Searching for stocks with good dividends and solid fundamentals? One way to find such stocks is to check out GuruFocus' Dividend Growth Portfolio screener. Only 14 stocks currently make this list due to the strict criteria, and one of those is Automatic Data Processing Inc. (ADP, Financial), better known as ADP.
In this article, we will review ADP based on the Dividend Growth Portfolio screening criteria to see why I believe we can trust this company to sustainably deliver rising dividends over the long term.
Financial strength
The first criteria on the screener is the GuruFocus financial strength rank, which must be at least 6 out of 10. ADP just meets that benchmark. Reviewing the middling rank, we see its debt has been rising while its cash and cash equivalents have shrunk over most of the past decade:
At the end of the company's fiscal year 2022, which was on June 30, it carried just under $3 billion in long-term debt. Why the growing debt? In part, it’s because ADP was able to take out fixed-rate notes with interest rates ranging between 1.83% and 3.47%. That’s very inexpensive capital.
Otherwise, it has a reasonable interest coverage ratio of 23.13 but a concerning Altman Z-Score of 2.14, which is in the grey zone, implying some minor risk of bankruptcy.
Profitability
The GuruFocus profitability rank hurdle is a bit higher at 7 out of 10, but ADP passes it easily with a 9 out of 10 rank. The following chart of the income statement shows a net margin of more than 18.40%:
The operating margin is another requirement it has no trouble meeting, clearing the minimum hurdle of 10.0% at 21.26%. The company also was profitable in 10 of the past 10 years, another screener requirement.
Growth
In the revenue category, the screener calls for an average five-year revenue growth rate of at least 3.0% per year. The company exceeds that with a rate of 6.90%.
It’s a similar story for the five-year earnings per share without non-recurring items growth. The requirement is an average of at least 5.0% per year, while ADP delivers an average of 12.10% per year.
While it’s not required by the screener, I also wanted to know about ADP’s free cash flow, which is the source of dividend funding. Over the past five years, it has grown by an average of 10.30% per year, which is enough to fund an ambitious dividend growth program.
Dividends
To qualify for the Dividend Growth Portfolio, a company needs a dividend yield of at least 2.10%, and ADP currently yields 2.12%. To put these numbers into context, the S&P 500 average dividend yield for March 2023 was 1.66%. This close to the edge, it's possible ADP could rop off the screener if the share price rises.
The second metric is the five-year dividend growth rate, which must be at least 5.0%. At 12.90%, ADP easily passes that hurdle. Still, make a note that free cash flow has increased by an average of just 10.30% per year over the past five years.
Next comes the dividend payout ratio, which must be less than 60.0%, and the company just barely squeaks by with 58.0%. This is another area that may push it off the screener.
In its consolidated fiscal 2023 outlook, which was part of the fourth quarter fiscal 2022 earnings report, ADP said it expects its adjusted diluted EPS growth to be between 13.0% and 16.0%. As we saw above, the five-year dividend growth rate has been 12.90%.
The dividend payout ratio is calculated by dividing the dividends per share by earnings per share without non-recurring items. Assuming the latter is close to the adjusted diluted EPS, that could be enough to push the payout ratio over 60.0%.
My take
Given the possibility that the stock could fall from the Dividend Growth Portfolio screener because of the yield or payout ratio, is it worth considering for dividend investors? I believe it is. The stock is considered modestly undervalued by the GF Value chart, which sees a 13.81% margin of safety. That’s reinforced by a look at its five-year price chart. The chart shows a sawtooth pattern, with sharp rises and dips in recent years. And at the moment, it appears to be at or near the bottom of the cycle.
Overall, the company has a GF Score of 92 out of 100. According to a backtesting study by GuruFocus, stocks with higher GF Scores tend to perform better than those with lower GF Scores. The ranks for profitability and growth suggest its dividend will be sustainable in the long term.
Investors now have an opportunity to lock in the current dividend yield and perhaps bag a significant capital gain if and when the share price rises again. Both benefits would be on top of owning a stock with a solid history of raising its dividend payments more quickly than inflation.
