Recent Buy (17)

Purchases for my FI Portfolio have been few and far between the last few years.  That's not for lack of opportunities or desire rather it had to do with our lives being on a roller coaster.  However, there's a light at the end of the tunnel as our main goal for this year is to get rid of all non-mortgage debt and then refocus our energy towards building up the portfolio.  

We aren't contributing fresh capital to our investments just yet as we're focused on getting rid of our non-mortgage debt.  However, that doesn't mean that we're not able to make new purchases thanks to the dividends that keep rolling in from our other positions and some sales that we've made.  Although I'm hopeful to start making at least one regular purchase each month starting in September!

One of my goals for my FI Portfolio for 2019 is to build up the positions rather than build out the number of positions.  Essentially I want to increase my exposure to the companies that I own instead of many smaller positions that make it hard to be motivated to monitor the company.  With the dividend growth strategy I still think it's fine since the bulk of the work is done upfront; however, I still think that in general the less the better.

I've been pretty good with sticking to that plan; however, after adding a new position in Paychex (PAYX) a few weeks ago I decided to add yet another new position last week.  Kind of.  You see the company I added was Paychex's largest competitor, Automatic Data Processing (ADP).

I really like the payroll and HR/benefits outsourcing sector.  The sector is ripe for further consolidation with the two big players winning out and carries strong cash flows with high returns on invested capital.  

On October 30th I initiated a new position by purchasing 3 shares of Automatic Data Processing (ADP) at $158.50 per share.  The total cost basis for this initial purchase was $475.50.  Based on the most recent quarterly payout of $0.79 per share, this lot carries a YOC of 1.99% and I can expect to receive $9.48 in dividends over the next year.  Automatic Data Processing is a Dividend Champion with 44 consecutive years of dividend growth.

You can read my full business and valuation analysis of Automatic Data Processing over on Seeking Alpha.



Due to this purchase my FI Portfolio's forward 12-month dividends increased to $7,678.52.

Dividends

Automatic Data Processing's dividend growth streak of 44 years clearly puts them in the camp of being a business that will reward shareholders.  
 

*A full screen version can be found here.

Automatic Data Processing's dividend growth has been fantastic and more than outpaced inflation.  

Of the 28 1-year periods since 1991, ADP's dividend growth has ranged from 3.6% to 33.0% with an average of 14.2% and a median of 13.9%.  

Expanding the time frame out to the 24 rolling 5-year periods smooths out the fluctuations.  Annualized dividend growth has ranged from 7.6% to 21.0% with an average of 13.4% and a median of 13.5%.

Looking at the 19 rolling 10-year periods it's ranged from 8.8% to 18.1% with an average of 13.5% and a median of 14.0%.

As a company that's tied a bit more to the state/direction of the economy and employment I'm not surprised to see larger variance in dividend growth.  That being said if going forward the worst case scenario is dividend growth around 3-4% during the next recession I'll gladly take it.

The 1-, 3-, 5- and 10-year rolling dividend growth rates since 1991 can be found in the chart below.  

*A full screen version can be found here.

Valuation

One valuation method that I like to use is dividend yield theory.  The idea behind dividend yield theory is that large, stable companies will see their dividend yields revert to their mean over time.  So when the yield is higher than "average", shares are undervalued and when it's lower than "average", shares are overvalued.

*A full screen version of this chart can be found here.

The 5-year moving average dividend yield for Automatic Data Processing currently sits at 2.22% while the YOC for my purchase is 1.99%.  Dividend yield theory that suggests a fair price of $142 or roughly 10% lower than my purchase price.

The fair value range based on dividend yield theory corresponds with yields of 2.00% to 2.44%.  Using the current annual payout of $3.16 puts the fair value range at $130 - $158.  My purchase price at $158.50 is right at the upper end of fair value.

Since ADP should announce an increase to the dividend next week the fair value range should shift higher.  Assuming an increase to $0.86, which I believe is the low end of where the new payout will be, the fair value range would subsequently climb to $141 to $172.

Based on a quick and dirty Gordon Growth Model calculation ADP needs to grow the dividend at 7.85% per year in order to generate 10% annual returns which I believe is easily achievable over the long term.

Looking at a multiples analysis the valuation isn't all that compelling.  Based on estimates of $6.16 for FY 2020, the current year, and $6.93 for FY 2021 my purchase was made at a 25.7x and 22.9x P/E's, respectively.  

I've also started looking at multiples using enterprise value.  The reason I like using enterprise value is that it encapsulates purchasing the entire business, both the equity and the debt, net of cash.  I think this better encapsulates the true cost to buy the business.  

Using EV/EBIT, Joel Greenblatt's Magic Formula valuation metric, Automatic Data Processing is trading at a 22.9x EV/EBIT multiple or a 4.4% EBIT yield.  Looking at EV/EBITDA it's 20.1x or a 5.0% EBITDA yield.

As a proxy for annual returns we can use the 5-year estimated earnings growth rate of 16.6% plus the starting dividend yield of 1.99% which gives 18.5% estimated annual returns before valuation changes.  

Conclusion

There's not much bad that you can say about Automatic Data Processing.  Free cash flow margins in the 15-20% area with returns on invested capital in the 25-30% range.  Even better is that FCF ROIC has been improving suggesting that incremental ROICs are improving as well.  

The dividend is well covered by both net income and free cash flow with payout ratios in the 50-60% range over the last decade.  

Much like Paychex, the potential growth for Automatic Data Processing is pretty astounding.  ADP has 810,000 clients with operations across the globe.  Their expertise in navigating payroll and HR in a timely manner across numerous locations is what has fueled their growth.  If you're an international company looking to outsource your payroll ADP is a one-stop shop.

Much like my purchase of Paychex I kept this purchase small due to the valuation rather than any concerns about the business.  I also know myself well enough that if I don't own shares in a business, even if I want to eventually add them to my portfolio, I pay less attention to the share price and have often missed substantial dips.

I've started compiling the dividend history, growth rates and dividend yield theory for many dividend growth companies.  Automatic Data Processing's can be found here and the remaining companies that I've already gathered the data on can be found here.  As new companies are added the list will be updated.

What do you think of my purchase of Automatic Date Processing?  Do you set up price alerts for businesses or just play it by ear?