Automatic Data Processing: A Bargain for a Solid Company

by: Dan Wieman posted on: January 23, 2008 | about stocks: ADP

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I first purchased Automatic Data Processing (NYSE: ADP) during the last recession after a poor earnings report that broke a string of 25 years of double digit earnings growth. Since then, the company has offered steady returns and a nice level of dividend growth. This is a Warren Buffet type stock: simple business, great operating history, and rational management. Long-term prospects also remain solid. The key, of course, is getting this for a great price.

About the Company

Automatic Data Processing provides outsourcing solutions to employers, vehicle retailers, and manufacturers. It operates in three segments: Employer Services, Professional Employer Organization [PEO] Services, and Dealer Services.

The Employer Services segment offers human resource information, payroll processing, and tax and benefits administration products and services. This is ADP’s core and traditional business. The serve over 560,000 employers and pay nearly 33 million workers in 30 countries.

The PEO Services segment provides small and medium sized businesses with employment administration services such as payroll, payroll tax filing, HR guidance, 401(k) plan administration, benefits administration, compliance services, health and workers’ compensation coverage, and other supplemental benefits for employees.

The Dealer Services segment offers integrated dealer management systems and business solutions to automotive, heavy truck, and powersports vehicle retailers.

History

The current CEO, Gary Butler, has committed to focusing ADP on its core strengths and returning value to shareholders. He has done this by spinning off ADP’s broker service business, now known as Broadridge Financial (NYSE: BR), increasing dividends and continuing share repurchases.

The financial highlights below have not been adjusted for the spin-off. They represent actual reported numbers except for the revenue, earnings, and earnings per share growth noted in 2007. These numbers are adjusted to account for the spin-off of Broadridge Financial.

(in millions)	2007	2006	2005	2004
Revenues	$7,800.0	$8,881.5	$7,500.7	$7,754.9
Operating Expenses	$4,087.3	$4,289.5	$3,969.5	$3,525.4
Total Expenses	$6,176.5	$7,327.5	$6,821.2	$6,260.4
Taxes	$602.3	$670.6	$622.5	$558.9
Net Earnings	$1,138.7	$1,554.0	$1,055.4	$935.6
Depreciation & Amortization	$288.8	$288.6	$304.4	$306.8
Capital Expenditures	$172.8	$292.3	$196.1	$204.1
Owner Earnings	$1,254.7	$1,550.3	$1,163.7	$1,038.3
Dividends	$461.3	$393.9	$344.9	$308.6
Retained Earnings	$793.4	$1,156.4	$818.8	$729.7
Shareholder Equity	$5,147.9	$6,011.6	$5,783.8	$5,417.7
Shares Outstanding	$549.7	$574.8	$583.2	$591.7

Owner Earnings / Share	$2.28	$2.70	$2.00	$1.75
Dividend Dist. / Share	$0.92	$0.74	$0.62	$0.56
Gross Profit Margin	47.6%	51.7%	47.1%	54.5%
Net Profit Margin	14.6%	17.5%	14.1%	12.1%
Return on Equity	22.1%	25.9%	18.2%	17.3%
Revenue Growth	14.1%	18.4%	-3.3%	8.5%
Earnings Growth	21.3%	47.2%	12.8%	-8.1%
Earnings/Share Growth	27.4%	49.4%	14.4%	-6.8%

The margins and returns of equity have been very strong in the past, and will likely continue.

Valuation

The valuation I’ve derived is pretty straightforward. I start with owner earnings of $1,254,700 and grow them at a 12% rate for five years followed by a 5% rate for years 6-30. I then discount the cash flows back at 10%. The resulting value is $48 per share.

If earnings per share are further leveraged by share buybacks in the coming five years and ADP achieves an 18% earnings per share growth, shares would be valued at $61 per share. If ADP achieves only 5% growth for the next 30 years, shares would be worth only $36.

Conclusion

The market has recently provided a nice discount for ADP. If shares approach $35, I will likely add a bit to my current holdings. Returns are never going to be tremendous for this company, but it provides relatively stable and predictable returns. Add to it a very shareholder friendly management team, and it has the makings for a great long-term holding.

Look for dividends to continue to increase, share buybacks to continue, and earnings per share growth to be surprisingly strong for a company as mature as ADP.