Good Growth Potential, But Not At This Price

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

I'll admit I'm a sucker for growth and income stocks. I honestly think they provide one of the best ways to get ahead in any market. After all, who doesn't like the idea of getting paid every quarter while their company earns more money each year? One company I've heard recommended many times for long-term investors is the payroll company, Automatic Data Processing (NASDAQ: ADP). Since ADP pays a yield over 3%, and is expected to grow at about 9% in the next few years, the stock certainly fits the criteria of a growth and income pick. There is just one problem, the stock has gotten a bit ahead of itself, and to make matters worse, the company's growth may not be as good as analysts expect.

ADP has an enviable business model. The company provides services to businesses large and small that range from dealer services for car dealerships to payroll for some of the largest companies around. The great part is for the companies that let ADP handle their payroll, they have to give ADP the money for payroll at least a few days before the payroll checks are actually sent or deposited. This allows ADP and its competitor Paychex (NASDAQ: PAYX) to hold these funds and make money on someone else's money.

This might not sound very exciting, but consider that ADP and Paychex do this for millions of dollars at a time. In addition, both companies charge for their services, and they are both expanding their offerings into handling tax related issues, human resources, and other areas as well. In short, the more businesses choose to outsource their work, the more money both ADP and Paychex stand to make.

Don't get me wrong, though this is a business dominated by two big players, there are many competitors. For instance, Intuit (NASDAQ: INTU) through its Quickbooks software is trying to convince small businesses that they can handle payroll on their own. Some business owners go this route, to avoid having to pay ADP or Paychex to handle payroll for them. However, given the right pricing, many business owners are realizing that their time is worth more than they would pay to ADP or Paychex to deal with this hassle. Even if they don't outsource payroll and other functions to the “big 2” they can certainly find hundreds of smaller payroll providers across the country. If there is one difference between ADP and the rest, it is the company's strong link to banks, and this partnership is paying dividends for the company.

ADP has relationships with multiple financial institutions that want to be in the payroll business, but they don't have the resources that ADP brings to the table. Paychex tends to go after small businesses, and competes on price, but has less connections to the thousands of businesses that are in front of bankers every day. This profit sharing agreement between ADP and banks gets the company in front of a lot of businesses, and ADP's size, reputation, and capabilities wins a lot of business. I know at this point some people are thinking, all of this sounds great, so why in the heck wouldn't I just buy the stock? There are two primary reasons in my opinion to avoid ADP at the current time, tepid growth and the current price.

I'll admit I gave ADP a long hard look for my personal portfolio. What I couldn't get past was the lackluster growth the company has been posting versus what analysts expect in the future. ADP's recent quarter is a perfect example of this disconnect. While ADP's PEO (think HR and other services) and Dealer Services saw good revenue growth of 13% and 9% respectively, their main business is still Employer Services. In fact, this division makes up nearly 69% of revenues, but over 90% of pre-tax earnings.

In short, as ADP's payroll processing goes, so does the company's earnings. With revenue in Employer Services up just 6%, and growth in number of employees up 3.3%, there just isn't a lot to get excited about. In addition, the company was only able to generate 5% overall revenue growth, and 2% continuing EPS growth. I understand that ADP has a great business, but 2% EPS growth is just not going to cut it. In addition, there is a trend that will likely create slow EPS growth over the near term.

Unless you live under a rock, you know that short-term interest rates are down. No where is this more clear than ADP's financial statements. The company saw an increase of 6% in client funds held, but the interest on these funds declined 12% year-over-year. This is a problem, because with continued Federal Reserve action to keep rates low, it's unlikely that ADP will see this decline in interest abate in the short term. Granted, lower interest rates are hurting multiple businesses. However, in ADP and Paychex's case, the decline in short-term interest rates hurts a core part of their business.

Intuit is harmed much less in this scenario, because their business doesn't rely on holding client funds as much as selling software solutions. Since low interest rates and slow growth are probably going to continue for the near term, you have to wonder why the stock is valued at over 19 times next year's earnings.

Talk about a double whammy, ADP is growing slowly and yet the stock sells for over 19 times projected earnings. Though I do believe that the economy will continue to improve, it will likely be a few years before significant growth in the employment rolls is seen. Until significant employment growth occurs, and short-term interest rates begin to move upward, ADP and Paychex both will be stuck between a rock and a hard place. ADP's five year high P/E ratio is about 21. With the stock selling for just less than this five year high, investors seem to have high expectations.

Even if you believe analysts, and think the company will deliver on 9% EPS growth, there are still better options in the same industry. By comparison, Paychex looks like a better value. The company sells for a nearly identical P/E ratio to ADP, yet is expected to grow faster, and pays a yield that is more than 1% higher. If you are a growth investor, Intuit seems like a much better opportunity. Intuit sells for a P/E ratio less than either ADP or Paychex, and yet is expected to outgrow both by a significant margin.

The bottom line is, ADP has a great business, but slow growth, economic headwinds, and a high stock price are not a combination I would bet on.

MHenage has no position in any stocks mentioned. The Motley Fool recommends Automatic Data Processing, Intuit, and Paychex. The Motley Fool owns shares of Intuit. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus