ADP Could Benefit From An Increase In Interest Rates

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ADP: Automatic Data Processing logo
ADP
Automatic Data Processing

Automatic Data Processing (NASDAQ:ADP) a leading human capital management company, currently generates a little more than 3% of its revenues from interest earned on funds held for clients. Though this is an insignificant contribution to the top line, the interest earned forms an important part of the company’s valuation, accounting for more than 25% of our price estimate. This is because the interest earned has very few costs attached to it, leading to higher cash flows compared to ADP’s service segments.

However, it is pertinent to note that interest earned on funds held for clients used to account for a higher proportion of ADP’s overall revenues. Its revenue contribution has almost been cut in half since 2010, as a result of the low interest rate environment in the U.S., which pushed down returns on fixed-income securities. However, things could turn around soon, as there are indications that interest rates are likely to be increased next year.

See our complete analysis of ADP here

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Quantitative Easing Drove Down Returns

In 2008, the Federal Reserve began a Quantitative Easing program in order to stimulate the U.S. economy to come out of the recession. This was achieved by keeping interest rates low and increasing liquidity in the financial system. The Federal Reserve began purchasing long term bonds and mortgage-backed securities, and in return gave credit to banks who would then lend at lower rates to push out the extra liquidity. As a result, the Federal Funds Rate (the overnight rate at which banks lend to each other) declined from 1.92% in 2008 to 0.11% in 2013. [1]

ADP, who receives funds from clients for tax and payroll payments, invests clients’ funds in AAA and AA rated debt. For fiscal year 2008, ADP’s interest earned on funds held for client was $684 million. [2] However, because of the low interest rate environment, the interest earned declined to $373 million by fiscal year 2014, despite a 32% increase in the average balance of clients’ funds. [3] The average interest rate earned declined from 4.4% to 1.8% over that period.

Fed May Raise Interest Rates Late Next Year

In October, the Fed ended the Quantitative Easing program. On December 17, the Fed held a meeting to discuss the interest rates in the U.S., after which Janet Yellen, Chair of the Board of Governors of the Federal Reserve System, announced that rates will likely remain near zero in the short term. [4] She also mentioned various conditions depending on which interest rates will be increased, and said that rates will be increased gradually but are not likely to return to normal levels until 2017. Experts are of the view that an interest rate hike is likely in the second half of 2015, given the relatively strong economic conditions in the U.S.

An increase in interest rates next year will have a positive impact on ADP’s interest earned on funds held for clients in the fiscal year 2016, since it will help increase returns on investments. However, until interest rates rise, ADP will have to rely on growth in the average balance of clients’ funds to help boost interest earned, as seen in the first quarter fiscal year 2015.

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Notes:
  1. Effective Federal Funds Rate, www.ycharts.com []
  2. ADP’s 2008 10-K SEC Filing, www.sec.gov []
  3. ADP’s 2014 10-K SEC Filing, www.sec.gov []
  4. Fed’s ‘Patience’ on an Interest Rate Increase Has Its Limits, December 18, 2014, www.bloomberg.com []