Last week I looked at whether or not Paychex’s (PAYX) dividend growth was a function of EPS growth or growth in its payout ratio. This week I’ll take the same look at Paychex’s rival in the payment processing business, Automatic Data Processing (ADP). Has ADP’s dividend growth been a function of EPS growth or payout ratio growth? Which company is a better choice based on its dividend policy, business prospects, and valuation?
Business Description
Automatic Data Processing is another dividend aristocrat with the company raising its dividend the past 35 years. The company’s main business is payment processing, whereas; Paychex (PAYX) focuses on small businesses ADP focuses on large businesses.
Taken from Yahoo! Finance (click here for the full profile):
Automatic Data Processing, Inc. provides technology-based outsourcing solutions to employers, and vehicle retailers and manufacturers. It operates in three segments: Employer Services, Professional Employer Organization Services, and Dealer Services.
Dividend and Earnings Growth
The table below outlines the compound annual growth rate for both earnings per share and dividends per share on a 5 and 10 year basis.
While not as egregious as Paychex’s growth rates Automatic Data Processing’s (ADP) growth rates show an imbalance too. This means that while earnings growth has helped ADP grow its dividend it has relied on increasing its dividend payout ratio too. 10 years ago ADP had a payout ratio of 26% and 5 years ago the payout ratio increased to 48%. Today ADP’s payout ratio resides at 56% leaving the dividend well covered in case earnings come under further pressure, whereas; Paychex’s payout ratio resides at 94% leaving the dividend vulnerable to depressed earnings.
Business Growth
In the August commentary, “A Tale of Two Economies“, Contrary Investor lays out the argument that while things may be OK and even improving for large businesses, small businesses are still under tremendous pressure. Automatic Data Processing (ADP) caters to large businesses and Paychex (PAYX) caters to small businesses. If a choice had to be made between two dividend-paying-payroll-processors the better choice, based solely on business prospects, would be the company servicing large businesses, Automatic Data Processing.
Valuation
With Automatic Data Processing (ADP) trading at $39.09 as of August 31, 2010 it offers a better value than Paychex based on my discounted cash flow model.
My model consists on using ADP’s average gross, operating, and net margins over the last 9 years and a growth rate of 5%, this has been around ADP’s growth rate for the past 5 years. I used two discount rates, 12.5% and 10%. I also factored in a 1% share reduction each year which is below ADP’s average share reduction rate. With these inputs I come up with a value for ADP between $42 and $51.
When I run a similar discounted cash flow analysis for Paychex (PAYX) I come up with a value of $25 and Paychex is currently trading at $25.17.
Choice
If a dividend-paying-payroll-processor needed to be picked then in my opinion Automatic Data Processing (ADP) is the more compelling choice based on its dividend policy, its business prospects, and its valuation.
