Automatic Data Processing (ADP, Financial), which provides businesses of all sizes with payroll, tax and human resource services and software, has compounded investor wealth at 13.2% a year in the last decade.
Automatic Data Processing was founded in 1949 in Patterson, New Jersey. It has grown rapidly since 1949. The company now processes payroll for one in six (24 million total) workers in the U.S. and another 12 million internationally.
Dividend analysis
Automatic Data Processing 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. Automatic Data Processing’s dividend yield is 0.5 percentage points above the Standard & Poor's 500’s dividend yield of 2.2%.
The company’s payout ratio is generous without being overly aggressive. Automatic Data Processing’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.
Automatic Data Processing’s payout ratio wasn’t always so high. The company has expanded its payout ratio from 33% in 2005 to 55%-plus 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. Automatic Data Processing’s average dividend yield since 2010 is 2.4%. As mentioned earlier, the stock currently has a 2.7% dividend yield.
Business segment overview: PEO and Employer Services
Automatic Data Processing operates in two primary business segments. Each segment is shown below along with percentage of total earnings generated for Automatic Data Processing in its first quarter 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 Automatic Data Processing’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.
Competitive advantage
Imagine the agony a business goes through when finding the right compliance and payroll processing company.
Automatic Data Processing 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.
Automatic Data Processing is the human resources provider for over 80% of Fortune 500 companies. Automatic Data Processing’s market dominance is not confined to the U.S. The company is also the No. 1 outsourced human resource provider in Europe.
Another competitive advantage for Automatic Data Processing is its global scale. The company can manage the payroll for virtually all employees of multinational corporations. This is a key selling point that smaller rivals cannot match.
Automatic Data Processing’s size gives it the ability to better serve the largest multinational companies in a way that reduces the complexity of their operations by having only one payroll provider globally.
The fundamental reasons for Automatic Data Processing to exist (payroll taxes and government compliance) give the company a very long life expectancy. Automatic Data Processing is not going anywhere anytime soon.
ADP’s growth prospects and expected total returns
Automatic Data Processing is one of the largest companies in a large industry. The human resources, compliance and payroll industry is growing – and Automatic Data Processing is growing faster than the industry.
Source: NASDAQ 33rd Investor Program Presentation, slide 10
There are two primary growth drivers for the industry in general and Automatic Data Processing 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 U.S. 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 Automatic Data Processing will drive above-average growth for Automatic Data Processing 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%
Automatic Data Processing 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%
Automatic Data Processing has grown its revenue 2.3% a year over the last decade. It is difficult to believe that Automatic Data Processing 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, 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? Margins can only expand so much in a competitive environment. Automatic Data Processing’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, investors in Automatic Data Processing 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 Automatic Data Processing’s expected total returns, shareholder-friendly management, stability and competitive advantage, a fair price-to-earnings multiple for the company is around 20.
Automatic Data Processing 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.
Investors looking to initiate or add to a position in Automatic Data Processing are encouraged to wait until the company is trading below a price-to-earnings ratio of 20. A price-to-earnings ratio below 18 would make Automatic Data Processing a bargain.
ADP’s recession performance
Automatic Data Processing performed very well during the recession of 2007 to 2009. The company’s revenue per share and earnings per share increased each year.
Despite economic downturns, businesses must pay employees and keep up with government regulation.
As a result, Automatic Data Processing 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 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.
