2023-09-21 05:42:00 ET
Summary
- Automatic Data Processing's adjusted diluted EPS and free cash flow payout ratios easily support a quickly growing dividend.
- The human capital management company posted impressive results for its fiscal year ended 2023.
- ADP's interest coverage ratio clocked in above 18 in its most recent fiscal year.
- My presumptions for the discounted cash flows model and dividend discount model show ADP to be trading at a 4% discount to fair value.
- The stock is priced reasonably enough that dividend growth investors could buy some now and even more on a pullback.
If you feel like the purchasing power of your dollar is consistently diminishing year after year, you're not wrong: An item that used to cost $100 in 2020 would now cost $118.63 today on average. Unfortunately, for many workers, wages have not kept up with these rising costs.
So, what can you do to help keep up with inflation? Assuming you already have at least a small emergency fund, your best bet is to live below your means and invest surplus capital into best-of-breed dividend growth stocks. Over enough time, such a decision can help you transition from being a worker into an owner.
Accounting for 1.4% of my portfolio value, Automatic Data Processing ( ADP ) is my ninth largest individual stock holding. Just two years away from the 50-year dividend growth streak needed to become a Dividend King, let's dive into what currently makes ADP stock a buy for dividend growth investors.
Robust Results In FY 2023
As the millions of business owners around the world can attest to, it takes an awful lot of time and resources to run a business. Who has time to deal with payroll, human resources, and taxes? And even if you do, why would you when ADP's software and services can free up your time to focus more on your business?
These rhetorical questions help to explain the success of ADP since its founding in 1949. That is how the company has grown to more than a million clients in 140 countries around the world. For context, ADP is so huge that it processes payroll for 41 million workers around the world - - 1 in 6 in the U.S. alone.
And as massive as the company has become, ADP's share of the $150 billion industry pie (growing at 5% to 6% annually) was only about 12% in the fiscal year 2023. Thanks to its industry-leading human capital management technology and expertise, ADP retained 92.2% of its clients during FY 2023. Along with growing demand for its software and services, this is how the company's total revenue grew by 9.2% year over year to $18 billion for FY 2023.
ADP's adjusted diluted EPS soared 17.4% higher over the year-ago period to $8.23 in FY 2023. Due to the company's smart cost management, total expenses rose just 7.7% during FY 2023. This allowed ADP's non-GAAP profit margin to expand by 110 basis points to 19%. Paired with a decline in its outstanding diluted share count from share repurchases, that explains why the company's adjusted diluted EPS growth greatly outpaced revenue growth for FY 2023.
As ADP continues to improve the quality of its software and services, the company should keep gaining clients and market share. This is the crux of how analysts believe ADP's adjusted diluted EPS will increase by 13.5% annually for the next five years.
The company also boasts immense profitability: ADP's interest coverage ratio was 18.5 in FY 2023. This demonstrates that the company can cover its roughly $900 million in net debt without worry. That is why ADP enjoys an admirable AA- credit rating from S&P (all info according to ADP August 2023 Investor Presentation and ADP Q4 2023 earnings press release ).
A Strong Dividend Grower With A Secure Payout
You'll be hard-pressed to find companies that are as skilled at and committed to rewarding shareholders as ADP. For the past 48 years, the company has hiked its dividends paid to shareholders. In the last 10 years, ADP's dividend has compounded at 12.5% annually - - better than the industrial sector median of 8.1% during that time. This explains why Seeking Alpha grades the company's 10-year dividend growth at a B+ relative to peers.
And if the most recent 20.2% dividend boost announced last November is any indication, ADP's big-time dividend growth could persist. That is because the company's payout is adequately covered by both adjusted diluted EPS and free cash flow.
ADP generated $8.23 in adjusted diluted EPS in its fiscal year 2023. Compared to the $4.58 in dividends per share that it paid to shareholders during the year, this is an adjusted diluted EPS payout ratio of 55.7%. For perspective, that is well within the company's targeted adjusted diluted EPS payout ratio range between 55% and 60%.
An even better metric to gauge dividend safety is the free cash flow payout ratio. At the end of the day, a company either produces enough free cash flow to cover its dividend or it doesn't. Fortunately, ADP is a free cash flow machine. The company threw off $4.2 billion in operating cash flow in fiscal year 2023. Against the measly $200 million that it invested in capital expenditures due to its light capex business model, this is $4 billion of free cash flow. Stacked up to the $1.9 billion in dividends paid for the year, this is an FCF payout ratio of just 47.7% (details sourced from page 50 of 91 of ADP 10-K filing ).
Risks To Consider
ADP is a remarkable business with a track record of enriching shareholders. However, all companies are exposed to risks that investors must know, and ADP is no exception.
The nature of ADP's business involves a significant amount of personal and business information. The company does all that it can to protect the integrity of this data. However, it's not a guarantee that these actions will be enough to prevent a cyber breach. If a major cyber breach were to happen, significant legal liability could result and ADP's reputation could be damaged.
The company also faces the risk of industry competitors better adapting to the changing needs of clients. ADP has done an excellent job of meeting shifting preferences so far. But if it falls behind, peers like Paycom Software ( PAYC ) could capitalize. That could harm ADP's operating fundamentals.
ADP Is A Decent Value
Buying blue-chip businesses around fair value is an investing strategy that tends to work well. So, what are shares of ADP worth? Let's use two valuation models to answer that question.
The first valuation model that I'll utilize to value ADP's shares is the discounted cash flows model. The DCF model consists of three inputs.
The first input for the DCF model is the last 12 months of adjusted diluted EPS. ADP's trailing 12 months of adjusted diluted EPS is $8.23.
The next input into the DCF model is growth predictions. I will assume a 7.5% annual adjusted diluted EPS growth rate for the first five years of my model. Then, I'll factor in a slowdown to 6.5% annually in the years that follow.
The final input for the DCF model is the discount rate, which is simply the annual total return rate required by investors. My preference is for 10% annual total returns, so that's what I will use.
Plugging these inputs into the DCF model, I get a fair value of $261.66 a share. This implies that shares of ADP are trading at a 6.2% discount to fair value and offer a 6.6% upside from the current share price of $245.38 (as of September 20, 2023).
The other valuation model that I will employ to appraise ADP's shares is the dividend discount model or DDM. This also has three inputs.
The first input into the DDM is the annualized dividend per share of a stock. ADP's annual dividend per share is currently $5.
The second input for the DDM is the cost of capital equity, which is the annual total return rate. Again, I will use 10%.
The third input into the DDM is the annual dividend growth rate. Since ADP is a steadily growing business with a manageable payout ratio and a healthy balance sheet, I believe 8% is a fair forecast.
Using these inputs for the DDM, I arrive at a fair value of $250 a share. That means shares of ADP are priced 1.8% less than fair value and could appreciate by 1.9% from the current share price.
Averaging out these two fair values, I compute a fair value of $255.83 a share. This indicates that ADP's shares are trading at a 4.1% discount to fair value and offer a 4.3% upside from the current share price.
Summary: A Must-Own Dividend Growth Stock
Barring Armageddon, ADP will become a Dividend King in 2025. And unlike some well-established dividend growers, ADP isn't just handing out token increases to keep its streak alive. That is evidenced by its double-digit annual dividend growth rate over the past decade.
Better yet, ADP looks like it is marginally undervalued based on my inputs into the DCF model and DDM. That is why I would argue the stock is an intriguing buy for dividend growth investors anywhere below $250 a share.
For further details see:
Automatic Data Processing: A Future Dividend King To Help You Sleep Well At Night