1 Stock That Is Just Too Expensive
What do you get when you mix a wide-moat dividend growth stock with a bull market? The answer to that question is a really, really expensive stock.
Since the beginning of the year, Automatic Data Processing has surged more than 28%, besting the return of the S&P 500 Index by nearly 9 percentage points.
What's to like about ADP
There's ample reason to like this payroll processor. For one, it's a leader in an industry with an enviable competitive position. The last quarter revealed that more than 91% of its customers stick with the company each year, giving it recurring revenue and the potential to raise prices year after year.
Also, it benefits from a growing tailwind: falling unemployment. As more people go to work, Automatic Data Processing has more paychecks to process, driving up top-line revenue.
Hyperfocus is driving up the stock
One of the reasons ADP is such a high-flying stock is its float. The company has more than $20 billion of customers' money, which it invests in high-rated corporate and government debt to generate a return on its customers' money. Now that higher interest rates are on everyone's mind, investors have big expectations for ADP. If rates go up, then ADP should earn substantially more money on its float.
But there's just one problem: ADP's income from its float is going down, not up. And it now seems this tailwind is more than priced in.
Recent ADP guidance calls for the company to earn just 1.8%-1.9% on its investments in its fiscal year 2014, down 30-40 basis points from 2013. If earnings come in line with guidance, one can expect ADP to generate roughly $2.6 billion in pre-tax income from its investments.
You're probably wondering why it would earn less from its float in 2014 given that rates have actually gone up for much of the last few months. If the 10-year Treasury yield was higher at the end of the fiscal year than the beginning, ADP should stand to earn more from its float, right?
Well, not exactly.
The simple explanation is that ADP's investment portfolio is invested in longer-dated debt securities. Thus, it's still benefiting from higher interest rates before the 2008 financial crisis and subsequent meltdown. So, even though rates are higher today than they were in, say, May 2013, they're still lower than interest rates that ADP locked in before the Fed drove down rates in 2008.
ADP Chief Financial Officer Jan Siegmund had this to add on the company's latest conference call:
"As you see from our quarterly SEC filings, we anticipate less than 10% of the investments will mature in fiscal year 2014, while the maturities in fiscal year 2015 will be more in line with the 15% to 20% range."
Finance that fits on an envelope
If 10% of the investments mature in 2014, and earnings from its float decline by 30-40 basis points, we can surmise that ADP needs interest rates to be 3%-4% higher than they are today to maintain its 2013 level of investment profitability.
What's the likelihood interest rates rise by 3%-4% in 2014, or even 2015? Probably fairly low, especially given that the Federal Reserve still hasn't made the decision to even begin tapering its asset purchases, let alone drive up the federal funds rate.
ADP's smaller competitor, Paychex , may offer a more compelling opportunity. The company has roughly half of its $4 billion average float invested in short-term securities. Thus, when rates move higher, Paychex sees instantaneous movement in its interest income. (Less than 20% of ADP's float is invested in shorter-term, low-yield investments.)
Paychex CFO Efrain Riveria dropped a valuable tidbit of information to investors on the latest conference call, confirming that a 25 basis point increase in short-term rates would add roughly $0.01 to annual earnings per share.
The Foolish bottom line
Rising rates are a catalyst for rising earnings for Automatic Data Processing and Paychex, but this catalyst is already well-known by Wall Street. At more than 20 times forward earnings expectations, neither stock is particularly cheap, given that the S&P as a whole trades for 15.5 times estimated forward earnings.
All in all, Paychex may offer better exposure to rising rates, but investors may be better off waiting to snap it up at less than 20 times forward earnings, a 10%-15% discount to the current price. Both are great brands, but they'll only be great stocks if purchased at the right price.
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The article 1 Stock That Is Just Too Expensive originally appeared on Fool.com.Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Automatic Data Processing and Paychex. The Motley Fool owns shares of Paychex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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