Automatic Data Processing: Strong Upside Potential From Rising Interest Rates

| About: Automatic Data (ADP)
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Brief Fundamental Overview

Market Cap: $28 Billion

Dividend Yield: 3.04%

Estimated 2013 P/E: 18.1x

Automatic Data Processing (NASDAQ:ADP), one of the nation's largest payroll processors, is known for its history of increasing dividend payments as earnings grow. Just last month, the company announced that it is increasing the dividend by 10%, making it the 38th consecutive year that the company has increased dividend payments to shareholders (Press Release). The company also has a history of buying back fairly large amounts of stock as part of publicly announced programs.


ADP is a company that will benefit significantly when interest rates increase from current levels. While the 2012 and 2013 earnings valuations may seem a bit stretched, ADP has serious potential to grow earnings over the medium to long term as interest rates rise. While investors will likely have to wait some time before this scenario plays out, there is real long-term upside potential to ADP. Many investors like ADP for its stable business model, combined with its dominant market position in the business services sector. ADP is definitely a name to watch as the employment situation improves.

ADP Payrolls

As one of the nation's largest payroll services company, ADP holds a significant amount of cash for short periods of time before it writes paychecks to employees of clients. This business model is beneficial for ADP as the company is able to earn interest on this money for the few days that it holds it. Once payments are made on paychecks to client employees, a different client most often replaces the money that is held on their behalf by ADP. This allows ADP to have a fairly stable float from client funds that the company can invest in short-term and long-term securities to earn a return for its shareholders.

The Interest Rate Problem

As the Federal Reserve has set the Federal Funds Rate at a range of 0%- .25%, bond prices are high, especially for top rated debt such as US Treasuries. ADP primarily holds AAA and AA rated debt. This development in the bond market has hurt ADP significantly as the rate of return on the money held for clients has been less than it has received historically. At the end of the Q3 this year, ADP held $22.1 billion in corporate investments and funds held for clients. Importantly, ADP has a very minimal amount of outstanding debt.

In Q3 of this year, ADP averaged 2.5% APR on its corporate investments and funds held for clients. It is easy to see how small changes in bond yields can affect ADP's bottom line. The APR of 2.5% is a decrease of 50bps from last year's Q3 average APR earned of 3%. It is estimated that a change of 100bps in short-term and medium-term interest rates would result in approximately $40 million in earnings before taxes. This hypothetical change in interest rates would increase EBT by approximately 9%.

Interest Rate Outlook

Historically, interest rates have been highly cyclical generally increasing as economic conditions improve. As economic conditions improve, it is likely that the ultra-low interest rate environment currently experienced will eventually end, resulting in higher yield bonds, most likely across all maturities. The one problem with this is the timing of the change in interest rates.

The Federal Reserve has indicated that it would like to keep interest rates low until the unemployment rate drops significantly or until inflation increases substantially. This scenario may take some time to play out, so investors betting on increasing interest rates may have to wait some time. All eyes will be on the Federal Open Market Committee (FOMC) this week, as it meets on December 11-12 to discuss monetary policy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.