Automatic Data Processing: A Safe Way to Play Jobs in 2010

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Includes: ADP, PAYX
by: Bottom Up Investments

Given Friday’s better than expected jobs report and expectations for jobs growth in the coming months, we believe it is prudent to look for companies that will benefit from improvement in jobs and the economy.

However, we remain concerned about the second half of 2010 and 2011 due to the potential for several negative catalysts (interest rates, political risks, China, etc…). As the market has already rallied significantly from the lows of 2009, we believe caution is warranted going forward.

As we discuss next, we believe Automatic Data Processing's (NASDAQ:ADP) defensive qualities, potential upside catalysts, and reasonable valuation suggest the company is a safe way to play an improvement in jobs and the economy.

Defensive Qualities

  1. Strong industry dynamics: ADP controls approximately 20% of the US payrolls-processing industry, an industry characterized by its high barriers to entry and high switching costs. As a result, the company is able to lock in customers into multi-year contracts and increase pricing in any environment. Accordingly, while the US shed millions of jobs since the onset of the recession, ADP has been able to report stable revenue and moderate earnings growth.
  2. Stable dividend: ADP has increased its dividend in 35 consecutive years. Given its earnings stability, the company’s payout ratio has average 45-55% of earnings in recent years, which suggests the company continues to generate enough profits to invest in the business without sacrificing the dividend (or vice versa). Its current yield is 3.3%.
  3. Strong balance sheet: As of FY 09, ADP had nearly $2.3 billion in cash and minimal debt. In addition, ADP is one of the few remaining AAA-rated companies.

Potential Upside Catalyst

  1. Improvement in the unemployment picture: As a payrolls-processor, the company’s future revenue and earnings growth is heavily dependent upon lower unemployment figures. Given the scale of its business, we believe any top-line benefits would fall to the bottom-line. Thus, further improvement in the employment picture may lead to earnings acceleration.
  2. Increase in interest rates: The company generates interest on the cash held for clients. Accordingly, rock-bottom interest rates have negatively impacted earnings. Any increases in interest rates would provide a significant earnings benefit.
  3. Cash returned to shareholders via dividends and share buybacks: As mentioned above, ADP has increased its dividend in 35 consecutive years. We believe the company will continue to increase its dividend in the coming years. In addition, we believe the company will continue to buy back shares with excess cash flow.

Valuation

At $43.18, the company trades at 17.1 times estimated FY 11 (ended 6/30/10) earnings of $2.53, which is a discount to its ten-year average of 21.7. Its best peer, Paychex Inc. (NASDAQ:PAYX) trades at 21.6 times expected FY 11 earnings.

Summary

In our opinion, ADP is a compelling investment given its risk versus reward characteristics. Given its defensive qualities, we believe downside is limited and weakness should be utilized as a buying opportunity.

Disclosure: The author is long ADP at the time of publication