Leading payroll processor, ADP (NASDAQ:ADP), has seen its stock price rise by about 10% from $70 to $80, in the last month or so. Much of this increase is surrounding the positive Q1 FY 2014 (Jul-Sep 2013) earnings results of the company. For the quarter, ADP’s revenue increased 8% y-o-y to $2.8 billion, better than management’s guidance of 7% growth. Rising by 9% y-o-y, net income grew faster than revenues to $329 million due to a lower effective tax rate. 
Although the company has demonstrated strength in its business, we think that the market has overreacted to the results. Currently, we have a price estimate of $73 for ADP, and believe that this assigns a fair value to the stock due to the reasons that follow.
The employment statistics released by the U.S. Department Of Labor for the month of October 2013 suggest that the size of the work force is declining due to a weakness in the job market. This could lower new business bookings growth for payroll processors, including ADP which added less than 1% new businesses in the first quarter of fiscal year 2014. Additionally, the present low interest rate environment, which adversely affected ADP’s interest revenue on clients’ funds during the quarter, is expected to continue in the near future.
A Squeezing Work Force Will Slowdown New Business Bookings Growth
According to the U.S. Department Of Labor, unemployment rate in the U.S. economy stood at 7.3% last month, drastically lower than 10% in October 2009.  However, the numbers are not so encouraging, because labor force participation rate in the U.S. has been on a downward trend, and declined to 63% from 65% during the same period.  This was also its lowest in 35 years.
The labor force includes people available for and willing to work. It excludes people who opt out of the labor force due to their unwillingness to work. Such people are not accounted for as unemployed. The number of unemployed workers in October 2013 stood at 11.3 million, lower than 12.2 million a year ago, while the number of employed workers stood at 143.6 million, nearly unchanged from year ago values.  This suggests that the decline in unemployment rate has come on the back of a rise in the number of workers who are not willing to work, and not of an actual increase in the number of workers employed.
Economists believe that a weaker job market since the recession has led to discouraged people leaving the work force.  Even if the job market, along with the economy, improves over the years to come, it is unlikely that the labor force participation rate will rise above its current level. This stems from the fact that an increasing number of baby boomers have been retiring since 2000. The Federal Reserve Bank of Chicago believes that the labor force participation rate will be lower in 2020 than it is today. 
Payroll processing is the primary source of revenue for ADP. The business is directly related to the employment scenario in the economy and makes up approximately 40% of our value estimate for the company. A decrease in the size of the workforce impacts ADP by hampering the fee earned by the company per client. If coupled with sluggishness in economy, a squeezing workforce also adversely affects new client additions by payroll processors such as ADP. The following table summarizes our forecast for the growth in number of new clients acquired by ADP:
Declining Client Interest Revenue Is Still The Most Significant Drag On ADP’s Earnings
Interest earned on client funds is also one of the major determinants of ADP’s stock value as it accounts for 20-25% of the company’s operating income. ADP invests client funds in U.S. Treasury securities. It takes a small percentage of the interest earned as commission. In this way, interest rates in the U.S. economy and average client funds significantly affect its earnings. The interest earned by ADP on client funds has been falling year-over-year due to the low interest rate environment prevailing in the U.S. This has been the most significant drag on ADP’s earnings.
The company earned $684 million as interest on client funds in FY2008. This declined to $421 million in FY 2013, even as average client fund balances increased from $15.5 billion to $19.2 billion during the same period. The interest on client funds continued its downward trajectory in Q1 FY 2014, falling by about 15% y-o-y. ADP sees the decline in interest earned on client funds to be bottoming out in terms of the size of the year-on-year decline. However, due to the downbeat U.S. economy, interest rates are not expected to reach their pre-recession levels until 2017, which would restrict ADP’s ability to charge its clients higher commissions. Notes:
- Automatic Data Processing Management Discusses Q1 2014 Results – Earnings Call Transcript, Seeking Alpha, October 30, 2013 [↩]
- Unemployment Rate, United States Department Of Labor, November 21, 2013 [↩]
- Labor Force Participation Rate, United States Department Of Labor, November 21, 2013 [↩]
- Employment Situation Summary, United States Department Of Labor, November 9, 2013 [↩]
- Oct jobless report paints dim picture of US job market, China Daily USA, November 9, 2013 [↩]
- The U.S. labor force is still shrinking. Here’s why., The Washington Post, November 8, 2013 [↩]
- Fed rates to stay low until Miley Cyrus is 30, CNBC, November 5, 2013 [↩]