Automatic Data Processing: Better Suited to Survive This Downturn than Its Competitors

Automatic Data Processing (ADP) provides technology-based outsourcing solutions to employers. It operates in three segments: Employer Services, Professional Employer Organization Services, and Dealer Services. One of the major risks to their bottom line comes from auto dealer services division. In fiscal year 2008, 16% of their revenue came from that division. Some of their main competitors are Paychex (PAYX) and Administaff (ASF). ADP and PAYX are members of the dividend achievers club. ADP has been there for 33 years and PAYX has been there for 20 years.

Fundamental Analysis

The table below shows a comparative analysis between the three companies:

click to enlarge

My analysis shows ADP is undervalued when its dividend yield reach 2% or higher. My conservative fair value is $52. Morningstar and Valueline have fair value at $51.

ADP is closest among the three companies to the 52 week low and that attracted my attention. After some analysis, I see that at $35, the stock is yielding 3.76%. As a dividend achiever since 1976, their prestigious dividend record sets them apart from ASF and PAYX. Since 1993, ADP increased their dividend by 16% compound annually. As a result, if you invested $10,000 in ADP at its 52 week high in 1993 ($12.77), you would be sitting on a 10% yield, or a yearly income of $1,000. Using a conservative scenario, if you purchased the stock at the 52 week high in 1993 ($12.77) and sell it at its 52 week low in 2009 ($32.03), you would have gained 150% profit excluding dividends. Including dividends, your $10,000 would be $27,140 or 171% gain. That is not bad considering the 2000 and 2008 crashes in the market.

Unemployment is one of the reasons the stock is deeply discounted. I took a look at 1982 when unemployment reached 10.8%. Shortly after, ADP reached its high of $2.50. How could this be? How can a company which deals directly with the employment market be reaching its peak corresponding to the peak in unemployment? The answer is, the stock discounted all the bad news. Please see the chart below.

Our current unemployment is at 9.5% and I expect that figure to go higher. The stock at this price should have discounted most of the bad news. The dividend yield has never been this high. The same goes for the payout ratio which sits at 56%. Based on the lowest analyst estimate, their earnings should not fluctuate much so I am fairly confident that the dividend is safe.

Another highlight is ADP's strong balance sheet. Debt due in five years is $16.9 million. They hold $1.4 billion in cash. They reduced their debt level by 70% since 1999 (from $145.8 million to $45 million). Fundamentally, I believe ADP should be able to weather this downturn relatively better than their competitors and should come out of this with greater market share.

Technical Analysis

Immediate term (1 year), there are mixed signal in the chart. A bearish sign is coming from the chart trading below its 200 day MA. It's been unsuccessful at breaking and remaining above that trend line. The higher-low indicated by the blue line is a bullish pattern.

The longer term chart (5 years) shows a trading range from $34 and $42. Technical analysis shows a downside risk of $28.

Summary

I see ADP as a bargain below $41. Keynes once said "The market can stay irrational longer than you can stay solvent" and thus I must be very particular about my purchase. As a result, I will wait until the stock is 10% within its yearly low.

Disclosure: None

Comments

[Ravi Nagarajan:]

Another factor that could be very significant for payroll/benefits outsourcing is health care mandates for small business. I think PAYX is well positioned to profit from this opportunity.

Jul 16 02:21 PM

[4Foolz:]

Nice analysis. The only thing I would add about your compare to the 1982 unemployment numbers is that ADP at the time was a much smaller company trading at a higher multiple because of significant room for growth which it lacks now IMO. So, at that time, ADP had a lot more going for it than it does now as the company has matured.
Disc: Long ADP

Jul 16 04:41 PM

[Brad Castro:]

I agree with the first two comments. I like ADP a lot, but I like PAYX more. They have a steller balance sheet as well but much more room to grow. I also like their focus on contracting with smaller businesses. That enables their revenues to increase as those businesses expand while at the same time exposing them to a market that's always creating new potential clients.

A rececession is a great opportunity to pick up shares in any one of these companies.

Jul 17 11:25 AM

[Arsuron Pap...:]

I agree with all the comments. PAYX has no debt, but my concern is the risk of dividend cut. With payout ratio sitting at 86%, PAYX has little room to fall on earning basis before depleting into their cash. But 0 debt will allow them to borrow at a lower rate so it's also a plus. Now that I see so many interest on PAYX, I will do a research on that name shortly.

The 1982 case was just an example and I don't expect the stock to mimic that. They were not paying out dividend then so I wasn't able to see their yield then.

Thanks for all the constructive comments.

Jul 17 05:11 PM

[maz:]

Paychex is the better opportunity. You are correct on the dividend payout ratio but you pay dividends from cash not earnings - the cash payout ratio is still high but at 70% is better than the earnings payout ratio.

A big key for Paychex & ADP is the inflation/deflation debate. Right now they are both earning very little off customer float and their own cash because interest rates are so low & a deliberate policy to preserve capital & maintain liquidity. Paychex interest income is less than half long term average on $4 billion cash (float + own cash). If you believe we're in for Japan like deflation this will continue for many years. If you believe that at some time - may be 2, 3 or 4 years - inflation will really take hold then these guys will get a big boost

Jul 20 12:44 PM

[Arsuron Pap...:]

I understand that dividend are paid from cash flow, but if you fail to earn, you will deplete into your cash for dividend. As a more conservative investor, I look for risk/reward and constantly asking myself what am I willing to pay for this stock. Currently ADP appears to be a better bargain.
About inflation or deflation, I frankly don't really care and aren't too concern about it.
All I know is ADP is trading at a big discount relative to its past. Its future is unknown but I believe in reversion to the mean.

I'm going to look into PAYX.

These are great comments!

On Jul 20 12:44 PM maz wrote:

> Paychex is the better opportunity. You are correct on the dividend
> payout ratio but you pay dividends from cash not earnings - the cash
> payout ratio is still high but at 70% is better than the earnings
> payout ratio.
>
> A big key for Paychex & ADP is the inflation/deflation debate.
> Right now they are both earning very little off customer float and
> their own cash because interest rates are so low & a deliberate
> policy to preserve capital & maintain liquidity. Paychex interest
> income is less than half long term average on $4 billion cash (float
> + own cash). If you believe we're in for Japan like deflation this
> will continue for many years. If you believe that at some time -
> may be 2, 3 or 4 years - inflation will really take hold then these
> guys will get a big boost

Jul 24 02:14 PM

[mlatem:]

You are not accounting for the fact that things are a bit different this time. Unemployment is likely to remain high for a very long period of time and that would have significant impact on future growth rate. Tax rate would most certainly increase in next few years.

Are they present in emerging markets?

Jul 28 12:10 PM