Automatic Data Processing (ADP) is a durable business that provides mission-critical software and outsourcing solutions. The company’s high mix of recurring revenue (91% retention rate), participation in large and fragmented markets (10% share in $100+ billion market), strong balance sheet ($1.8 billion net cash), asset-light business model, and commitment to shareholders (40 years of consecutive dividend growth; targets total return in the top quartile of the S&P500) underscore its fundamental strength. With a Safety Score of 99 and a Growth Score of 82, ADP is one of the more attractive dividend stocks.
Business Description:
ADP provides a range of solutions, via a software and service-based delivery model, which businesses of all sizes can use to recruit, staff, pay, manage, and retain employees. The company serves more than 490,000 clients (80% of total clients) via ADP’s software as a service (SaaS) offerings, commonly referred to as “the cloud.” As a leader in the growing HR Business Process Outsourcing market, ADP also offers fully integrated outsourcing solutions that enable its clients to outsource their HR, time and attendance management, payroll, and benefits administration functions to ADP. Altogether, ADP’s offerings cover everything from recruitment to retirement and provide a sizeable base of recurring revenue – with a 91.4% client retention rate, client retention is estimated at 12 years in Employer Services and 7 years in Professional Employer Organization Services, providing nice predictability.
ADP’s clients range from single-employee small businesses to some of the world’s largest corporations, including 90 of the Fortune 100 companies. ADP claims to pay 1 in 6 private sector workers in the US and maintains the biggest data set of employment data, allowing it to deliver better HR insights and analytics to help clients run their businesses better.
ADP previously had a dealer services business called CDK Global. It spun off this unit to shareholders last fall and used proceeds ($700M) to repurchase stock, focusing the company completely on human capital management (HCM).
Sales Mix
By segment: Employer Services 78% (e.g. payroll services, benefits administration, talent management, HR management, time and attendance management, etc.), Professional Employer Organization Services 22% (employment administration outsourcing solutions)
By geography: United States 81%, Europe 11%, Canada 4%, Other 4%
Shareholder Value Creation:
The table below shows ADP’s total return over several periods. The stock has beaten the market nicely over the last 12 months and outperformed by 4.5% per year from 2010 to 2014.
Looking even longer-term, ADP has created value for its shareholders. The orange line below shows ADP’s total return relative to the market, indexed to 100 in 1994. In other words, when the orange line is rising, ADP is outperforming the broader market.
ADP’s management team targets a total shareholder return in the top quartile of the S&P500, and it has more than achieved this ambitious goal over the past ten years with solid outperformance:
Dividend History:
Before we dig into ADP’s fundamentals, let’s review its dividend history. As seen below, the company has increased its dividend for 40 years, compounding its dividend paid by 8% over the last five years.
While a growing dividend is a critical part of the total return equation, it is even more important that the dividend growth is sustainable. The payout ratio shows us what portion of a company’s earnings and free cash flow is paid out as a dividend. Lower payout ratios suggest the current dividend is safer and might have greater long-term growth potential. When a payout ratio rises, it means the company is growing its dividend faster than its underlying earnings or free cash flow.
Looking below, we see ADP’s EPS payout ratio has increased from 57% in CY10 to 68% in CY14 but remains close to management’s targeted range of 55-60%. ADP’s free cash flow (FCF) payout ratio has generally remained below the company’s EPS payout ratio and is at an even healthier level (closer to 40% last fiscal year), suggesting ADP is in a healthy position.
With moderate sales and earnings growth expected to continue far into the future and a reasonable payout ratio today, ADP seems to have a long runway to continue growing its dividend by 5-10% per year.
Long-term Fundamentals
ADP has maintained a strong return on equity over the past decade, even as its business model has been transitioning to the cloud. With a healthy client retention rate (91.4%) and a large base of recurring revenue, return on equity seems likely to remain in excess of 20%.
Revenue has grown at a 7% CAGR over the last seven years and a 7% CAGR over the past three years, demonstrating nice consistency. Sales also held up well during the financial crisis, growing 1% in FY09 and FY10. These results underscore the stickiness and mission-critical importance of ADP’s HCM software and services. While macro changes in employment levels can impact ADP’s near-term growth trends, expansion of other HCM services outside of payroll can help ADP take more wallet share at each client, and healthcare reform / increasing regulation provides a tailwind.
