Automatic Data Processing (ADP, Financial) shares seem to be out of favor as they have lost about 8% in 2023 when all major U.S. stock market indices have gained. From a contrarian approach, I like Automatic Data Processing now due to the combination of a low valuation, a strong business model, high profitability and growth in revenue and earnings. I believe the positive factors could soon drive a turnaround for the stock price. It is dangerous to be a contrarian investor, but contrarians can improve our chances by conducting in-depth analysis.
Business model and economic moat
Automatic Data Processing, better known as ADP, was founded in 1949 and is based in New Jersey. It is a global provider of human capital management (HCM) solutions and payroll services. ADP's business model is built around offering comprehensive technology-based solutions to help businesses manage their workforce and payroll processes efficiently.
In terms of an economic moat, ADP benefits from its large scale and extensive network of clients, which creates network effects. As more companies and individuals use ADP's services, the value of the network increases, making it harder for competitors to attract customers and gain similar economies of scale. ADP's vast client base also provides valuable data that can be leveraged to improve its products and services. ADP has invested heavily in developing advanced technology platforms and solutions. Its comprehensive suite of cloud-based HCM software and services offers features such as payroll processing, time and attendance tracking, benefits administration, talent management and more.
ADP operates in a heavily regulated industry, particularly in the areas of payroll, tax and benefits administration. The company has built deep expertise in navigating complex regulatory landscapes, ensuring compliance with local, state and federal laws. The high regulations create a barrier to entry for new entrants.
ADP has established long-term relationships with its clients, including businesses of various sizes across different industries. These relationships are built on trust, reliability and a proven track record of delivering accurate and timely payroll and HR solutions. Switching from ADP to a competitor involves significant effort and potential disruption, making client retention a significant advantage for ADP.
Another important advantage is the global presence the company has. ADP operates around the world, serving clients in more than 140 countries. Its international footprint and localized expertise allows ADP to adapt its services to meet the unique requirements of different markets. This global presence and localized approach give ADP a competitive advantage, as it can provide tailored solutions to multinational companies and navigate local regulations and compliance issues effectively.
Overall, ADP's economic moat is built on its scale, network effects, technological capabilities, regulatory expertise, long-standing relationships, brand reputation and global presence. These factors make it challenging for competitors to replicate ADP's comprehensive suite of services, established client base and industry-leading position, which is one of the main reasons why I think the company and its stock are set for long-term success.
Solid financials and growth
ADP has a GF Score of 94 out of 100, which means it has high outperformance potential based on a historical study by GuruFocus.
The financial strength rank is moderate at 6 out of 10, but I see no problem with this given the debt-to-equity ratio of 0.9, though the Altman Z-Score of 2.01 is in the grey zone. The company has generated consistent positive free cash flows over the past five years, which slowed down in 2021 and 2022 with growth of 2.14% and 0.36% respectively, but stability in the free cash flow trend is at least better than declines.
It is very positive to see that ADP has a rank in profitability from GuruFocus at 9 out of 10, along with growth receiving a perfect rank of 10 out of 10. The momentum is not bad either with a rank of 7 out of 10.
Automatic Data Processing's operating margin is expanding, with a five-year average growth rate of 5.40% per year. For the quarter ending in March 2023, the operating margin was 23.87%. The net margin was also very good at 22.30% for the same quarter, the highest figure over the past 12 quarters.
The return on equity of 97.77% is magnificent. The company has also shown predictable revenue and earnings growth over the past five years, especially on the bottom line, with a five-year average earnings per share without non-recurring items growth rate of 12.10%. The company also has a three-year revenue per share growth rate of 7.2%, and Morningstar analysts estimate a three to five year total revenue growth rate of 6.08%.
In terms of valuation, the GF Value chart rates the stock as modestly undervalued.
In conclusion, I believe that ADP shares could soon rebound as the market is clearly ignoring the strength of the business model as well as the strong historical profitability and growth. The low valuation is quite unfair in my opinion, and I think this may be due to temporary factors such as the current labor market.
