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Dividend Stock Analysis: Automatic Data Processing

ADP has an appealing payout that's adequately covered


Dependable Dividend StocksAutomatic Data Processing (NYSE:ADP) is a dividend stock that provides business outsourcing solutions.

The company operates in three segments: Employer Services, Professional Employer Organization Services, and Dealer Services. The company’s largest competitors include Paychex (NASDAQ:PAYX), Convergys (NYSE:CVG) and CSG Systems (NASDAQ:CSGS).

ADP is a member of the dividend aristocrats’ index, has paid dividends since 1974 and increased them for 37 years in a row. Its last dividend increase was in November 2011, when its board approved a 9.7% increase to 39.5 cents per share.

During the past decade, this dividend growth stock has delivered an annualized total return of 7.8% to its shareholders.

ADP has managed to an impressive increase in annual EPS growth since 2003. Earnings per share have risen by 5.9% per year. Analysts expect Automatic Data Processing to earn $2.93 per share in FY2013 and $3.20 per share in FY2014. In comparison, Automatic Data Processing earned $2.82/share in FY2012. The company next reports earnings Oct. 30.

ADP has consistently repurchased stock during the past seven years, reducing its share count from 620 million shares in 2002 to 489 million in 2012.

The company will generate higher revenues over the next decade as a result of acquisitions, improving client retention rates and increased North American auto sales, which would boost its Dealer Services segment. While the employment picture in the U.S. isn’t rosy at the moment, the economic recovery should lead to additions to jobs in the near-term. Also, the market for payroll outsourcing services is relatively untapped with small- and medium-sized businesses, which could deliver strong growth for well-positioned firms like ADP. International expansion in payroll outsourcing could be another area where ADP could look for to generate growth.

The market for HR Management services, which represent a high portion of ADP’s Employer Services segment, is expected to increase by 4.5% per year until 2014, according to IDC. The market for Business Process Outsourcing, where ADP is trying to expand into, is expected to increase by almost 5% per annum during the same time frame.

The barriers to entry in payroll outsourcing are very high, as they require sizable investments in technology and infrastructure to process the information for thousands of employees. This business also requires regular investment in technologies to stay competitive. This creates economies of scale for larger processors such as ADP, which further differentiates them from the competition.

ADP’s return on equity has increased from 19% to 23%. Rather than focus on absolute values for this indicator, I generally want to see at least a stable return on equity over time.

annual dividend payment has increased by 13.4% per year over the past decade, which is higher than the growth in EPS. The expansion in the dividend payout ratio allowed the company to raise distributions at a rate that is higher than earnings.

A 13% growth in distributions translates into the dividend payment doubling almost every five-and-a-half years. If we look at historical data, going as far back as 1986 we see that Automatic Data Processing has actually managed to double its dividend every five years on average.

The dividend payout ratio increased from 28.6% in 2003 to 55% in 2012. You’d like to see a lower payout ratio, since it leaves room for consistent dividend growth, minimizing the impact of short-term fluctuations in earnings.

Currently, Automatic Data Processing is slightly overvalued at 20.7 times earnings, has an adequately covered dividend and yields 2.7%. I would consider adding to my position in the stock on dips below $56.

Full Disclosure: Long ADP

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