Published October 5th, 2017 by Bob Ciura
Automatic Data Processing (ADP) might not be a household name. But it should be, at least for income investors.
Automatic Data Processing, or ADP for short, has raised its dividend each year for 42 years in a row. Its most recent increase was on November 8th, 2016, when the company announced a solid 7.5% raise.
ADP is a member of the Dividend Aristocrats, a group of 51 stocks in the S&P 500 Index, with 25+ years of consecutive dividend increases.
ADP’s long history of dividend growth is the result of a strong business model, and multiple competitive advantages.
This article will review ADP’s fundamentals and discuss whether the stock is trading at an attractive valuation right now.
ADP is a business outsourcing services company. It was founded in 1949, and began with a single client. In the nearly 70 years since, ADP has grown into the leading payroll and human resource outsourcing company. It has approximately 700,000 clients, in more than 110 countries, worldwide.
ADP has two business segments:
- Employer Services (81% of revenue)
- Professional Employer Organization Services (19% of revenue)
ADP provides services including payroll, benefits administration, and human resources management, to companies of all sizes. ADP enjoys high demand for these services, as companies would prefer to outsource these functions, to better focus on their core business activities.
Source: 2017 Investor Presentation, page 3
ADP has a highly diversified client list. No single customer represents more than 2% of annual revenue.
The company has undergone a significant restructuring in recent years. In 2014, ADP spun off its human capital management business, which now trades as CDK Global (CDK).
Its reshaped business model will place greater emphasis on helping clients streamline their business functions, by investing in cloud-based software as a growth initiative.
ADP has strong growth prospects. The company recently concluded fiscal 2017, which was another very good year. Total revenue increased 6%, to $12.4 billion. Excluding the impact of currency exchange, organic revenue increased 7% for the year.
Revenue growth, combined with share repurchases, drove earnings-per-share growth of 13% for 2017.
Source: FY17 Earnings Presentation, page 4
Both core segments performed well. Employer Services revenue increased 4%, while the PEO Services segment generated 13% revenue growth.
Growth in Employer Services is slower, but the segment is highly profitable. In fiscal 2017, Employer Services had a 30% gross margin.
The PEO Services gross margin is less than half that, but in return, it is the company’s main growth engine.
For fiscal 2018, ADP expects the Employer Services segment to grow revenue by 2%-3%. The PEO Services segment is expected to grow revenue by 11%-13%.
Overall, revenue and adjusted earnings-per-share are expected to increase 5.5% and 3%, respectively, at the midpoint of fiscal 2018 guidance.
Source: FY17 Earnings Presentation, page 6
Two key growth catalysts for ADP are continued increases in payrolls, and regulation. First, as the economy continues to grow at a modest rate, businesses are adding employees. The number of employees on ADP clients’ payrolls in the U.S. increased by 2.4% in fiscal 2017.
Next, the increasingly complex regulatory environment creates significant compliance costs for businesses.
This also helps provide ADP with steady growth. The company expects new business bookings to increase 5%-7% in the upcoming fiscal year.
Competitive Advantages & Recession Performance
ADP’s growth is fueled by its competitive advantages, of which it has many. ADP has a deep connection with its customers, and enjoys a strong reputation for customer service. This helps keep customer retention very high.
ADP enjoys tremendous scale, that its competitors cannot match. As a global company, ADP is uniquely positioned to help companies that have employees on multiple continents.
In addition, ADP benefits from a recession-resistant business model. ADP’s earnings-per-share during the Great Recession are shown below:
- 2007 earnings-per-share of $1.83
- 2008 earnings-per-share of $2.20 (20% increase)
- 2009 earnings-per-share of $2.39 (8.6% increase)
- 2010 earnings-per-share of $2.39 (flat)
ADP increased earnings-per-share in 2008 and 2009, which is a rare accomplishment. Businesses still need ADP’s payroll and human resource services. This helps insulates ADP from the effects of a recession.
Valuation & Expected Returns
ADP generated adjusted earnings-per-share of $3.70 for fiscal 2017. Based on the current share price, the stock has a price-to-earnings ratio of 30.1. This is a fairly rich valuation. The S&P 500 Index has an average price-to-earnings ratio of 25.3.
Put differently, ADP is valued at a 19% premium to the S&P 500. The stock appears to overvalued.
As a result, investors cannot rely on an expanding price-to-earnings ratio to fuel shareholder returns. Instead, future returns will likely be generated from earnings growth and dividends. In fact, the company’s high valuation could weigh down total returns for the stock.
The good news is, the company is growing at a high enough rate, that could justify its current valuation. A potential breakdown of future returns is as follows:
- 5%-7% revenue growth
- 1% margin expansion
- 2%-3% share repurchases
- 2% dividend
In this forecast, total returns would reach 10%-13% per year, including dividends.
ADP is likely to increase its dividend, before the end of 2017. It has not yet announced a dividend increase during 2017, but will need to do so to continue its streak of consecutive increases.
A dividend increase is easily justified by the company’s fundamentals. ADP maintains a target payout ratio of 55%-60% of annual earnings. ADP has an annualized dividend of $2.28 per share.
In fiscal 2017, earnings-per-share were $3.70, resulting in a dividend payout ratio of 61%. While this is slightly higher than the company’s target payout ratio, there should be enough future earnings growth to justify a dividend increase.
ADP is a strong business. The company maintains a large list of customers, and holds a top position in the industry. This gives it a wide economic “moat”, a term popularized by investing legend Warren Buffett. Indeed, ADP’s most keeps competitors at bay, and leads to high profitability.
There should be plenty of growth going forward, both in terms of earnings, as well as dividends. Regulations continue to increase, and only become more complex. And, as the economy expands, companies are adding employees.
If a recession occurs, ADP should continue to increase its dividend, as customers will still need its services. This makes ADP a highly consistent dividend stock