Friday, August 16, 2013

Automatic Data Processing (ADP) Dividend Stock Analysis

Third analysis of the week is now up.  I previously looked at Dr. Pepper Snapple Group and International Business Machines, and now we'll move on to a financial services firm, Automatic Data Processing.  It feels good to get back to analyzing stocks and learning as much as I can.  The more you learn and study and practice the better you'll get.  Investing is a skill as much as an art.  ADP closed trading on August 13th at $72.99.

Company Background (sourced from Yahoo! Finance):

Automatic Data Processing, Inc. and its subsidiaries provide business outsourcing solutions. The company operates in three segments: Employer Services, Professional Employer Organization (PEO) Services, and Dealer Services. The Employer Services segment offers a range of human resource (HR) information, payroll processing, time and labor management, and tax and benefits administration solutions and services, including traditional and Web-based outsourcing solutions to employers in the United States, Canada, Europe, South America, Australia, and Asia. Its solutions assist employers to recruit, staff, manage, pay, and retain their employees. The PEO Services segment provides employment administration outsourcing solutions comprising payroll, payroll tax filing, HR guidance, 401(k) plan administration, benefits administration, compliance services, health and workers’ compensation coverage, and other supplemental benefits for employees. The Dealer Services segment offers integrated dealer management systems, digital marketing solutions, and other business management solutions to auto, truck, motorcycle, marine, recreational vehicle, and heavy equipment retailers in North America, Europe, South Africa, the Middle East, and the Asia Pacific region. It also provides integrated applications for various department and functional areas of the dealership, such as customer relationship management applications, front-end sales and marketing/advertising solutions, and IP telephony phone systems; and computer hardware, hardware maintenance services, software support, system design, and network consulting services, as well as designs, establishes, and maintains communications networks for its dealership clients.

DCF Valuation:

Analysts expect ADP to grow earnings 9.67% per year for the next five years and I've assumed they can grow at 2/3 of that, or 6.45%, and continue to grow at 3.50% per year thereafter. Running these numbers through a three stage DCF analysis with a 10% discount rate yields a fair value price of $66.31. This means the shares are trading at a 10.1% premium to the discounted cash flow analysis.

Graham Number:

The Graham Number valuation method was conceived of by Benjamin Graham, the father of value investing, and calculates the maximum price one should pay for a company given the earnings and book value.  ADP earned $2.89 per share in the last twelve months and has a current book value of $12.82.  The Graham Number is calculated to be $28.87, suggesting that ADP is overvalued by 152.8%.

Average High Dividend Yield:

ADP' average high dividend yield for the past 5 years is 3.60% and for the past 10 years is 2.85%.  This gives target prices of $48.37 and $60.96 respectively based on the current annual dividend of $1.74.  The dividend yield took a big jump during the financial crisis and between 2009-2010 the average high yield was 3.96%.  Before then the average high yield was around current yield levels in the low 2% range and has been sliding down since the end of FY 2010.  I expect it to come more back in line with the longer term history, so I'll use the 10 year price target to calculate the entry price.  ADP is currently trading at a 19.7% premium to the average high dividend yield valuation.


 Average Low PE Ratio:

ADP's average low PE ratio for the past 5 years is 15.48 and for the past 10 years is 16.60.   This corresponds to a price per share of $48.91 and $52.45 respectively based off the analyst estimate of $3.16 per share for fiscal year 2014.  If you remove FY 2009 from the 5 year average it becomes 16.25 which is in line with the 10 year norm.  For the sake of being conservative I'll use the average of the two for the target entry price.  This gives a target entry price of $50.68 which shares are currently trading for a 44.0% premium.

Average Low P/S Ratio:

ADP's average low PS ratio for the past 5 years is 2.09 and for the past 10 years is 2.28.  This corresponds to a price per share of $55.23 and $60.23 respectively based off the analyst estimate for revenue growth from FY 2012 to FY 2013.  Currently, their current PS ratio is 3.11 on a trailing twelve months basis.  Both ratios are relatively close so I'll use the 5 year ratio just to be conservative.  ADP is currently trading at a 32.2% premium to this price.

Dividend Discount Model:

For the DDM, I assumed that ADP will be able to grow dividends for the next 5 years at the minimum of 15% or the lowest of the 1, 3, 5, or 10 year growth rates. In this case that would be 7.99%.  After that I assumed they can continue to raise dividends for 3 years at 75% of 7.99% or 5.99% and in perpetuity at 3.50%.  The dividend growth rates are based off fiscal year payouts and don't necessarily correspond to quarter over quarter increases.  To calculate the value I used a discount rate of 10%.  Based on the DDM, ADP is worth $33.50, meaning it's overvalued by 117.9%.

