Why Does Arnold Van Den Berg Love Automatic Data Processing (ADP)

Arnold Van Den Berg owns 768,519 shares of Automatic Data Processing (ADP, Financial). While the stock is only his 13^th largest position – it’s one of the highest quality companies in his portfolio. That’s why Arnold Van Den Berg chose to write about ADP in his most recent letter to investors.


And that’s why I’ll be talking about it today.


Since Arnold Van Den Berg says ADP is a great company – and I said Microsoft (MSFT, Financial) was a great company yesterday – let’s compare the two stocks. Arnold Van Den Berg owns both. Microsoft is his largest position. For more information, see my article on why Arnold Van Den Berg loves Microsoft.


ADP vs. Microsoft – Vital Signs





ADP’s Z-Score of 387.44 is not a typo. Remember: a Z-Score above 3 is considered safe.


ADP is a AAA rated company. One of only about half a dozen left. You could make the argument that ADP is the best business credit on planet Earth. I won’t. We’re talking about stocks. Not bonds. But ADP is a super safe debtor.


I’ll let Arnold Van Den Berg explain why:


“ADP’s annuity”like business is a great model. For starters, it can bundle many of its services. This has helped ADP maintain fairly consistent after”tax profit margins in the 12% to 15% range for more than 10 years. Furthermore, this company has a reasonably predictable recurring revenue stream, as well as a very “sticky” business. For example, ADP has a 90% client retention rate; and the average client relationship is more than 10 years old. This is a sign of a great company.”


Retention rates are very important in terms of both profitability and safety. Usually companies with high retention rates – low churn – earn higher returns on capital. And they are almost always safer from a bond buyer’s perspective. ADP’s customers are super sticky. The company’s ultra-low free cash flow and return on capital variation coefficients – 0.13 and 0.19 respectively – support the idea that ADP is an incredibly reliable business.


ADP holds billions of dollars in client funds. This unique aspect of the business – a lot like an insurance company – excites Arnold Van Den Berg:


“ADP also has the opportunity to earn money on what is referred to as ‘float.’ This is the money that ADP collects for payroll taxes from its clients each pay period. It then holds this money on behalf of its clients until it is time for them to send these payroll taxes into the government…until this money is due to the government, ADP basically escrows this money for its clients…The investment income gained from this float currently provides approximately $600 million in pretax income to ADP. Eventually when interest rates go up, so will its profits on this float. This company will likely do well in an inflationary environment.”


More on this later.


Right now, I want to temper Arnold Van Den Berg’s hot talk about ADP’s great business – all of it true – with some cold reality. The last 10 years haven’t been kind to ADP. Low interest rates and the mother of all recessions is a bad combination for a company that depends on low unemployment and high interest rates to juice its profits.


Let’s compare ADP’s free cash flow growth with another – alleged – high quality, no growth business: Microsoft.


ADP vs. Microsoft – Real Free Cash Flow Per Share





Microsoft’s average real free cash flow from 2000-2002 was $1.93 a share. From 2007-2009 it was $2.23. Microsoft’s free cash flow grew by 2.1% – over inflation – during those 7 years.


ADP’s average real free cash flow from 2000-2002 was $3.09 a share. From 2007-2009 it was $2.92. ADP’s free cash flow shrank – after inflation – during those same 7 years.


Why?


Because the economy sucks.


The economy wasn’t great in 2000-2002. But it was a lot worse in 2007-2009. This influences the growth comparison more for an employment dependent company like ADP than for a tech company like Microsoft. Although, it should hurt Microsoft too. Yet the 2.1% a year growth in real free cash flow makes it clear the 2000s weren’t a lost decade for Microsoft. They were for ADP.


I’m going to deal with the interest rate issue in-depth a little later – it’s a bit math heavy. Always best to put the math at the end of the article. Right now, let’s talk about ADP’s possible future growth apart from rising interest rates.


Arnold Van Den Berg is upbeat about ADP’s growth prospects:


“Currently, with only 20% of sales coming from outside the U.S., ADP has plenty of room to grow for many years to come…In our analysis, we are growing its earnings at the annualized rate of 9.7% over the next five years. Even during the past three years in a challenging economy with high unemployment, ADP grew its earnings at an annualized rate of 5.7%. We believe our growth rate is reasonable, especially when you factor in its rapidly expanding international business and the ability to bundle its various products and services. Under this scenario, we believe ADP has future earning power of $3.75.”


I disagree.


Arnold Van Den Berg has an amazing track record. So, you should probably go with him. But I have a hard time coming up with reasonably conservative future growth numbers that get ADP past $3.50 a share in normal earning power. I definitely wouldn’t invest with the idea you’re going to see more than $3.50 a share in earnings from ADP anytime soon. It could happen. But it’s not something you want to risk your retirement savings on. ADP needs to justify its stock price without assuming earnings above $3.50 a share. At least in my opinion.


Again, Arnold Van Den Berg doesn’t agree. He sees earnings of $3.75 a share in ADP’s future.


That’s the minor disagreement between Arnold Van Den Berg and me.


