2023-11-28 01:18:14 ET
Summary
- Buying stocks with strong and steady dividend growth is the core strategy of my portfolio.
- Automatic Data Processing just handed out a 12% dividend raise to its shareholders, putting it one year away from becoming a Dividend King.
- The human capital management company reported respectable operating results to start its fiscal year 2024.
- Trading at a 17% discount to fair value, ADP offers investors a reasonable margin of safety at its current valuation.
- The stock could produce 415% total returns over the next 10 years, which could be 3X the S&P 500.
As those who have followed me over the years are aware, the core of my portfolio revolves around buying proven dividend growers of the utmost quality. What do I mean by this statement?
I generally prefer to own companies for the long haul that have boosted their dividends paid to shareholders for decades on end. That is because such a reputation shows a clear ability to reward shareholders and a commitment to doing so.
Having just hiked its quarterly dividend per share by 12% to $1.40 , Automatic Data Processing ( ADP ) is one of my core holdings. The company is my 16th largest holding, comprising 1.5% of my individual stock portfolio.
For the first time since September , I will revisit ADP's fundamentals and valuation to explore why I am reiterating my buy rating on the stock.
ADP's 2.4% dividend yield isn't going to garner much attention from income investors in the current interest rate environment. But with its track record of double-digit dividend growth, it's a must-own stock for dividend growth investors for my money. This is because ADP's 55% EPS payout ratio is less than the 60% payout ratio that credit rating agencies view as sustainable for its industry per Dividend Kings.
Not to mention that ADP's financial health is also robust. The company's 53% debt-to-capital ratio is somewhat higher than the 40% ratio that rating agencies prefer. But thanks to its industry-leading status and high profitability, S&P awards an upper- investment-grade credit rating of AA- to ADP on a stable outlook. That implies the risk of bankruptcy between now and 2053 is just 0.5%. For these reasons, it shouldn't be a surprise to learn that in an average recession, the risk of a dividend cut from ADP is just 0.5%.
Besides the overall exceptional fundamentals that make ADP an ultra SWAN according to Dividend Kings' quality rating, the stock also looks to be attractively valued. If historical dividend yield and P/E ratio are any guides, ADP is worth $269 a share per Dividend Kings.
I get a fair value of $280 a share for ADP, which is due to the following assumptions in the dividend discount model: A $5.60 annualized dividend per share, a 10% discount rate, and an 8% long-term annual dividend growth rate.
Averaging these two fair values together, I get a fair value of $275 a share. That suggests ADP's shares are priced 17% below fair value from the current $229 share price (as of November 27, 2023).
If the company meets growth expectations and returns to fair value, here are the 10-year total returns that it could generate for shareholders:
- 2.4% yield + 13.6% annual earnings growth + a 1.8% annual valuation multiple boost = 17.8% annual total return potential or a cumulative 10-year total return of 415% against the 9% annual total return potential or 137% cumulative 10-year total return of the S&P 500 ( SP500 )
A Nice Start To FY24
True to form, ADP once again performed well in its fiscal first quarter ended September 30, 2023. The company posted $4.5 billion in revenue during the first quarter, which was up 7% over the year-ago period. For context, this missed the analyst revenue estimate by just $10 million .
These results were largely driven by two factors. First, revenue other than interest on funds held for clients and professional employer organization surged 7.4% higher year-over-year to $2.8 billion for the first quarter. According to President and CEO Maria Black's opening remarks in the recent earnings call , this growth was fueled by record-level volume in the first quarter for new business bookings within Employer Services. This proves that ADP remains the most trusted player in its industry.
The company also benefited from higher interest rates. This is how the interest on its funds held for clients revenue soared 43% over the year-ago period to $201.7 million during the first quarter. These growth rates offset the slower growth in PEO revenue, which rose by 2.8% year-over-year to $1.5 billion for the quarter.
ADP's adjusted diluted EPS grew by 11.8% over the year-ago period to $2.08 in the first quarter. That exceeded analyst expectations by $0.06. The company's careful cost management helped its non-GAAP profit margin to expand nearly 70 basis points to 19.1% during the quarter. Coupled with a slight reduction in the share count, this is what led adjusted diluted EPS growth to outpace revenue growth for the quarter.
ADP continued to easily cover its interest expenses from earnings: The company's interest coverage ratio was 12.9 in the first quarter. ADP's net debt stood at just $1.5 billion to end the quarter. Compared to the $5.2 billion in annualized EBITDA that the company generated during the quarter, this is a net debt to EBITDA ratio of just 0.3.
Excellent Dividend Growth Can Persist
Factoring in ADP's most recent dividend increase that will be paid in January, its quarterly dividend per share has rocketed 77.2% higher in the last five years. That's good enough for a 12.1% compound annual growth rate, which suggests dividend growth isn't slowing down.
In the first quarter of this fiscal year, ADP's adjusted diluted EPS payout ratio was 60.1%. That's basically within the company's targeted payout ratio of between 55% and 60% . Thus, I would expect dividend growth to roughly track earnings growth moving forward.
Risks To Consider
From my vantage point, ADP belongs in the discussion of the top 20 or 30 businesses on the planet. Even so, the company does have risks that investors must be confident they can tolerate before buying.
As I noted in my previous article, ADP is a frequent target of cyber breaches due to its massive amounts of sensitive information. I would just remind readers that if a significant breach were to occur, ADP could be subject to legal liability and reputational harm.
The company's industry is also constantly changing. So far, ADP has been very receptive to the evolving needs of its customers. If the company wants to continue to lead its industry, it will need to keep this up. Otherwise, it risks losing market share to competitors.
Finally, ADP's business is highly dependent on data centers and cloud computing to run smoothly. If these third-party vendors fail to deliver, the company's operations could be interrupted and hurt financial results.
Summary: ADP Is An Ultra SWAN On Sale
ADP's solid operating fundamentals, fortress-like balance sheet, and dedication to shareholders make it an all-around wonderful business. It isn't often that these types of businesses are discounted, so it's always a good idea to buy them when they do get cheap.
Trading at a double-digit discount to fair value, ADP hasn't been this compelling of a buy in a few years now. That's why I would recommend dividend growth-focused investors think about opening a position in ADP or adding to it now if it isn't yet a full position within their portfolios.
For further details see:
Automatic Data Processing: Buy This Cheap Dividend Aristocrat For Generous Income Growth