Image Source: Pixabay

Most investors are undoubtedly familiar with Automatic Data Processing (ADP). It does, after all:

• operate in 140 countries;
• has more than 1 million clients ranging from small businesses to large multi-national corporations for whom it provides Human Capital Management (HCM) and HR Outsourcing (HRO) services; and
• distributes payroll to more than 41 million people.

There is no disputing that ADP is a high-quality company, and therefore, this post focuses on its valuation. Based on my analysis, I think ADP is overvalued.

Business Overview

ADP’s website and Part 1 Items 1A and 1B in the FY2023 Form 10-K provide the information to learn about the company.

Financials

Q4 and FY2023 Results

ADP releases Q3 and YTD2024 results in roughly one month. I, therefore, dispense with a review of ADP’s Q2 and YTD2024 results. You can, however, review ADP’s Q2 and YTD2024 results by accessing them here.

The following Q2 2024 highlights are provided solely for ease of reference.

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Source: ADP – Q2 2024 Earnings Presentation

Operating Cash Flow (OCF) Free Cash Flow (FCF)

In FY2014 – FY2023, ADP generated 1.821, 1.974, 1.897, 2.126, 2.515, 2.688, 3.026, 3.093, 3.100, and 4.208 of OCF (in Billions of $). ADP has generated $1.359B in the first half of FY2024.

In FY2014 – FY2023, ADP generated 1.518, 1.639, 1.511, 1.655, 2.044, 2.122, 2.410, 2.587, 2.546, and 3.636 of FCF (in Billions of $). ADP has generated $1.099B in the first half of FY2024.

NOTE: In the case of ADP, FCF is calculated by subtracting CAPEX and Additions to Intangibles from Net cash flows provided by operating activities.

Net income (GAAP) during this same time frame is 1.516, 1.453, 1.493, 1.788, 1.885, 2.293, 2.467, 2.599, 2.949, and 3.412 (in Billions of $). In the first half of FY2024, ADP has generated $1.738B.

Clients Funds Investment Strategy

Note 4 in ADP’s FY2023 Form 10-K starting on page 59 of 165 provides a comprehensive overview of ADP’s Clients Funds Investment Strategy.

The purpose of this Investment Strategy is to generate income from significant client fund balances. When deemed prudent, ADP will further enhance its investment returns by investing long and borrowing short to take advantage of the yield spread.

This strategy allows ADP to average its way through an interest rate cycle by laddering the maturities of investments out to 5 years (in the case of the extended portfolio) and out to 10 years (in the case of the long portfolio). ADP’s short-term financing arrangements necessary to satisfy short-term funding requirements relating to client funds obligations supports this investment strategy.

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Source: ADP – Q2 2024 Earnings Presentation

FY2024 Outlook

The following reflects ADP’s current and prior FY2024 outlook.

Management’s adjusted diluted EPS outlook is the same as that provided with the release of Q4 and FY2023 results on July 26, 2023. In FY2023, ADP generated $8.23 in adjusted diluted EPS. A 10% – 12% increase gives us a ~$9.05 – ~$9.22 range for FY2024.

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Source: ADP – Q2 2024 Earnings Presentation

Risk Assessment

Every investment comes with potential reward and risk. Regrettably, some investors never assess an investment’s potential risks OR they overestimate their risk tolerance.

My investor profile is such that I invest in high quality companies with a promising future. I am, therefore, prepared to forego ‘potential reward’ if the risk is likely to lead to a ‘loss of sleep’.

While the credit rating agencies are not infallible, I take into consideration their take on a company’s risk. The following are ADP’s senior domestic unsecured long-term debt ratings:

• Moody’s: Aa3 with a stable outlook – last reviewed March 19, 2024
• S&P Global: AA- with a stable outlook – last reviewed March 1, 2024
• Fitch: AA- with a stable outlook – last reviewed October 6, 2023

All 3 ratings are the lowest tier of the high grade investment grade category. These ratings define ADP as having a very strong capacity to meet its financial commitments. These ratings differ from the highest-rated obligors only to a small degree.

NOTE: Equity investors have greater risk exposure than senior domestic unsecured long-term debt holders. Investing in a company whose credit ratings are the lowest investment grade levels, therefore, means an equity investor assumes non-investment grade risk.

I also look at the details of a company’s Operating Leases, Short-Term Financing, and Long-Term Debt.

The Q2 2024 Form 10-Q is the most current set of financial statements. Details regarding ADP’s financing arrangements are in Notes 7, 9, and 10.

Looking at ADP’s Long-Term Debt, we see three series of fixed-rate notes with staggered maturities of 7 and 10-years totaling $3B. These Notes are senior unsecured obligations, and interest is payable in arrears, semi-annually.

The following reflects ADP’s long-term debt at FYE2023 (June 30, 2023) and the end of Q2 2024 (December 31, 2023).

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Source: ADP – Q2 2024 Form 10-Q

The maturity dates of ADP’s long-term debt are well dispersed and financing was raised at VERY attractive rates.

