2023-07-31 04:17:16 ET
Summary
- Automatic Data Processing is a blue-chip software company with almost 50 years of dividend growth.
- The company has shown steady growth in sales and EPS, with room for further expansion.
- However, there are risks of competition from larger software companies and a lack of margin of safety in the current valuation.
Introduction
As a dividend growth investor, I always seek new investment opportunities in income-producing assets. I often add to my existing positions when I find them attractive. I also use market volatility to my advantage by starting new positions to diversify my holdings and increase my dividend income for less capital.
The IT (information technology) sector has been on the rise lately. Following a harsh 2022, the leading companies in the industry have led the indices in 2023. While the most prominent companies performed well, the rest of the market did not shine. Therefore, I try to find attractive IT companies that trade for a fair valuation. One of the companies I have been looking for is Automatic Data Processing ( ADP ).
I will analyze Automatic Data Processing stock using my methodology for analyzing dividend growth stocks. I am using the same method to make it easier to compare researched companies. I will examine the company's fundamentals, valuation, growth opportunities, and risks. I will then try to determine if it's a good investment.
Seeking Alpha's company overview shows that:
Automatic Data Processing provides cloud-based human capital management solutions worldwide. It operates in two segments, Employer Services and PEO (Professional Employer Organization). The Employer Services segment offers strategic, cloud-based platforms and HR (human resources) outsourcing solutions. Its offerings include payroll, benefits administration, talent management, HR management, workforce management, insurance, retirement, compliance services, and integrated HCM solutions. The PEO Services segment provides HR outsourcing solutions to small and mid-sized businesses through a co-employment model. This segment offers benefits packages, protection and compliance, talent engagement, expertise, comprehensive outsourcing, and recruitment process outsourcing services.
Fundamentals
The revenues of Automatic Data Processing have increased by 96% over the last decade. It equates to roughly a 7% increase annually. The company grows sales by expanding its client base and raising software and HR services prices. While the company does acquire other companies, they are mostly small companies that it uses to improve its value proposition and not increase its revenues. In the future, as seen on Seeking Alpha, the analyst consensus expects Automatic Data Processing to keep growing sales at an annual rate of ~6% in the medium term.
The EPS (earnings per share) of Automatic Data Processing has increased by 179%, which means it has almost tripled over the last decade. The company achieved such high EPS growth due to its sales growth, buybacks, and improving margins. The shift of organizations to the cloud allowed the company to limit expense increases as it has been selling its subscription. In the future, as seen on Seeking Alpha, the analyst consensus expects Automatic Data Processing to keep growing EPS at an annual rate of ~10% in the medium term.
The company is getting extremely close to the position of a dividend king. With 48 years in a row of dividend increases, the company will become a dividend king in two years. The dividend yield is 1.9%, and while it doesn't look as attractive as risk-free options, the dividend has room to grow. The current payout ratio stands at 55%, which means the dividend seems safe. Moreover, there is plenty of room to grow as the company expands its EPS. Investors should expect the dividend growth to be 10-12%, in line with EPS growth.
Automatic Data Processing returns capital to its shareholders via buybacks. The buybacks come in addition to the dividends. Over the last decade, the company has decreased the number of shares by almost 15%. Buybacks are beneficial as they support the EPS when the share count is reducing. Buybacks are highly efficient when the share price is low, as every dollar buys more shares. Therefore, investors may expect more modest buyback plans in the current environment.
Valuation
The P/E (price to earnings) ratio is 27.4 when using the EPS estimate for the next fiscal year. The P/E ratio has increased lately as the share price rose following the Q4 results. The current valuation is not low, even though it is almost the lowest point we have seen over the last twelve months. Yet, I believe that paying 27 times future earnings for a company growing at 10% annually when the risk-free return is above is risky.
The graph below from Fast Graphs also implies that shares of Automatic Data Processing are overvalued. The average P/E ratio of the company is 25, and the current one is 27.4. The company's forecasted growth rate is 10%, which aligns with the historical annual growth rate of 9.7%. The company is not highly overvalued, yet there is some mismatch between the growth rate and the valuation when considering today's higher interest rates. Thus I believe that the shares are overvalued.
Opportunities
Human capital is key to every organization. The last decade has shown us that there is fierce competition for talented and capable employees. Automatic Data Processing has created expertise in that realm. That expertise is extremely valuable to organizations seeking to recruit and maintain an elite workforce. Therefore, it allowed the company to increase prices and enjoy higher margins. As high-end employees are hard to find, the company will capitalize on it.
Another opportunity that comes from the company's expertise is its brilliant execution. The company manages to execute well and beat the analysts' expectations constantly. In the last twelve months, which were challenging due to inflation and higher costs, the company achieved 130 basis points of Adjusted EBIT margin expansion. The ability to grow EPS and, more importantly, margins during inflation shows that a capable management team will likely continue to execute well.
Another growth opportunity for the company is the fact that it has an international presence. In a world where more and more companies don't have a single location, the offer of a one-stop shop for HR needs is compelling. For companies who are doing business in multiple countries, the company offers payroll services and global human capital management capabilities using a single platform and a single provider. Therefore, the company has an edge in winning the business of multinationals and companies who strive to be one.
Risks
We are now seeing some changes in the job market. While the market looks tight, we see more layoffs, even by high-end lucrative employers. This trend may increase if we enter a recession as economic activity slows down. In that case, originations will be less focused on HR, and their focus will be elsewhere. If that happens, they may leave Automatic Data Processing for a cheaper alternative, or simply not buy additional services or agree to price increases.
Automatic Data Processing is a niche player. It is an expert in its niche, which is a crucial niche, yet it is still a niche. Therefore, there is always a risk of being replaced by one of the software giants, who may wish to enter deeper into the HR world. Companies like Microsoft (MSFT), Oracle (ORCL), and Salesforce (CRM) are a risk for Automatic Data Processing as they have the size, the capital, and the access to the clients. They can offer a comprehensive value proposition and dethrone ADP.
The margin of safety doesn't exist when looking at the current outlook for the coming year. The company reported this week its fiscal 2023 results and published its outlook. The current outlook aims for a 7% increase in sales and a 12% increase in EPS at the highest point. While this is a healthy growth rate, I do not believe it justifies such a premium valuation. The company is priced for perfection. Therefore, every miss can be extremely painful for investors as the current P/E ratio is close to 30.
Conclusion
To conclude, Automatic Data Processing is a blue-chip software company that managed to increase its dividend for almost 50 years. It has done so by increasing sales and EPS steadily and even left room for buybacks. The importance of high-quality employees has helped the company to capitalize on its expertise and look forward. There is more room to grow, and it will grow by supporting the HR needs of all kinds of businesses, from small ones to multinational corporations.
While there is room to grow for the company, several risks exist. First, the possibility of competition from giant software companies. Moreover, a recession may weaken the growth prospects. Lastly and above all, there is a lack of margin of safety, as the company is trading for more than 27 times future EPS. I do not feel comfortable with the shares without a margin of safety, so I rate them a HOLD. I will consider buying the shares in the current interest rate environment if the P/E ratio is around 23.
For further details see:
Automatic Data Processing Is Simply Too Expensive