Automatic Data Processing (ADP): 41 Straight Years of Dividend Increases

With more than four consecutive decades of dividend increases, Automatic Data Processing (ADP) is one of my favorite dividend aristocrats.

 

The company’s excellent dividend growth track record is the result of its reliable business model.

 

ADP benefits from providing mission-critical services, generating a high percentage of recurring revenues, maintaining a strong client retention rate, running asset-light operations, and throwing off loads of free cash flow each year.

 

Although ADP’s stock has nearly doubled the market’s performance over the last decade, the company has plenty of room for continued growth.

 

Not surprisingly, ADP scores extremely well for Dividend Safety and Dividend Growth and is the type of business I like to own in our Top 20 Dividend Stocks portfolio. Let’s take a closer look at the business.

 

Business Overview

ADP has been in business for more than 65 years and is one of the largest providers of human capital management (HCM) solutions in the world.

 

ADP offers a wide range of cloud-based software solutions and services, which companies use to pay, recruit, staff, manage, and retain employees.

 

According to the company’s annual report, over 50 million people around the globe depend on ADP for accurate pay, reliable benefits administration, effective performance management, or other human resource services.

 

The company generates most of its revenue from providing payroll services (handles the preparation of employee paychecks, pay statements, journals, and summaries) but has meaningfully expanded its suite of products over the last decade to cover most of the HCM spectrum.

 

The HR Business Process Outsourcing market has been a major focus. In this market, ADP offers fully integrated outsourcing solutions that enable companies to outsource their HR, time and attendance management, payroll, and benefits administration functions to ADP.

 

Overall, ADP provides HCM solutions to more than 630,000 businesses, which range from single-employee companies to some of the world’s largest enterprises. In fact, ADP serves over 80% of Fortune 500 companies, over 90 Fortune 100 companies, and more than 440,000 small businesses. No client accounts for more than 2% of total revenue.

 

By geography, approximately 81% of ADP’s sales are generated in the U.S., 11% in Europe, 4% in Canada, and 4% in other countries.

 

Segments

Employer Services (77% of total segment revenue; 90% of total segment earnings): provides a wide range of business outsourcing and technology-enabled HCM solutions, including payroll services, benefits administration, recruiting and talent management, HR management, insurance services, retirement services, and compliance solutions.

 

Professional Employer Organization Services (23% of total segment revenue; 10% of total segment earnings): serves approximately 8,700 clients with employment administration outsourcing solutions. ADP helps small and mid-sized businesses with HR management and employee benefits functions.

 

Business Analysis

ADP’s primary competitive advantages are derived from its scale and long-standing customer relationships.

 

The company has the most complete suite of products and services in the HCM market. ADP also boasts the broadest market coverage by geography and client size. In fact, ADP services 104 countries and covers 99% of multinational employees.

 

As a result of its scope, ADP can offer a more complete suite of cloud-based HCM solutions to expand its existing client relationships. It is also uniquely positioned to serve larger clients with operations spread around the world. This is no small task thanks to the different regulations, languages, and integration issues from one country to the next.

 

With more than $10 billion in annual revenue and little capital required to run its business (capital expenditures were just 1.4% of sales last year), ADP also has the luxury to reinvest heavily in the latest solutions and technology.

 

The company has spent several decades building out the depth and breadth of its solutions and invested $767 million in systems development and programming during fiscal year 2015 to further improve its offerings. These investments have helped the company transition more than 80% of its customers to cloud-based software and get 5 million people using its mobile app.

 

ADP can also acquire smaller companies with solutions or technologies it can use to further broaden its suite of HCM solutions.

 

As ADP becomes more ingrained with clients, switching costs rise because users are trained to use more of ADP’s software solutions.

 

Additional switching costs are created by many of the challenges ADP solves for clients. ADP manages complex regulatory environments for many businesses to make sure they remain compliant with the law.

 

ADP handles employment taxes, tax credits, unemployment claims, workers compensation, and healthcare reform issues. Its clients must comply with each regulation to remain in business and avoid fees, increasing their dependence on ADP’s expertise and ability to manage complex transactions.

 

Over the years, ADP has established a relationship built on trust and reliability with clients. After all, ADP handles some of the most sensitive information about its clients’ employees (e.g. tax statements, social security numbers, healthcare information).

 

Building up the necessary security systems and technology infrastructure to safeguard this data takes many years of heavy investments, but winning clients’ trust takes even more time.

