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An Overview

Automatic Data Processing (NASDAQ:ADP) provides business outsourcing services. These services include processing payroll, human resource information, and tax and benefits administration, among others. They collect for these services, and also earn interest on funds held for their clients. This portion of the business is very similar to ADP's closest publicly traded competitor, Paychex (NASDAQ:PAYX) which I looked at for its return prospects in an earlier article.

ADP has two other main business segments as well. Their Professional Employer Organization segment places employees at various companies that are dual-employed by ADP and their client. This serves as a sort of in-house outsourcing for their clients. Their other main business segment is Dealer Services, which offers systems, marketing, and management assistance to auto, truck, marine, and heavy equipment dealers. (Company description provided at Yahoo! Finance)

ADP recently hit both a 52-week high and a new all-time high and currently sells at 20X forward earnings estimates (per Morningstar). ADP is a stock I currently own, and I am wondering if its future return prospects still meet my requirements for total return. I only buy stocks that offer an attractive total return profile of 9-11% annually over the next 5 years. Obviously you want stocks that will continue to gain after 5 years, but trying to do any analysis more than 5 years out includes more guessing than I am willing to do. I view ADP as being of the highest quality, so my threshold for buying would be the lower 9% hurdle.

So where does ADP need to be 5 years from now to earn 9% annually? The short answer: $88.22/share

Now, let's take a brief glance at how that number is calculated:

Looking forward, we can expect the next full year's worth of dividends to get 2.7% of the year 1 return. That leaves the stock price to make up for the other 6.3% in year 1. Given ADP's history of increasing their dividends (see table provided below), it is reasonable to assume that the dividend will be able to, at a minimum, grow at the same pace as the stock price over the next 5 years. For this reason, we will assume that these ratios will hold, with ADP's dividend providing 2.7% of the annual return, and the stock price needing to make up the remaining 6.3% each year.

Year of Dividend Hike

2007

2008

2009

2010

2011

2012

New Quarterly Rate

0.29

0.33

0.34

0.36

0.395

0.435

Percentage Hike

26.1%

13.8%

3.0%

5.9%

9.7%

10.1%

$65/share * (1.063) ^5 = $88.22/share

We know what share price we need 5 years from now to earn our 9% annually, now let's figure out what we would expect the share price to be. With a company as stable as ADP, we should be able to make a fairly accurate calculation of what the company's earnings will be five years from now. Taking into account the ongoing share buybacks, we should then be able to predict the share count in that year as well and get our earnings per share number. Let's start the process of figuring out what ADP's 2018 earnings will be. Here is a quick table showing five years of some popular metrics taken from the 2012 Annual Report.

Fiscal Year (ended June 30)

2008

2009

2010

2011

2012

Total Revenues

8733.7

8838.4

8927.7

9879.5

10665.2

Earnings before Taxes

1803.4

1900.1

1863.2

1932.7

2122.1

Taxes

647.7

575

655.9

678.5

733.6

Effective Tax Rate

35.9%

30.3%

35.2%

35.1%

34.6%

Net Earnings

1155.7

1325.1

1207.3

1254.2

1388.5

Net Earnings Margin

13.2%

15.0%

13.5%

12.7%

13.0%

Basic Shares Outstanding

521.5

503.2

500.5

493.5

487.3

Basic Earnings per Share

2.22

2.63

2.41

2.54

2.85

(all numbers in millions except Basic Earnings per Share)

If this is all the data I had, I would not have a shot at analyzing this company. Fortunately for all of us, though, there is another 100+ pages worth of data to analyze offered up in each annual report.

Here is a table of what I view to be the key metrics for ADP's business, broken down and rearranged into segments as I feel appropriate. Information was pulled from the 2010 and 2012 Annual Reports (form 10-K) for ADP. All numbers were either listed in Financial Statements, Analysis of the Financial Statements, or were calculated using numbers listed in one or both of these sections.

