Automatic Data Processing (NASDAQ:ADP), referred to as ADP from here on, is a global leader in payroll and human resources outsourcing. At the end of FY 2020, ADP had >680k clients worldwide with options supporting freelancers up to Fortune 500 companies.

The value proposition for ADP’s clients is that by outsourcing the rather mundane tasks of running a business, i.e. payroll, HR, etc., management can focus on the things that are truly important to improving the business over time.

ADP is one of those chronically expensive businesses that I had long refrained from adding to my portfolio. Roughly one year ago, I finally initiated a position and have been slowly building up my stake since then.

Dividend History

The investment strategy that I gravitated towards most is dividend growth investing. By adopting that strategy, I want to build my portfolio with businesses that generate plenty of excess cash flow that can then be returned to owners via a rising dividend payment.

ADP Dividend HistoryImage by author; data source Automatic Data Processing Investor Relations

According to the CCC list, ADP is a Dividend Champion with 44 consecutive years of dividend growth. That puts its streak starting back in 1976, and every year, ADP has been there rewarding shareholders with pay raises throughout all sorts of economic and political cycles.

Starting with 1991, ADP has shown year-over-year dividend growth ranging from 3.6% to 33.0% with an average of 14.3% and a median of 14.8% across those 29 periods.

Of the 25 rolling five-year periods over that time, ADP has shown annualized dividend growth between 7.6% and 21.0% with an average of 13.4% and a median of 13.4%.

There’s been 20 rolling 10-year periods over that same time where ADP has an annualized dividend growth ranging from 8.8% to 18.1% with an average of 13.3% and a median of 13.8%.

The 1-, 3-, 5- and 10-year period annualized dividend growth rates since 1991 can be found in the following table.

Year Annual Dividend 1 Year DGR 3 Year DGR 5 Year DGR 10 Year DGR
1991 $0.08
1992 $0.11 33.00%
1993 $0.13 18.70%
1994 $0.15 14.81% 21.92%
1995 $0.18 20.76% 18.06%
1996 $0.21 18.50% 18.00% 21.00%
1997 $0.24 15.08% 18.09% 17.55%
1998 $0.27 11.06% 14.84% 15.99%
1999 $0.32 19.31% 15.10% 16.89%
2000 $0.37 15.36% 15.19% 15.82%
2001 $0.42 15.75% 16.79% 15.28% 18.11%
2002 $0.47 10.06% 13.69% 14.26% 15.89%
2003 $0.50 7.53% 11.06% 13.52% 14.75%
2004 $0.58 15.00% 10.82% 12.69% 14.77%
2005 $0.65 13.04% 11.81% 12.23% 14.02%
2006 $0.79 20.77% 16.23% 13.19% 14.23%
2007 $0.98 24.84% 19.45% 16.08% 15.16%
2008 $1.20 22.45% 22.67% 19.14% 16.29%
2009 $1.33 10.83% 19.21% 18.26% 15.44%
2010 $1.38 3.76% 12.09% 16.25% 14.22%
2011 $1.48 6.88% 7.12% 13.44% 13.32%
2012 $1.62 9.83% 6.80% 10.58% 13.29%
2013 $1.79 10.19% 8.96% 8.27% 13.57%
2014 $1.93 8.12% 9.38% 7.73% 12.87%
2015 $2.00 3.63% 7.28% 7.70% 11.90%
2016 $2.16 8.00% 6.56% 7.93% 10.65%
2017 $2.34 8.33% 6.63% 7.63% 9.09%
2018 $2.80 19.66% 11.87% 9.42% 8.84%
2019 $3.28 17.14% 14.94% 11.19% 9.45%
2020 $3.64 10.98% 15.87% 12.72% 10.18%

Table and calculations by author; data source Automatic Data Processing Investor Relations

*Based on calendar year record dates of dividend payments.

**2020’s dividend assumes a 4Q payout of $0.91 whereas Automatic Data Processing has traditionally increased the dividend with a record date in December.

As a dividend growth investor, the safety of a dividend payment is very important. That means the payout ratio, whether based on net income or free cash flow, is a critical metric to track because inevitably the business will hit a rough patch that depresses the ability to pay and grow a dividend.

ADP Dividend Payout RatiosImage by author; data source Automatic Data Processing SEC filings

Over the last decade, ADP’s payout ratio has been quite stable based on both net income and free cash flow. Dividends have accounted for 59% of net income and 57% of free cash flow on average over the last 10 years.

Quantitative Quality

When adopting a dividend growth strategy, the quality of the business as well as its ability to continue to grow the dividend is of paramount importance. In order to get a gauge on the quality of the underlying business, I have a variety of metrics that I examine that help me get a glimpse of the business strength and growth as well as analyze management.

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ADP Revenue Operating and Free Cash FlowImage by author; data source Automatic Data Processing SEC filings

ADP has managed 56% total revenue growth from FY 2011 through FY 2020 which is ~5.1% annualized. Some of that is due to the spinoff of CDK Global in FY 2015. Outside of the decline in FY 2015, ADP’s average year-over-year revenue growth has been 7%.

