A Perfect Play on the Economic Recovery
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
You know the company is tied to the economy when investment analysts use the company's employment projections to determine the strength of the domestic economy. Such is the case with Automatic Data Processing (NASDAQ: ADP), which is better known by its stock symbol ADP. For investors looking for a way to play the recovery of the domestic economy, ADP seems to be a logical choice. The company benefits directly as employment improves, not only by processing more payroll, but also through higher client balances to invest. Looking at the company's most recent earnings report, you can see that even in an uncertain economy, ADP still manages to do fairly well.
In the payroll processing industry there are basically two giants that dominate the field, ADP and their smaller competitor Paychex (NASDAQ: PAYX). Additionally, ADP faces competition from software related companies like Intuit (NASDAQ: INTU), which makes the popular QuickBooks program. The primary difference between the three companies is the size of customer, and their involvement in payroll processing. ADP has multiple relationships with large financial institutions to cross-sell their services. Paychex traditionally goes after smaller businesses that are still interested in outsourcing payroll processing. Intuit on the other hand, is traditionally favored by small business owners that don't wish to pay the cost to outsource their payroll. That being said, over time both ADP and Paychex should benefit as business owners become more educated on both the savings, and the risk avoidance, that comes from outsourcing payroll. With this as a backdrop, let's take a look at how ADP did in the most recent quarter.
The company saw revenue growth of 5%, and EPS increased by 10%. ADP reports in three separate divisions, and each one saw organic revenue growth. The company's Employer Services division saw revenue growth of 7%, with the number of employees serviced up 3.2%. Most impressive was the company's client retention rate came in at 91%. ADP's second division, Professional Employer Organization Services offers dedicated HR and benefit administration. This division reported revenue growth of 12%, supported by an 11% increase in average worksite employees. Last but not least, the company's Dealer Services division saw revenue growth of 7%, offering services such as auto marketing, parts and inventory management, and payroll to the auto industry. As you can see, all three divisions did fairly well, considering the seemingly directionless domestic economy. One challenge that ADP faced in the most recent quarter was, the decline in short-term interest rates hurt the company's ability to earn money on funds held for their clients. The company's interest declined 11% on a year-over-year basis, with an average interest yield of just 0.40%. On a positive note, the company did see a 4% increase in average client balances which helped offset lower interest rates. While ADP expects lower interest rates to be a challenge into next year, they are still forecasting positive growth in both revenue and earnings.
ADP's outlook for 2013 is for 5% to 7% revenue and EPS growth. The company expects that average client balances will climb by about the same rate, but average interest yield is expected to fall further. Analysts are calling for long-term earnings growth of about 9.5%. ADP's commitment to repurchasing shares should help the company attain this longer-term goal. In the most recent quarter, the company retired 6.4 million shares at an average price of $53.44. With good cash flow generation, the company's ongoing share buybacks and the dividend consistently being raised, should serve investors well.
When you consider the alternatives in the payroll processing field, between ADP and Paychex, ADP seems like the clear winner. My biggest problem with Paychex is the company's high payout ratio. While the dividend of 3.85% does look more attractive than ADP's roughly 2.7% yield, there is a big difference in the two companies payout ratios. Paychex last year paid out 74.6% of their free cash flow, and this year so far the payout ratio has climbed to nearly 100%. By contrast, ADP has a payout ratio of just 62%. This should allow the company to not only continue raising their dividend, but investors can have confidence in its stability. With both ADP and Paychex selling for similar P/E ratios, ADP's more stable dividend is really the deciding factor. While Intuit would seem like an attractive choice, this company is more of a software producer than a pure play on payroll processing. While Intuit will benefit somewhat if the economy continues to recover, ADP and Paychex will benefit more directly. ADP should definitely be on your Watchlist to keep up with future results.
MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Automatic Data Processing and Paychex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