PE Ratios:

ADP's trailing PE is 25.26 and it's forward PE is 20.91.  The PE3 based on the average earnings for the last 3 years is 26.61.  I like to see the PE3 be less than 15 which ADP is currently well over.  Part of this is due to lower earnings coming out of the recession but it still seems it's price has gotten a bit ahead of itself.  Compared to it's industry, ADP seems to be overvalued versus NSP (22.80) and undervalued versus PAYX (25.35).  All industry comparisons are on a TTM basis.  ADP's PEG for the next 5 years is currently at 2.38 while NSP is at 1.43 and PAYX is at 2.37.  Based on the PEG ratio, ADP is overvalued versus Insperity but even against Paycheck.  A lower PEG ratio is better because it means you're paying less for every dollar of growth the company achieves.

Fundamentals:

ADP's gross margins for FY 2011 and FY 2012 were 42.6% and 42.4% respectively. They have averaged a 50.0% gross profit margin over the last 10 years.  Their net income margin for the same years were 13.4% and 13.7%.  Since 2003 their net income margin has averaged 14.6% with a low of 12.6% in FY 2004.  I typically like to see gross margins greater than 60% and at least higher than 40% with net income margins being 10% and at least 7%.  Both gross and net profit margins have been trending down over the last decade although I expect them to both increase from here.  Their gross profit margin is above the 40% threshold but their net income really excels being well over the 10% level despite trending lower.  Since each industry is different and allows for different margins, I feel it's prudent to compare ADP to its industry.  For FY 2012, ADP captured only 75.7% of the gross margin for the industry but a pretty stunning 137% of the net income margin.  While the gross margin is lower than the industry as a whole, it's reassuring that their net income margin is well higher than the average.

Share Buyback:

ADP has shown a tendency to repurchase shares as a way to return cash to shareholders.  Since FY 2002, they've purchased 22.0% of their shares outstanding for an average annualized decrease of 2.45%.  Buybacks are great as long as they are purchasing shares at a value price point, otherwise they are reducing shareholder value through the buyback program.  Looking at the historical data, they increased their buyback program during FY 2006-08 which just glancing at doesn't seem like it was the best time as shares on average weren't trading at bargain prices although it was around their historical norms.


A negative number for the % change value means shares were bought back by the company and a positive value means the shares outstanding increased.

Dividend Analysis:

ADP is a dividend champion with 38 consecutive years of dividend increases.  They have increased the dividend at a 9.68%, 7.99%, 9.10%, and 13.48% rate for the last 1, 3, 5 and 10 year periods.   Their payout ratio based off EPS has increased since FY 2002 which has allowed the dividend to increase faster than EPS have grown.  I expect it to track closer to EPS growth going forward although with over 9% projected EPS growth for the next 5 years you could still see solid growth of the dividend.  Since FY 2002 the payout ratio has increased from 28.6% to 55.0% and has averaged 43.0% over that time.


ADP is a very solid cash generator.  They have very low required capital expenses which has allowed them to turn 84% of their operating cash flow into free cash flow to the company.  Their free cash flow has grown from $1.276B in 2002 to $1.660B in 2012, good for a 2.7% annualized increase.  The free cash flow payout ratio has averaged only 38.7% since FY 2002, which is about 4.5% less than the payout based on earnings.  For FY 2012 their FCF payout ratio was only 45.9% which was around 9% less than their earnings payout.  Annual total shareholder return when accounting for buybacks plus dividends has averaged 111.9% of FCF since FY 2003.  If you exclude FY 2006-2008 when the buyback program was increased, the average drops to 88.6%.  I really like that management is willing to return around 100% of their free cash flow to shareholders.



Return on Equity and Return on Capital Invested:

ADP earns a very solid ROE averaging 21.8% over the last 10 years.  Their ROCI has been solid as well averaging 21.5%.  The difference is due to the debt that ADP has, but it's a very negligible amount of debt.  I don't necessarily look for any absolute values for ROE or ROCI but rather fairly stable or increasing levels.  ADP has done a great job of earning consistent returns on equity and invested capital as well as being able to increase it over time as well.  Due to the negligible debt that ADP carries their debt-to-equity ratio is essentially zero.  Their balance sheet is pristine and I don't expect that to change anytime soon as their operations require very low capital expenditures and almost no inventory.