Gross profits have shown 70% total growth over the last decade or ~6.1% annualized. Meanwhile operating profits grew 145% in total or ~10.5% annualized with operating cash flow showing growth of 77% and 6.6% annualized. Over that same time, free cash flow grew 69% in total or ~6.0% annualized.

ADP Margins Image by author; data source Automatic Data Processing SEC filings

ADP’s gross margins have shown solid improvement over the last decade, rising from 38.6% to 42.1%. The average over the last 10 years is 41.2% with the five-year average at 41.8%.

ADP Free Cash Flow Returns Image by author; data source Automatic Data Processing SEC filings

My preferred profitability metric is the free cash flow return on invested capital, FCF ROIC. Much like the FCF margin from above, I want to see a FCF ROIC greater than 10%. ADP has easily surpassed the 10% FCF ROIC each year of the last decade with FCF ROIC regularly greater than 20%. ADP has managed a 10-year average FCF ROIC of 26.7% with the average over the most recent five-year period at 29.5%.

When investing my capital, I want to take the perspective of a business owner. That means I want to see capital allocation decisions that make sense. Of course the first priority would be to invest in the business through capital expenditures to protect and grow it. Sustainable excess cash flow should then be returned to shareholders via a rising dividend payment. Any surplus cash flow above that should then be split between debt reduction, share repurchases, strategic acquisitions and building up a cash buffer.

To understand how ADP has used its cash flow, I calculate three variations of the metric, defined below:

  1. Free Cash Flow, FCF: Operating cash flow less capital expenditures
  2. Free Cash Flow after Dividend, FCFaD: FCF less total cash dividend payments
  3. Free Cash Flow after Dividend and Buybacks, FCFaDB: FCFaD less cash spent on share repurchases

Ideally the business would be generating enough cash flow to support the entire capital allocation process. I’m not concerned if any year dips negative, because opportunities can be short-lived; however, I do want to see the trend over time to show a positive FCFaDB.

ADP Free Cash Flows Image by author; data source Automatic Data Processing SEC filings

As we saw earlier, ADP has shown positive FCF every year over the last decade with FCF showing year-over-year growth in 8 of the last 10 years. In total, ADP has generated $17.11 B in cumulative FCF which has allowed it to pay out $9.81 B to shareholders via a dividend that’s grown every year. The 10-year cumulative FCFaD comes to $7.30 B.

With that $7.30 B in FCFaD, management has further returned $9.69 B to shareholders via share repurchases. Unfortunately, that puts the cumulative FCFaDB at -$2.40 B for the decade. However, as you can see, ADP has generally returned 100% of FCF back to shareholders except for FY 2015 through FY 2017 which are the main offenders with regards to outspending FCF generation.

That $9.69 B spent on repurchasing shares reduced the share count from 498.3 M in FY 2011 to 432.7 M by FY 2020. That’s a total decrease of 13.2% or ~1.6% annualized.

ADP Shares OutstandingImage by author; data source Automatic Data Processing SEC filings

As an investor in the equity of a business, the balance sheet is high on the list of things to keep an eye on since equity is lower on the capital structure. If debt levels are too high and not supported by the cash flows generated by the business, then shareholders’ investment will be at risk.

ADP Debt to CapitalizationImage by author; data source Automatic Data Processing SEC filings

ADP has been judicious with its approach to debt over the last decade. Over the last decade, the average debt-to-capitalization ratio works out to 18% with the median at 25%. In terms of the capital structure, debt is not a concern at this time.

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ADP Debt RatiosImage by author; data source Automatic Data Processing SEC filings

In analyzing the balance sheet, I also want to see how much debt there is in relation to a variety of “income” metrics. Essentially what I want to find out is how quickly the debt load could be reduced should the cost of debt materially increases. The 10-year average debt-to-EBITDA, debt-to-operating income and debt-to-FCF levels are 0.7x, 0.5x and 0.7x, respectively.

Valuation

For valuing investment candidates, I use multiple methods to come up with a rough idea of the fair value. The approaches that I like to use are the minimum acceptable rate of return (MARR), dividend yield theory and a reverse discounted cash flow as a “reality check” to see what expectations are built into the share price.

A MARR analysis requires you to estimate the future earnings and dividends that a business will produce, apply a reasonable expected multiple on those future earnings and calculate the expected return. If the expected return is greater than your hurdle rate, then you can feel free to invest; if not, then you either wait for the price to value relationship to change and look for other opportunities.

Analysts expect ADP to show FY 2021, the current year, EPS of $5.00 and FY 2022 EPS of $5.96. They also expect ADP to be able to show 10.6% annual EPS growth over the next five years. I then assumed that ADP would manage 5.0% annual EPS growth for the following five years. Dividends are assumed to target a 60% payout ratio.

I like to use history as a guide when determining what multiple future market participants might value ADP’s earnings at. As you can see in the following YChart, ADP has typically traded between ~16x and ~30x TTM EPS. For the MARR analysis, I’ll examine P/E ratios ranging from 15x to 30x.

