Automatic Data Processing – As Jobs Recover So Will ADP

Automatic Data Processing, Inc. [ADP: $40.30] expects nearly $9 billion in revenues from approximately 570,000 clients. They are one of the world’s largest providers of business outsourcing solutions. ADP offers the widest range of HR, payroll, tax and benefits administration solutions from a single source. ADP is also a leading provider of integrated computing solutions to auto, truck, motorcycle, marine and recreational vehicle dealers throughout the world.

After decades of consistent growth ADP’s earnings have likely plateaued in the FY ending June 30^th. As the largest provider of payroll and tax filing services to large businesses ADP has been hit with reduced demand tied to the absolute loss of jobs since the recession began in 2008. Despite that substantial headwind, ADP posted all-time record earnings of $2.39 /share in FY 2009.Zacks sees FY 2010 (ends June 30, 2010) coming in at the same $2.39 level with the year ahead forecast at $2.53.

Finances are solid with over $2 billion in treasury cash against total debt of only $41 million. Value Line gives ADP their highest rankings for both safety and financial strength. They also note that ADP falls into the top 1% (of all 1700 equities they cover) in terms of ‘stock price stability’ and ‘earnings predictability’.

Capital needs are minimal and dividends have been raised every year to sit today at $0.34 quarterly for a current yield of 3.37% – better than the interest on a 5-year U.S. Treasury note. 

ADP is now offered for about 16.8x trailing and 15.9x year-ahead earnings versus its 10-year median multiple of 25x. 2009 and YTD 2010 have been the only years of the past sixteen that the P/E has averaged below 20x.

While it’s unlikely that ADP will command a historically high multiple soon I don’t think it’s farfetched to expect a bounce back to at least 18x forward earnings. That would take these shares back to $45.54 or about 13% above this afternoon’s quote. Standard and Poors reached a similar conclusion with a 12-month target price of $47 /share.

Add in the yield and you’ve got a top-quality, low-risk issue that could produce better than a 15% twelve-month total return. Not too bad in our present, near-zero interest rate world.

Want something more exciting with even lower risk? Consider this:

If ADP merely rises to $42.50 or higher [+5.5%] by Jan. 22, 2011:

• The $42.50 calls will be exercised.
• You will sell your shares for $42,500.
• The $42.50 puts will expire worthless.
• You will have collected $1,020 in dividends.
• You will have no further option obligations.
• You will end up with no shares and $43,520 in cash.

This best-case scenario would show a profit of $43,520 – $33,750 = $9770.

$9,770/$33,750 = 28.9% achieved over about eight months on shares that only needed to go up by 5.5% or better.

What’s the risk?

If ADP remains lower than $42.50 on Jan. 22, 2011:

• The $42.50 calls will expire worthless.
• The $42.50 puts will be exercised.
• You will have collected $1,020 in dividends.
• You will have no further option obligations.
• You will end up with 2000 ADP shares and $520 in cash.

What’s the break-even on the whole trade?

• On the original 1000 shares it’s their $40.30 cost basis less the $1.75 /share call premium = $38.55 /share.
• On the ‘put’ shares it’s the $42.50 strike price less the $4.80 /share put premium = $37.70 /share.
• Your overall break-even would be $38.13 /share excluding dividends and $37.86 /share if you figure in the yield.
• ADP could drop by as much as (-6%) without causing a loss on this trade.

Summary:  ADP offers a predictable, relatively safe way to make double-digit total returns as a straight stock purchase. Those who are willing to buy shares and sell options for January 2011 could end up with almost 29% cash-on-cash returns over the next eight months.

Dr. Paul Price – May 26, 2010

www.BeatingBuffett.com

Disclosure:  Author is long ADP shares and short ADP options