Automatic Data Processing Q2 Earnings: Strong Fundamentals; Overpriced (NASDAQ:ADP)

Automatic Data Processing, Inc. (NASDAQ:ADP) is a New Jersey-based HCM solutions provider for SMEs and larger businesses. Its cloud-based platform includes strategic HR solutions and data analytics. Like its peers I covered last November, it streamlines HR processes from application to resignation. It includes payroll and benefits management, workforce management, insurance retirement, and talent acquisition. Since its inception over seventy years ago, it has capitalized on prudent expansion and acquisitions. It has secured its spot as one of the largest companies in sales.

Today, ADP maintains its impeccable performance as it balances revenue growth and margins. It remains fired up as it sustains its already robust historical growth. Even better, it has a solid financial position, given its well-managed liquidity. Despite the mixed market conditions, the company exudes its capacity to withstand market slowdowns. It stays conservative by keeping its financial leverage manageable while earning enough to cover it. It is no surprise that cash reserves and borrowings are relatively stable despite the interest rate hikes.

Meanwhile, the stock price continues to move downward. However, it does not still reflect its intrinsic value as it seems to be overvalued.

Company Performance

The unforeseen events in the last two years have transformed the labor market. Restrictions affected the financial aspect of most businesses, leading to layoffs and shutdowns. Even more noticeable was how companies coped with these drastic changes to stay afloat. One of these was to implement remote and hybrid work setups to stay operational. And through these changes, human capital management solution providers boomed. Unlike many other industries, HCM companies saw it as their primary growth driver. It has been fruitful for them as entrepreneurs relied on cloud-based platforms for workforce management. Even better, ADP took advantage of the situation through its capitalization on expansion. It already had about 20 acquisitions, and two of them were made in the last two years. With its increasing capacity, ADP remains the industry leader.

This year, Automatic Data Processing, Inc. remains unperturbed despite market volatility. It ended FY 2022 with a relatively weaker performance as inflation peaked. But this fiscal year, ADP has regained its momentum, given its sustained revenue growth. The operating revenue amounts to $4.39 billion, a 9% year-over-year growth. It is also one of the highest quarterly values in history. Thanks to its solid customer bases amidst the demand influx for HCM solutions. ADP enjoys high client retention and new business bookings in its service stream. Amidst recession fears, it works on delivering solutions and services to help clients improve efficiency. Indeed, HCM solutions remain a staple as digital transformation peaks, more businesses enter the market, and hybrid work setups prevail.

Concerning its peers, ADP is still the king. It holds the vast majority of the market share with 53.2%. It is lower than the comparative share of 54.3%, but it secures its spot in the market. It maintains its strong market positioning with its expansion and adaptation to digital trends. Workday (WDAY) ranks far second with only 19.3% while Paychex (PAYX) has 14.4%. Their market share also decreased by similar percentages. It shows that a small portion of their respective market shares is taken by small competitors. Revenue growth is relatively smaller but stays decent.

What makes ADP an impeccable company is its well-managed costs and expenses. Indeed, it is exciting to see a company stabilize costs and expenses amidst rising prices. Year-over-year and sequential uptrends are visible. So as ADP expands, it keeps the gap of revenues wide. We can also see that revenue growth offsets the increase in costs and expenses. As such, it is worth noting that ADP remains consistent with the essence of its solutions. That is to improve operational efficiency to maximize viability. Its operating margin is high at 26% compared to 22% in 2Q 2022 and 24% in 1Q 2023. The inflation lull is also helpful in helping ADP balance its growth with viability. It is also way better than the market average of 16%, making it one of the most efficient and profitable HCM companies. Given the higher income, it can maintain its already robust performance and cover its current capacity.

In the second half of FY 2023, I expect ADP to sustain its robust performance. The accelerating inflation lull can increase the purchasing power of its clients. There may be more business reopenings, given the easing of restrictions. The expansion of e-commerce and increased preference for cashless transactions can make more businesses turn to HCM solutions. Despite all the opportunities, ADP must still watch out for interest rate hikes that may affect its clients. But I am more on the optimistic side as prospects continue to outweigh risks. The company stays as the industry leader and its popularity may help fortify its customer base.

How Automatic Data Processing, Inc. May Sustain Its Robust Performance

Inflation has become challenging for many industries in the second half of 2022. Even the HCM giant, ADP, was no exception. Despite this, it easily adjusts to volatility as it manages costs and expenses with increased efficiency. And now that inflation is only 6.5%, it is easier for the company to stabilize its core operations. The main challenge now is the persistent interest rate hikes that may cause another recession. But I don’t adhere to the overpessimistic economic outlook. After all, inflation has been more demand-pull than cost-push. It is also part of economic recovery as spending increases in line with business and job openings. I believe the Fed will stay conservative to ensure the consistency of the inflation lull. It may still increase interest rates, but I expect increments to be more relaxed. It may peak at 4.5-5% versus the 5-5.25 anticipated rates. While I agree there may be slowdowns at some point, they may not be as disruptive as many people expect. The demand across industries is softening and normalizing as supply starts to catch up. Seasonality may prevail, and demand levels may become as stable as pre-pandemic levels. Hence, inflation may keep decreasing and become more manageable.

