High Switching Costs Make This Stock a Bargain
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Determining whether a company has a sustainable competitive advantage is the most important part of any investment analysis for long-term shareholders. Companies that do not have sustainable competitive advantages will eventually succumb to competition. However, those that have wide moats often reward shareholders for years to come.
When looking for wide-moat companies, investors need look no further than the payroll processing industry. Two payroll processors -- Paychex (NASDAQ: PAYX) and Automatic Data Processing (NASDAQ: ADP) -- combine to have a 40% share of the payroll processing market.
Even better, the two companies have essentially divided the market: Paychex caters to small- and medium-sized firms while ADP handles mostly larger clients. This enables the two companies to dominate the industry without having to compete with one another in an all-out price war.
Sources of Moat: Switching Costs, Scale of Offerings, Brand
Both companies have achieved economies of scale, which allows them to match any would-be competitor's price.
But the real competitive advantage comes from the high cost associated with switching payroll processors. Switching providers is a pain in the neck; business does not stop while the transition to a new processor is made. The transition has to be carefully planned in order to avoid disruptions.
But the myriad of things that could go wrong when switching providers is enough to make it a last-ditch option for most customers.
As a result of the high risk of selecting the wrong payroll processor, companies tend to go with the firm that offers the best chance of a long-term relationship.
ADP's average client has used the company's services for more than 10 years. Paychex has a similarly-high customer retention rate.
The reason that these firms are able to attract and retain customers is that they not only offer a trusted brand name, but they also offer a wide array of services. Companies who want to sign up with a payroll processor and never think about it again want a company that can provide them with nearly every service they could possibly want from a payroll processor.
This is why Paychex is now making the push into services like 401(k) record-keeping and workers' compensation insurance. The firm is becoming a one-stop shop for its customers, which is especially important for many small businesses.
Finally, the companies' reputations are the icing on the cake. Paychex and ADP have good reputations in their respective client bases, which is a natural magnet for new and continued business.
The two companies are rewarded for their superior competitive positioning; Paychex's operating margin approaches 40% in most years, while ADP's is about 18%. In addition, Paychex's ROE is consistently in the mid-30% range, while ADP's is in the low 20%s.
Sound Like Microsoft?
High switching costs (and a network effect) have enabled Microsoft (NASDAQ: MSFT) to stay afloat amid nearly a decade of value stagnation. The Microsoft's Windows operating system was so prevalent that the company could effectively decide winners and losers in application development (before anti-trust suits forced it to tone it down).
Over the last decade, however, the company has strayed into markets where switching costs are quite low. Tablets, portable music players, and similar consumer devices do not have the competitive characteristics that enabled Microsoft to achieve dominance in the PC market.
The future of the company depends on the Windows operating system, its server and tools business, and similar business lines that have high switching costs. Everything else will eventually (or immediately) succumb to competitive pressures.
Paychex and ADP undoubtedly have competitive advantages. It is up to each investor to decide whether or not those advantages are sustainable. If Paychex's moat is judged to be permanent, the stock's near-4% dividend yield is a good indication that the company might be a bargain.
Ted Cooper III has no position in any stocks mentioned. The Motley Fool recommends Automatic Data Processing and Paychex. The Motley Fool owns shares of Microsoft. 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!