Automatic Data Processing: A Spin-Off Play And An Endlessly Increasing Dividend

| About: Automatic Data (ADP)


The company plans to spin-off their dealer services division in late 2014 to enhance shareholder value.

The company is a leader in most markets that it participates in.

The company has a long history of yearly dividend increases to reward investors.

Automatic Data Processing (NASDAQ:ADP) is a company that is entering an exciting period. The company has decided to spin-off their dealer services division later this year. The company currently yields about 2.4 percent and has a long history of yearly dividend increases. While no stock should be considered a "safe stock" without any risk, ADP shares are relatively safe in comparison to many high profile stocks and should be strongly considered as a building block of any long-term investors' portfolio. With the split of ADP into 2 companies approaching in October 2014, investors will be able to hold shares in 2 high-quality companies.


Automatic Data Processing is the largest global provider of payroll outsourcing services based on revenue. The company offers a wide range of human resource, payroll, tax and benefits administration solutions and is also a leading provider of integrated computing solutions to automotive, heavy truck, motorcycle, marine, recreational vehicle and heavy machinery dealers. In addition to basic payroll processing, ADP sells companies other outsourced human resources services, such as payroll tax administration, retirement plan administration, health benefit administration, and workers' compensation insurance services. Additionally, ADP earns interest on funds that are temporarily held for its clients (The time between the transfer of money to ADP and the time a direct deposit is made or that checks are sent to and cashed by employees). Economic downturns pressure ADP's earnings because higher unemployment decreases demand for payroll services and falling interest rates decrease the revenue earned from interest on funds held for clients.

In addition to ADP's payroll and human resources divisions, which the company refers to as "employer services," the firm has two other divisions: "professional employer organization (PEO) services," in which ADP handles nearly all of its clients' employment tasks, and "dealer services," which provides inventory management, accounting, and related business services to automobile and other vehicle dealers in over 50 countries.

Fourth quarter fiscal 2014 earnings

ADP reported 10 percent growth in revenues to $3.1 billion for the quarter. Pretax and net earnings from continuing operations increased 24 percent and 29 percent, respectively. As adjusted, pretax and net earnings from continuing operations increased 15 percent and 14 percent, respectively. Diluted earnings per share from continuing operations of $0.60 increased 30 percent from $0.46 in the year ago quarter. As adjusted, diluted earnings per share from continuing operations of $0.63 increased 15 percent from adjusted $0.55 from the year ago quarter. The employer services' division revenues grew 8 percent for the fourth quarter. PEO services' revenues increased 19 percent for the fourth quarter. Dealer services' revenues grew 8 percent for the fourth quarter.

For the fourth quarter, interest on funds held for clients declined $5.5 million, or 5 percent, from $100.5 million a year ago to $95.1 million, due to a decline in the average interest yield to 1.7 percent, partially offset by an increase of 7 percent in average client funds balances from $20.4 billion to $21.8 billion. The CEO of ADP characterized fourth-quarter earnings as follows:

"These results were just below our expectations. … Nonetheless, we are very pleased to have sold over $1.4 billion in new annualized recurring revenues, which will contribute to our revenue growth over the coming months.

New business bookings growth for the fourth quarter was mixed by market segment. In the small and mid-markets, we were very pleased with the double-digit growth ADP experienced and the PEO results continued to be strong. However, we were disappointed with the results in the high end of the upmarket where we sold fewer deals to companies with more than 10,000 employees compared with a year ago. In the low end of our national accounts market, meaning companies with 1,000 to 10,000 employees where ADP has historically been successful, new business bookings of both our Workforce Now and Vantage solutions were good. …

In our International business, we continue to see softness in new bookings growth in our in-country solutions in Europe due to continued economic recovery on the continent. However, we are pleased with the growth of our multinational solutions for companies based outside of the U.S. In Latin America, our new bookings growth was strong.

As a result of the mixed results in the upmarket, our forecast for fiscal 2015 is for about 8% growth. Our long-term goal of 8% to 10% annual new bookings growth remains intact. …

The success of the PEO continued with strong revenue growth reaching 15% for the year, primarily from growth in average worksite employees paid, which was a very strong 15% for the year. Dealer Services posted solid revenue growth in fiscal 2014 primarily through additions to its client space. The global automotive market continues to be strong with U.S. vehicle sales reaching prerecessionary levels."