 

As a result, ADP enjoyed a 91.4% client retention rate in fiscal year 2015. Client retention is estimated at approximately 12 years in Employer Services and 7 years in Professional Employer Organization Services, highlighting the important role ADP plays for its clients.

 

Long-lasting relationships with hundreds of thousands of businesses have provided another advantage that will likely become increasingly important over the coming years – big data analytics.

 

Big data is transforming virtually every industry today, and human capital management is no exception. Companies are constantly looking for ways to better identify talent, hire the right people, retain them for longer, and make them more productive.

 

ADP has more employee records than all of its competitors, providing it with a treasure trove of data that can be used for more detailed and insightful benchmarking for clients.

 

Management is also opening up the company’s platforms via APIs to add further value for clients. This action allows clients to integrate ADP’s HCM platforms with the rest of their enterprise suite. Third-party developers can also create applications that exchange data with ADP’s core HCM systems to further improve productivity and gain new insights.

 

While data and analytics could further solidify ADP’s market position and provide new growth opportunities, the HCM market is still very attractive as it stands today. The market is estimated to be $110 billion in size, which gives ADP a market share of approximately 10%.

 

The HCM market is also growing at a mid-single digit rate, providing plenty of opportunity for ADP’s sales team of 5,500 employees to continue expanding the company.

 

Increasing regulations are further helping growth for the industry and ADP. For example, ADP recently launched the ADP Health Compliance product line, which assists mid and large companies in complying with the requirements of the Affordable Care Act in the U.S.

 

A final unique element about ADP’s business is its holding of client funds. ADP holds over $21 billion of client funds that are primarily used to pay clients’ employees as part of ADP’s payroll processing services.

 

ADP invests these funds predominantly in AAA/AA-rated fixed-income securities to earn interest income until the funds need to be paid out. This is very similar to insurance companies investing their float, which is one of Warren Buffett’s favorite qualities in Berkshire Hathaway’s portfolio of dividend stocks.

 

Declining interest rates have limited the amount of high-margin interest income ADP can earn. The company generated $378 million in interest last year, earning a 1.7% rate.

 

However, for every 25 basis points that short-term and intermediate-term interest rates change, ADP sees a $12 million impact to earnings (close to a 1% impact to net income). In other words, ADP would likely enjoy a moderate boost to earnings growth if interest rates were to ever rise.

 

Overall, Automatic Data Processing appears to be a wonderfully positioned business with numerous strengths. The company provides mission-critical services, is a trusted partner with clients, requires little capital, enjoys high recurring revenue and client retention, and has a long runway for growth in a large and fragmented market.

 

Key Risks

It’s difficult to identify many risks that could impair ADP’s long-term earnings power. The company’s continual investments in programming and people help it maintain its leading market position.

 

However, new entrants are always looking for ways to deliver a similar quality of service at a lower price and in a more user-friendly format. As the pace of technology advancements accelerates, this could become increasingly true.

 

Zenefits, which gives away free software that automates payroll and health insurance for small businesses, has been the big name mentioned as a potential disruptor in the space (the startup launched in April 2013 and was valued as much as $4.5 billion last year). However, the company has hit a wall of challenges that have severely disrupted its growth path.

 

Technology advancements could make it easier for new entrants to try and disrupt the industry’s pricing structure. However, given clients’ need to make sure their businesses remain 100% compliant and fully functional, any such change is likely to be gradual in my view. ADP has the resources to remain relevant – either by building or buying the technology or capabilities it needs to maintain its dominant market positions. It also has something very important that new entrants lack – trust (many of its customer relationships span decades).

 

Changing laws and regulations could also pose a challenge. After all, ADP primarily makes money because its clients do not want to internally deal with complex tasks that don’t add direct value to their businesses.

 

While there is not much ADP can do to combat this risk, the company has increasingly diversified its business across an entire suite of HCM solutions, which helps reduce the risk of any single product line bringing down the firm.

 

Dividend Analysis: ADP

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. ADP’s dividend and fundamental data charts can all be seen by clicking here.

 

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

ADP’s Dividend Safety Score of 90 suggests that the company’s dividend payment is extremely safe. ADP’s strong safety rating begins with its payout ratios.

 

Over the last four quarters, ADP’s dividend payments have consumed close to 60% of the free cash flow and earnings the company has generated.

