What's an Investor to Think of ADP and Paychex?

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

The two major payroll processing companies in the United States, Automatic Data Processing (NASDAQ: ADP) and Paychex (NASDAQ: PAYX), are favorites of many income investors. Both companies provide a critical service that nearly all companies need, and they pay their investors solid dividends.

However, the painfully slow recovery in the U.S. labor market has served as an anchor on growth for both these companies, and Paychex’s fourth quarter earnings report landed on the market with a thud. What’s an investor to think of these stocks in light of recent events?

Ideal for income investors…

Income investors are understandably hungry for yield, since interest rates are near historic lows in an attempt to juice the slow-growing economy. Because of that, it’s reasonable to consider securing the dividends offered by ADP and Paychex.

Moreover, ADP’s financial position is strong, thanks to a very healthy balance sheet. ADP remains one of only four non-financial U.S. companies rated AAA by both leading credit rating agencies. In addition, the company is clearly committed to rewarding shareholders. In 2012, ADP increased its dividend 10%, raising its distribution for the 38th year in a row. ADP also bought back nearly $750 million in stock last year.

Paychex actually does its investors even better, with a higher dividend yield than its closest peer. At recent prices, Paychex yielded more than 3.5%.

…but not so much for growth investors

Unfortunately, the payroll processing business simply isn’t growing to a satisfactory degree, and the lack of growth is starting to impact investors.

For example, despite Paychex’s hefty dividend yield, the company hasn’t grown its dividend by much over the past several years. After not raising its dividend for three years, Paychex’s last two dividend raises have been in the amount of one penny per share.

The lack of growth was evident in the company’s recently released fourth quarter and full-year results. Fourth quarter revenue and profit both missed analyst expectations, sending the stock down more than 5% on a day in which the broader market rallied.

In all, revenue rose 6% in the quarter and 5% for the entire year. Diluted earnings per share, meanwhile, was flat in the quarter and up 3% in the fiscal year.

These stocks look fully valued

Paychex booked $1.56 in full fiscal year diluted earnings per share, meaning at its recent price of $38 per share, Paychex was trading for 24 times trailing earnings.

Quite frankly, it shouldn’t be a surprise that Paychex fell so much when it released earnings. Businesses have been extremely reluctant to add to their payrolls in light of the economic uncertainty facing the global economy. As a result, there simply isn’t enough growth to justify paying 24 times Paychex’s earnings.

To be fair, ADP has shown better growth in recent periods than its rival. ADP recently reported a solid fiscal third quarter, in which revenue and earnings per share from continuing operations increased 7% and 9%, respectively. Taking a longer-term view, the company’s revenue and diluted earnings per share have grown 6% and 5.7%, respectively, through the first nine months of the fiscal year.

Those numbers are certainly respectable, but judging by its immense share price appreciation, you’d think ADP was a high-growth start-up. The stock is up more than 20% just to start 2013, and as a result, the company now trades for 24 times its trailing earnings per share.

Both these stocks trade for significantly higher earnings multiples than the broader market. The S&P 500 Index carries a P/E ratio in the high teens.

As a result, investors would be wise to wait for a meaningful pullback before jumping in to either Paychex or ADP.

The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus