2023-06-27 04:40:27 ET
Summary
- ADP is a leading human capital management company with a strong market position and diversified global presence.
- The company has a consistent dividend growth history and is incorporating artificial intelligence for improved efficiency and growth opportunities.
- Economic uncertainty and recession risks pose challenges, but the stock remains an attractive long-term investment opportunity.
Introduction
Automatic Data Processing ( ADP ) isn't just one of America's largest companies with a market cap of almost $90 billion, but it is also a cornerstone of small businesses, thanks to its portfolio of products and services that allow businesses to outsource staffing-related tasks.
In this article, we'll assess the attractiveness of this dividend aristocrat, which currently yields 2.3% after losing roughly a quarter of its market cap since last year's peak.
While the company continues to do very well, pressure is mounting as weakness in economic indicators doesn't bode well for small businesses.
The good news is that this comes with opportunities, as I believe that ADP is a fantastic stock to generate long-term outperforming capital gains with a side of consistently rising income.
So, let's get to the details!
Making Money With Small Businesses
The other day, one of my Twitter friends, Neely Tamminga, tweeted a very interesting note. Apparently, 89% of all firms in the United States classify as small businesses, which have fewer than 20 employees. Despite the fact that most firms are small businesses, they only employ 15.8% of all employees and pay 12.1% of the total payroll.
If there's one thing these small businesses need, it's efficiency. This means less focus on annoying tasks to allow for a better allocation of time and money on the things that grow revenues.
These annoying services often include HR-related tasks.
That's where ADP comes in.
Headquartered in Roseland, New Jersey, ADP is a leading company in human capital management, which provides a wide range of services such as payroll, HR outsourcing, time and attendance, and more.
Not only does ADP service the United States, but it has operations in over 30 countries and the capability to process payroll in approximately 45 countries.
ADP serves both small businesses and large enterprises, offering a wide range suite of HCM products. Their growth strategy focuses on expanding their product suite, continuing HR outsourcing, and building a global presence.
According to the company :
Our unmatched experience, expertise, insights and cutting-edge technology have transformed HCM from an administrative challenge to a strategic business advantage. Tailored to meet the needs of businesses of all sizes, we help them work smarter today so they can have more success tomorrow. We serve over 990,000 clients and pay over 39 million workers in 140 countries and territories.
Furthermore, ADP has a solid financial position with consistent dividend increases over 48 years, which makes the company a dividend aristocrat that is just two years away from becoming a dividend king, but more on that later.
Automatic Data Processing
What's interesting is that ADP is now increasingly incorporating artificial intelligence in its products. After all, everyone who has experimented a bit with AI recently will know how big of an impact this can have - especially when it comes to standardized tasks in the (online) services sector.
Automatic Data Processing
During this year's Bair Global Consumer Technology and Services Conference in June, the company commented on the potential benefits of generative AI and large language models.
ADP already made progress in using AI through chatbots to improve customer service and provide faster, more accurate answers to inquiries. This is becoming quite common, as companies like Bloomberg are applying it too.
It's an easy but very efficient way to implement AI.
Furthermore, ADP believes that their extensive data from paying millions of people worldwide gives them an advantage in leveraging generative AI. They see opportunities for operational enhancements, such as better understanding customer needs, improving reporting capabilities, and optimizing sales efforts.
However, they acknowledge that the technology is still in its early stages, and the ability to effectively utilize data models needs further validation.
While the company is right, and it's hard to predict the longer-term benefits of AI, they are already making tremendous progress, as a big part of their business is dealing with customers (like handling client calls). Automating these processes would result in increasing mid-term margins.
And even beyond its current customers and potential cost-saving capabilities, the company is very bullish on further growth in its total addressable market ("TAM"), which it estimates to be roughly $150 billion.
The company continues to expand its payroll services in the US and internationally.
During the aforementioned conference, ADP highlighted specific growth areas, such as retirement services, driven by government mandates for employers to provide pension plans and insurance services.
The legislation will require companies with as few as ten employees and over three years of operation to offer a 401(k) plan as the default option. Needless to say, states are looking to penalize non-compliance, which will trigger the demand for mandated pension plans to rise rapidly.
While I do not agree with new government mandates, ADP believes that this alone could increase potential revenues by $1 billion. It's also one of the reasons why I started this article by showing the note with small business statistics, as this new legislation will impact so many businesses.
Hence, by offering the right tools and services, ADP continues to bet on long-term market share gains.
The Dividend & Recent Developments
ADP isn't just known as a trusted service provider to millions of companies, but it is also known as a trusted source of consistently rising income for millions of investors.
The company has hiked its dividend for 48 consecutive years, which means this dividend aristocrat is just two years away from joining the dividend king club.
Despite its mature business, ADP is everything except a slow-growing business.
While its 2.3% yield isn't something that gets income-oriented investors excited, it's not only backed by its long and consistent dividend growth history but also high dividend growth.
- Over the past five years, ADP has hiked its dividend by 13.7% per year - on average.
- On November 9, 2022, the company hiked its dividend by 20%.
- Despite strong dividend growth, the company's net income payout ratio remains below 60%.
