Is ADP A Defense Play?

| About: Automatic Data (ADP)

As more news validates the possibility of a global economic slowdown my focus has turned to identifying stocks that could be a good defensive play. Recently I looked at Automated Data Processing, Inc. (NASDAQ:ADP).

Automated Data Processing, Inc. is a global leader of business outsourcing solutions. They are the largest payroll processing company in the United States with a market capitalization of $29.11B and a 17% market share. ADP pays 1-in-6 employees in the United States and approximately 33 million worldwide. Its size is a competitive advantage for two reasons. They are one of a few companies that can handle the human resource outsourcing for large organizations while the services they provide come with high switching costs. The success of ADP's products along with the high switching costs are two reasons for its 8% revenue growth year-over-year, 90% revenue retention and an average client tenure of approximately 10 years.

Business Description
Below is a table that describes ADP's three major operating segments and their earnings for the 2012 fiscal year which ended June 30, 2012.
(click to enlarge)
ADP ES is the largest and most profitable division with a 26% profit margin, however, the margin decreased 30 basis points due to the effects of acquisitions and the increase in sales headcount. The acquisitions and increase in sales headcount are two good investments in the future of the division and will likely contribute to future revenue and earnings growth.

PEO Services' is the fastest growing division by both revenue and earnings. The increases are due to the 12% growth of worksite employees from both new and existing clients.

Growth was also seen in Dealer Services, however operating margins decreased from the previous year due to implementing and servicing new clients.

Comparison to Competitors
ADP does not look impressive when compared to Intuit Inc. (NASDAQ:INTU) and Paychex, Inc. (NASDAQ:PAYX) on a fundamental basis. ADP lags the other two stocks in return on assets, return on equity and return on investment while its gross margin, operating margin, and profit margin are smaller.
(click to enlarge)
The argument could be made that ADP is an undervalued stock based on its lower P/E and P/B ratios but its PEG ratio of 2.21 is the highest of all three stocks.
(click to enlarge)

Discounted Earnings Per Share Valuation
Below is a model that calculates ADP's fair value based on its discounted EPS and its terminal value after year 5. The average earnings growth for the last 5 years was 7.02% per annum. The average long-term EPS growth estimate of the 24 analysts covering ADP is currently 9.19%. ADP's discounted EPS valuation was based off of these estimates. The EPS projection was taken from the 2013 mean EPS estimate and grown for five years at the mean long-term growth rate of 9.19%. An 11% discount rate was used while the terminal growth rate was 5%.
(click to enlarge)
The model calculated a $61.18 per share price. Considering ADP's October 9th, 2012 closing price of 58.48, the stock appears to be trading near fair value.

ADP qualifies as a "defense play" considering its high revenue retention, low beta of .71 and low debt levels. But I would look at Intuit or Paychex to see if they provide a better investment for the future.

Financial data was provided by, and Yahoo Finance.

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.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Tagged: , , , Business Software & Services
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here