Automatic Data Processing (ADP) was going strong into 2020 and they laid out plans in their February Investor Day of goals to have 5-6% top-line growth given their new product rollouts, large addressable market, and favorable operating environment. Both the business performance and stock price were hit hard by the COVID-19 pandemic. Although FY20 revenue and margins were slightly higher compared to the previous year, the fourth quarter ended 6/30 was rough as revenue declined and margins compressed. To preserve cash, management put share repurchases on hold. These were reasons why the stock price crumbled from ~$180 per share to ~$140 per share before rebounding to where it is currently trading ~$160 per share. This article will explore ADP’s future cash flows and valuation to see if there is coverage for business operations, expansion, share buybacks, and dividends, and how ADP can expand its premium.
ADP had some consistent revenue growth over the last several years. The real outlier was FY20 that was plagued by the pandemic.
Source: Seeking Alpha
The figures outlined in the FY20 Press Release show how the pandemic impacted the fourth quarter (the wavy highlighting was included for emphasis). Bookings were down, retention rate was down, and margins were down. A bright spot is that the business was doing well enough into the second half that they still generated revenue growth.
In February, ADP had its Innovation Day and it laid out its plans for long term of 5-6% per annum. This was to be achieved by continuing to penetrate the addressable market and rolling out products that they spent a bunch of capital on. 2020 was to be the year that these new products were supposed to be scaled and drive incremental revenue. The increase in sales from these products will not be as robust as initially anticipated. Management did make it clear that they will continue to roll out the products as planned and to continue to invest in these products and new products as planned.
ADP’s financial performance is really a lagging indicator in the health of the economy. As the GDP expands, so does ADP’s revenue growth. With low GDP and high unemployment, generating revenue growth or incremental growth from the new products will be tough and this is reflected in the stock price.
Given the tight economy, revenue is expected to decline YoY. There really are no bright spots here and the stock price has remained pinned down and valuation is stuck in a rut. Investors would like to hear about an improvement in sales and how the new products are rolling out. Positive cadence and improvement in some of the operating segments could push this stock higher.
Unsurprisingly, margins have compressed in the fourth quarter but were favorable on a YoY basis. Once again, this points to a solid first half of 2020.
Total margins are expected to decline ~300bps YoY in FY21. To get out of this rut, they will need higher volumes and more incremental revenue from their higher-margin new products being rolled out. Investors would like to see higher margins (of course) in the 1st quarter results or at least discussion of improvement and the roll out is moving ahead of schedule.
ADP has historically generated strong cash flow and has returned about $2Bn annually to shareholders in the form of share repurchases and dividends. The share buybacks have been suspended, which is another strike against ADP’s stock price. Even with a decline in revenues and margin compression, I would not worry about the dividend payment going down or not being covered. My model even shows that the Company can repurchase shares and maintain solid liquidity.
My model assumes a three percent decline in revenue and 300bps in EBIT margin compression in FY21. Over the next two years, revenue growth expands to 4-5% per annum and margins head back to historical levels. As the table below outlines that there is strong unlevered free cash flow, but it should be considered additionally changes in the sources and uses of cash for long-term balance sheet items. The table below models net working capital and not long-term balance sheet items.
The debt payments are aligned with recent historical figures and assume that their notes are refinanced with largely the same terms. Levered free cash flow is solid and provides sufficient coverage from dividend payments and an opportunity to restart the share repurchase program.
I think that investors see that cash flow will remain solid in the near term and this has provided support for the stock price. The halt on share repurchases is a bummer, but it is a prudent move by management to preserve cash.
There is nothing new to show here that wasn’t said earlier in the article. The pandemic made all stocks correlated for a short period of time and all stock prices fell drastically. Some returned faster than others, but as mentioned earlier, the tie to the broader economy really put a ceiling on the stock price.
The closest comparable to ADP is Paychex (PAYX) and its valuation is similar.
For the stock price to go higher, investors would like to see improved performance or trends improving in the individual segments. Margin expansion will also be helpful. If management provides hints that liquidity is solid and the share repurchase program may start up in the near term would improve confidence and expand multiple valuations. Perhaps most important is the general health of the economy. If more funds are plowed into people’s pockets or unemployment improves, look for the stock price to rip higher.
ADP had three strikes in the second half of the year:
Revenue compression and unfavorable outlook
- Margin compression and that trend is expected to continue in FY21
- Temporary halt on the share repurchase program
It is not all bad at ADP. They will continue to roll out their new products and continue to invest in their business. I have modeled cash flow to remain ample and support both dividends and share repurchases (whenever that starts up). For the stock price to improve, look for actual improvement in financial performance in the first quarter or favorable outlook from management, the restart of the share buyback program, and improvement in the general health of the economy. Hopefully, some of these areas will be discussed in the first quarter earnings call.
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.