Here’s the major disagreement:


“If we were to use the five”year median Value Line P/E of 17.1 and add a 20% premium since ADP is much better than the average company, the P/E we would use is 20.5. If we multiply this P/E times the five”year earnings potential of $3.75, it would suggest a price of $76.90 for a potential five”year annualized return of 12.9% from today’s price. However, if you add the 3.2% dividend yield to this return, there is potential for a 16% total return over the next five years…Now, if we assume ADP gets back to its last five” year average P/E of 22.39, it suggests ADP could sell for approximately $84 per share. This means that from today’s price of $42, this stock has the potential for a five”year annualized return of 15%. This does not include the 3.2% dividend yield that is paid out every year. If we include the dividend, the potential total annualized return would be 18.2% over the next five years.”


Although Arnold Van Den Berg and I both consider ourselves followers of Ben Graham – he’s okay with assuming a P/E premium and I’m not. I just can’t apply a future P/E of 20 to a stock I’m buying. Maybe I’m old fashioned. Maybe I’ve got – deservedly – less faith in my prophetic powers than Arnold Van Den Berg.


But I just can’t assume a stock I buy will ever trade at a P/E of 20.


That difference in process explains the difference in outcome. Arnold Van Den Berg is willing to assume ADP will one day trade at a P/E of 20. I’m not. So Arnold Van Den Berg is willing to buy ADP stock. And I’m not.


Finally, I promised a discussion of ADP’s float and the interest it earns on that float. For those readers brave enough to stick with me…


Here’s a comparison of ADP’s inflation adjusted float and interest on that float. As always, I’m showing you per share numbers that use the current number of shares outstanding. That’s all that matters to new investors. I’ve also included the “yield on float” which is just interest divided by float.





Interest rates haven’t helped ADP. They’ve hurt. But they’ve only hurt to the tune of about 11 cents per share. That only explains two-thirds of ADP’s real free cash flow shrinkage. The rest is explained by high unemployment.


ADP has made competitive progress in the last 10 years. None of that shows up in the inflation adjusted numbers. That’s because the U.S. economy is so bad right now that any progress ADP made is more than offset by where we are in the economic cycle.


Does that mean ADP will bounce back with the economy?


Lower unemployment and higher interest rates will both benefit ADP. As a result, the 12 times EBIT and 16 times free cash flow multiples you see for ADP may be overstating how expensive the stock is right now. It’s possible the 10 year numbers are not normal, because interest rates were low for much of the last 10 years.


Depending on what you consider a normal interest rate, it’s possible to conclude ADP’s normal earnings power is anywhere from 35 cents to 70 cents higher than what is was over the last 10 years. I think 35 cents of improvement due to higher interest rates is possible. 70 cents of improvement looks possible, when you think in terms of nominal rates. But inflation hasn’t been high these last 10 years. So that’s part of the explanation for low interest rates. An adjustment to normal real interest rates is likely to increase the yield on ADP’s float by 1% rather than 2%.


Still, if we moved to a normal real interest rate – as judged by averages going back 50, 100, or 150 years – we’d probably see ADP’s yield on its float rise by 1 full percentage point. Earnings would rise by 35 cents per share. That interest rate increase alone would warrant a $5.25 rise in the stock price ($0.35 * 15 = $5.25).


Is that what Arnold Van Den Berg is looking for? Higher interest rates. Probably not. Higher interest rates alone will only do so much for ADP. But the combination of higher interest rates and lower unemployment – basically a stronger economy – will do wonders for ADP.


My best guess – and this is only a guess – is that ADP’s normal earning power in the sense of what it would earn with “normal” interest rates and “normal” unemployment given its competitive position is $3.50 a share. That implies a normal stock price of $52.50 a share.


That’s not a best case scenario. I’m really just assuming ADP would match its real free cash flow from the early 2000s and then add another 35 cents in additional interest from float.


It’s hard to imagine ADP stock trading below $52.50 in normal economic times. But I’m not an economist. I’m an investor. And 13% upside – which is all the increase to $52.50 from $46 amounts to – just isn’t enough.


Like I’ve said before, I need at least a 30% upside in any stock I buy. And I don’t want to have to assume the stock trades at a premium P/E. I’m always looking at something like net current assets, tangible, book value, EBIT, or – most often of all – 10-year average real free cash flow.


With ADP, we only get really impressive annual return numbers when we assume the stock will trade at more than 15 times free cash flow.


That’s risky. And uncertain.


I like to find stocks that will outperform even while the company underperforms. ADP’s stock will only outperform if the company outperforms. Or, if ADP regains its historical premium over the market wide P/E.


ADP is a great company. It deserves its AAA rating. And for someone looking for high-quality stocks like Arnold Van Den Berg this investment makes sense.


I just don’t see the upside.


The margin of safety here is all qualitative. You’ve got no quantitative protection. The stock is basically trading at fair value for an average company. The only thing protecting you is the idea ADP is an above average company. I agree with that assessment. But I don’t like investing based on my qualitative assessments.


I need some protection from the numbers. And ADP doesn’t offer any.


I wouldn’t recommend buying the stock at $46 a share.


There are cheaper stocks out there.


ADP shares have a 3.1% dividend yield. The company has a history of increasing the dividend while simultaneously decreasing the number of shares outstanding. It’s a wonderful company that does a wonderful job allocating capital. In all likelihood – like Microsoft – ADP stock will do as well or better than the S&P 500.


But it just isn’t cheap enough. Unless you’re limited to owning 20 plus big cap stocks – and I’m not sure why any individual investor would be – you shouldn’t buy ADP at $46 a share.


You should wait for a margin of safety.