Introduction

Looking at the oldest investment account statements I can locate, I know I am an Automatic Data Processing (ADP) shareholder dating back to at least 2005. In my April 2021 holdings review, I reflect ADP as my 20th largest holding; this exposure is in a retirement account for which I do not disclose details. ADP has increased its quarterly dividend every year I have been a shareholder. In fact, ADP is a member of the Dividend Aristocrats,  a group of companies in the S&P 500 Index with dividend increases for at least 25 consecutive years; ADP’s track record is 46 consecutive years. During my 16+ years as an ADP shareholder, I have automatically reinvested the quarterly dividends. In addition, I own Broadridge Solutions (BR) and CDK Global (CDK) shares since March 2007 and September 2014 when they were spun-off from ADP. With the release of Q3 2021 and YTD results on April 28, 2021, I view this as an opportune time to look at ADP’s valuation to determine if I should acquire additional shares. In my analysis, you will see why I think that currently ADP is an overvalued Dividend Aristocrat but should be on your watchlist.

ADP – An Overvalued Dividend Aristocrat – Business Overview

Most people are likely somewhat familiar with ADP. Many people reading this article may receive their payroll remittances and cheques/direct deposits from ADP. My former employer (one of the ‘Big 5’ Canadian banks) sold its payroll operations to ADP around the turn of this century. Now, it has a payroll referral service arrangement with ADP.

I strongly recommend an investor understand a business before initiating a position. A great source of information is the company’s 10-K. The first section of ADP’s 10-K includes a review of the company. An explanation of various risk factors follows the company review.

Client Funds Investment Strategy

A little under a decade ago, ADP implemented its Client Funds Investment Strategy. This sophisticated investment strategy generates interest income which is an important component of ADP’s earnings. This strategy has several priorities. First and foremost, these are client funds. ADP, therefore, only invests in very safe and liquid investments. Secondly, ADP uses a hold-to-maturity and borrowing strategy to maximize the overall yield.

The following is an excerpt about ADP’s Client Funds Investment Strategy from page 51 of 153 in ADP’s 2020 10-K.

Our investment portfolio does not contain any asset-backed securities with underlying collateral of sub-prime mortgages, alternative-A mortgages, sub-prime auto loans or sub-prime home equity loans, collateralized debt obligations, collateralized loan obligations, credit default swaps, derivatives, auction-rate securities, structured investment vehicles or non-investment grade fixed-income securities…..This investment strategy is supported by our short-term financing arrangements necessary to satisfy short-term funding requirements relating to client funds obligations.

I encourage you to review NOTE 4. CORPORATE INVESTMENTS AND FUNDS HELD FOR CLIENTS which commences on page 75 of 153 in ADP’s 2020 10-K. The information in this note indicates how ADP invests BILLIONS of dollars to generate significant investment income even in this low-interest-rate environment.

Page 13 of 18 in the Q3 8-K shows the degree to which ADP has been successful in generating income from this strategy in Q3 and YTD.

Additional supplemental financial data that includes information about the Client Funds Investment Strategy is found here.

ADP – Financial Review

Q3 2021 and YTD 2021 Results and FY2021 Guidance

The Q3 10-Q, April 28, 2021 8-K, and accompanying investor presentation provide investors with a high-level overview of the company’s Q3 and YTD performance. The 8-K and investor presentation include management’s guidance for the remainder of the current fiscal year.

ADP – Free Cash Flow

FCF provides management with the ability to:

• repay debt;
• increase dividends;
• repurchase shares.

I closely monitor this metric and compare current and historical levels. I do this to determine if the variance is the result of a major change in CAPEX. Variances from historical FCF levels are possible but I want to know why. ADP has generated ~$2.3B of FCF in the first 3 quarters of FY2021 (deduct CAPEX from Net cash flows provided by operating activities found on page 11 of 18 in the Q3 8-K). Looking at FCF for 2011 – 2020 we see $1.428B, $1.661B, $1.342B, $1.518B, $1.639B, $1.511B, $1.655B, $2.044B, $2.122B, and $2.41B.

ADP – Credit Rating

It is prudent for investors to look at the credit risk aspect of a company and not just the potential return. Regrettably, many investors completely overlook the degree of risk assumed. This often leads to a permanent impairment of the investment. ADP’s local currency unsecured long-term debt ratings are:

• Moody’s: Aa3 since August 28, 2015.
• S&P Global: AA since April 10, 2014.
• Fitch: AA-: Fitch initiated coverage on December 23, 2020

Moody’s and Fitch’s ratings are the lowest tier of the high-grade investment-grade category. S&P Global’s rating is one notch higher. These ratings define an obligor a having a VERY STRONG capacity to meet its financial commitments. It differs from the highest-rated obligors only to a small degree. ADP’s ratings satisfy my prudent investor profile.

Peer Group Credit Ratings

Let’s quickly look at the credit ratings of a few ADP peers.