I see no reason why ADP should be unable to retire these obligations as they come due.

Dividends and Share Repurchases

Dividend and Dividend Yield

Investing based solely on dividend metrics is a fundamentally flawed method by which to invest. Investors would be wise to look at the TOTAL potential return.

In the case of ADP, for example, the bulk of the ~349% total investment return over the past decade has come from capital appreciation. Nevertheless, some investors may fixate on ADP’s ~2.25% dividend yield (based on the $1.40 quarterly dividend and the ~$249 share price) and 49 consecutive years of dividend increases.

As a long time ADP shareholder and Canadian resident, I incur a 15% dividend withholding tax on all dividends received from US companies when shares are held in a taxable account. In addition, I have to declare all dividend income on my annual tax return. This leads to a further tax liability.

If ADP’s capital allocation policy prioritized share repurchases, the current value of ADP shares would likely be much higher. Furthermore, I have not sold any ADP shares since I became a shareholder over 2 decades ago (ie. no capital gains tax liability).

NOTE: Legislation enacted in 2022 as part of the ‘Inflation Reduction Act’ (IRA) imposed a non-deductible 1% ‘stock repurchase excise tax’ on the net value of certain share repurchases by publicly traded corporations (or by their subsidiaries) within a tax year, effective with respect to repurchases on or after January 1, 2023. Despite this relatively new legislation, I remain of the opinion that investors in some companies could come out ahead if share repurchases took priority over dividend distributions.

Having said this, the cumulative rate of return on my ADP holdings over a span of more than 2 decades far outweighs the ‘drawback’ of the tax liability resulting from the receipt of ADP dividends.

Share Repurchases

Management has done a commendable job of reducing the issued and outstanding shares. In the FY2014 – FY2023 time frame, ADP’s share count (in millions of outstanding shares) is 483, 476, 459, 450, 443, 438, 433, 428, 421, and 416. There were 412.5 million at the end of Q2 2023 (December 31, 2023).

Earlier, I mention that that many investors may come out ahead if a company prioritized share repurchase over dividend distributions. Naturally, this is not applicable to every company. Furthermore, the price at which shares are repurchased has a significant impact on shareholder returns. Repurchase shares when they are undervalued and shareholders benefit. Investors, however, suffer if shares are repurchased when the valuation is in the stratosphere.

Looking at ADP’s share repurchases in Q2 2024, it appears recent share repurchases were made when shares were either slightly undervalued and/or fairly valued.

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Source: ADP – Q2 2024 Form 10-Q

Valuation

We have determined that ADP’s risk is acceptable. Now, we must determine the potential reward. To do so, I like to look at a company’s valuation.

Some investors use formulas to estimate the current value of a future stream of income. These formulas, however, typically require estimates about future earnings several years into the future.

In addition, the value of $1 several years into the future differs from the present value of $1. An appropriate discount rate, therefore, must be used to adjust for the time value of money.

Much can happen to impact these assumptions. I am, therefore, reluctant to try to value a company using adjusted earnings estimates beyond a couple of years. Even many of the brokers who regularly interact with senior management are reluctant to provide earnings estimates beyond a couple of years! Roughly 40% of the brokers which cover ADP (see below) provide no adjusted diluted earnings estimates for FY2026!

ADP’s forward adjusted diluted PE levels using the current ~$249 share price and brokers’ adjusted diluted earnings estimates are:

• FY2024: 20 brokers – current mean $9.21 and $9.05/$9.21 low/high range; ~27.0 using the mean.
• FY2025: 20 brokers – current mean $10.16 and $9.80/$10.16 low/high range; ~24.5 using the mean.
• FY2026: 12 brokers – current mean $11.25 and $10.66/$11.25 low/high range; ~22.1 using the mean.

Management’s FY2024 adjusted diluted EPS forecast is ~$9.05 – ~$9.22. Using the current ~$249 share price, the forward adjusted diluted PE range is ~27X – ~27.5X.

In the first half of FY2024, ADP generated $1.099B in FCF. If ADP were to generate ~$2.7B in FCF in FY2024 and the weighted average outstanding shares for the year were to be 412 million, we arrive at ~$6.55 FCF/share. Using the current ~$249 share price, the P/FCF per share is ~38.

In my opinion, ADP appears to be overvalued.

ADP Is Overvalued – Final Thoughts

I have no idea how ADP’s share price will behave in the very short term. I am, however, reasonably confident its share price will be higher a decade from now. Nevertheless, I try to acquire undervalued shares with the objective of being able to generate a double digit annual rate of return over several years. I must pay attention to share valuation otherwise the odds diminish that I can generate this rate of return.

I have been an ADP shareholder for ~2 decades and it was my 17th largest holding when I completed my 2023 Year End FFJ Portfolio Review. My plan is to add to my exposure when appropriate. At the moment, however, I think ADP is overvalued and it is not sufficiently attractive and I will bide my time.

I wish you much success on your journey to financial freedom!

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