Automatic Data Processing Inc. (ADP, Financial), the largest provider of business outsourcing solutions in the U.S., held up well during its most recent quarter. Given the number of jobs that have been lost over the last quarter to the Covid-19 pandemic, this is a surprising result. At the same time, Automatic Data Processing offers a yield higher than its historical average that is well protected by free cash flow.
Let's look closer at Automatic Data Processing to see why long-term investors should consider buying shares of the company now.
Company background, quarterly highlights and analysis
Automatic Data Processing is composed of two segments: Employer Services, which provides payroll and tax services, and Professional Employer Organization Services, which supplies all-inclusive human resources services to smaller companies. Employer Services account for 70% of revenues, while the PEO services contributed the rest. Automatic Data Processing works with more than 700,000 corporate customers around the country. The company is valued at just under $60 billion as of Tuesday's close.
Automatic Data Processing reported earnings results for the fourth-quarter and full fiscal year 2020 on July 29 (the company's fiscal year ends June 30).
Source: Automatic Data Processing's Fourth-Quarter Earnings Presentation, slide 4.
Revenues were down 3% to $3.4 billion, though this was $55 million ahead of what Wall Street analysts had expected. Adjusted earnings per share of $1.14 were flat from the prior year, but 18 cents better than consensus estimates.
For fiscal 2020, revenue improved 3% to $14.6 billion. Organic growth was 4% when adjusted for currency exchange rates. Adjusted earnings per share grew 47 cents, or 8.6%, to $5.92.
Revenues for the Employer Services division declined 6% to $2.3 billion for the quarter. Organic growth declined 5%. New bookings were down 67% on a sharp decline in employment and lower spending by clients. Pays per control decreased nearly 11%.
On the plus side, client revenue retention declined just 20 basis points to 90.5%. Automatic Data Processing struggled to gain new clients during the quarter, but this shouldn't be a shock due to what the business environment looked like during this time. In addition to a very strong retention rate, the Employer Services segment's margins were flat at 25.7%, showing that the company managed its costs extremely well during the quarter. Despite the headwinds from the fourth quarter, margins actually improved 60 basis points for the year.
The Professional Employer Organization Services segment had a 4% improvement in revenue to $1.1 billion in the fourth quarter. Average worksite employees paid by PEO Services was down 3% to 548,000, but grew 4% to 571,000 for the year. Margins did decrease 450 basis points to 10.9% due to losses in ADP Indemnity, which provides workplace compensation insurance.
Interest on funds held for client fell 22% to $115 million, while average client funds balance was down 8% to $24 billion. Average interest yield on client funds decreased 30 basis points to 1.9% for the quarter.
Automatic Data Processing has a very impressive balance sheet. The company ended the fiscal year with current assets of $31.6 billion, including $1.9 billion of cash and cash equivalents. The company does have $30 billion in current liabilities, but just $1 billion of current debt. In fact, it has less than $2.4 billion of total debt on its balance sheet. This leaves Automatic Data Processing in excellent financial shape, which should allow the company to weather the Covid-19 pandemic.
Despite a tough fourth quarter, the company's free cash flow for the year improved $755 million, or 60%, to $2.4 billion.
Automatic Data Processing also gave guidance for fiscal 2021. The company anticipates a revenue decline of 1% to 4% while adjusted earnings per share is seen as falling 13% to 18%. The company expects to see a weak environment through at least its third quarter (end of March) before turning positive in its fourth quarter.
According to Yahoo Finance, the analyst community believes Automatic Data Processing will earn $5 per share in fiscal 2021, down 15.5% from the previous year's result.
Automatic Data Processing wasn't expected to show growth during the fourth quarter as the business community has been severely impacted by the Covid-19 pandemic. Still, the company topped reduced expectations on both revenue and earnings. The fiscal year results were still solid, showing that the company can perform well outside of a pandemic.
The company also held up nicely during the last recession. It saw a 31% increase in earnings per share from 2007 to 2009. Results look good even when adjusting for the reduced share count as net income improved more than 22%.
The company has generally done well over the last decade as earnings have compounded by almost 9% annually. Revenues have nearly doubled and the net profit margin has improved more than 400 basis points during this time.
The ability to grow during a recession and put up strong numbers in a more normalized business environment bodes well for Automatic Data Processing's future.
Dividend and valuation analysis
At 44 years, Automatic Data Processing has one of the longest dividend growth streaks in the market. This shows the company has proven to be adept at growing its dividend payment through all portions of the economic cycle.
According to the Dividend Investing Resource Center, Automatic Data Processing has raised its dividend by an average of:
- 14.2% per year over the past three years.
- 13.4% per year over the past five years.
- 10.6% per year over the past 10 years.
Companies with lengthy dividend growth streaks often have declining dividend growth rates, but Automatic Data Processing bucks this trend and has actually provided higher average growth over the listed periods of time.
As evidence of this, Automatic Data Processing raised its dividend by 15.2% for the payment made Dec. 31, 2019. This is higher than the three-year average raise and was an improvement from the prior year's dividend increase of 14.5%.
Shareholders will receive at least $3.64 in dividends per share in 2020. Using analysts' earnings per share estimates, the payout ratio would be 73%. The average payout ratio since 2010 is 60%, so this year's projected payout ratio is meaningfully higher than usual. This can be explained by the impact from Covid-19 on results. Because of this, there is a chance dividend growth this year will not be as generous as in the past.
The company's free cash flow payout ratio is much better.
Automatic Data Processing distributed $1.5 billion worth of dividends in fiscal 2020, which results in a payout ratio of 63%. For the prior three fiscal years, dividends paid totaled $3.35 billion and free cash flow generated was $5.8 billion for an average payout ratio of 58%.
The company's free cash flow is much more reassuring than the earnings per share payout ratio. This should be taken as a sign that the company's dividend is well covered and should be safe from a cut.
Shares of Automatic Data Processing yield 2.6% at the moment. According to Value Line, this is above the 10-year average yield of 2.5% and the five-year average of 2.3%.
Automatic Data Processing closed Tuesday at $138.53. Using expected earnings of $5 per share for the year, shares have a forward price-earnings ratio of 27.7. This is a discount to the five-year average price-earnings ratio of 28.3, but a premium to the 10-year average price-earnings ratio of 25.3.
Final thoughts
Automatic Data Processing felt the effects of the loss of jobs related to Covid-19 in the most recent quarter, but still produced results that were better than expected. The company expects that fiscal 2021 will be a challenge as well since management believes that a rebound in jobs won't occur until the fourth quarter.
While challenged short-term, investors holding the stock are getting a higher-than-usual dividend yield that is more than covered by both earnings per share and free cash flow. Automatic Data Processing has proven over the last four decades that it can and will raise its dividend, which should reassure income investors.
The current valuation makes it look like Automatic Data Processing's stock is approaching fairly valued status at best and is approximately 9% overvalued at worst. For those with a longer investment time frame, the stock looks a bit more promising. Analysts expect that the company will produce earnings of $5.96 per share for fiscal 2022, which results in a multiple of 23.2 times next fiscal year's earnings.
The analyst community understands that fiscal 2021 is going to be difficult for the company, but they expect Automatic Data Processing to return to growth the following year. Those covering the company can always be wrong, but investors who are patient and understand the circumstances could do well long term by buying Automatic Data Processing while enjoying an above-average dividend yield. For those investors, Automatic Data Processing looks like a buy.
Disclosure: The author has no position in any stock mentioned in this article.
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