Why Paychex and ADP Earnings will Rise with Interest Rates
Joe is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
A substantial portion of the bottom line of payroll processors Automatic Data Processing (NASDAQ: ADP) and Paychex (NASDAQ: PAYX) comes from interest income on float (i.e., excess funds held between receiving funds from clients and paying it out to their employees). Several recent articles have highlighted the positive impact of higher interest rates on these firms, yet no one has quantified it. Below I will lay out just how significant the impact will be from increased interest rates on PAYX and ADP’s EPS.
At its height from the last 6 years, interest income represented 18.0% of PAYX EBIT, while ADP’s represented an astounding 40.4%. This has since fallen to 5.1% and 23.2%, respectively.
Interest income on client funds as a % of EBIT
|
FY'06 |
FY'07 |
FY'08 |
FY'09 |
FY'10 |
FY'11 |
FY'12 |
|
|
PAYX |
14.9% |
18.0% |
15.4% |
9.3% |
7.5% |
6.1% |
5.1% |
|
ADP |
40.4% |
40.3% |
37.8% |
32.1% |
29.1% |
27.9% |
23.2% |
Source: SEC filings.
ADP’s higher percentage of EBIT from interest income is driven by higher interest rates on client funds held, at 2.8% versus 1.2% at PAYX in FY'12.
Average interest rate earned on client funds
|
FY'06 |
FY'07 |
FY'08 |
FY'09 |
FY'10 |
FY'11 |
FY'12 |
|
|
PAYX |
3.3% |
4.1% |
3.9% |
2.3% |
1.7% |
1.4% |
1.2% |
|
ADP |
4.1% |
4.5% |
4.4% |
4.0% |
3.6% |
3.2% |
2.8% |
Source: SEC filings.
The large discrepancy in interest rate earned seemed odd to me at first, but a deeper look revealed that ADP’s investment portfolio may have a much higher average maturity than PAYX. The PAYX 10-K states that their investment portfolio has a duration of 3 years, while ADP's disclosure about maturity is less transparent. ADP only discloses that they invest in maturities of up to 10 years with 67% having maturities of less than 4 years. While a longer duration may benefit ADP in the short term, it will take them longer to realize the benefits of higher interest rates than PAYX, who will be able to reinvest the proceeds faster at higher interest rates.
Turning to the impact on future financials using FY’12 EPS as our basis and adjusting interest income to pre-crisis levels, we see that EPS will be substantially higher at both firms. Diluted EPS at ADP would be 13.0% higher, while PAYX would be 10.5% higher.
EPS adjusted for higher interest rates
|
|
FY'12 |
FY'12 |
|
ADP |
PAYX |
|
|
Diluted EPS |
$ 2.82 |
$ 1.51 |
|
Diluted EPS - adjusted |
$ 3.19 |
$ 1.67 |
|
% impact |
13.0% |
10.5% |
Source: SEC filings. Adjusted EPS was calculated using FY’06 to FY’09 average interest rate earned.
Bottom Line
ADP and PAYX stand to benefit from rising rates, which should occur at the same time employment rebounds (an employment rebound would be another boon to these payroll processors.)
Some may argue that interest rates will remain low for an extended period, given the Federal Reserve’s intention to keep interest rates low through at least 2014. Yet, investors will be rewarded by the 3.7% yield at PAYX and 2.7% yield at ADP while they wait for economic conditions to normalize. For my own portfolio I selected PAYX, due to the higher yield and limited disclosure around duration of ADP's investment portfolio compared to PAYX.
JoeMazzone owns shares in PAYX. He has no intention of buying or selling PAYX or ADP within the next 48 hours. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Automatic Data Processing and 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. If you have questions about this post or the Fool’s blog network, click here for information.
