Payroll heaven
Growth Report Free
Volume 4, Issue 71
growthreport.com
After a two year pause in earnings growth, ADP regains its
footing and aims once again for the stars.
The good Lord giveth, and the good Lord taketh away. And after 41 straight years of double digit earnings growth at Automatic Data Processing Inc. (NYSE: ADP), the good Lord did the unthinkable – she took it away.
Over the past two years, not only did ADP fail to register double-digit earnings growth, it locked in back-to-back single digit earnings declines for fiscal years 2003 and 2004 for the first time in over four decades. In fact, this year’s 7 percent slide in earnings proved even more disappointing than last year’s 4 percent slippage in net income. Despite revenue that continues to expand steadily – 9 percent sales growth for Q4 2004 mirrored 9 percent revenue growth for the entire 2004 fiscal year – increased job losses across the country and lower interest rates overall have cast a dark cloud over what had traditionally been a “sure thing” business, not to mention a “sure thing” investment.
There is, however, hope – particularly for those with either more faith, or more foresight, than Warren Buffett. Buffett had signaled to the market back in September 2003 that Berkshire Hathaway (NYSE: BRK.A) had not only fully liquidated positions in four of its holdings -- Duke Energy (NYSE: DUK), Dun & Bradstreet (NYSE: DNB), Great Lakes Chemical (NYSE: GLK), and Level 3 Communications (Nasdaq: LVLT) – but that it had sliced positions in another eight, of which ADP was one.
Given that Buffett only sells or liquidates when he either has a more profitable alternative and needs the cash, or feels the current investment is overvalued, it’s likely that the sage of Omaha was considering the latter reason (overvaluation) when he ditched some of his shares of ADP. (With $35 billion in cash, he certainly didn’t need the money.)
Yet, if investors can bring themselves to see beyond Mr. Buffett’s decisions of nearly a year ago, and consider several emerging signs of strength at ADP, a case can be made for again believing in the future of this traditional Wall Street favorite.
When investors now look at ADP, two years into its earnings slump, they should now consider a few separate, but distinctly bullish, data points.
First, as part of the IT services industry – rather than considering it a pure high tech company – ADP enjoys the attention of many large scale institutional investors who either want (or need) to play in the tech sector, but who now seek safer bets than investing in pure hardware, software, semiconductor or networking stocks. To that end, IT services companies such as ADP are forecast to enjoy a 19 percent per-share earnings growth rate in 2005, as predicted by industry analysts; this compared to an expected 22 percentage point earnings decline for the tech sector overall.
Next, several recent ADP sales numbers in various categories have indicated things may not be as bad as they once seemed. New business sales jumped 19 percent in Q4, and average client payroll expanded by 1.5 percent despite US Department of Labor statistics indicating that employment numbers have at best remained stagnant. Though employer services (including 401K, payroll, tax filing, workers comp insurance, among other things) still remains 60 percent of ADP’s business – and is thus at the mercy of the health of the US labor market -- the company continues to expand into other venues, including insurance claims processing and the financial services sector. Toss in the fact that, because ADP plays the short term float with its clients’ money, earning interest on massive amounts of capital held in its hands before being redistributed, ADP becomes one of the few companies to benefit as (or I should say, if) the Federal Reserve continues to raise interest rates.
Add in several other bullish factors for ADP -- including relatively little debt, $1.3 billion in annual cash flow, an annual dividend of $0.56 per share (yield of 1.35 percent), and fiscal 2005 guidance from management predicting a return to double digit earnings growth, and the Lord may once again be in a giving mood for the ADP faithful. Though some investors may point out competition in a tightened payroll processing market from the likes of companies such as Paychex (PAYX), among others, the reality is that ADP and Paychex serve relatively different customers.
ADP provides paychecks for roughly 30 million workers, most of whom work for large companies, whereas 80 percent of Paychex customers have fewer than 20 employees. Though Paychex bests ADP in terms of gross profit margin (82 percent to 58 percent) and net profit margin (28 percent versus 15 percent), ADP brings in far more cash per share ($2.29 versus $0.93), while sporting a much more reasonable, and expandable, P/E ratio of 21, versus a P/E of 38 for Paychex.
Granted, ADP is hardly a small cap stock, and in full disclosure it remains a stock I have yet to purchase. Like most investors, I got spooked when ADP broke its 41 year streak of consecutive double-digit earnings growth. When a company severs a track record like that, it’s difficult to recapture its faithful stable of investors, and that’s precisely what I’m banking on. If ADP can again deliver on its earnings projections – and with employment and interest rate numbers trending its way – prescient investors are sure to be rewarded for believing in it again, and doing so by jumping back in ahead of Wall Street’s longer term skeptics. It’s a risk that requires a leap of faith, but that leap is getting shorter and shorter with each quarter of bullish news ADP delivers. |
