ADP: A Great Company Facing A Huge Problem

| About: Automatic Data (ADP)

By Jeff Bailey

Automatic Data Processing (NASDAQ:ADP) is undoubtedly a fabulous company, growing year-after-year, maintaining its AAA credit rating, and slowly-but-steadily expanding the work it does for companies beyond payroll to encompass all things related to personnel.

But, as we've seen more dramatically with Southwest Airlines (NYSE:LUV) and furniture component maker Leggett & Platt (NYSE:LEG), it's tough to be a great company in a crummy industry.

And the HR-outsourcing business has, domestically at least, one giant problem: American companies will do just about anything to avoid adding to their employee counts. With each recession, businesses learn how to be more productive. They come out of downturns leaner and determined to remain that way. As a long-term trend, it's a marvelous productivity story, though one that has left millions of lower-skilled workers behind:

US Employment Chart
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US Employment data by YCharts

That's right, on a not-quite-150% increase in workforce, U.S. corporate profits since 1948 are up more than 7,500%; $1.75 trillion in profits churned out using 144 million domestic workers.

As an aside, ADP's recent score on worker productivity is somewhat less impressive: Its 57,000 workers (as of June 30, 2012) brought in $10.7 billion in revenue, or about $187,000 per worker; 10 years earlier, with 40,000 employees at June 30, 2002, ADP had revenue for that year of $7.0 billion, or roughly $175,000 per employee. That's a lot of elbow grease in each dollar of sales, especially compared to technology companies like Google (NASDAQ:GOOG) and Amazon (NASDAQ:AMZN).

If ADP earned a tiny fee for each dollar of U.S. corporate profits, or for each productivity-enhancing machine installed -- rather than for processing payroll and other services related to headcount -- it would be a fabulous growth vehicle. But its fortunes are tied to employment, as are those of companies like Manpower (NYSE:MAN).

Because of ADP's long record of stellar financial results, increasing market share and its bulletproof balance sheet, its shares command a premium PE ratio. ADP expects to report revenue growth of 6%-to-7% for the fiscal year ended June 30, and diluted earnings per share from continuing operations growth in the same range. Solid performance, but its valuation puts it in the company of stocks like Google, eBay (NASDAQ:EBAY), Davita (NYSE:DVA) and Nike (NYSE:NKE).

ADP PE Ratio TTM Chart
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ADP PE Ratio TTM data by YCharts

Those companies have enjoyed far more rapid sales growth over the past decade (though that's certainly no guarantee of growth going forward).

ADP Revenue TTM Chart
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ADP Revenue TTM data by YCharts

ADP's main business, called Employer Services (and including the well-known payroll service) accounts for nearly three quarters of revenue and that business's revenue is in turn nearly 80% domestic. That makes sense. ADP is all hooked up with 7,000 government bodies, from very local to Uncle Sam, in the U.S., and adding each additional customer represents a lower cost than the last one, allowing it to price aggressively to win customers and still maintain a lush profit margin.

ADP Profit Margin Quarterly Chart
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ADP Profit Margin Quarterly data by YCharts

ADP holds employers' payroll money for a very short time before the checks are deposited, or automatic deposits are effective, and that client money in total is in the $20 billion-or-so range. Interest earned on those funds goes to ADP, a nice perk of the business. But with interest rates so low, its return on those funds has fallen, to 2.8% in fiscal 2012 from 3.6% as recently as fiscal 2010. ADP expects to report interest on client funds, for the year ended June 30, fell 15% to $420 million. Rising interest rates would help.

ADP Shares Outstanding Chart
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ADP Shares Outstanding data by YCharts

Investors also like ADP because it has steadily reduced its shares outstanding through buybacks, and upped its dividend regularly. The dividend yield of 2.45% is no great shakes, but dividend growth is perhaps a better goal in choosing stocks. To keep the dividend growing, ADP has upped its payout ratio, and now it would seem future dividend growth is more dependent on profit increases.

ADP Payout Ratio TTM Chart
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ADP Payout Ratio TTM data by YCharts

LinkedIn (NYSE:LNKD), of course, is essentially in the HR business, too. But as an entirely new business, it has years or growth ahead. ADP is a more mature business, and the hire-only-as-absolutely-needed mindset of major U.S. and international companies could significantly limit its future growth.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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