 

As seen below, ADP’s payout ratios have about doubled over the last decade but have remained remarkably consistent in recent years. Stable payout ratios can indicate a predictable business, and ADP is no exception.

 

While a payout ratio north of 60% would start to give me pause when dealing with a cyclical business, it is a perfectly healthy level for ADP. The company’s high recurring revenue and asset-light business model provide very stable earnings each year.

 

 

As I mentioned earlier, ADP provides essential services that businesses need regardless of how the economy is doing. Payroll still needs to be processed, HR activities must continue, and regulations still need to be complied with.

 

As a result, ADP performed well during the last recession. The company’s sales actually grew by 1%, free cash flow per share remained relatively stable, and ADP’s stock beat the S&P 500 by nearly 30% in 2008.

 

Changes in employment levels can impact near-term growth trends for the company, but expansion of HCM offerings outside of payroll services provides diversification and opportunity to expand existing client relationships.

 

 

ADP’s strong Dividend Safety Score is further aided by the company’s remarkable free cash flow generation. Free cash flow fuels sustainable dividend payments and dividend growth.

 

Software-focused businesses such as ADP generate wonderful cash flow once they have achieved scale. As I previously mentioned, ADPs’ business requires very little capital to run and benefits from strong client retention rates and pricing power.

 

 

In my opinion, return on invested capital is one of the most important financial ratios to understand. The metric can be a good indicator of a company’s economic moat and ability to grow earnings and pay higher dividends.

 

Since ADP’s operations require little capital to operate, the company has enjoyed strong returns on invested capital north of 20% most years. This is a clear sign of ADP’s moat and allows the company to compound its earnings at a faster rate than most businesses.

 

 

ADP’s balance sheet is important to analyze as it relates to dividend safety because companies will make debt payments before issuing dividends. Firms with too much financial leverage can be more likely to cut their dividend if they fall on challenging times.

 

In ADP’s case, its balance sheet is a definite strength. The company has historically remained debt-free but recently took on $2 billion of debt, which will be used to repurchase shares.

 

As seen below, ADP still maintains more cash ($3 billion) than total book debt ($2 billion), providing it with plenty of flexibility to continue paying and growing its dividend.

 

 

Overall, ADP’s dividend payment is very safe. The company maintains reasonable payout ratios, provides non-discretionary services, generates substantial free cash flow, benefits from high recurring revenue and client retention rates, and has a balance sheet with more cash on hand than debt.

 

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

ADP’s Dividend Growth Score of 79 suggests that the company has above-average dividend growth potential. ADP began paying dividends in 1974 and last increased its dividend by 8% in November 2015, marking 41 years of consecutive dividend increases for the company. I wouldn’t be surprised to see ADP join the dividend kings list within the next decade.

 

The company’s dividend has grown by 13.8% per year over the last 20 years, although growth has come in closer to a high-single digit rate more recently.

 

 

Looking ahead, ADP’s management team targets a dividend payout ratio of 55-60% and expects the company’s earnings growth to remain at a double-digit rate longer term.

 

Since the company’s payout ratio is sitting near 60% today, future dividend growth will likely be fueled by earnings growth. I expect ADP’s dividend to continue compounding by at least 7-9% per year over the medium-term.

 

Valuation

Shares of ADP trade at a forward-looking P/E multiple of 29.3 and offer a dividend yield of 2.2%, which is slightly below the stock’s five-year average dividend yield of 2.55%.

 

It’s hard to argue that ADP is a bargain today. If anything, the stock seems somewhat overpriced – the market is clearly rewarding the company’s predictability (high recurring revenue, strong client retention rates, and mission-critical services) and ability to deliver reliable earnings growth.

 

Over the longer term, ADP’s management targets 7-9% annual revenue growth and 12-14% annual earnings per share growth with an objective to deliver a total shareholder return in the top quartile of the S&P 500.

 

If the company continues delivering on its promises, ADP’s stock certainly has potential for double-digit annual returns over the long run. However, the current multiple seems to provide little margin for error.

 

Conclusion

Automatic Data Processing is a wonderful business and certainly a blue chip dividend stock. Few companies have a more dependable business model and dividend growth track record than ADP, and the future continues to look bright thanks to the large and highly fragmented nature of the HCM market.

 

The stock doesn’t look cheap today but should be watched by income investors seeking long-term dividend growth and capital appreciation.