Updated January 11th, 2019 by Josh Arnold
Automatic Data Processing (ADP) might not be a household name, but it should be for dividend growth investors.
Automatic Data Processing, or ADP for short, has raised its dividend each year for 44 years in a row. Its most recent increase came in December of 2018, when the company implemented a very strong 14.5% raise.
ADP is a member of the Dividend Aristocrats, a group of 53 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 huge competitive advantages. This article will review ADP’s fundamentals and discuss whether the stock is trading at an attractive valuation right now.
Business Overview
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 approximately 700,000 clients, in more than 110 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 Day Presentation, page 9
ADP has a leading position across its strategic pillars, as well as 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.
Growth Prospects
ADP has produced strong growth in recent years and we expect that will continue. The company recently reported fiscal 2019 Q1 earnings, which was another terrific quarter. Total revenue increased 8%, to $3.3 billion. Excluding the impact of currency exchange, organic revenue increased 7% for the first quarter.
Strength was seen in both of its business segments as Employer Services saw bookings rise 8%, while PEO produced 9% growth in employees during the quarter. ADP also raised its revenue growth forecast for the fiscal year to 6% to 7% from the prior range of 5% to 7%.
Revenue growth, margin growth, a lower tax rate, and share repurchases combined to drive a staggering 28% gain in earnings-per-share in Q1.
Source: Earnings Slides, page 4
Both core segments performed well once again in Q1. Revenue increased 7% for Employer Services while PEO saw a 10% increase in the top line. In addition, margins rose significantly for both segments, increasing 260bps and 110bps, respectively, during what was an extremely productive first quarter.
For fiscal 2019, ADP is a bit more cautious as it has guided for 6% to 7% revenue growth. Employer Services is expected to contribute 4% to 6% and PEO was guided for 8% to 9% on a reported basis, while excluding zero-margin benefits pass-through revenue will bring segment growth down to 6% to 7%. Still, adjusted EBIT margin should rise 100bps to 125bps in fiscal 2019, helping to lead to 15% to 17% adjusted earnings-per-share growth during the year.
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 is forecast to increase by 2.5% in fiscal 2019, continuing years of steady growth.
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 6%-8% in the current fiscal year, in addition to a slightly higher customer retention rate.
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, 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 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. The reason for ADP’s continued growth during the Great Recession is that businesses still need payroll and human resource services. This helps insulates ADP from the effects of a recession.
Valuation & Expected Returns
ADP forecast adjusted earnings-per-share of approximately $5.26 for fiscal 2019. Based on the current share price, the stock has a price-to-earnings ratio of 25. 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 20 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 be a mid-single digit (-4.4%) headwind to total returns annually.
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 its current valuation.
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 2.4%. The combination of a contracting P/E multiple, earnings growth, and dividends yields a total expected return of 6% per year through 2024.
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 always very safe with room to grow. The payout for fiscal 2019 is $3.16 per share. Based upon the forecast for earnings-per-share management provided, the payout ratio for this year should be right at 60%.
Final Thoughts
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 and using ADP’s services.
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 growth stock, although its mid-single-digit expected total returns make the stock a hold.
