This article first appeared on Dividends & Income
Automatic Data Processing (ADP) is a leader in what used to be called payroll processing, but today is referred to as cloud-based human capital management (HCM) solutions. ADP serves over 860,000 clients in 140 countries and territories.
ADP’s Dividend Record
This is a really good dividend record. The only thing you wish were better is the yield itself.
The 2.6% yield would be considered too low by some investors, but plenty good enough by many others, especially:
- younger investors with many years of investing ahead of them, and
- older investors with a “complete” dividend growth portfolio who are looking to round it out with a few high-quality defensive companies.
At 2.6%, ADP’s yield is still 50%+ higher than the S&P 500’s yield of 1.7%. And it’s combined with ADP’s fast dividend growth rate: Over 13% per year for the past five years, and almost 11% per year for the past 10.
With so many people out of work because of the Covid recession, we must consider that ADP’s annual end-of-year dividend increase could be in jeopardy for 2020.
The company usually declares its December dividend, including the annual raise, in early November.
We’ll find out then whether ADP’s 44-year streak of increasing its dividend survives its fifth recession.
ADP’s Business Model and Company Quality
ADP was founded in 1949 on what was then an innovative idea: Help business owners focus on their core business activities by freeing them from certain non-core tasks such as payroll. What we now call “business outsourcing” was not common then. Most companies handled their own payrolls.
Today’s ADP customer coverage is vast.
ADP follows three “strategic pillars” to guide its actions:
- Grow a complete suite of cloud-based HCM solutions (HCM Solutions).
- Grow and scale its market-leading HR Outsourcing solutions (HRO Solutions).
- Leverage its global presence to offer clients HCM solutions wherever they do business (Global Solutions).
ADP pioneered automation in HCM, most recently by introducing cloud and mobile versions. The company serves its strategic pillars through successful product and technology innovation, providing industry-leading service and compliance expertise, and enhancing its world-class distribution.
In its 4th-quarter report for fiscal 2020 (their fiscal year ends in June), ADP stated that its client service and product innovation are competitive differentiators, with client satisfaction standing at or near record levels across its business units.
ADP’s next-gen payroll solution supports workers of all types and enables real-time, transparent, continuous payroll calculations. It also provides flexible pay choices. Compliance capabilities are built-in.
ADP serves a diverse range of businesses and workforce models across a spectrum of types and sizes of businesses and many geographies, that are used to recruit, pay, manage, and help retain their clients’ workforces. Examples of products include:
- RUN Powered by ADP, serving over 690,000 small businesses (<50 employees)
- ADP Workforce Now, serving approximately 75,000 mostly mid-sized businesses (50-999 employees)
- ADP Vantage HCM, serving over 500 large enterprise businesses (>1000 employees)
ADP SmartCompliance can be combined with any of the above to address increasingly broad and complex compliance needs of employers. Outside the United States, ADP addresses the needs of over 60,000 clients with local in-country solutions and multinational offerings.
As one would expect, the Covid-19 outbreak has had a significant impact on ADP’s clients, resulting in a negative impact on ADP’s revenue and new business bookings. Per its latest report, ADP considers Covid’s overall impact to be unpredictable on a variety of levels:
- Duration and scope of the event
- Governmental and business actions taken in response
- Cost of responses initiated by ADP
- Impact on economic activity and employment levels
- Ability to sell and provide solutions and services to clients
- Ability of ADP’s clients to pay.
Despite the “pause” caused by Covid-19, ADP gets very high marks for its business quality from third-party evaluators.
In my own personal grade, I would have given ADP an A except for Covid.
ADP’s Financials
ADP gets an A++ financial grade from Value Line, their highest grade, a designation that the company has held since 1992. Let’s look at specific financial categories and see if we agree.
Return on Equity (ROE) is a standard measure of financial efficiency. ROE is the ratio of profits to shareholders’ equity.
The average ROE for all Dividend Champions, Challengers, and Contenders is about 15%, which is similar to the ROE for S&P 500 companies generally. The following chart shows ADP’s ROE for 2011-2020 (fiscal years ending in June).
[Source of all yellow-bar charts: Simply Safe Dividends]
ADP’s ROE is extraordinarily high. It has been over 40% the past four fiscal years. As we will see next, ADP’s high ROE is not a result of being highly leveraged.
Debt-to-Capital (D/C) ratio measures how much a company depends on borrowed money. Companies finance their operations through a mixture of debt, equity (new shares), and their own cash flows.
A typical D/C ratio for a large, healthy company is 50%, meaning equal dependence on debt and equity. Debt is an indicator of financial risk. All else equal, stocks with high D/C ratios are riskier than those with low D/C ratios.
ADP does not have a high reliance on debt. Its long-term debt level has never been above 33% in the past decade. In a couple of years, it was close to zero.
And as noted earlier, ADP has a high investment-grade credit rating of AA. Debt should not be a problem for this company.
Operating margin measures profitability: What percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses?
Per recent research, typical operating margins for S&P 500 companies have been in the 11-12% range.
Once again, ADP shines, with operating margins close to or exceeding 20% every year in the past decade.
Earnings per Share (EPS) is the company’s officially reported profits per share. We want to see if a company has had years when it officially lost money, or if its earnings are steadily increasing, declining, or flat.
ADP’s earnings have all been positive in the last decade, and it is on a seven-year streak of rising each year.
Analysts are projecting a 16% drop in EPS for 2021 due to Covid-19, followed by a 19% increase in 2021, followed by a 10% increase in 2022. Of course, these estimates must be considered little more than educated guesses at this time.
