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Written by Bob Ciura

Automatic Data Processing (ADP) traces its roots all the way back to 1949, when it was started by a 21-year old entrepreneur named Henry Taub. ADP began with a single client, and in the decades since, has grown to an industry leader in payroll processing services.

ADP currently has more than 600,000 clients spread across the world.The stock has generated strong total returns over the last decade.The image below shows an investment in ADP vs the S&P 500 (SPY) over the last decade.

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ADP has a long history of paying and raising its dividend. The company has increased its shareholder payout each year for the past 41 years.

This streak qualifies ADP as a Dividend Aristocrat. In fact, ADP is the only Dividend Aristocrat in the information technology sector.Rapidly advancing technology makes building a durable competitive advantage in the IT sector difficult.ADP is the exception, not the rule.

Being a Dividend Aristocrat matters.ADP’s excellent performance over the last decade is not an exception.The Dividend Aristocrats Index has outperformed the S&P 500 by 3.1 percentage points a year on average over the last decade, according to S&P.You can see all 50 Dividend Aristocrats here.

ADP’s most recent dividend increase was 8.1% in November 2015. ADP’s new annualized dividend of $2.12 per share represents a 2.4% current dividend yield. It has been four quarters since the last increase. Since the company typically raises its dividend each year in the fourth quarter, another raise is likely next month.

ADP maintains a target payout ratio of 55%-60% of earnings. This is the percentage of profits that the company seeks to distribute to shareholders as a dividend. Last year, ADP’s declared dividends of $2.08 per share represented 64% of its diluted earnings for the year. That is slightly above its target payout ratio, but the company is likely to generate enough earnings growth to justify a dividend increase this year. Therefore, investors should expect a mid-single digit dividend increase in the coming month.

Keep reading this article to learn more about the investment prospects of ADP.

Business Overview

ADP operates two separate reporting segments, which are Employer Services and Professional Employer Organization Services. The Employer Services business is ADP’s largest, and constitutes more than 80% of annual earnings.

ADP provides administrative tasks like payroll services, benefits administration, and human resources management to companies of all sizes. ADP’s clients utilize these services because outsourcing these functions allows them to focus on their core business activities. With hundreds of thousands of clients, ADP is highly diversified. No single customer represents more than 2% of ADP’s annual revenue.

Moving forward, ADP will concentrate solely on its Human Capital Management business, as a result of its 2014 spin-off of CDK Global CDK. The HCM business is comprised of software and service-based products designed to help clients streamline their recruiting, payroll, and management functions. Specifically, ADP will invest mostly in cloud-based software, to fuel future growth.

While ADP is in the information technology sector, it’s important to note that its business is service relates; not based on technology.Both small and large businesses will continue to need payroll processing and help with ever-increasing regulatory burdens, regardless of how quickly technology advances.

And make no mistake…The amount of regulations that both small and large businesses must keep up with is only increasing – and that’s good news for ADP.

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Source: NASDAQ 33rd Investor Program Presentation, slide 15

Growth Prospects & Competitive Advantage

ADP had a very successful company performance last year.

Despite the HCM business being highly competitive, with new and established industry players vying for market share, ADP retained 91.4% of its customers last year, which set a record for the company.

This helped fuel 7% revenue growth last year and adjusted 14% growth in earnings-per-share.

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Source:  ADP 4th Quarter 2016 Presentation, slide 4

ADP also managed to grow new business bookings by 13% in 2016, a promising indication of future growth potential. Analysts on average expect ADP will generate $3.50 per share of earnings in the current fiscal year.

This projection would represent 7.7% earnings growth this year. Analyst forecasts are in-line with management’s internal projections. ADP anticipates 7%-9% revenue growth along with 6%-8% earnings growth this fiscal year.

The company is expecting strong growth in fiscal 2017 as well, as the image below shows:

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Source:  ADP 4th Quarter 2016 Presentation, slide 6

Looking at the company’s growth in 2016 and expected growth in 2017, a long-term earnings-per-share growth rate of 7% to 9% is certainly reasonable and in line with current trends.

One of the fundamental tailwinds ADP will look forward to is an increasingly complex regulatory environment, both in the U.S. and internationally. Among ADP’s core functions is to help its clients navigate the changing regulatory landscape. This has been a driving force behind ADP’s impressive growth in recent years.

Over the past five years, ADP has increased revenue and earnings per share by 31% and 34%, respectively.This is solid growth for an established blue chip dividend payer like ADP.

ADP’s solid growth is also the result of its competitive advantage, which is itsscale and excellent reputation among its customers. As a global company, ADP has the resources to work with companies that have employees across multiple nations. This is an ability that smaller companies do not possess.ADP is the largest publicly traded HCM business in the world.You want a trusted and established business to handle your benefits, health care, and payroll.The company’s reputation and brand add to its competitive advantage.

Recession Performance

Another quality ADP possesses that make it an appealing long-term dividend investment is its recession-resistant business model. Even when the global economy enters recession, employers still need the payroll and human resource management services that ADP provides. This sufficiently insulates ADP from the ravaging effects of a deep recession, such as the one the U.S. experienced in 2008 and 2009.

For example, in 2008 ADP grew earnings per share by 20%. This was a notable achievement, as it was very rare for any large company in the S&P 500 to post such a high rate of earnings growth. Then, ADP grew earnings by 8.6% in 2009. From 2007-2010, ADP generated 31% earnings growth.The company’s earnings-per-share over the great recession are shown below:

• 2007 earnings-per-share of $1.83
• 2008 earnings-per-share of $2.20
• 2009 earnings-per-share of $2.39
• 2010 earnings-per-share of $2.39

Valuation & Expected Total Returns

ADP’s future shareholder returns will be a function of its earnings and dividend growth, along with any changes in its valuation. The current dividend yield of 2.7% plus 7% to 9% expected earnings growth leads to an implied future return of 9.7% to 11.7% per year, before changes in the valuation multiple.

Since 2000, ADP stock has traded for an average price-to-earnings ratio of 24.The company is currently trading for a price-to-earnings ratio of 26.The company appears a bit overvalued given its historical price-to-earnings ratio.

The S&P 500 is currently trading for a price-to-earnings ratio of 24.6.ADP is trading a bit above the S&P 500’s price-to-earnings ratio.This should be expected, as the company’s solid growth prospects and stability command a premium over the ‘average’ S&P 500 stock.

Considering the above, ADP is likely trading around fair value in today’s market given the elevated level of the S&P 500.

Final Thoughts

ADP is a highly profitable company with a strong business model and many competitive strengths. It also has a strong balance sheet, and is one of only two U.S. based companies to hold the ‘AAA’ credit rating from Standard & Poor’s. This provides investors with a considerable margin of safety.

Because ADP’s future earnings growth forecasts are roughly in-line with the S&P 500’s, investors may want to wait for a better valuation before buying ADP stock. Compression of ADP’s valuation multiple would negatively impact future returns for shareholders who buy at the current price.

ADP currently has a slightly below average ranking using The 8 Rules of Dividend Investing.The company’s fairly high valuation multiple holds the company back from ranking higher.

While value investors may quibble with ADP’s current valuation, ADP is a high quality business that will very likely continue to reward shareholders with rising dividends.The company makes a compelling long-term hold in a dividend growth portfolio – especially for investors looking for exposure to the notoriously fickle information technology sector.