"Automatic" Gains

06/11/2004 12:00 am EST


James Stack

President, Stack Financial Management

"Remarkably, some stocks have actually managed to thrive in an environment of stronger economic growth countered by rising interest rates," says James Stack, editor of InvesTech Market Analyst. "This is the case with Automatic Data, our latest featured stock. Here's his review.

"Automatic Data Processing (ADP NYSE) has provided consistent growth since we added it last year, but it is particularly timely under the current circumstances. The investment philosophy at InvesTech Research and Stack Financial Management is centered on the goal of building wealth in a prudent and patient fashion. We would rather pay a fair price for a superior business than a great price for a mediocre business. By almost any measurement, ADP is a superior business franchise. Because the primary catalyst for purchasing this security was an improvement in the US employment picture, we thought it was a timely opportunity to highlight the company. In addition, ADP is in the enviable position of having higher interest rates actually benefit part of their business.

"ADP is the nation’s largest payroll and tax filing processor with about 450,000 accounts. Among employers of 5,000 or more employees that outsource payroll management, the company holds a 70% market share. As part of its payroll services, ADP collects funds for federal, state, and local employment taxes from clients before remitting the funds to the appropriate parties and tax agencies. The company receives interest during the interval between receipt and disbursement of these funds by investing the funds in fixed-income instruments. The "float" has averaged approximately $8.5 billion over the past three years.

"Besides having a virtual monopoly in its core businesses, creating what Warren Buffett describes as a "wide moat" to protect the business from competition, ADP has a sterling balance sheet. The company has more than $1.2 billion in cash and just $82 million in long-term debt, and is one of only seven US companies outside the financial sector to hold a AAA credit rating. The competitive advantage generated by their controlling market share has translated into high returns on equity and strong operating cash flow growth. For the past five-year period, ROE has averaged 20% and cash flow has grown at an annual rate of 16.3%. The positive attributes of the company and the realization of the primary catalyst have not gone unnoticed by the market.

"Not withstanding that selected valuation measures for the stock are significantly higher than the market average, we feel that there are further profits to be realized given ADP’s unique financial and operating qualities. In a perverse fashion, the US equity market rewarded the riskiest securities in 2003; shares with the lowest quality ratings from Standard and Poor’s rose by 81% last year. It seems both likely and logical that superior returns in 2004-2005 will be focused on those issues with top-tier financials and predictable revenue growth, like ADP, as we expect the "flight to quality" and risk aversion to continue over the next six-12 months."

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