Because rival First Data (FDC) was taken private just a few months ago, our interest in ADP was immediately piqued.
Given ADP’s bulletproof balance sheet, strong free cash flow, & potential for an LBO event, we are recommending investors buy into any and all pullbacks in ADP’s share price.
ADP is one of the largest providers of computerized transaction processing, data communication, and information services. It is a leader in human resources services such as payroll and tax, and it also provides benefit administration and comprehensive outsourcing services. It serves about 600,000 clients and helped 32 million employees get paid last year. From 2004-2006, ADP’s revenues, EBIT, net profit, and cash flow grew at a CAGR of 10%, 10%, 29%, and 14%, respectively. The NJ-based company employs over 46,000 people.
ADP’s large size (its controls 30% of its market) enables scale economies to come into play. It’s Employer Services division is immensely attractive to us as it produces stable cash flows and boasts an economic moat other payroll processing firms would die for. Because of the sheer amount of client data that ADP possesses, we think the switching costs in this industry are quite high, a characteristic private equity practitioners often seek to capitalize on.
The recent LBO of student loan giant Sallie Mae (NYSE: SLM) was really about private equity’s interest in controlling a wealth of information, cross-selling SLM’s clients (educational costs are soaring and the potential to cover the entire loan cycle got much easier for Sallie Mae after it gobbled up privately held UPromise® last summer), and obtaining a “best of breed” asset whose shares had temporarily tumbled and dirt cheap. Like Sallie Mae, ADP generates stable cash flows that can be levered against. ADP may sound like a boring company, but investors should note that besides suspicious & erratic spikes in call volume, shares are trading within 5% of their 52 week high
Although ADP is facing pricing pressure from the #2 player Paychex (NYSE:PAYX), there are a number of other qualities we can’t but help think private equity would be interested in claiming, namely, ADP’s low debt (1% of assets), high client retention ratio (90%), trailing 12 FCF/sales yield of 17%, and reputable AAA credit rating. As the table above indicates, investments in new fixed assets are low and the recent spinoff of ADP’s securities clearing business should help drive management focus going forward as well as bolster aggressive share buybacks.
Valuation & Risks
ADP’s future looks bright, as cross selling opportunities are rife, core payroll growth remains robust, and management continues to unlock shareholder value (current CEO Gary Butler, a 30Y ADP veteran, has galvanized ADP to repurchase over 20M shares in the last 3 quarters). Furthermore, improving EBIT margins (due to better SG&A expense control) and a pristine balance sheet with close to $4/share in cash strikes us as attractive and nuanced ADP’s currently undervalued stock price. Long time believers, that “best of breed” names, should sell at above-average premiums, we deem shares of ADP undervalued by at least 10%.
Our back of the envelope DCF model (see Exhibit 3 below) is certainly no Picasso, but under a reasonable assumption that sales will continue to grow almost 8% for the next couple of years (approximately ADP’s 3Y average), then taper to 4% thereafter, as well as an assumption that management will sustain a FCF/revenue yield of 15-17%, we arrive at a $54 target price for ADP (we use a 10% required rate of return to account for ADP’s US market concentration (86%/sales), a potentially weaker job milieu, and lower bargaining power vis-à-vis a rapidly consolidating financial services industry (from 2000-05, the number of US commercial banks declined by about 9.7%). As to whether or not ADP is really a $30B+ company, only time will tell – if traditional investors don’t capitalize on ADP’s cheap stock price, private equity probably will.
Appendix: Could ADP Recapitalize?
To “size up” ADP in terms of a potential LBO deal, we ran a quick LBO Litmus Test. First, we took ADP’s enterprise value by adding its market cap to its debt and backing out cash – we arrived at $24.5B, approximately. Then, we multiplied ADP’s enterprise value by the prime rate of 8.25% (which we assumed would be ADP’s cost of debt, although we should note that private equity deals have been firing away at higher rates) to determine what level of operating cash flow ADP would need to generate in order to cover interest expense (market rate * book value of debt). This landed us at a $1.95B -- it happens to be right in the ballpark of ADP’s 2006 operating cash flow, $1.81B. Although a quick and dirty approach, it illustrates that ADP should have no problem levering up its balance sheet as cash thrown off from operations seemingly covers potential debt obligations.
Disclosure: Dan Jacome is an MBA candidate at the Kelley School of Business as well as founder of Ceviche Fund Partners LP. At the time of publication, he did not hold a position in any of the securities mentioned.