Fiscal Year (ended June 30)

2008

2009

2010

2011

2012

Segment Earnings Data

Combined Operating Segment Revenues

8049.2

8228.6

8384.9

9339.4

10171.9

Segment Earnings before Taxes

1032.9

1215.6

1227.8

1284.6

1465.7

Segment Pretax Earnings Margin

12.8%

14.8%

14.6%

13.8%

14.4%

Investments of CFH Earnings Data

Average Client Funds Held

15654.3

15162.4

15194.5

16865.4

17898.2

Interest Earned on CFH

684.5

609.8

542.8

540.1

493.3

% Earned on CFH

4.4%

4.0%

3.6%

3.2%

2.8%

Corporate Investments Earnings Data

Corporate Investments

3387

3744.7

3839.2

3467.6

4024.6

Income from Corporate Investments

166.5

108

101.2

116.6

104.8

Interest Expense

80.5

33.3

8.6

8.6

7.7

Net Corporate Investment Income

86

74.7

92.6

108

97.1

% earned on corporate investments

2.5%

2.0%

2.4%

3.1%

2.4%

Overall Profitability

Pre-Tax Earnings from Cont. Operations

1803.4

1900.1

1863.2

1932.7

2056.1

Overall Pre-Tax Margin

20.6%

21.5%

20.9%

19.6%

19.3%

Provision for Income Taxes

647.7

695

668.1

678.5

708.8

Effective Tax Rate %

35.9%

36.6%

35.9%

35.1%

34.5%

Net Earnings

1155.7

1205.1

1195.1

1254.2

1347.3

Earnings per Share

Diluted Weighted Average Shares Outstanding

527.2

505.8

503.7

498.3

492.2

Earnings per Diluted Share

2.19

2.62

2.37

2.52

2.74

(Source: Nick Eerkes - Article Author, all numbers in millions USD except earnings per Diluted Share and Diluted Weighted Average Shares Outstanding-Diluted Weighted Average Shares Outstanding is in millions)

Fiscal 2012 numbers are adjusted to remove the effects of the sale of assets related to rights and obligations to resell a third-party expense management platform. Fiscal 2009 and 2010 numbers are adjusted to reverse the effects of favorable tax rulings of 120 million and 12.2 million, respectively, in those years. Since the value of these two occasions was received in these years, but was not the result of business operations in those years, I thought it best to reverse it out.

Also of note, I assigned $0 of operating and SG&A (Sales, General, and Administrative) expense to the income earned on Corporate Investments, and to the income earned on Client Funds Held. The reasoning for this is simple. The costs associated with earning extra income off of your corporate investments are a reality for all large, publicly traded companies. Investing Client Funds Held is just an extension of that. Furthermore, there is little to no incremental cost to investing each additional dollar. It is my opinion that to try and allocate operating and SG&A expenses to this portion of this business would create more distortions than simply allocating it all as a cost of operations.

So what was the point of dissecting the income statements and balance sheets of the last 5 years, flushing out the undesirable portions, and then reassembling them in this way? Well, now the numbers are "cleansed" and we can really look at what trends are happening in the underlying business and try and project out 5 more years of business operations. When we take into account the timing of their fiscal years in relation to the date of our analysis, we will need 6 more years of projections to get us to the fiscal year ended June 30, 2018, are best proxy for five years from now.

The Projections

So what are these numbers going to be over the next 6 fiscal years? Let's take them one at a time.

Segment Earnings Data

Combined Operating Segment Revenues:

Here is a table focusing in just on Combined Segment Revenue Growth over the last five fiscal years.

Fiscal Year (ended June 30)

2008

2009

2010

2011

2012

Combined Segment Revenues

8049.20

8228.60

8384.90

9339.40

10171.90

% Change Year/Year

2.2%

1.9%

11.4%

8.9%

(Revenues in millions USD)

Here is another table looking at Revenue growth by region. This is not shown in constant currencies, nor does it break out revenue into the segments I have, but I think it still sheds some light on where growth is coming from.

2008

2009

2010

2011

2012

USA Revenues

7028

7222.8

7195

7930

8543

% Change Year/Year

2.8%

(0.4%)

10.2%

7.7%

Europe Revenues

1081

1051.6

1090

1191

1270

% Change Year/Year

(2.7%)

3.6%

9.2%

6.7%

Canada

388.7

343.4

383.4

428.2

447.5

% Change Year/Year

(11.7%)

11.6%

11.7%

4.5%

Other (Global)

191.5

220.6

259.5

330.4

405.4

% Change Year/Year

15.2%

17.6%

27.3%

22.7%

(all non-percentage numbers in millions USD, Other includes South America, the Middle East, Asia, and Australia)

Revenue growth for ADP comes from a variety of sources. A growing population (more importantly a growing workforce) can lead to more business clients and more employee checks per business client. Taking market share from competitors, buying smaller competitors, and expanding operations into an untapped market also grows this revenue. Additionally, ADP is able to raise prices at a rate equal to or above inflation given their sticky relationship with their customers.

