Updated on February 12th, 2021 by Bob Ciura
Automatic Data Processing (ADP) might not be a household name, but it should be for dividend growth investors. ADP has raised its dividend each year for over 40 years in a row. Its most recent increase came in November 2020. While last year’s 2% dividend increase was smaller than in previous years, it is still noteworthy for ADP to raise its dividend in such a challenging year.
ADP is a member of the Dividend Aristocrats, a group of 65 stocks in the S&P 500 Index, with 25+ years of consecutive dividend increases. ADP has one of the longest streaks of dividend increases among the Dividend Aristocrats.
We have created a full list of all 65 Dividend Aristocrats, along with important metrics like P/E ratios and dividend yields, which you can download by clicking on the link below:
ADP’s long history of dividend growth is the result of a strong business model and huge competitive advantages. This article will review ADP’s fundamentals and discuss whether the stock is trading at an attractive enough valuation to buy now.
ADP is a business outsourcing services company. It was founded in 1949, and began with a single client. In the 70+ years since, ADP has grown into the leading payroll and human resource outsourcing company. It has over 860,000 clients, in more than 140 countries worldwide.
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 in order to better focus on their core business activities.
Source: Investor Presentation
ADP has a leading position across its strategic pillars, as well as a highly diversified client list. 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).
2020 was a particularly difficult year for ADP. It is very closely reliant on the health of the economy, but the coronavirus pandemic had a negative impact on employment and economic growth. As a result, recent earnings reports have been underwhelming.
ADP reported fiscal second-quarter results on January 27th, 2021. Revenue increased 1% year-over-year to $3.7 billion. Employer Services sales totaled $759 million, easily beating consensus of $663 million. However, new business bookings declined 7%, which is also uncharacteristic for ADP.
While growth wasn’t very strong for ADP, the company did beat estimates widely by simply not contracting at the expected rate. Adjusted earnings-per-share were flat at $1.52 for the quarter. Despite the significant impact of the coronavirus pandemic, ADP management is confident that the headwind is only temporary, and that the company will return to growth in the years ahead.
Along with quarterly results, ADP also raised guidance for the current fiscal year. The company sees rapidly improving employment trends among its customers. As a result, revenue is now expected to be up 1% to 3% for fiscal 2021, which is up from the prior range of -1% to +1%. In addition, earnings-per-share are now expected to be -2% to +2%, which is up strongly from the prior range of -7% to -3%.
Source: Investor Presentation
Two key long-term 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 continues to grow, and we believe this will continue for the foreseeable future.
Next, the increasingly complex regulatory environment creates significant compliance costs for businesses; this also helps provide ADP with steady growth. We believe ADP is likely to succeed in executing on its long-term growth objectives, thanks in large part to its competitive advantages.
Competitive Advantages & Recession Performance
ADP’s growth is fueled by many competitive advantages. ADP has a deep connection with its customers, and enjoys a strong reputation for customer service, which 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 with 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. The reason for ADP’s continued growth during the Great Recession is that businesses still need payroll and human resource services, even in an economic downturn.
The company continued to perform relatively well in the 2020 economic downturn caused by the coronavirus pandemic. ADP remained highly profitable last year, which allowed it to maintain its streak of annual dividend increases.
The necessary nature of ADP’s services helps insulate the company from the effects of a recession. Given ADP’s size and scale, we believe it will perform well during the next recession, which increases the attractiveness of the stock. Rarely do investors find a combination of strong growth prospects and recession resilience, along with a world-class dividend increase streak.
Valuation & Expected Returns
We forecast adjusted earnings-per-share of approximately $5.90 for fiscal 2021. Based on the current share price of ~$165, the stock has a price-to-earnings ratio of 28. This is a fairly rich valuation by most standards, and it is high by ADP’s own historical norms as well. We see fair value for ADP at 24 times earnings, which is a meaningful discount to the current valuation. Indeed, should the stock return to its historical norm in terms of valuation, it would encounter a -3.0% annual reduction to total shareholder returns.
As a result, investors cannot rely on an expanding price-to-earnings ratio to fuel shareholder returns. Instead, future returns will be generated from earnings growth and dividends. The good news is that the company is growing at a high enough rate that it could help justify something close its current valuation. Still, the recent rally in the stock has made ADP less attractive from a valuation perspective.
We expect ADP to grow earnings-per-share by 8% annually over the next five years. In addition, the stock has a current dividend yield of 2.2%. The combination of a contracting P/E multiple, earnings growth, and dividends yields a total expected return of 7.2% per year through fiscal 2026.
ADP will almost certainly continue to increase its dividend for many years to come given that its fundamentals are so strong. ADP maintains a target payout ratio of 55%-60% of annual earnings, so the payout is very safe with room to grow.
The current annual dividend payout is $3.72 per share after the November 2020 increase. Based upon the forecast for earnings-per-share management provided, the payout ratio for this year should be 63%. With robust forecast earnings-per-share growth, ADP should have ample room to continue to raise the payout for many years to come.
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 moat keeps competitors at bay, and leads to high levels of profitability.
There should be plenty of growth going forward, both in terms of earnings and dividends. Regulations continue to become more complex. And, as the economy expands, companies are adding employees and increasingly use ADP’s services.
If a recession occurs, ADP should continue to increase its dividend, as customers will still need its services. Although ADP is a highly consistent dividend growth stock, 7.2% expected annual returns make the stock a hold. But ADP stock would be an attractive buy on any meaningful pullback in the share price, which would result in a lower valuation and higher dividend yield.