Automatic Data Processing: Avoid This Overpriced Dividend Growth Star's Shares For Now

| About: Automatic Data (ADP)

Summary

Interest earned on client funds held is important to the company as it generates substantial cash flows given the low costs associated with the earning of such funds.

An unprecedented low interest rate environment has dramatically reduced the company's interest earned on client funds.

Investors once expected the U.S. Federal Reserve to raise interest rates four times in 2016 but now expect interest rates to be raised once.

Without a more significant rise in interest rates, the company will have to rely on average balance of client funds growth to increase interest earned on client funds.

We recommend investors wait to purchase the company's shares, as they trade at a price-to-earnings ratio above their historical mid-to-upper teens.

Automatic Data Processing (NASDAQ:ADP) is the largest global provider of payroll outsourcing services and offers a wide range of human resource, payroll, tax and benefits administration solutions to businesses of every size. The company also sells other outsourced human resources services, such as payroll tax administration, retirement plan administration, health benefit administration, and workers' compensation insurance services. In addition, ADP earns revenue from interest on funds that it temporarily holds 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). While the company has a client base of hundreds of thousands of U.S. clients, in recent years it has sought to diversify this base by making a significant effort to expand its international business. Further, ADP also offers an increasing number of cloud-based solutions to compete against startup companies that offer similar services. In addition to pursuing growth through global expansion, ADP is experiencing growth from providing services to help its clients comply with the legal requirements of the Affordable Care Act ("Obamacare").

Economic downturns pressure ADP's earnings because higher unemployment reduces demand for its payroll services. Such downturns also result in falling interest rates that adversely affect the company's revenue earned from interest on held client funds. While ADP's revenues from interest earned on client funds held currently account for no more than about 5 percent of total revenues, such revenue is important to the company nonetheless. The interest earned on client funds is important to the company given that it generates substantial cash flows because there is little cost associated with the earning of such funds. ADP used to generate more income from the interest on client funds, but unprecedented cuts to interest rates due to the 2008-09 recession have dramatically reduced such funds since then.

Since 2008, an ultra low interest rate environment has been in place. At the end of 2015, investors widely believed that the U.S. Federal Reserve ("the Federal Reserve") would raise interest rates four times in 2016. Now, however, investors see the Federal Reserve raising rates once in 2016 given their concerns regarding slow economic growth. Any increase in interest rates in 2016 should have a positive effect on ADP's interest earned on client funds since it will help increase returns on investments. The projected single rate hike, however, will likely not be significant enough to increase interest earned to pre-2008 recession levels. Until interest rates rise in a more significant manner, ADP will have to rely on growth in the average balance of client funds to help growth of interest earned on client funds. We believe that rising interest rates given projected Federal Reserve rate increases in 2016 will not have enough of an impact on ADP's interest earned on client funds to recommend buying ADP's shares now. We believe further, as noted below, that ADP's shares are trading near 52-week highs and are highly priced given the historical price-to-earnings ratio for the company's shares. As such, we believe a potential investor should wait to buy ADP's shares until the share price pulls back to a level near its historical price-to-earnings ratio.

Third quarter fiscal 2016 earnings

In late April 2016, ADP announced earnings from continuing operations of $1.17 per share, a 13.6 percent increase from the year-ago quarter. Total revenues were $3.25 billion, a 7.4 percent increase from the year-ago quarter. Revenues for the employer services division increased 5 percent from the year-ago quarter to $2.58 billion. Revenues for the PEO services division increased 16 percent from the year-ago quarter to $866.3 million. ADP's combined worldwide new business bookings (annualized recurring revenues expected from new orders) increased 13 percent from the year-ago quarter. Interest on funds held for the company's clients increased about 2 percent to $103 million. The company's average client funds balance increased 2 percent from the year-ago quarter to $26.7 billion while the average interest yield was 1.5 percent.

ADP expects fiscal 2016 revenue growth to be about 7 percent from fiscal year 2015. The company expects earnings per share to increase about 12 percent from fiscal 2015 year. Further, the company expects interest on funds held for clients to remain flat from year-ago levels at $378 million.

Our view

ADP has been engaged in a strategy of increasing its offering of global services outside the U.S. to increase its growth rate as the company participates in a saturated U.S. market for large-company employer solutions, and competition exists from established companies and emerging participants for small and mid-sized clients. While the company should benefit from improving unemployment levels, ongoing underemployment is likely to continue.

ADP's results are also being adversely affected by the strong U.S. dollar. ADP will, however, continue to benefit due to compliance issues arising from the Affordable Care Act. The company, which is improving its execution to allow it to have a high rate of client retention, will continue to experience a volatile economic environment and increasing competition from Paychex (NASDAQ:PAYX) and Equifax (NYSE:EFX). To combat competition, ADP has been increasing its service and support resources to meet with rising demand. Increased investment in service and support will drive growth in the long term, but in the near term will adversely effect earnings. The company, however, with its higher revenue per client and lower cost of operations allow it to compete more effectively against competitors. We should note that in the past year, ADP in an uncharacteristic move, issued $2 billion in debt to fund share buybacks. The Moody's Investors Service downgraded the company's debt and stated the debt issuance represented the company's "… first-ever debt-funded buyback, which represents an abrupt shift away from the company's historically conservative financial practices. … Future long-term debt issuances could diminish ADP's financial flexibility, including its ability to pursue prudent strategic opportunities and to defend its market share against emerging competition." With respect to ADP's debt issuance, we agree with Moody's outlook, but we also note that we never like to see a company issuing debt and engaging in share buybacks when its shares are trading near 52-week highs.

ADP's stable business, recurring revenues from an established client base, solid free cash flow and dividend that increases annually have long made the company's shares attractive to investors. Although interest rates are not likely to rise sufficiently to boost earnings in the near term, there is plenty to like about an investment in ADP's shares if an investor can buy at a value-oriented price. With that said, we recommend that potential investors wait for a strong overall market selloff to purchase the company's shares. ADP's shares currently trade near their 52-week high with a price-to-earnings ratio of about 26. Earnings estimates for fiscal year 2016 are $3.24 per share and for fiscal 2017 are $3.69 per share. The forward price-to-earnings ratio based on fiscal 2017 earnings is about 23.60. The shares are expensive given the company's historical price-to-earnings ratio being in the range of the mid-to-upper teens. We believe that investors should wait for ADP's share price to fall within the range of $66.45 to 73.80 (an 18 to 20 price-to-earnings ratio based on 2017 fiscal year earnings) before initiating a full position.

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Disclosure: I am/we are long ADP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.