Looking at the revenue growth trends, I would assume that the 2011 numbers had some snapback effect locked in from a down 2010, and some of this played out still in 2012. When you factor in a strengthening US and World growth outlook, as well as a slowly shifting revenue base to the faster growing parts of the world, I would peg a conservative yet realistic Revenue growth estimate for the next 6 years at 8% per year.

Segment Pretax Earnings Margin:

Fiscal Year (ended June 30)

2008

2009

2010

2011

2012

Combined Segment Revenues

8049.2

8228.6

8384.9

9339.4

10171.9

Segment Earnings before Taxes

1032.9

1215.6

1227.8

1284.6

1465.7

Segment Pretax Earnings Margin

12.8%

14.8%

14.6%

13.8%

14.4%

(all non-percentage number in millions USD)

The above table shows the trend for this margin over the last 5 years. I expect this number to move around a little over time, but in the end to average around the 14.4% experience in 2012. For this reason, and since 2012 is arguably the most similar operating year to what we would expect over the next five years, 14.4% is the margin I will use for the Segment Pretax Earnings Margin over the next 6 years.

Segment Earnings before Taxes:

Using the projections I was able to come to above over the next five years, with 2012 as a base, this table shows what I would expect from this segment of the business over the coming 6 years.

Fiscal Year (ended June 30)

2012

2013

2014

2015

2016

2017

2018

Combined Segment Revenues

10171.9

10985.7

11864.5

12813.7

13838.8

14945.9

16141.5

Segment Earnings before Taxes

1465.7

1581.9

1708.5

1845.2

1992.8

2152.2

2324.4

Segment EBT Margin

14.4%

14.4%

14.4%

14.4%

14.4%

14.4%

14.4%

(all non-percentage numbers in millions USD)

Investments of CFH Earnings Data

Average Client Funds Held:

Here is a table focusing in just on Average Client Funds Held Growth over the last 5 fiscal years.

Fiscal Year (ended June 30)

2008

2009

2010

2011

2012

Average Client Funds Held

15654.3

15162.4

15194.5

16865.4

17898.2

% Change Year over Year

-3.1%

0.2%

11.0%

6.1%

(all non-percentage numbers in millions USD)

It is difficult to predict changes in this metric from this data alone. Calling on my experience from writing an article on Paychex (link earlier in article), and what I know about the business model as a whole, I can say with reasonable certainty that Average Client Funds Held will grow roughly in line with payroll services growth. However, because of the business mix at ADP, a degree of uncertainty is added. Due to the lack of clarity, I am prompted to estimate lower, and therefore be more conservative. Therefore, I will use a 5% growth rate for Average Client Funds Held over the next 6 years.

% Earned on CFH:

This number is the real crapshoot. ADP holds both short-term and intermediate-term (3-5 years) bonds and has them laddered, so changes in interest rates have an immediate effect on reinvested bonds, but is diluted by the remainder of the portfolio. Over the next 5 years, I would expect interest rates to head back towards where they were in 2008, without quite reaching those levels. The % earned on CFH would remain below that until the portfolio fully cycled into higher yielding assets. I view my guess as good as any other so I will use a conservative estimate of 2.5%, 2.5%, 2.7%, 3%, 3.3%, and 3.6% for the fiscal years 2013-18.

Interest Earned on CFH:

With my projections for Average Client Funds Held and % Earned on CFH here is the table for what I would expect the Interest Earned on CFH to be through 2018.