ChartData by YCharts

The following table shows the potential internal rates of return that an investment in ADP could produce provided the assumptions laid out above are reasonably close to how the future plays out. Returns include dividends taken in cash and are calculated assuming a purchase price of $149.20, Friday’s closing price. Returns are run through the end of calendar year 2025, “5 Years”, and calendar year 2030, “10 Years”.

IRR
P/E Level 5 Year 10 Year
30 14.4% 11.0%
25 10.7% 9.2%
22.5 8.6% 8.2%
20 6.3% 7.2%
17.5 3.8% 6.0%
15 1.0% 4.6%

Alternatively, I also calculate at what level I could purchase shares in order to generate the returns that I desire from my investments once again provided the assumptions above are reasonable expectations. My typical hurdle rate is a 10% IRR, and for ADP, I’ll also examine 9% and 8% hurdle rates.

Purchase Price Targets
10% Return Target 9% Return Target 8% Return Target
P/E Level 5 Year 10 Year 5 Year 10 Year 5 Year 10 Year
30 $183 $163 $191 $177 $200 $193
25 $155 $141 $162 $153 $169 $166
22.5 $141 $130 $148 $141 $154 $153
20 $128 $119 $133 $129 $139 $140
17.5 $114 $109 $119 $117 $124 $127
15 $100 $98 $105 $105 $109 $114

Dividend yield theory is another method of valuing an investment and is built on the idea of mean reversion. This valuation method is best suited for stable businesses. For dividend yield theory, I will use the five-year average dividend yield as a proxy for the fair value of ADP.

Automatic Data Processing Dividend Yield Theory Passive Income Pursuit

Image by author; data source Automatic Data Processing Investor Relations and Yahoo Finance

Shares of ADP currently offer a 2.44% dividend yield compared to the five-year average of 2.24%.

The reverse discounted cash flow analysis is a way to decipher what market participants are expecting out of the business in the future. I use a simplified version of the DCF built on revenue growth, the maximum of the 3-, 5- and 10-year average EBIT margin, a tax rate of 24%, and I vary the EBIT margin from no improvement of the forecast period up to 10% improvement to 22.6% over that time. Future cash flows are discounted at 8% and 10% hurdle rates.

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For the 8% hurdle rate and 0% EBIT margin improvement scenario, revenue growth needs to be around 4.9% annualized over the forecast period to justify the current share price. Whereas the 8% hurdle rate and 10% EBIT margin improvement scenario requires revenue growth of 4.6% to support the current share price. The required revenue growth rates are 7.9% and 7.4% respectively for the 10% hurdle rate scenarios.

Conclusion

ADP appears to be an attractive business with strong cash flow margins and returns on invested capital. The balance sheet is strong with debt not posing any substantial risk at this time. Management has also shown a willingness to return excess cash to shareholders as evidenced by its ever growing dividend payment as well as the share repurchases, reducing the share count 13.2% in total over the last decade.

Dividend yield theory suggests a fair value range between $148 and $180. While the MARR analysis with 8% IRRs suggests a fair value between $140 and $166. The MARR analysis with 10% IRRs suggests a fair value between $119 and $141.

The reverse discounted cash flow analyses don’t throw up any red flags with respect to the current valuation as the required revenue growth appears realistic over time and that 8% to 10% returns should be achievable.

A rough calculation for the compounding rate of the business using reinvestment rate and ROIC puts the intrinsic value growing around 6-8% per year.

At the end of FY 2020 ADP has 860,000+ clients compared to 810,000+ at the end of FY 2019. That’s just over a 6% increase in the client base during a very difficult period for businesses due to the COVID-19 lockdowns and certainty around how the economy would look once it was re-opened.

Future growth is likely to come in the form of both acquisitions and on-boarding new clients and the potential for both is huge. It’s estimated that there’s greater than 30 M businesses in the United States. With ADP’s client base of 880k that’s only ~2.9% of the potential enterprises that ADP could provide payroll and HR outsourcing services too.

Management expects FY 2021, the current year, to be quite rocky with sales declining 1-4%, 300 basis points of EBIT margin compression and EPS to be down 13-18%. That’s not exactly a rosy picture in the near term.

Automatic Data Processing Q4 FY 2020 Earnings Call Presentation

However, if you believe that the economy, both domestically and globally, will rebound within a 3-5 year horizon, then short-term weakness becomes an opportunity for those that can expand their time horizon.

I’m a bit skeptical of the optimistic earnings growth forecasts by analysts at this time considering the rough outlook for FY 2021. If we take the earnings growth assumptions down to a flat 5% over the next 10 years, returns are likely to disappoint, but I also wouldn’t be too upset with those results.

IRR
P/E Level 5 Year 10 Year
30 10.9% 9.3%
25 7.3% 7.6%
22.5 5.3% 6.7%
20 3.2% 5.7%
17.5 0.7% 4.5%
15 -1.9% 3.2%

In my opinion, the current price around $149 is attractive enough when looking out three to five years to continue adding to my position through continued dollar cost averaging. Should there be weakness that brings the share price back into the mid-$130s or lower, I would be much more inclined to add shares with bulk purchases.

Disclosure: I am/we are long ADP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com