Take Profits at Automatic Data Processing

 | Aug 16, 2013 | 10:30 AM EDT
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As a result of the market's strong gains during the past 18 months, we have been recently suggesting that investors periodically reassess their winners to appropriately declare victory. They should then re-deploy proceeds into stocks that are best positioned for upcoming periods.

In June of 2012, we recommended that investors take profits in bonds and to begin investing some of the proceeds into rock solid, lower volatility and higher dividend paying blue-chip names. One of the names at the top of our list was Automatic Data Processing (ADP), then trading around $53.25.

At the time, ADP was trading at 19x earnings and had a 3% dividend yield. We expected this leading payroll processing firm to grow its earnings at 5% to 7% per year and its dividends at double-digit rates. In addition, the financial position of the company was pristine, with a strong AA credit rating, $2 billion in cash and a comfortable 57% payout ratio.

In our view, ADP offered investors the best of both worlds: 1) a stable business franchise that would protect investors in a volatile business environment, and 2) a steady dividend stream that would match or beat comparable corporate or government bonds.

Since then, our recommendation has performed better than we had imagined. The shares have risen 34.5% to $71.60. Reflecting this appreciation, the dividend yield has declined from the previous 3% to a current 2.4%. Given both the significant stock appreciation and the reduced yield potential, we would recommend that investors get ready to take profits in the name.

As the outlook is favorable we would be price sensitive and start scaling back at $72.50 or better. (We would not be a seller into Thursday's weakness).

Automatic Data Processing continues to run a strong industry leading business franchise. In fact, business has been modestly better than expected and management has revised guidance upward. Revenues are now projected to grow 7% for the year versus the 5% to 7% range for the original estimates. As for profits, management now expects profits to rise 8% to 10% per year versus a 5% to 7% level. Business is getting better.

Importantly, all these improvements precede a full recovery in employment growth or substantially higher interest rates. A normal jobs picture and higher interest rates will further add to the improving profit outlook at ADP.

While the intermediate term outlook is therefore favorable, two of the important factors driving our recommendation are no longer present -- a healthy yield and reasonable valuation.

Valuation no longer looks compelling. At $71.60, ADP's shares are trading at 24.8x 2013's earnings per share estimate of $2.89 and 22.4x 2014's earnings  estimate of 3.20, compared with the 19x multiple at the time of our recommendation.

From current valuation levels, we believe it will not only be unlikely for investors to experience meaningful capital appreciation potential over the next few years, but they might also be vulnerable to downside in a market pull back. Finally, while the current 2.4% yield exceeds the market yield and is expected to grow nicely over time, that level now provides less stock price protection than a year ago.

ADP has sold off a bit during the past few days. With any kind of bounce back, however, investors should consider taking some profits. The overall ADP franchise and fundamentals are still intact, and the company is winning in the marketplace. It also is generating positive revenue and earnings growth. At $72 plus, the stock has reached our objective and we are happy to declare victory and move on.

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