Automatic Data Processing (NASDAQ:ADP) was founded in 1949 in Patterson, New Jersey. The company provides businesses of all sizes with payroll, tax, and human resource services and software.
ADP has grown rapidly since 1949. The company now processes payroll for 1 in 6 (24 million total) workers in the United States, and another 12 million internationally. Over the last decade, ADP stock has compounded investor wealth at 13.2% a year.
This article examines ADP’s dividend, competitive advantage, growth prospects, recession performance, and valuation.
ADP has registered a decline in popularity among smart money investors as of late. At the end of September, 32 funds (out of some 730 tracked by Insider Monkey) held long positions in ADP, down from 42 funds a quarter earlier. These funds reported stakes with a total value of $957.22 million as of the end of the third quarter, which represented around 2.60% of the company’s outstanding stock. Andy Brown’s Cedar Rock Capital, David Harding’s Winton Capital Management, and Cliff Asness’ AQR Capital Management reported sizeable positions in ADP in their last 13F filings.
ADP Dividend Analysis
ADP has increased its dividend payments for 41 consecutive years, making the company a Dividend Aristocrat. The image below shows the company’s quarterly dividend history since 1983.
The company currently has a payout ratio of ~60% and a 2.7% dividend yield. ADP’s dividend yield is 0.5 percentage points above the S&P 500’s dividend yield of 2.2%.
The company’s payout ratio is generous without being overly aggressive. ADP’s management is targeting a payout ratio in the 55% to 60% range. This means dividends are likely to grow in line with earnings-per-share going forward.
ADP’s payout ratio wasn’t always so high. The company has expanded its payout ratio from 33% in 2005 to the 55%+ since 2010. With that in mind, take a look at the company’s long-term dividend yield history below:
The effects of the company’s payout ratio hikes are evident in its dividend yield history. ADP’s average dividend yield since 2010 is 2.4%. As mentioned above, the stock currently has a 2.7% dividend yield.
Business Segment Overview: PEO & Employer Services
ADP operates in two primary business segments. Each segment is shown below along with percentage of total earnings generated for ADP in its 1stquarter of fiscal 2016:
– Employer Services generated 87% of earnings
– PEO Services generated 13% of earnings
Both segments provide payroll, human resources, and compliance services to ADP’s customers. The PEO Services segment operates by creating a shared tax ID number with its small and medium sized business customers.
The Employer Services segment manages payroll (and other human resources and compliance activities), but does not create a shared tax ID number for its clients. That is the primary distinction between the two segments.
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Competitive Advantage
Imagine the agony a business goes through when finding the right compliance and payroll processing company…
ADP operates in a field where cutting corners can cost companies dearly. As a result, the human resources and payroll industry is not about commodity pricing, but rather quality service.
ADP is the Human Resources provider for over 80% of Fortune 500 companies. ADP’s market dominance is not confined to the U.S. The company is also the number one outsourced human resource provider in Europe.
Another competitive advantage for ADP is its global scale. The company can manage the payroll for virtually all employees of multi-national corporations. This is a key selling point that smaller rivals cannot match.
ADP’s size gives it the ability to better serve the largest multi-national companies in a way that reduces the complexity of their operations by having only one payroll provider globally.
The fundamental reason for ADP to exist (payroll taxes and government compliance) gives the company a very long expected life. ADP is not going anywhere anytime soon.
ADP’s Growth Prospects & Expected Total Returns
Automatic Data Processing (NASDAQ:ADP) is one of the largest companies in a very large industry. The human resources, compliance, and payroll industry is growing – and ADP is growing faster than the industry.
Source: NASDAQ 33rd Investor Program Presentation, slide 10
There are a two primary growth drivers for the industry in general and ADP in particular:
– Global GDP Growth
– Growing Regulatory Burdens
As the global economy grows, more businesses will need more payroll processing and human resources services.
On top of this, growing regulatory burdens – both in the United States and internationally – incentivize businesses (especially small businesses) to outsource payroll services.
Source: NASDAQ 33rd Investor Program Presentation, slide 15
These two growth drivers combined with expanding services from ADP will drive above-average growth for ADP going forward. The company’s management is targeting long-term total returns of 14% to 17% (!) a year from the following sources:
Source: NASDAQ 33rd Investor Program Presentation, slide 22
Obviously, returns in the mid-teens would be exceptional. Can the company really grow at this rate? Each of management’s expected growth drivers are compared to historical or current results below.
Expected dividend yield of 2% to 3%
ADP currently has a 2.7% dividend yield. There is no question that management’s expected dividend yield is in line with current numbers.
Expected share repurchases of ~1% a year
The company has reduced its share count by 2% a year over the last decade. Again, this estimate appears very reasonable.
Revenue growth of 7% to 9%
ADP has grown its revenue 2.3% a year over the last decade. I find it difficult to believe that ADP will be able to grow its revenue at 3x to 4x its historical rate over the last decade over a longer period of time. With that said, the company’s performance in recent years has been stronger. As a result, I believe a more reasonable (given historical numbers) revenue growth estimate is 3% to 7% per year.
Margin expansion of 4% per year
Can any company expand its margins at 4% a year consistently? I certainly don’t think so. Margins can only expand so much in a competitive environment. ADP’s net profit margin in 2005 was 12.4%. In 2015, it was 12.6%. A better margin expansion estimate is 1% to 2% per year.
With the above adjustments above, investors in ADP should expect total returns of 7.7% to 12.7% a year from the following sources:
– Dividend yield of 2.7%
– Share repurchases of 1.0% per year
– Revenue growth of 3% to 7% per year
– Margin expansion of 1% to 2% per year
Valuation – Is Now the Time to Buy ADP?
With a payout ratio range of 55% to 60% and a dividend yield range of 2% to 3%, this means management is estimating a fair price-to-earnings ratio of 18.3 to 30.
Based on ADP’s expected total returns, shareholder friendly management, stability, and competitive advantage, I believe a fair price-to-earnings multiple for the company is around 20.
ADP is currently trading for a price-to-earnings multiple of 26.2. This is near the higher end of management’s price-to-earnings ratio estimate, and above my estimate of fair value. For comparison, the S&P 500 is currently trading for a price-to-earnings ratio of 20.3.
For investors looking to initiate or add to a position in ADP, I would wait until the company is trading below a price-to-earnings ratio of 20. A price-to-earnings ratio below 18 would make ADP a bargain.
ADP’s Recession Performance
ADP performed very well during the recession of 2007 to 2009. The company’s revenue per share and earnings per share increased each year from 2007 to 2009.
Despite economic downturns, businesses must pay employees and keep up with government regulation.
As a result, ADP is fairly well insulated from the effects of recessions. The company’s earnings-per-share through the Great Recession are shown below:
– 2007 earnings-per-share of $1.83
– 2008 earnings-per-share of $2.20
– 2009 earnings-per-share of $2.39
– 2010 earnings-per-share of $2.39
Final Thoughts
Automatic Data Processing (NASDAQ:ADP) is a high quality blue chip stock with good future growth prospects. The company is the dominant player in the payroll and human resources industry and offers shareholders safety due to its competitive advantages and conservative balance sheet.
The downside to the company is that it appears to be somewhat overvalued at this time. As a result, ADP does not rank particularly well using The 8 Rules of Dividend Investing.
Disclosure: None
