Automatic Data Processing (ADP) provides cloud-based human capital management solutions worldwide. The company has solid fundamentals that allow it to create value for its shareholders.
In addition, its business risk profile is relatively safe compared to most of its peers. However, we are currently neutral on the stock.
ADP Creates Value for Shareholders
While profitability is what determines the viability of a business, not all profitability equates to value creation for shareholders. As a result, we like to use the economic spread to determine if a company is effectively allocating capital to its projects. The formula is as follows:
Economic Spread = Return on Invested Capital – Weighted Average Cost of Capital
The idea is very simple; if the return on invested capital is greater than the cost of that same capital, then the company is creating value for its shareholders through well-thought-out projects. Otherwise, the company is destroying value and would be better off simply investing money into risk-free bonds.
For ADP, the economic spread is as follows:
Economic Spread = 32.3% – 6.8%
Economic Spread = 25.5%
As a result, the company is creating value for its shareholders, implying that management is efficiently allocating capital.
However, what is more important than the current economic spread is the company’s financial trends. ADP has seen steady growth in free cash flow over the past several years.
In 2018, this figure was $2.31 billion, which then increased to $2.53 billion, $2.85 billion, and $2.91 billion in 2019, 2020, and 2021, respectively.
In addition, gross margins have remained relatively flat over the past few years, ranging between 43.3% and 45.3% since 2017. This suggests that the business is stable and predictable, and competition is not chipping away at its margins.
To measure Automatic Data Processing’s risk, we will first check to see if financial leverage is an issue. We do this by comparing its debt-to-free cash flow. Currently, this number stands at 1.14.
Overall, we don’t believe that debt is currently a material risk for the company because its interest coverage ratio is 53x (calculated as EBIT divided by interest expenses).
However, there are other risks associated with Automatic Data Processing. According to TipRanks’ Risk Analysis, ADP disclosed 15 risks in its most recent earnings report. The highest amount of risk came from the Tech & Innovation category.
Nonetheless, the total number of risks for ADP is less than the sector average, making it potentially safer on a relative basis to most of its peers.
Wall Street’s Take
Turning to Wall Street, Automatic Data Processing has a Hold consensus rating, based on two Buys, seven Holds, and zero Sell ratings assigned in the past three months.
The average Automatic Data Processing price target of $228 implies 10.5% upside potential.
ADP is a profitable company that creates value for shareholders through growing cash flows. In addition, its risk profile is less than the sector average, and analysts expect further upside from its current levels.
That being said, the 10.5% upside target doesn’t provide enough of a margin of safety to make us bullish on the stock. This is especially true since the stock is currently on a downtrend, and we would like to see a clear trend reversal before jumping in. Therefore we are neutral.
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