This Company is Doing Better than You Think

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When investors think of exciting investment prospects, payroll processing is probably not at the top of their list.

However, in this ever consolidating industry the two largest players both appear attractive at current levels. Paychex's (NASDAQ: PAYX) recent earnings positively surprised me. When I compared Automatic Data Processing (NASDAQ: ADP) and Paychex in a previous post, ADP looked like a better deal at the time. One of my primary concerns in the past was that Paychex had a much higher free cash flow payout ratio than ADP. I'm happy to say in their recent earnings report, not only has the company addressed this issue, but the rest of the numbers look pretty good as well.

The payroll processing field is made up of the two huge competitors I've mentioned and everyone else. While Intuit (NASDAQ: INTU) offers QuickBooks, which is a popular do-it-yourself payroll solution, the rest of the industry is highly fragmented into very small localized payroll processors. One of the big competitive advantages that both ADP and Paychex possess is their ability to handle benefits management and human resources issues for businesses.

Selling these additional services beyond traditional payroll processing has become a big win for both companies. Any corporate executive will tell you that the less time the company spends dealing with benefits administration and human resources, the more productive its workers can be. Since both ADP and Paychex can handle these responsibilities, this segment is seeing better growth than their traditional payroll processing.

ADP still continues to go after larger clients and has partnered with multiple financial institutions to cross-sell its services. Paychex, on the other hand, continues to go after smaller businesses and is aggressive on pricing to win these accounts. For investors looking to benefit from a continued economic recovery, either ADP or Paychex would be a good bet.

In Paychex's most recent quarter, the company reported total revenue of 3% and diluted EPS of 2%. On the surface these numbers don't sound very good, but we'll see in a minute that even small growth can lead to big cash flow for this company. The company's Payroll Service saw revenue up 1% and checks per payroll increasing 2%. While Human Resources represents just over 31% of total revenue, growth was much stronger in this division. Revenue increased 7% and health and benefits services was up 21%.

ADP saw similar trends in their earnings report, with number of checks per payroll up 3.2%, and benefit administration sales up 12%. Both companies also saw an increase in funds held for clients, but low interest rates hurt the interest they earned. Paychex showed a 9% decrease in interest and ADP suffered an 11% decline. Where these companies really shine is their ability to turn even small growth into much larger cash flow.

Paychex reported operating cash flow up 16.29% on a year-over-year basis. The company was also able to increase its cash and corporate investments by 23.59%. But the most impressive number was the company's free cash flow payout ratio, which has been an ongoing concern of mine.

During the past quarter, Paychex generated nearly $200 million in free cash flow, and paid out $116.4 million in dividends, creating a free cash flow payout ratio of 59.48%. The company also said it sees both revenue and net income growth increasing between 5% and 7% for this year. With good operating cash flow growth and a now reasonable free cash flow payout ratio, Paychex looks solid. The only question left is, Which is the better buy: ADP or Paychex?

Investors could hardly go wrong choosing either ADP or Paychex. However, based on each company's quarterly earnings, which company is the better deal really depends on what investors are looking for. ADP offers a respectable dividend yield of just under 2.7%, and analysts expect earnings growth of around 9% for the next few years. Paychex, on the other hand, offers a better yield at about 3.7%. Analysts are calling for Paychex to post closer to 10% earnings growth during the same timeframe.

Which one is a better buy will probably be determined by each company's dividend increases. By this measure, ADP would seem to have the lead as they are consistently increasing their dividend payout. Paychex left their dividend the same from July 2008 until July 2011, but the company did increase its payout in October 2011.

Considering that October would be the expected month for an additional dividend increase, a lot will probably ride on whether this occurs. If the company increases its dividend again in 2012, investors could comfortably bet on Paychex because of its higher yield and resumed dividend growth. However, if the company does not issue an increase in October, investors may see the stock fall from a lack of conviction that the dividend will grow on a consistent basis.

Both companies sell for P/E ratios that are almost the same, so valuation is a non-factor. The primary issue facing both companies will be the rate and continuation of the economic recovery. If the economy continues to improve and new jobs are added, both companies will benefit. Whereas before I would have suggested choosing ADP hands down, Paychex's impressive results show this company is doing better than people think.

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.

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