08/12/13 Covered Call Pick: Automatic Data Processing (NASDAQ:ADP)
Automatic Data Processing (ADP) is an American-based multinational business process and human resource outsourcing company that specializes in payroll services. Founded in 1949, ADP has expanded their offerings beyond merely payroll services and into payroll tax, retirement planning, health benefit, and worker's compensation administration, in addition to a full professional business management service in where ADP handles nearly every employment task a company could require. With a large portfolio of expertly designed services, ADP has become the leader in payroll administration.
Automatic Data Processing has a market capitalization of $35.16 billion with 485.2 million outstanding shares.
ADP currently pays a $0.435 quarterly dividend for a current yield of 2.4%.
With a a beta of 0.89, ADP trades with approximately 10% less volatility than the current market.
ADP is one of those companies that you may never have heard of before, but you have most certainly come in contact with. That is because they process more payrolls in the country than any other HR-outsourced company. A company like ADP isn't as flashy or recognizable as companies like Google, Coca-Cola, and Apple, but they provide two things that we love to find for our Covered Call Strategies: income and stability.
While you may not have known about ADP before, you should be interested in them if you are an income investor. This dividend aristocrat has increased its dividend on an annual basis for 38 years, with the last increase coming in at 10.1%, while keeping its payout ratio at 56%. A dividend isn't the only way that ADP returns to shareholders though - with a steady buyback program it has reduced its outstanding shares by 14.5% over the past two decades, on par with buyback champion Coca-Cola.
When it comes to stability, the company has a very large moat around it, as it is well entrenched as the leader in payroll solutions. Their services vary enough that businesses can customize them to fit their needs, making them an easy choice when shopping for payroll solutions. The services they provide would also be very difficult and time-consuming to switch to another company, something that a large corporation would be reticent to undergo, meaning that they lose very few customers to competitors once they have them. ADP is also one of only four companies with a triple-A credit rating by both Standard & Poor's and Moody's, making it one of the safest companies to bet on.
The stock itself has had wonderful success as the company has shown steady growth over the past few years, running up year-to-date 24.10% off the back of the broader market rally and the slow, but steady, positive employment growth. For a Covered Call Strategy though we are recommending the January 2014 $70 in-the-money Call. We are using an in-the-money Call for a few reasons.
Firstly, the stock is currently sitting at a relatively expensive valuation at a P/E of 25 after the recent rise in the stock price. This is at the top end of their 5-year P/E Range, and at a premium to the broader market.
Secondly, while the job recovery is moving along, it is doing so slowly. American companies have found more and more ways to get around hiring additional workers and still remaining profitable. This increased efficiency can only go so far, as after awhile companies will need to hire to properly expand, but we do not believe that the trend of slimmer, more streamlined operations is going to disappear. ADP will still remain profitable (even during The Great Recession, earnings only dropped by $0.01 year-over-year and still remained positive) but we don't expect earnings to shoot through the roof overnight.
Lastly, we still have "The Taper" on the horizon (the experiment continues). This could cause a broad market pullback between 5-10%, especially in names that are currently trading at a premium. ADP has an Up/Down ratio of 1.3, so we won't expect people to rush for the doors, but we would be remiss to not expect any profit taking.
By selling an in-the-money Call we address each of these issues. The increased premium we receive will effectively put our cost basis at a more reasonable valuation in the stock, while providing some safety in the case of a pullback followed by tepid growth. ADP is part of OakTree Investment Advisors' Legacy Portfolio, a portfolio specifically designed with a long-term investment horizon in mind. So if ADP pulls back and the Call expires, we will happily sell another Call and continue to profit from ADP's stellar dividends and dominating market share, alongside the country's employment recovery. If the stock gets called away from us we are happy picking up the income on the strategy, and will head back into the stock as earnings catch up to the stock price, the stock price pulls back, or we see job growth really start to pick up. That is why we are recommending buying ADP and selling the January 2014 $70 in-the-money Call.
- Buy 100 shares of ADP @ $72.39 = $7,239 + Commission ($12.95) = $7,251.95
- Write 1 ADP January 2014 $70 Call @ $360 - Commission ($8.70) = $351.30
Note: Prices may vary from the time of post. Actual commissions paid will vary returns.
Static Return (Not Called):
(Call + Dividend)/Stock Price X (Days/Year)/Days to Expiration
(3.51 + (2*0.435))/72.51 X (365)/159
= 13.87% Static Return
(Call + Dividend + Strike Price - Stock Price)/Stock Price X (Days/Year)/Days to Expiration
(3.51 + (2*0.435) + 70 - 72.51)/72.51 X (365)/159
= 5.92% If-Called Return
Disclosure: Clients and/or principles of OakTree Investment Advisors may or will have an investment in the above positions, but only on the same sides of the trades. The above numbers are analytic estimations based on information known at the time of this post. OakTree Investment Advisors does not guarantee the above, or any, result. All investment decisions should be made based upon individual's personal investment goals and risk tolerance.
Disclosure: I am long ADP.
Additional disclosure: As active managers we own and may continue to buy ADP, OakTree investments "Legacy Portfolio" is long ADP.