Where Cash Flow Is Automatic

03/17/2009 12:00 pm EST


Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, and analyst Vishnu Lekraj say human resources service provider ADP can continue to reel in the cash even in a weak economy.

Automatic Data Processing (NYSE: ADP) competes in the human resources administration services industry. It provides services such as payroll processing and benefits administration. The firm was founded in 1949 and is headquartered in Roseland, NJ.  It serves over 550,000 clients with 46,000 employees worldwide.

ADP’s scale, high customer switching costs, and respected brand give the company a durable competitive advantage. The minimal amount of capital necessary to run the business allows the company to generate strong free cash flow, and management’s conservative investment philosophy has insulated it from the problems competitors have faced.

[Several] factors contribute to ADP’s wide moat and strong profitability. First, due to the difficulty companies face in switching their outsourced HR processes over to another provider, ADP is able to lock clients into its services through long-term contracts. Average client retention is estimated to be more than ten years, and this stickiness allows ADP to raise prices with very little resistance.

Second, ADP’s scale allows it to be price-competitive without feeling margin pressure as it can leverage its large 550,000-member client base to spread costs associated with its servicing infrastructure.

Finally, the firm’s strong brand also plays a role as clients are hesitant to entrust their critical HR functions to an unproven competitor.

ADP’s established competitive position and the industry’s minimal capital-reinvestment
requirements have enabled the firm to turn 17% of its revenues into free cash flow on average over the last five years.

Approximately 8% of the firm’s income is generated by the massive amount of client funds the firm holds through its payroll services division. This division collects and pays wages and other payroll-related requirements on behalf of its corporate clients. ADP invests these temporary funds and keeps the interest that is earned. The firm is very conservative in investing these funds, with the majority held in money-market and US government securities.

We think ADP can continue to grow its revenues and margins through new service offerings, increased market share, and price increases, even though it may face some light head winds in the current economy.

Our fair value estimate is $58. (The stock closed Monday above $35—Editor.) We factor in the effect of a global economic decline, but we believe ADP is in a strong enough position that the effects upon profitability will be moderate.

We forecast revenue growth to slow slightly in the near term but recover to a compounded annual growth rate of 9% over our ten-year forecast period. We expect operating margins to stay positive and trend upward over the long term, ranging from a low of 18% due to a weak employment picture and low interest rates, but then trending to 21% by the end of our projection period. We estimate the company will earn an average interest rate of 4.5% on its investment portfolio.

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