Revenue and Net Income:

Since the basis of dividend growth is revenue and net income growth, we'll now look at how ADP has done on that front.  Their revenue growth since 2002 has been decent with a 4.46% annual increase while their net income has only grown 2.35% per year.  This has led to their net profit margin decreasing over time but I expect it to start trending back higher.  Analysts expect great revenue growth over the next two years of 7.10% and 7.60%.  If those come to pass then ADP will be in an even better situation than they are now.


Forecast:



The chart shows the historical high and low prices since 2001 and the forecast based on the average PE ratios and the expected EPS values. I have also included a forecast based off a PE ratio that is only 75% of the average low PE ratio.  I like to the look to buy at the 75% Low PE price or lower to provide for a larger margin of safety, although this price doesn't usually come around very often. In the case of ADP, the target low PE is 16.04 and the 0.75 * PE is 12.03.  This corresponds to an entry price of $54.74 based off the expected earnings for FY 2013 of $3.16, with a 75% target price of $36.68.  Currently ADP is trading at a $36.31 premium to the 75% low PE target price and a $14.51 premium to the average PE price.  If you believe the analyst estimates are pretty close, then ADP is trading right around it's fair value range.

Conclusion:

The average of all the valuation models gives a target entry price of $49.26 which means that ADP is currently trading at a 48.2% premium to the target entry price. I've also calculated it with the highest and lowest valuation methods thrown out.   In this case, the DCF and Graham Number valuations are removed and the new average is $50.09.  ADP is trading at a 45.7% premium to this price as well.

Assuming that ADP can grow their earnings and dividends at the rates that I assumed, you're looking at pretty poor returns over the next 10 years.  In 2023, EPS would be $6.30 and slapping an average PE of 18.51 gives a price of $116.64.  Over the next 10 years you'd also receive $26.05 in dividends for a total return of 195.49% which is only a 6.93% annualized rate if you purchase at the current price.  If you purchase at my target entry price of $50.09, your projected 10 year total return jumps to 284.86% for an annualized return of 11.04%.  This is why valuation matters when making your initial purchase.

According to Yahoo! Finance the 1 year target estimate is at $74.66 suggesting only about 2.3% upside from recent prices.  Morningstar has PM rated as a 2 star stock meaning it's a hold and should provide subpar returns going forward.  This has nothing to do with the company or the potential for growth, rather it's based off it being very richly valued.



If you believe in the long term growth of the economy and subsequent improvement in the employment levels then ADP is a great company to invest in.  One of the things I like the most about ADP is that for companies that it provides payroll processing services to; they receive enough cash beforehand to cover all paychecks and still have a buffer, but ADP gets to put that money in an interest bearing account.  As the economy improves and interest rates rise, ADP could get to reap more service charges as larger amounts of people are being employed and also earn higher rates on that cash.  Another great thing about ADP is that it's very hard, especially for large companies, to change their HR service company or payroll processor without potentially causing problems for their employees.  This leads to very little turnover in ADPs customers which means fairly predictable performance from ADP from year to year.

While I believe in the tailwinds that can lead to growth of ADP and in turn its' dividend, the stock is just too rich at this point in time.  The average valuation based off dividend yield, P/E ratio and P/S ratio gives fair value price target of $62.16.  This would require around a 15% pullback from current levels.  I would certainly welcome this because ADP is one of those companies with a great business model and really sticky services.  Their performance is going to be tied to the economy as a whole so eventually there will be another opportunity to become a part owner in this great company.  I would probably shy away from selling puts on ADP because the price is just too far away from even the fair value price.  If there happens to be a 7% pullback then I'd consider selling puts as a way to enter a position, but until then I'll just keep looking for other opportunities.

To check out more reports check out my Stock Analysis page.

What do you think about Automatic Data Processing as a DG investment at today's prices?  How do you think the long-term dividend growth prospects are?

13 comments:

  1. Thanks for analyzing ADP. This company has been on my watch list since the beginning, but I never got around to starting a position. I'm unlikely the buy shares at the moment because I see it as over valued too.

    Anyways, just stopping by to show some support. Hope you guys were able to close the house!

    ReplyDelete
    Replies
    1. CI,

      No problem and if there's any other companies you'd like me to take a deeper look at I'll do my best. I'm hopefully going to be able to get a post on Visa up later this week because I really like their prospects going forward. ADP seems to be another one of those chronically overvalued companies, but that's for good reason. I remember looking at them when I first started investing and it seemed a little pricy then. Ooops!