Fiscal Year (ended June 30)

2012

2013

2014

2015

2016

2017

2018

Average Client Funds Held

17898.2

18793.1

19732.8

20719.4

21755.4

22843.1

23985.3

Interest Earned on CFH

493.3

469.8

493.3

559.4

652.7

753.8

863.5

% Earned on CFH

2.8%

2.5%

2.5%

2.7%

3.0%

3.3%

3.6%

(all non-percentage numbers in millions USD)

Corporate Investments Earnings Data

Before beginning projections there are some items worth noting. ADP carries a much larger amount of Corporate Investments than their closest comparative company Paychex. From what I can surmise, the reason they do this is two-fold. First, having a large amount of additional corporate investments can smooth out the variances in Client Funds Held (CFH) over a given year, and therefore mean less buying and selling as a percentage of the portfolio to meet cash distribution needs. Second, by having their own capital invested alongside the money invested from CFH, they can invest in securities with a slightly higher risk profile, and thus earn higher interest rates. This is much like how a bank operates. For this reason, I also find it appropriate to deduct interest expense from these earnings. Now let's get back to projections.

Corporate Investments

Let's look at the balance of Corporate Investments over the last five years, here is a table showing the year-over-year change.

Fiscal Year (ended June 30)

2008

2009

2010

2011

2012

Corporate Investments

3387

3744.7

3839.2

3467.6

4024.6

% change Year over Year

10.6%

2.5%

-9.7%

16.1%

(all non-percentage numbers in millions USD)

There are so many factors that go into this number including timing of acquisitions, disposal of assets, share buyback programs, changes in dividend policy, etc. For simplicity, let's assume that ADP will grow Corporate Investments at a rate to match Client Funds Held growth, thus keeping the bank-like capital buffer that I referenced above. So, for the next 6 fiscal years: 5% annually.

Interest Expense and Net Corporate Investment Income:

As can be seen in the earlier table, over the last five years, the interest expense for ADP appears to be on a collision course with zero. This is a result of ADP paying back its long-term debt without issuing any new long-term debt. The base case would be to expect this to continue, and just project interest expense as 0 for our time period. This then removes the need to have different line items for Income from Corporate Investments and Net Corporate Investment Income as well.

% Earned on Corporate Investments:

Once again, this number is the real crapshoot. Look under Investments of CFH Earnings Data specifically at % Earned on CFH for more analysis. I will use a conservative estimate of 2.2%, 2.2%, 2.4%, 2.7%, 3%, and 3.3% for the fiscal years 2013-18. This is an annual .3% discount from my % Earned on CFH projections, as there seems to be a fairly consistently lower earnings yield on Corporate Investments than CFH over the previous five years. This can be explained by ADP's desire for a high-quality bank-like buffer.

Income from Corporate Investments:

Using our projections above, we can calculate our expectations for Income from Corporate Investments over the next 6 fiscal years. Here is a table with the projections, note the two data points that have been omitted for reasons listed above under: Interest Expense and Net Corporate Investment Income.

Fiscal Year (ended June 30)

2012

2013

2014

2015

2016

2017

2018

Corporate Investments

4024.6

4225.8

4437.1

4659.0

4891.9

5136.5

5393.3

Income from Corporate Investments

96.6

93.0

97.6

111.8

132.1

154.1

178.0

% Earned on Corporate Investments

2.4%

2.2%

2.2%

2.4%

2.7%

3.0%

3.3%

(all non-percentage numbers in millions USD)

Overall Profitability

Pre-Tax Earnings from Cont. Operations:

This number is just a combination of Pre-Tax Earnings from the three segments I have outlined. It is included in the table under Net Earnings.

Overall Pretax Margin:

This number is a calculated number, therefore no projection is needed. It is calculated and included in the table under Net Earnings.

Effective Tax Rate %:

The table below shows the effective tax rates, as calculated by me (netting out tax benefits and asset disposals) over the last five years.

Fiscal Year (ended June 30)

2008

2009

2010

2011

2012

Effective Tax Rate %

35.9%

36.6%

35.9%

35.1%

34.5%

There appears to be a downward trend, I believe this to be a result of a sales mix shift out of the United States and into lower tax portions of the world. I am not comfortable projecting this to continue at the rate we have seen, but I do think it will continue. Additionally, since 2012 is our lowest year, the chances that this is an outlier and that would throw off both trend and starting point are quite high. This uncertainty pushes me towards being conservative in my estimates. Therefore, I will account for a drop of .1% per year over the next 6 fiscal years, but will use 35% as my starting point, rather than 34.5%.

Provision for Income Taxes:

This number is a calculated number, therefore no projection is needed. It is calculated and included in the table under Net Earnings.