Intuit Inc. (INTU) – Moody’s: A3 and S&P Global: A-. Fitch does not rate the company. Both ratings are the lowest tier of the upper-medium grade investment-grade category. This is three notches below those of ADP. These ratings define an obligor as having a STRONG capacity to meet its financial commitments. It is, however, somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

Ceridian HCM Holding Inc. (CDAY) – Moody’s: B3 (downgraded from B2 on March 2, 2021, and S&P Global: B+ (last reviewed March 2, 2021). Fitch does not rate the company. The credit rating assigned by Moody’s is two notches below that assigned by S&P Global. Both ratings are non-investment grade speculative and are several notches below those of ADP. Ceridian’s ratings mean it is MORE VULNERABLE than the obligors rated ‘BB’. It does, however, currently have the capacity to meet its financial commitments. Having said this, adverse business, financial, or economic conditions will likely impair Ceridian’s capacity or willingness to meet its financial commitments.

Paychex, Inc. (PAYX) is in a strong financial position but its debt is not rated by any rating agency.

ADP – Dividend Yield and Growth and Share Repurchases

Dividend Yield and Growth

ADP’s dividend history on its website only dates back to 1990. Based on the current ~$191 share price and the $0.93/share/quarter dividend, the $3.72 annual dividend is a sub 2% dividend yield.

This table reflects the compound annual growth rate of ADP’s dividend over the past 20-years and the past decade.

Some investors cast aside a potential investment because a company’s dividend yield does not:

• meet a specific minimum threshold;
• the company has not increased its dividend for a certain number of consecutive years.

Personally, I think it is extremely shortsighted to have such rigorous metrics. An investor should be looking at the total potential return and not just the dividend return. In my opinion, the timeframe over which a company increases its dividend should have minimal bearing on an investment decision. Relying on a company’s dividend history is akin to driving while looking in the rearview mirror.

I think it is far more important to look at the company’s ability to increase its dividend going forward. This is why it is important to look at the extent to which the company is indebted and the degree to which it generates FCF. Based on this information reflected above, I am quite confident ADP will be able to adequately service its dividend going forward.

Share Repurchases

The weighted average number of issued and outstanding shares in FY2011 – FY2020 (in millions) was: 498, 492, 487, 483, 476, 459, 450, 443, 438, and 433; the diluted weighted average shares outstanding at the end of Q3 is 427.7 million. We can see from this data that ADP has steadily reduced the number of issued and outstanding shares. The company’s historical valuation, however, is a P/E in the very high 20s and low 30s since 2013 except for ~26 in 2014. My preference is that management repurchase shares at more attractive valuations.

ADP – Current Valuation

Guidance calls for ADP to generate diluted EPS (GAAP) of $5.70. YTD diluted EPS is $4.80 so FY2021 guidance looks achievable.

At the time this post is being composed, ADP is trading at ~$191. Based on GAAP guidance of $5.70, the forward diluted P/E is ~33.5. ADP’s diluted P/E in 2011 – 2020 has been 21.02, 20.41, 28.25, 26.22, 28.33, 30.77, 29.74, 33.79, 31.40, and 30.59. We can see that ADP valuation has been somewhat lofty for a few years but even the current P/E is higher than the prior years’ lofty valuations making ADP an overvalued Dividend Aristocrat.

YTD adjusted EPS (non-GAAP) is $4.82 and FY2021 adjusted diluted EPS (non-GAAP) guidance is ~$5.92. On the basis of the current ~$191 share price, the forward adjusted diluted P/E is ~32.3. Adjusted diluted EPS guidance from 21 brokers is a mean of $5.95 and a low/high range of $5.88 – $6.00. Using guidance from these brokers, the forward adjusted diluted /PE range is ~31.8 – ~32.5.

I am looking for the share price to retrace to at least ~$160. At this level, the P/E is ~28. Even this valuation is slightly high but I think ADP stands to benefit from higher employment levels as the global economy recovers. Furthermore, an uptick in interest rates will be to ADP’s advantage because of its Client Funds Investment Strategy.

Peer Valuation – Paycom

Paycom Software, Inc. (PAYC), one of ADP’s peers is trading at a ridiculous valuation; PAYC is not rated by the major rating agencies.

Shares are currently trading at ~$401 and FY2021 adjusted earnings guidance from 14 brokers is a mean of $4.18 and a low/high range of $3.90 – $4.32; keep in mind these are adjusted earnings forecasts. In FY2019 and FY2020, Paycom’s adjusted earnings exceeded GAAP earnings by $0.41/share and $1.03/share. A significant degree of these variances is attributed to ‘Non-cash stock-based compensation expense’.

Being generous and giving Paycom Software the benefit of the doubt that FY2021 GAAP earnings will be the same as FY2021 guidance. Based on the current ~$400 share price, the forward PE is ~95.7 (using the mean of $4.18).

Any investor who thinks this valuation is reasonable should find someone who invested in Intel Corporation (INTC) or Cisco Systems (CSCO) at the height of the .com days. Investors would be wise to pay heed to a company’s valuation!

ADP – An Overvalued Dividend Aristocrat – Final Thoughts

In my opinion, ADP is a great company in which to invest. My concern is that it might be difficult to achieve a reasonable rate of return if shares are acquired at the current valuation. ADP clearly is overvalued and despite being a Dividend Aristocrat the stock should probably be placed on your watch list. There are periods off times that companies like ADP are overvalued but inevitably reversion to the mean occurs and there may better entry points in the future.

In Charlie Munger’s 13 Personal Attributes To Improve Investment Success post, Munger identifies Patience and Discipline as key attributes. I think it is wise to heed Munger’s advice. Wait until ADP’s valuation based on P/E retraces to the high 20s which, based on FY2021 guidance, is ~$160.