ADP’s operating margin has remained steady for many years. Profitability actually improved during the financial crisis, highlighting the strength of ADP’s business model. Going forward, margins should see some modest lift as ADP’s recurring revenue base expands and if interest rates ever start to rise (ADP holds over $20 billion in funds for clients and makes interest income from bonds).
As seen below, ADP has compounded its diluted earnings per share by 8% and 8% over the past seven and three years, respectively.
All of ADP’s earnings showed up as cash. Once they reach critical mass, software businesses require little incremental capex to maintain their revenue base, throwing off plenty of free cash flow. ADP’s free cash flow per share has compounded at a rate of 7% over the past seven years and 3% over the last three years.
ADP maintains a very strong balance sheet and has been managed conservatively for a long time. As seen below, the company has rarely carried any meaningful debt, and as of the most recent quarter had over $1.8 billion in net cash. This flexibility provides room for ADP to continue raising its dividend while investing to remain relevant far into the future.
In addition to dividend increases, we see ADP has also been active buying back its own shares. In fact, ADP’s total diluted shares outstanding have decreased at a 1% CAGR over the last five years. This capital allocation decision has proven to be a good one over the past decade as ADP has grown in value and each shareholder has happily increased his or her relative ownership stake. Management expects to continue reducing ADP’s shares outstanding by approximately 1% annually going forward.
Quarterly Results
ADP reported healthy results last quarter as sales and earnings grew 7% and 16%, respectively. Fiscal year-to-date, new business bookings have grown 11% and position ADP well to meet its full year goal of 10% bookings growth. Adjusted for the spin-off of ADP’s dealer services business in 2014, sales growth has persisted in the mid-single digits over the last eight quarters, and earnings per share have increased around 10%.
While ADP competes in a fairly mature market that will not grow much faster than GDP, the market is very large (over $100 billion in size) and fragmented (ADP has 10% market share), supporting continued growth.
Management Commentary
“ADP had another successful quarter as we continue to help our clients maximize their investments in their people,” said Carlos Rodriguez, president and chief executive officer, ADP. “Our results are directly attributable to the continued focus and dedication of ADP teams around the world that are driving our HCM strategy.”
“ADP delivered a solid quarter of revenue and earnings growth despite pressure from unfavorable foreign currency translation, and I am pleased with the margin expansion in our business segments,” said Jan Siegmund, chief financial officer, ADP. “ADP continues its shareholder friendly actions, and through the third quarter of fiscal 2015 has repurchased 13.3 million shares at a cost of $1.1 billion, reflecting our continued commitment to return excess cash to shareholders.”
ADP’s Fiscal 2015 Outlook
ADP now anticipates full-year fiscal 2015 revenue growth of approximately 7% compared with the prior forecast of 7% to 8% due to negative pressure from foreign currency translation which is expected to impact full year revenue growth by about two percentage points. Diluted earnings per share from continuing operations is now expected to grow about 14% from $2.58 in fiscal 2014 compared with the prior forecast of 12% to 14%.
This forecast anticipates at least 75 basis points of pretax margin expansion from 18.4% in fiscal 2014. ADP now anticipates an effective tax rate of 33.7% compared with the prior forecast of 34.2%. Worldwide new business bookings are still anticipated to grow about 10%.
Looking Ahead
ADP appears well positioned for the future. The nature of its business results in high switching costs with customers, which should provide a predictable revenue stream for years to come. While most software-oriented businesses have built-in switching costs in the form of training users to use a particular platform, ADP benefits from an extra kicker. More specifically, ADP manages complex regulatory environments for many of its clients to ensure they remain compliant with the law. ADP handles employment taxes, unemployment claims, tax credits, workers compensation, and healthcare reform issues. Its clients absolutely must comply with each regulation, increasing their dependence on ADP’s expertise and ability to handle very complex transactions.
In addition to regulatory compliance, ADP’s clients need a trusted partner. ADP handles the most sensitive information about its clients’ employees – tax statements, social security numbers, healthcare information, and more. Building up the systems to protect this information takes years of investment and iteration, but gaining clients’ trust takes even more time.