      We were finally able to agree on everything for the house so now we're just waiting for the underwriting to finish. Actually it's pretty much done from what I understand so I'm looking forward to that, although we still have to wait until the close date which is scheduled for September 9th right now.

      Thanks for stopping by!

      Delete
  2. ADP is a great business, much like Paychex. Solid moat, high switching costs, nice barriers to entry. Its one of the few firms that will directly benefit from an increase in interest rates. Now that the hiring picture looks more promising for the US economy, I expect it to additionally benefit. Shame about the price, but this is one to watch on market declines.

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    Replies
    1. Integrator,

      I like that it's another one of those de facto duopolies. And what's even better is that it's a huge undertaking to change from one provider to another. Companies won't be changing for a small price break because it's too hard to implement the changes. They're definitely poised to do very well as interest rates rise and the economy strengthens. Like you I'm hoping to get a broad market pullback, possibly in response to the Fed's Jackson Hole meeting next month, to give at least fair value prices on ADP. If not then I'll just have to wait until the next recession, because ADP won't be going anywhere.

      Thanks for stopping by!

      Delete
  3. I've been tracking ADP for months waiting for a dip. My models give it a fair valuation of $52...painfully expensive at this point. Great analysis. New to your blog, looking forward to further analyses.

    ReplyDelete
    Replies
    1. BidAskDividends,

      I'm also hoping for a dip in price to at least somewhere close to fair value. It is quite expensive, although at least it's very high quality. I still don't think I could justify purchasing right now though because the starting yield is too low for me and that whole price is what you pay, value is what you get thing.

      I've got a few more analyses lined up and a new motivation to get some written up. I went into a bit of a slump there in the middle of the year but I've gotten a second wind.

      Glad to have you on board. If there's any companies you'd like me to take a further look at feel free to let me know.

      Thanks for stopping by!

      Delete
  4. Glad you picked this one to look at - I've held ADP for some time now, it was a great addition into my portfolio, I believe I am up a good 35% plus dividends. I agree that it is getting into the overvalued territory, so I'll likely just keep holding it and keep collecting the dividends until the price comes down and I can buy some more.

    Michael

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    Replies
    1. Michael,

      I really wish I had picked up ADP a few years back but it seemed on the high end of its fair value range and now it's pushed up into overvalued. I wouldn't say grossly overvalued, but I wouldn't be purchasing shares at these prices. Great move on buying a great company and their future just looks better and better as the economy improves. I'd love for you to be able to buy some more shares because then I could be starting my position. Time will tell when that will come. Looking forward to being a co-owner.

      I like your DT scores. I'd be trying to come up with a system similar to your scores but couldn't figure out a way to do it. You beat me to it!

      Thanks for stopping by!

      Delete
  5. Great analysis, I picked up ADP during the recession and it's been one of my best performers ever since. ADP's stock price seems to move along with the economy so as long as things are looking up, ADP will probably remain overvalued.

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    1. First Million,

      Congrats on a nice purchase of ADP. I wish I knew then what I know now. But I'm ready for the next time. I just hope that we can get a broad market spook to drop ADP down into fair value range, until then I'll just keep my eye on it and look for other opportunities. I'm seriously considering both IBM and V but the capital will be very light until next month.

      Thanks for stopping by!

      Delete
  6. I'm an employee of ADP, they offer an employee stock purchase program. If you were able to purchase the stock at a reduced rate of 5% would you buy it then? or still consider it over valued?

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    Replies
    1. Brad,

      I think ESPP programs are definitely worth it so I'd enroll in it. I use mine at Halliburton even though it doesn't fit with my overall investment strategy. But it really depends on how its set up. I have no holding requirement so I can sell my shares whenever they hit my brokerage account but some plans do have a holding requirement. I think ADP is such a great company at least from an investment perspective that its worth doing. Depending on how many shares you're able to purchase each time you can use my strategy of selling covered calls to sell the shares. I'd shy away from amassing a huge position though bc if things go bad with the economy or company you could find tourself in a situation where your income source and your investments are at risk. Even thoughits overvalued, at least in my opinion, its such a high quality company that I would use the plan. Plus with the dg history and improving economy and rising interest rates things still look good for ADP.

      Thanks for stopping by!

      Delete
  7. The Dividend History page provides a single page to review all of the aggregated Dividend payment information.

    ReplyDelete