Automatic Data Processing Gets A Catalyst From Revised Outlook

Summary

• Automatic Data Processing's strong FQ2 results have the company on track for double-digit earnings gains for the fiscal year.
• ADP's upgraded earnings guidance provides a catalyst for the stock.
• The valuation and growth will support a double-digit stock gain over the next year.

Automatic Data Processing (NASDAQ:ADP) exceeded estimates for both revenue and earnings for FQ2. Revenue increased 8.3% y-o-y and exceeded estimates by $70 million. Adjusted diluted EPS increased 30% y-o-y and exceeded estimates by $0.16 per share or 13.6%.

The strong results led the company to increase guidance for the full fiscal year which ends in June 2019. ADP now expects adjusted diluted EPS to increase 17% to 19% for FY19. This is up from the previous range of a 15% to 17% gain.

My thesis is that the increased guidance, ADP's overall growth, and reasonable valuation will drive the stock for a strong double-digit gain over the next year.

ADP's Segment Growth

Automatic Data Processing is achieving growth in their primary business segments. The company provides services for companies that encompass recruitment to retirement.

ADP operates two main segments: Employer Services (71% of total revenue) and Professional Employer Organization [PEO] Services (29% of total revenue). The Employer Services segment provides small to large businesses with human resources outsourcing and tech services, which include cloud-based solutions. The PEO segment offers a co-employment model for human resources outsourcing solutions.

ADP is expected to grow revenue in the Employer Services segment by 5% to 6% for FY19. The company is also expecting margins for this segment to increase 175-200 basis points and new business bookings growth of 6% to 8% for FY19. The margin improvement in this segment is important for ADP's earnings growth since Employer Services comprises 71% of total revenue.

The PEO segment also looks strong as ADP expects full-year revenue growth of 9% to 10%. However, margins for the PEO segment are expected to remain flat for FY19.

ADP is projecting to achieve total revenue growth of 6% to 7% for FY19. That will help drive the double-digit expected gains in earnings growth for the fiscal year as a result of the company's margins and P&L structure. The consensus earnings estimate among 19 analysts is calling for 21% growth for FY19.

Strategic Differentiators

ADP DataCloud is the company's data analytics solution. This is the company's differentiating solution for human capital management [HCM]. ADP DataCloud provides real-time data to help clients analyze patterns and trends on categories such as overtime, compensation, and turnover. The solutions can provide employers with information to help improve their businesses.

ADP DataCloud can also help employers analyze how they compare to the market averages. The benchmarks that are analyzed include: workforce demographics & changes, time & attendance, compensation, and ADP system usage. These tools help employers get quick access to help manage key aspects of their business more efficiently.

These tools can help employers pay competitive, equitable wages, while reducing turnover.

Another example of a differentiator is ADP's Accountant Connect solution. This allows CPAs to view and analyze their client's payroll, tax forms, and provide them with central practice management tools.

ADP's solutions are highly ranked from user recommendations and usability according to a survey from softwareadvice.com. The company has a well-known name in the industry with the resources to provide effective solutions to their clients.

ADP's Valuation

Since ADP is expected to grow earnings at an above-average double-digit rate for multiple years, I like to use the PEG ratio for valuation purposes. The PEG takes future earnings growth into consideration. In this case, I'm using the 5-year PEG, which takes a 5-year projection of average earnings growth into account.

Here's how ADP compares to their peers:

	ADP	SAP (SAP)	Workday (WDAY)	Ultimate Software Group (ULTI)	Paychex (PAYX)
PEG Ratio	1.5	2.13	3.57	2.2	2.6
Expected 2019 EPS Growth	21%	9%	23%	15%	12%

Click to enlarge

source: finance.yahoo.com

From the table above, we can see that ADP has the lowest valuation and one of the highest expected growth rates for 2019. Therefore, ADP's stock has a good chance of outperforming most of their peers. With an above-average growth rate, ADP is likely to outperform the S&P 500 (SPY).

ADP has a Solid Balance Sheet and Cash Flow

ADP has a strong balance sheet along with positive cash flow, which gives the company flexibility to grow the business and reward shareholders.

ADP has more current assets than current liabilities with a current ratio of 1.05. The company also has 1.14x more total assets than total liabilities for shareholders' equity of $4.76 billion. ADP has $2.79 billion in total cash with $3.2 billion in total debt.

The company produced $2.78 billion in operating cash flow and had $2.33 billion in free cash flow over the past twelve months. ADP also gets high returns for their investments. For the past twelve months, ADP achieved an ROE of 36.8% and an ROIC of 25.5%.

ADP's strong balance sheet, positive cash flow, and high returns allow the company to expand their core business, to do acquisitions, to increase dividends, and to do share repurchases. These are all positive things to drive strong shareholder returns.

Outlook for ADP

When all of the evidence is analyzed, ADP looks like a good combination of a fairly valued company with above-average growth. The company has effective solutions that can help other companies manage their human capital. ADP's ability to grow their business through acquisitions and other ways will help drive the company to grow at a strong pace going forward.

Investors should be aware that competition remains the biggest risk for ADP. There are numerous companies with HCM solutions. Therefore, ADP will have to effectively upgrade and provide clients with solutions that will improve their businesses. With that in mind, ADP does have strong capital resources to acquire some of their competitors going forward. With those resources and high returns, ADP is likely to continue their growth at an above-average pace.

With the valuation at a fair level, the stock can grow approximately in-line with earnings growth going forward. Since ADP's fiscal year ends in June 2019, I took the average expected earnings growth of 21% for FY19 and 13% for FY20 to get average expected earnings growth of 17% for the next 12 months.

So, my one-year price target is $166 based on that earnings growth. That would take the forward PE up to about 28 based on EPS of $5.97 for FY20. That may sound high, but other HCM software companies such as WorkDay and ULTI are trading with much higher forward PEs of 116 and 45 respectively. Therefore, a PE of 28 is reasonable for ADP's strong double-digit growth within a bull market.

Analyst’s Disclosure: I/we 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.

The article is for informational purposes only (not a solicitation to buy or sell stocks). I am not a registered investment advisor. Investors should do their own research or consult a financial advisor to determine what investments are appropriate for their individual situation. This article expresses my opinions and I cannot guarantee that the information/results will be accurate. Investing in stocks involves risk and could result in losses.