- Even better, looking at longer-term free cash flow expectations, analysts expect the company to generate a free cash flow yield of more than 6% in 2024, which indicates a cash payout ratio of less than 40%, leaving room for buybacks and debt reduction, if needed.
It also needs to be said that the company has an excellent balance sheet. This year, the company is expected to end up with a 0.1x net leverage ratio before analysts expect the company to become net cash positive next year (this implies more cash than gross debt on the balance sheet).
The company has an AA- credit rating, which is one of the healthiest balance sheets in the world.
Furthermore, since 2013, the company has bought back almost 15% of its shares, which artificially boosts the value of existing shares.
These factors also contributed to long-term outperformance. Despite its current weakness, ADP has returned roughly 290% over the past ten years, beating the S&P 500 by a considerable margin. I expect long-term outperformance to continue, as ADP has the right tools to continue to generate consistent shareholder value through dividends and buybacks.
That said, there are challenges. After all, there's a reason why the ADP stock price is down - despite its good long-term growth prospects.
Economic growth is declining, as both services and manufacturing indicators are pointing to high recession risks.
True Insights
On top of that, wage inflation is still hot, which means the Fed will have to do more damage in order to solve the problem of sticky inflation.
The fact that the Fed might have to hurt the labor market in order to achieve its goals isn't great news for a company that relies on a healthy labor market and thriving small businesses.
However, so far, ADP is doing well, financially speaking.
ADP's third quarter fiscal 2023 earnings showed strong results, including 10% organic (on a constant currency base) revenue growth, 110 basis points of adjusted EBIT margin expansion, and 14% adjusted EPS growth.
The company noted that the demand environment for ADP's employer services remained healthy, driving solid new business bookings growth, especially in the downmarket portfolio.
The company sold and onboarded over 60,000 new run clients in Q3, which led to record-level new client satisfaction rates.
Strong bookings were also observed in insurance and retirement services, supported by legislative tailwinds and competitive positioning in the downmarket HCM ecosystem.
But wait, there is more!
ADP also experienced better-than-expected employer services retention rates, with strong retention in the US mid-market and international businesses, offsetting normalization in downmarket out-of-business rates.
As a result, the company raised its full-year retention guidance. Employer services paid control grew 4% for the quarter, and ADP expects to achieve the higher end of its pays per-control guidance range.
With that said, and speaking of guidance:
Guidance covering all segments came in strong (emphasis added):
Putting it altogether, we still expect consolidated revenue growth of 8% to 9% in fiscal '23, but now believe it will be towards the higher end of that range . We are maintaining our outlook for adjusted EBIT margin expansion of 125 to 150 basis points and for a fiscal '23 effective tax rate of about 23%. And we now expect adjusted EPS growth of 16% to 17% and compared to our prior outlook of 15% to 17%.
As the overview below shows, the company has consistently hiked its FY2023 outlook, which includes the top and bottom lines of its guidance range.
Automatic Data Processing (Includes Author Annotations)
So, what about the valuation?
Valuation
ADP is currently trading at 18.1x NTM EBITDA, which is a fair valuation close to its longer-term median. Shares are trading at less than 17x 2024E free cash flow, which is a multi-decade low and caused by a strong free cash flow outlook.
The current consensus price target is $230, which is 8% above the current price.
While I do believe that this is a fair value for the time being and that ADP has tremendous long-term potential, I do not believe that ADP will take off anytime soon.
Economic developments are not favorable, and I wouldn't bet on lower guidance, as much as I respect the company's resilience in this environment.
However, as I prefer to buy great companies at great valuations, I'm not worried about ADP's future.
If anything, corrections can be used to either initiate a position or to add to an existing position.
FINVIZ
I believe that prices between $180 and $200 offer a great risk/reward. Needless to say, that also goes for anything below $180, as I do not expect to encounter an economic situation that could endanger ADP's ability to grow in the future.
I'm giving the stock a bullish rating to reflect its long-term potential and the current valuation, which is fair.
Takeaway
ADP, America's leading human capital management company, is not only a cornerstone for small businesses but also an attractive investment opportunity.
Despite recent market cap losses, ADP remains a fantastic stock for generating long-term capital gains and rising income. Small businesses, which make up 89% of all firms in the US, require efficiency and outsourcing of HR-related tasks, which is precisely what ADP offers.
With its extensive suite of HCM products and global presence, ADP is well-positioned for growth. The company's incorporation of artificial intelligence and its solid financial position further enhance its prospects.
ADP's consistent dividend increases over 48 years and strong dividend growth make it a reliable source of rising income.
Although economic challenges persist, ADP's recent strong financial performance and positive outlook demonstrate its resilience.
While the current valuation is fair, price corrections offer an excellent opportunity to invest in this promising stock.
Pros & Cons
Pros:
- Strong market position in human capital management.
- Diversified global presence.
- Long-term dividend growth as a dividend aristocrat.
- Incorporation of artificial intelligence for improved efficiency.
- Favorable growth opportunities in retirement services.
Cons:
- Economic uncertainty and recession risks.
- Challenges from wage inflation and labor market issues.
- Dependency on legislative changes for certain growth areas.
- Limited appeal for income-oriented investors with current yield.
For further details see:
Automatic Data Processing's Dividend Story: Steady Income, Strong Growth