More market opportunities can be observed this year. The increased preference for hybrid work setups makes HCM solutions a staple. Many businesses see the advantages of the current work setup in their cost-reduction strategies. Adapting to digital transformation is one of the many ways to avoid or at least minimize the impact of the Great Resignation. In a recent study, 87% of employees prefer remote work setups at varying levels. The five-day and above remote work per week comprises the largest portion. The same study shows that North Americans have the highest preference for remote work. Thankfully, businesses appear to give in to employees’ wishes. In a survey, 76% of companies will still implement hybrid work even after the pandemic. It is also essential to note that it matches the increased preference for cashless transactions. It is especially important for e-commerce companies and businesses transacting online. Currently, the share of Americans not using cash for their transactions is now 41%. The percentage increases as income levels increase, which we can see in the graph below. With HCM solutions, it will be easier to track payroll transactions instead of dealing with piles of invoices. They increase efficiency, which may lead to margin expansion. Hence, these changes point to the increased importance of ADP.

Amidst all these risks and opportunities, ADP must ensure adequate capacity to sustain its operations. As of this writing, ADP is still doing great, as shown by its stellar Balance Sheet. It maintains decent liquidity despite the increased borrowings. Cash levels can cover short-term borrowings, accounts payable, and dividends even in a single payment. Also, the Net Debt/EBITDA ratio of 1.53x shows that ADP has adequate earnings to cover borrowings. It proves the consistency between viability and liquidity. It is essential since the company needs more reserves as market volatility persists. Even better, its FCF/Sales Ratio of 15% is way better than 2% in the same quarter in FY 2022. It shows that ADP derives a decent amount of cash from the operating revenue.

Stock Price Assessment

The stock price has been in an uptrend since Automatic Data Processing, Inc. started trading. But there has been a noticeable decrease in the last two months. At $227.55, it is now 18% higher than its value last year but 11-16% lower than November highs. Despite this, the price does not appear cheap as its book value shows. Currently, its BVPS is 7.20 with a very high PB multiple of 32x. It is way higher than the 2019-2022 average of 26x. If we use it with the current BVPS, the target price will be $187.41, a 17% potential downside. Meanwhile, the EV Model shows that the stock price is still reasonably valued at ($96.46 B – $1.98 B) / 414,400,000 shares = $227.99. However, the upside potential is limited. If we compare its valuation, ADP appears to be the most expensive.

	Book Value	BVPS	Stock Price	PB Ratio	Average PB Ratio	Derived Value
Automatic Data Processing, Inc. (ADP)	$2.987 million	7.20	$227.55	31.6x	25.9x	$187.41
Paychex, Inc. (PAYX)	$3.205 million	8.89	$115.44	13x	13.2x	$117.20
Workday, Inc. (WDAY)	$5.409 million	21.05	$177.48	8.4x	9.8x	$206.26

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Despite this, ADP remains a secure and established dividend stock. It has been paying dividends and sustaining growth for 46 years, making it a part of the limited Dividend Champions list. It has a dividend yield of 2.19%. It is better than the S&P 500 and NASDAQ average of 1.69% and 1.35%. Also, dividends are well-covered, given the dividend payout ratio of 64%. It is almost the same as the ratio in the comparative quarter, showing consistency of split between earnings and dividends. To assess the stock price better, we will use the DCF Model.

FCFF $4,100,000,000

Cash $1,350,000,000

Borrowings $3,300,000,000

Perpetual Growth Rate 4.8%

WACC 9.2%

Common Shares Outstanding 414,400,000

Stock Price $227.55

Derived Value $220.15

The derived value adheres to our supposition of potential overvaluation. There may be a 4% downside in the next 12-18 months. Investors may wait for a better entry point before making a position.

Bottom Line

Automatic Data Processing, Inc. is a solid company in a thriving industry. It has well-balanced revenue growth and margins. It also maintains an impeccable financial positioning to sustain its capacity. Even better, it has had well-covered dividends for nearly five decades, making it a secure dividend stock. However, investors must be careful of potential overvaluation. The stock price adheres to fundamentals but exceeds the intrinsic value of the company. The recommendation, for now, is that Automatic Data Processing, Inc. is a hold.