Here’s How The Fed’s Decision To Taper QE Pace Will Impact ADP

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Automatic Data Processing

Automatic Data Processing (NASDAQ:ADP) is the largest provider of payroll processing & human capital management solutions in the U.S. The biggest contributor to ADP’s stock value is its Payroll Processing Division. Our last article on ADP pointed out how the job market data for November was disappointing news for the company. In this article, we look at how the recent announcement by the Federal Reserve to taper its QE program to $75 billion a month will affect ADP’s Client Funds Interest, the second biggest contributing division to its stock price. ((Fed tapers QE pace))

Client Funds Interest

A distinctive part of ADP’s business is the interest that it earns on funds held for its clients. Historically, the interest earned on client’s funds as a percentage of ADP’s operating income has been more than 30%. For instance, in FY 2008, it accounted for almost 35% of ADP’s operating income. In absolute terms, ADP earned $680 million as interest on client’s funds in 2008. In FY 2012, however, ADP earned only $490 million, translating into 22% of operating income. Both the relative and absolute figures for interest on client’s funds have taken a beating in the last few years due to the ultra low interest rates prevailing in the U.S. economy.

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The Federal Reserve and Quantitative Easing

The Fed’s monetary policy has been to keep the market rate on Treasury Bonds low. This was achieved in two ways: 1) by signalling that the Federal Funds Rate (the overnight rate at which banks lend to each other) is going to be kept at near zero levels for a long time, and 2) through the monthly purchase of assets such as long term bonds and mortgage backed securities from banks and other financial institutions, thereby increasing liquidity and lowering long term rates.

As a result of these policies, the average return on ADP’s investments in these securities has been low. However, given the recent announcement by the Fed that it plans to scale back the monthly purchases from $85 billion to $75 billion, there has been a rise in the yields of these securities. If the recent reversal in yields is anything to go by, a sustained and a steady increase in interest rates over the next few years could significantly increase ADP’s earnings.

Impact of Rise In US Bond Yields

As the Federal Funds Rate has been near zero levels, bond prices have been high, especially for top rated debt such as US Treasuries. At the end of the Q3 this year, ADP held $22.1 billion in corporate investments and funds held for clients, primarily in AAA and AA rated debt. Owing to lower yields, the return on these investments has been much lower than those earned by ADP historically.

In Q3 of this year, ADP averaged a 2.5% interest rate on its corporate investments and funds held for clients. It is easy to see how small changes in bond yields can affect ADP’s bottom line. The average interest rate of 2.5% is a decrease of 50 basis points from last year’s Q3 average of 3%. We estimate that a change of 100 basis points in short-term and medium-term interest rates would increase the Earnings Before Taxes by ~$40 million, a 9% increase.

Lower interest income due to low interest rates has been partially offset by rising client’s fund balances. As far as average client’s funds are concerned, ADP has been able to grow them steadily from 2010 onwards with anticipated FY2013 growth of 5-7%. Hence we will be closely looking at the ADP’s average investment balances (client’s funds) to see how they are holding up.

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