ADP provided initial fiscal year 2015 guidance of earnings per share range of $3.49 to $3.55. The week after the earnings report, the board of directors of ADP authorized the purchase of an additional 30 million shares of its common stock. This is in addition to the approximately 15.5 million shares remaining to be purchased under previous share repurchase authorizations, resulting in a total authorization of approximately 45 million shares. ADP currently has approximately 481 million common shares outstanding as of August 1, 2014.

Upcoming dealer services spin-off

In April 2014, ADP announced plans to spin-off their dealer services business into an independent publicly-traded company. The transaction is structured as a tax-free spin-off of 100 percent of dealer services to ADP shareholders and is expected to be completed by October of 2014. ADP expects to receive at least $700 million in conjunction with the spin-off. The dealer services business segment provides marketing solutions to over 26,000 auto retailers, distributors and manufacturers.
 The 100 percent tax-free spin-off will help ADP focus more on their core Human Capital Management (HCM) business, going forward. According to ADP management, the strong long-term growth prospects of the automotive market will provide significant growth opportunities to the dealer services business.

Fifteen percent of ADP's current revenue comes from the dealer services division. The dealer services division participates in the volatile auto industry. Analysts see ADP's exit from this industry as positive given that the company will no longer participate in the cyclical auto industry. Although analysts and investors consider the spin-off plan shareholder friendly, the credit rating agencies did not agree. 
Following the spin-off announcement, the Standard & Poor's service lowered ADP's credit rating from AAA to AA, primarily due to the company's plan of using the spin-off proceeds to buy back shares. Moody's Investor Service also decreased their rating to Aa1, citing lower scale and variety of ADP's product portfolio.

Competitors and risks

Market penetration for the industry that ADP participates in is high. In addition, the barriers to entry are high as well since payroll outsourcing requires a sizable infrastructure to process a large number of employees. Two of ADP's most well known competitors are Paychex Inc. (NASDAQ:PAYX) and Equifax Inc. (NYSE:EFX). Competition is likely to become more intense as more companies that specialize in business processing outsourcing (BPO) move into human resources outsourcing and may compete in the payroll services area. Large companies that are providers of commercial electronic data processing and BPO services (including back-office operations) include the technology consulting divisions of International Business Machines (NYSE:IBM) and Hewlett-Packard (NYSE:HPQ). The industry is highly competitive, mature, and characterized by rapid technological changes, evolving industry standards, and changing customer preferences. Companies compete on service quality, product performance, technological innovation, and pricing. Demand is affected by the spending budget of clients, which is affected by the level of economic activity in the industries and markets they serve.

Analysts' views and our views

Analysts see ADP shares as overpriced given the shares price appreciation. The shares have risen in anticipation of the perceived belief that the pending dealer services spin-off is favorable to ADP shareholders. Analysts also indicate that ADP participates in a saturated market for large-company employer solutions, and competition exists from established companies and emerging participants for small and mid-sized clients. While analysts acknowledge improving unemployment levels, and believe ADP should benefit as a result, they still see continuing underemployment. ADP is expected to perform well with improved execution and higher client retention. In addition, recovery in the job market will help the company. Finally, the company will face near-term challengers given the turbulent economic environment and increasing competition from Paychex Inc. and Equifax Inc. Analysts have ratings from mostly "hold" for ADP to some "buy" ratings with price targets from $80 to $94.

We generally agree with analysts, but we would recommend that potential investors watch the shares for a pull back before initiating a full position. The shares are currently near a 52-week high with a price to earnings ratio of about 27. Earnings estimates for fiscal year 2015 (which just started) are $3.52 per share. Earnings estimates for fiscal 2016 are $3.93 per share. The forward price to earnings ratio based on fiscal 2015 earnings is about 23.35. The shares are expensive given the company's historical price to earnings ratio being in the range of the mid to upper teens. Investors should watch ADP shares and wait for the share price to fall into (or close to) the range of $63.50 to 70.50 (an 18 to 20 price to earnings ratio based on 2015 fiscal year earnings) before initiating a full position.

Disclosure: The author is long ADP, HPQ, IBM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.