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This U.S. payroll duopoly throws off 'a ton of cash' Add to ...

It has been a little hairy for U.S. stocks so far in 2014, with the benchmark S&P 500 falling, at one point, nearly 6 per cent over the first few weeks of the year. The fears, as you’ve likely noted, are that the economic recovery isn’t all that it’s cracked up to be, and there’s a decent chance that things will actually head in the other direction.

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If the U.S. job numbers get worse, there might be few companies in a tighter spot than Automatic Data Processing Inc., and Paychex Inc., the duopoly of the country’s payroll-outsourcing market. And investors have reacted, sending the two companies’ shares down nearly 11 per cent from highs reached roughly a month before.

Or, should we ask, have investors overreacted? If the investment horizon is the long term, not the next few months, the answer may well be yes.

Certainly, it’s hard to say the two are out of favour; at $74.89 (U.S.) for ADP and $40.90 for Paychex, each still trades at more than 20 times forward earnings. Many analysts, while admiring the companies’ cash-generating business models, are hesitant to slap “buy” ratings on the shares because of doubts they can generate market-beating returns over the next year.

That was also true in the summer of 2013, however, when many analysts called them “fully valued.” The two stocks then continued runs that saw both rise nearly 50 per cent.

Perhaps it’s better, then, to focus on some longer-term thinkers: the dozen financial advisers who made the 2014 honour roll of the long-running Hulbert Financial Digest for their performance since 2000, the top of the Internet-driven stock bubble. Only a handful of strong, well-managed companies made the top-picks list of three or more of these advisers – and ADP and Paychex were among them.

“Both companies, and ADP in particular, are very well-run businesses,” says analyst Jeff Silber of BMO Nesbitt Burns’s U.S. affiliate, one of the analysts who has a “buy” rating on ADP. “To some extent, they have a captive market. They throw off a ton of cash, pay a dividend and buy back stock. ADP has increased their dividend every year since 1974 – I don’t know how many companies can say that. So they’re the type of stock you put in your grandmother’s portfolio.”

A look at the companies’ businesses, rather than a focus on their price-to-earnings ratios, makes this understandable. ADP has an estimated 30-per-cent share of payroll processing in the United States; Paychex has 10 per cent. Rather than compete for customers, says analyst Vishnu Lekraj of Morningstar, they’ve formed a “rational duopoly” with ADP focusing on larger businesses and Paychex targeting smaller concerns. “Competition has been relegated mainly to the fringe, and this dynamic has been a key driver of success for both players.”

While ADP is easily the larger of the two, they share advantages that give them, in Morningstar’s analysis, a “wide economic moat.” Once a business outsources payroll, it’s difficult to switch to another provider. ADP and Paychex are able to lock customers into long-term deals and consistently raise prices. And both companies have strong brand identities that help them against upstart, unproven competitors. (Says analyst Smittipon Srethapramote of Morgan Stanley, “As they say, you can’t get fired for using ADP.”)

The companies consistently put up return-on-capital figures of 20 per cent or 30 per cent or more, something that fewer than one in 10 S&P 500 companies achieves, per Standard & Poor’s Capital IQ. They pay out those profits as healthy dividends. (And no article about ADP is complete without mentioning it’s one of four non-financial companies in the U.S. with the highest possible AAA credit rating from S&P.)

The companies’ growth strategies are not limited to payroll outsourcing, which some analysts argue has reached a mature point. Instead, the companies continue to develop new products in what’s called “human capital management,” a description that also includes functions traditionally provided by a company’s human-resources department. ADP even has a division called “professional employer organization services,” in which a client can outsource everything and make ADP, not itself, the employer of record of its workers. It’s growing faster than ADP’s payroll business.

Morgan Stanley’s Mr. Srethapramote says ADP believes human capital management is a $51-billion market, versus $8-billion for just payroll. The bad news is it has many more competitors across many industries. The good news is that, according to ADP, adding other products to existing clients can triple revenue from them.

Both companies have an additional way to add to earnings: The money they hold as “float” before employees cash their paycheques generates a small part of revenue, but a meaningful portion of earnings – at least, when interest rates aren’t as low as they have been. Analyst Gary Bisbee of RBC Dominion Securities’ U.S. arm believes rising interest rates have the potential to boost ADP’s earnings by 30 per cent, “but it will take a long time to materialize.” He believes anticipation of rising interest rates was one driver of ADP’s 2013 stock performance, “which seems early,” given his belief the benefit will arrive in the fiscal year that starts in the middle of 2015.

Mr. Srethapramote started coverage of ADP in December with an $82 price target, and soon saw the stock outpacing his target. With the recent decline to the $74 range, the potential return now hits the double digits. But it’s also worth considering his “bull case” of $104 per share, in which ADP maintains the high-single-digit revenue growth it’s been posting and boosts earnings per share through $700-million to $900-million in buybacks this year.

Paychex is trading slightly above Mr. Srethapramote’s $39 target. But if it, too, sustains high single-digit revenue gains and it avoids losing its smaller customers to cheaper competitors (Paychex is more vulnerable, he feels), his “bull case” price is $51.

If the economy turns sour, a bear case for the two – as well as for most other stocks – may be appropriate instead. Investors who believe the economy will be just fine will likely find ADP and Paychex doing quite well, too.

 

 
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