Free Cash Flow (FCF) is the money left over after a company pays its operating expenses and capital expenditures. Whereas EPS is subject to GAAP accounting rules, cash flow is a more direct measure of money flowing through the company. It is the cash that a company has available for dividends, stock buybacks, and debt repayment.
FCF is yet another strong financial metric for ADP. The company has been a cash-generating machine. That’s one of the reasons that its dividend is so safe.
Share Count Trend shows whether the company’s outstanding shares are increasing in number, decreasing, or remaining flat.
I like declining share counts, because the annual dividend pool is spread across fewer shares each year. By retiring its own shares, the company is investing in itself, expanding each remaining share into a larger piece of the pie, and improving all per-share statistics.
ADP has been reducing share count steadily over the past decade. It has about 13% fewer shares now than it had 10 years ago.
The company approved a $5 billion share-repurchase program in 2019, and it has used very little of that money to date.
Here is a summary of the items above:
That’s about as much green in one of these tables as I can remember from the several years that I have been writing Dividend Growth Stock of the Month articles. The numbers fully support Value Line’s A++ rating.
My own grade would be an A, and if I had an A+ in my grading system, I would consider giving it to ADP. The potential weak spot looking forward, obviously, is the depth and length of the negative impact of Covid-19.
ADP’s Stock Valuation
My 4-model process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation. Let’s go through the steps.
Models 1 and 2: FASTGraphs relative P/Es.
This month for the first time, I am presenting both FASTGraphs models in the same section.
These two models compare the stock’s current price to (1) FASTGraphs’ basic estimate of its fair value, and (2) the stock’s own 5-year average valuation.
The orange line is FASTGraph’s default valuation line, based on a standard price-to-earnings ratio (P/E) of 15. The blue line is a second valuation reference line, based on ADP’s average 5-year valuation, which is 28.3.
The black line is ADP’s actual price. Since it now lies between the orange and blue reference lines, it is overvalued compared to one but undervalued compared to the other.
We can easily compute what I call “valuation ratios” by comparing ADP’s actual current P/E (24.1 as shown in the blue box) to the values used to draw the orange and blue lines. We do that by making a ratio out of the P/Es.
- Based on default (orange) P/E: 24.1 / 15 = 1.61.
- Normalized, based on historical (blue) P/E: 24.1 / 28.3 = 0.85
The first valuation ratio suggests a fair price for ADP is $139 / 1.61 = $86. The second valuation ratio suggests a fair price of $139 / 0.85 = $164.
Model 3: Morningstar Star Rating. Morningstar ignores P/E ratios. Instead, they use a discounted cash flow (DCF) process for valuation. Their approach is comprehensive and detailed. Many investors consider DCF to be the best method of assessing stock valuations.
Morningstar creates a detailed projection of all the company’s future cash flows. Each year’s number is discounted back to the present to reflect the time value of money, then they are added up. The resulting net present value of all future cash flows is considered to be the fair price for the stock today. They update their estimates periodically.
Morningstar considers ADP to be fairly valued, as shown by the 3-star rating on their 5-star scale. They calculate a fair price of $136.
Model 4: Current Yield vs. Historical Yield. Last, we compare the stock’s current yield to its historical yield. This approach to calculating fair value is based on the idea that if a stock’s yield is higher than normal, it may indicate that its price is undervalued (and vice-versa).
ADP’s current yield is 2.6%, compared to its 5-year average of 2.2%. That gives us a valuation ratio of 0.85 and a fair price of $164.
Valuation Summary:
Valuations are efforts to predict future price movements. If financial conditions return to normal after the Covid pandemic dies out, in a couple of years it is possible that ADP could look like a steal at its current price. Being able to obtain the stock with a yield 18% higher than its 5-year average is very attractive.
Miscellaneous Factors
Beta
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility, because they present fewer occasions to react emotionally to rapid price changes, especially sudden price drops that can induce a sense of fear. There is also academic research that suggests that low-volatility stocks outperform the market over long time periods.
ADP’s 5-year beta of 0.8 compared to the market as a whole (defined as 1.0) means that its price has moved about 20% less than the market on average. This is a positive factor.
Analyst’s Recommendations
Thomson Reuters’ IBES database compiles Wall Street analysts’ current recommendations. This is their latest summary:
The average recommendation of “hold” is a neutral factor.
What’s the Bottom Line on Automatic Data Processing?
Here are ADP’s positives:
- Very good dividend resume: Decent yield at 2.6%; 44 straight years of increases spanning four recessions; strong dividend growth record (13% per year over past 5 years); and excellent dividend safety.
- Excellent business model and high-quality company ratings.
- Excellent financial metrics highlighted by good profitability, moderate debt, consistent positive earnings, and characteristics of a “cash-flow-machine.”
- Fair price for high-quality 44-year dividend growth company.
ADP’s only negative, as I see it, is the global Covid-19 pandemic. For obvious reasons, the pandemic directly affects ADP’s employee-centric business products and services. Those effects will continue for an unpredictable length of time.
Overall, I see ADP as an intriguing candidate for a dividend-growth investor buying for the long term. It is a very high-quality company selling for a fair price, its dividend yield is higher than usual, and presumably business conditions will return to “normal” over the next one to three years.
That said, this is not a recommendation to buy, hold, or sell ADP. Any investment requires your own due diligence. Always be sure to match your stock picks to your personal financial goals.
Other Reading
We Just Bought Automatic Data Processing (ADP) for our Income Builder Portfolio (Mike Nadel, August 2020)
When to Buy or Sell a Stock, Part 3 (Chuck Carnevale, December 2019) — discusses ADP’s historically high valuation
And Now … A Few Words About My Upcoming E-Book
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Source: Dividends and Income