Net Earnings:

Fiscal Year (ended June 30)

2013

2014

2015

2016

2017

2018

Pre-Tax Earnings from Cont. Operations

2144.7

2299.4

2516.4

2777.5

3060.1

3365.8

Overall Pre-Tax Margin

19.5%

19.4%

19.6%

20.1%

20.5%

20.9%

Provision for Income Taxes

748.5

800.2

873.2

961.0

1055.7

1157.8

Effective Tax Rate %

34.9%

34.8%

34.7%

34.6%

34.5%

34.4%

Net Earnings

1396.2

1499.2

1643.2

1816.5

2004.4

2208.0

(all non-percentage numbers in millions USD)

Earnings Per Share

Diluted Weighted Average Shares Outstanding:

Here is a table showing the effects stock buybacks have had on the share count over the last 5 years.

Fiscal Year (ended June 30)

2008

2009

2010

2011

2012

Diluted Weighted Average Shares Outstanding

527.2

505.8

503.7

498.3

492.2

% Change Year-over-Year

-4.2%

-0.4%

-1.1%

-1.2%

(share numbers in millions)

Share buybacks have been ongoing over the last 5 fiscal years, with a slowdown in the heart of the economic crisis. I have every reason to expect ADP to continue to retire around 1% of shares outstanding every year. The earnings that I have projected out cover this along with the dividend and additional investments needed to grow the business. Simple enough, I will assume a 1% reduction in share count each year for the next 6 fiscal years. This is shown in the final table below.

Earnings per Diluted Share:

This number is a calculated number, therefore no projection is needed. It is calculated and included below in the final table under Consolidated Projections.

Consolidated Projections

Fiscal Year (ended June 30)

2013

2014

2015

2016

2017

2018

Segment Earnings Data

Combined Segment Revenues

10985.7

11864.5

12813.7

13838.8

14945.9

16141.5

Segment Earnings before Taxes

1581.9

1708.5

1845.2

1992.8

2152.2

2324.4

Segment EBT Margin

14.4%

14.4%

14.4%

14.4%

14.4%

14.4%

Investments of CFH Earnings Data

Average Client Funds Held

18793.1

19732.8

20719.4

21755.4

22843.1

23985.3

Interest Earned on CFH

469.8

493.3

559.4

652.7

753.8

863.5

% Earned on CFH

2.5%

2.5%

2.7%

3.0%

3.3%

3.6%

Corporate Investments Earnings Data

Corporate investments

4225.8

4437.1

4659.0

4891.9

5136.5

5393.3

Income from Corporate investments

93.0

97.6

111.8

132.1

154.1

178.0

% earned on corporate investments

2.2%

2.2%

2.4%

2.7%

3.0%

3.3%

Overall Profitability

Pre-Tax Earnings from Cont. Operations

2144.7

2299.4

2516.4

2777.5

3060.1

3365.8

Overall Pre-Tax Margin

19.5%

19.4%

19.6%

20.1%

20.5%

20.9%

Provision for Income Taxes

748.5

800.2

873.2

961.0

1055.7

1157.8

Effective Tax Rate %

34.9%

34.8%

34.7%

34.6%

34.5%

34.4%

Net Earnings

1396.2

1499.2

1643.2

1816.5

2004.4

2208.0

Earnings per Share

Diluted Weighted Average Shares Outstanding

487.3

482.4

477.6

472.8

468.1

463.4

Earnings per Diluted Share

2.87

3.11

3.44

3.84

4.28

4.76

(Source: Nick Eerkes - Article Author, all numbers in millions USD except earnings per Diluted Share and Diluted Weighted Average Shares Outstanding-Diluted Weighted Average Shares Outstanding is in millions)

The Conclusion

With a final Earnings Per Diluted Share number of $4.76, what type of earnings multiple would be required to reach the $88.22/share stock price for my Total Return requirements. Simple enough:

$88.22/share / $4.76 share price = 18.5X earnings

Given the quality of the company we are looking at, this seems like a reasonable multiple. Another way of looking at it is with an earnings multiple of 20X, we would expect a share price of $95.20, about 8% higher than the $88.22 we projected as a minimum price.

It looks like this stock meets my total return requirements. ADP will remain safely tucked away in my portfolio for the time being.

Source: Evaluating Total Return Prospects For ADP