Beyond domain knowledge and trust, ADP offers significant global reach. The company operates in over 100 countries and is well positioned to meet the needs of multinational employers. Supporting multiple countries requires significant time and investment due to different regulations and integration issues. It would be impractical for smaller firms to pull it off. Perhaps not surprisingly, ADP serves 90 of the Fortune 100 companies.
ADP’s scale benefits extend beyond geographical advantages into perhaps an even more important category – analytics. Big data is transforming different industries and quickly becoming a source of competitive advantage for firms that embrace it the best. In human capital management, the story is no different – the firms that are able to identify and hire better people, retain them for longer, and make them more productive will ultimately win. ADP has more employee records than any of its competitors, generally 3-10x more records. This makes its benchmarking much better, more detailed, and more insightful for its clients.
All of this data will prove to be increasingly value to ADP’s platform as time goes on, but ADP also realizes that it will never be able to solve every problem for every client. To further solidify its positioning with clients, ADP opened up its platforms via APIs last year, enabling its clients to integrate its HCM platforms with the rest of their enterprise suite through those open APIs. This also allows third-party developers to create applications that exchange data with ADP’s core HCM systems to further add value for clients. By focusing more on collaboration and integration, ADP helps ensure that it will remain part of the solution for a very long time.
ADP spent almost two decades building out the depth and breadth of its product and has the financial firepower ($1.8 billion net cash) to build or bolt-on additional capabilities as needs change. These efforts have resulted in large recurring revenue base with high client retention (91%+). With a broad and deep HCM solution, a massive global sales team of 5,500 members, a highly fragmented market to keep penetrating (see image below), and an environment with increasing regulations (e.g. Affordable Care Act), there are enough factors to support management’s goals of 7-9% annual sales growth and 50-75 basis points of margin expansion.
Safety Score
Our Safety Score measures 20 fundamental factors covering a period of 10+ years to assess the safety of ADP’s dividend. It is measured out of a total possible score of 100 and accounts for the company’s performance during the financial crisis, the industry’s cyclicality, long-term and recent trends in growth and profitability, dividend growth track record, debt levels, stock price performance, free cash flow generation, company size, and more.
ADP achieved a ranking of 99, meaning it achieved a Safety Score in the top 2% of the 2,250+ dividend-paying stocks we analyze. The company’s solid balance sheet, stable sales and earnings growth trends, consistent free cash flow generation, stable performance during the financial crisis, commitment to dividend growth, and several other factors contributed to ADP’s stellar rating.
Growth Score
While the Safety Score is most concerned with the safety of a company’s current dividend, the Growth Score is all about a company’s potential to significantly grow its dividend in the years ahead. It assesses nearly 20 factors to gauge a company’s dividend growth potential, including EPS and free cash flow payout ratios, free cash flow generation, short and long-term sales and earnings growth trends, trends in return on capital, dividend growth track record, and more.
ADP’s Growth Score came in at 82, placing it in the top 20% of all dividend-paying stocks. The company’s above-average EPS payout ratio (60%) and more moderate historical dividend growth (8% five year CAGR) lowered its rank, but ADP’s solid profitability, consistent sales and earnings growth, 40-year commitment to growing its dividend, and lower free cash flow payout ratio all helped improve its rank.
Valuation
ADP has been awarded a premium valuation, likely for several legitimate reasons. Investors generally assign higher multiples to predictable companies, and a business like ADP’s with high recurring revenue, 90%+ client retention rates, mission-critical software services, a track record of 40 years of consecutive dividend increases, etc., certainly fits the bill.
At $84 per share, ADP trades at 28 times trailing twelve months earning, about 25 times forward earnings, and has a 2.3% dividend yield. Relative to the universe of over 2,800 dividend stocks that we monitor, ADP has one of the safest dividends you can find (99 Safety Score) and above average growth potential (82 Growth Score). The current dividend yield is approximately in line with the universe average, ranking in the 49th percentile.
Given the high quality nature of ADP’s operations and its high probability of continuing to grow its intrinsic value, its current valuation is not crazy, especially in today’s low interest rate environment. Should rates eventually start to rise, ADP could be one of the better positioned dividend stocks that is not a bank (recall that ADP invests over $20 billion in funds held for clients in bonds – falling rates have hurt high-margin interest income).
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