned on investments associated with its client funds and it includes interest expense on borrowings related to its client funds. This is done on the basis that these amounts are fundamental to the underlying operations of ADP's business model.

2016 EPS

Diluted EPS from continuing operations (GAAP) for fiscal 2016 was $3.25 (a 12% increase from fiscal 2015).

Factoring in the following adjustments:

1. Gain on sale of AdvancedMD business ($0.05)
2. Gain on sale of building ($0.02)
3. Workforce optimization effort $0.07 (approx.)

ADP achieved adjusted EPS from continuing operations (non-GAAP) of $3.26.

2017 EPS Projections

Diluted EPS from continuing operations (GAAP) of $3.74-$3.80 (15-17 % increase)

Factoring in the following adjustments:

1. Service Alignment Initiative 4%
2. Gain on sale of COBRA and CHSA businesses (8%)

Adjusted EPS from continuing operations (non-GAAP) of $3.62-$3.68 - an 11 to 13% gain

Historical Metrics

P/E

ADP's historical P/E for 2008 - current is as follows:

2008: 16.81

2009: 15.98

2010: 19.20

2011: 21.02

2012: 20.41

2013: 28.25

2014: 26.22

2015: 28.33

Current: 29.57

Dividend

ADP's historical dividend for 2008 - current is as follows:

2008: $1.20

2009: $1.33

2010: $1.38

2011: $1.48

2012: $1.62

2013: $1.79

2014: $1.93

2015: $2.00

Current: $2.28

Trailing Dividend Yield

ADP's historical trailing dividend yield for 2008 - current is as follows:

2008: 3.05%

2009: 3.11%

2010: 2.98%

2011: 2.73%

2012: 2.85%

2013: 2.21%

2014: 2.31%

2015: 2.36%

Current: 2.19%

Automatic Data Processing Stock Analysis - Final Thoughts

I am of the opinion the markets are currently in a period of irrational exuberance. I see absolutely no reason for the dramatic increase in ADP's valuation of around $90 just prior to the US Presidential election and the current value just north of $100.

I am, therefore, taking the position that at some stage in 2017 we will see a reversion to the mean and the current P/E of 29.57 will likely drop back to the 25 level (hopefully lower).

Using the projected adjusted EPS range provided by management, I would be prepared to add additional ADP shares to those currently held and acquired at an average cost of $40.626 should ADP shares drop below $92 ($3.68 projected adjusted EPS x 25 P/E).

Using a price of $92 and the current annual dividend of $2.28 we end up with a dividend yield 2.48% which comes closer to historical levels.

Naturally, any price below $92 would warrant a "strong buy" from my perspective.

Disclaimer: I have no knowledge of your circumstances and am not providing individualized advice or recommendations. I encourage you to conduct your own research and due diligence and to consult your financial advisor about your situation.

Disclosure: I am long ADP.

I wrote this article myself and it expresses my opinions. I am not receiving compensation for it and have no business relationship with any company mentioned.