Should You Buy or Avoid ADP Stock Right Now?

ADP stock crashed along with the overall market.
Is this a screaming BUY opportunity?

Automatic Data Processing, Inc. (NYSE: ADP), commonly known as ADP, is an American provider of human resources management software and services.

Until 2014, it was one of only four US companies in the S&P 500 to have a AAA credit rating from both Standard & Poor’s and Moody’s.

Like the stock market in general, the coronavirus crisis is hitting this stock hard and the price has decreased an astonishing 34% in just one month, falling from a high of $178.85 to a two-year low of $117.

So is it time to buy the dip on this renown dividend stock?

ADP Stock
Should investors buy the dip?

I will use a 5-criteria screen to evaluate this stock:

  • Franchise strength
  • Predictability and consistency of margins
  • Financial health
  • Dividend payout
  • Dividend growth

Remember, this criteria is by no means exhaustive and should serve only as a starting point to help you determine if the stock is worth further research.

1. Strong Franchise?

ADP is a well established market leader in HR management software and services. It is the USA’s main provider of payroll services, with over 650,000 clients.

In 2019, ADP’s revenues exceed $14 billion dollars. This revenue comes from two main sources: employer services ($9.9 billion in revenues) and PEO services ($4.1 billion in revenues).

Historically, ADP’s moat lies in its ability to keep up with changes in the tax code, labor regulations and compliance requirements. For most small and medium-sized enterprises (SMEs) without HR and accounting departments, the world of regulations is complex and difficult to apprehend. ADP capitalizes on this complexity by providing all-in-one solutions to these businesses. Once they sign up, they rarely opt out as the service provided is crucial for the business’ survival.

ADP’s main competition comes from companies such as Paychex, who targets small businesses with less than 25 employees, and Ultimate Software and Workday, who target large businesses with more than 1000 employees. These firms are slowly gaining market shares at ADP’s expense but ADP remains very strong in the segment of SMEs with 25-100 employees.

That being said, the company remains a market leader and has made strategic acquisitions such as WorkMarket, Global Cash Card, Celergo and The Marcus Buckingham Company. These purchases have expanded the company’s customer base and expanded its international presence.

Going forward, the challenge for ADP is twofold: first, to deal with the emergence of do-it-yourself software that will considerably lower the cost of doing payroll for many SMEs; and two, large businesses’ resources and bargaining power that ultimately drive down margins and switching costs.

Lastly, ADP has a structural problem relating to its technology. While the competition is releasing user-friendly software, ADP’s legacy technology is the result of years of acquisitions that hasn’t been effectively integrated.

Thus, ADP will have to continue investing to propose new solutions and services that will maintain its competitive advantage over the emerging competition.

2. Consistency and Predictability

For the 2014-2019 period, ADP’s average annual gross margin is 41.55% and its average annual net profit margin is 14.27%. The gross margin is basically increasing every year while the net margin oscillates between 12.7% and 16%. These are good figures that validate the company’s business model.

ADP Stock

Another positive sign is ADP’s Free Cash Flow (FCF), which increases on average 11.76% per year over the past 6 years (except in 2016).

ADP Stock
FCF per share is increasing

3. Financial Health

If Warren Buffet deems debt ratios important, then so do I.

Buffet says he looks for companies with Current Ratios above 1.5 and Debt/Equity Ratios of 0.5 or lower. In 2019, ADP’s current ratio is only 1.05. This means that its current assets barely cover its current liabilities, which is just about okay. However, ADP’s Long-term Debt/Capital Ratio is 0.27 and its Debt/Equity Ratio is 0.37, which means that the company’s total assets far outweigh its total liabilities. This signals that the company’s long-term financial future is secure.

All things considered, ADP’s debt ratios are very good.

ADP Stock

Other metrics often scrutinized by investors are Return on Assets, Return on Investments and Return on Equity. These metrics measure how efficiently a company is using its assets to generate profits:

  • Return on Assets (ROA) is calculated by dividing Net Income by Total Assets: In 2019, ADP’s ROA is 5.47, which means that every dollar invested in assets generates 5.47 cents in income, which is considered good. However, the years prior to 2019 ROA was consistently below 5, which is considered poor. We will see how ADP performs in the coming years but this increase in ROA for 2019 is a promising trend.
  • Return on Investments (ROI) is calculated by dividing the difference between the current value of investment and the cost of investment by the cost of investment: In 2019, ADP’s ROE is 30.97 which is considered excellent. The minimum ROI acceptable to shareholders if 15% and ROI that remains in the 20-30% range consistently is considered excellent
  • Return on Equity (ROE), is calculated by dividing net income by total shareholder equity: In 2019, ADP’s ROE is 42.46, which is considered very good.
ADP Stock
ADP’s returns range from good to very good

4. The Dividend

  • Dividend Payout Ratio

ADP’s payout ratio is 59%, which is considered high. This means that ADP is spending 59% of its earnings on dividend payments, which leaves the company with just 40% to reinvest. As an investor, I would be slightly worried about this high ratio. Given the challenges facing ADP, I would feel more comfortable knowing the company is investing to remain a market leader rather than focusing on pleasing its shareholders.

That being said, the dividend yield of 3% is standard for a company this size but the 13% growth rate of the dividend may be a little high, given what has been said about ADP needing to invest to fend off the emerging competitors.

ADP Stock Dividend
  • Dividend Growth

ADP has grown its dividend for the past 21 years and the dividend growth rate remains very high.

ADP Stock Dividend

Again, I will keep insisting on the fact that the while company’s focus on dividend growth is good for the investor’s pocket in the short-term, it diverts funds away from investments needed to grow the company’s economic moat. ADP is operating in a sector that will become hyper-competitive in the coming years and they should not rest on their laurels.

Nevertheless, their balance sheet is very healthy: Revenues are increasing steadily and net income in 2019 is 50% higher than it was in 2016.

ADP Stock
ADP posts increasing revenues and net income

Furthermore, Free Cash Flow is also increasing which indicates that the company is very good at generating cash.

ADP Stock

5. The Stock Price

Lastly, we will look at the stock price and the dividend yield.

ADP’s dividend yield has remained between 1.7% and 2.5% for the past 10 years so this recent “jump” to a yield of 3% is relatively enticing. In normal economic circumstances, a company with such a stellar track record of paying dividends is always an attractive purchase. However, we are not in normal economic circumstances.

In the time it’s taken me to write this article, ADP’s stock price has jumped from $117.67 to $121.58. Is this a “dead-cat bounce” or the support level of an oversold stock?

ADP Stock

As explained in the introduction, the stock price’s recent crash is due to the violence of the coronavirus’ effect on the global economy: Businesses across the world are suffering from the economic downturn and investors are unsure as to how this will affect ADP’s profitability in the coming year(s).

A major share of ADP’s revenues come from subscriptions and, although many businesses will layoff employees, they will not cancel payroll services altogether. Nevertheless, keep in mind that ADP’s main clientele, companies with 25-100 employees, will be severely impacted by the current crisis and their fate will have an enormous impact on ADP’s future.

Perhaps ADP’s valuation was inflated by last year’s bull run and the company’s true value lies between $125-$150, not $170-$180.

Ultimately, we will have to wait for the current crisis to end to see how the economy recovers and who the winners and losers will be. It’s too early to say conclusively that ADP will come out of this unscathed.

Should you buy the dip? Read my analysis of Realty Income Corp Stock.

Disclaimer: This is not financial advice. Do your own research before investing in any asset.

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