Less Is More at ADP

Payroll processor Automatic Data Processing (NYSE: ADP  ) has followed a path similar to other great firms, namely dominating an industry to the point where the law of large numbers begins to catch up with it and growth becomes more difficult. Much like Microsoft (Nasdaq: MSFT  ) and Dell (Nasdaq: DELL  ) , ADP's growth has slowed, leaving it less opportunity to invest substantial cash flow generated by its businesses. But unlike the two computer giants, ADP's industry has brighter growth prospects.

Judging by fiscal 2006 results released last week, investors may conclude that all is well at ADP. For the year, revenue increased 11% while diluted earnings from continuing operations increased an impressive 25%. Problem is, the couple of previous years were challenging due to anemic payroll trends and low interest rates as ADP earns a float on funds held for its payroll services.

The longer-term perspective also points to flagging growth at ADP. Overall profit margins have trended down slightly over the past decade, as have total revenue and earnings growth. ADP had a history of reporting double-digit bottom and top-line growth, but over the past five years both have grown just over 6% per year. The trend is similar regarding free cash flow that once averaged 20%-plus growth annually prior to 2001.

However, ADP could soon be a nimbler competitor as management announced plans to spin off the Brokerage Service Group to shareholders. The motivation is to jettison a business that is growing more slowly than the company's other two divisions, Employer Services and Dealer Services. The brokerage segment represented about 20% of total revenue last year and will also pay a dividend to ADP; this should benefit current shareholders as the company plans to keep its current dividend the same in dollar terms.

ADP falls into the category of a great company with an expensive stock price. The earnings multiple has fallen as growth has slowed over time, but the stock still trades at a forward multiple of about 20, based off of projected earnings for next year. Investors may still be hoping that impressive past growth will soon return. Spinning off the slowest-growing division may do the trick, but for now adds another layer of uncertainty.

Best case scenario, ADP will start to trade at a multiple closer to archrival Paychex (Nasdaq: PAYX  ) after the brokerage spinoff. Paychex reminds me of a younger ADP, growing close to 20% per year with stellar returns on equity and grabbing a dominant share in payroll processing for smaller firms. The situation between ADP and Paychex mirrors the dynamics of the two key players in the tax-return business, with a smaller and aggressive Jackson Hewitt (NYSE: JTX  ) growing faster than incumbent H&R Block (NYSE: HRB  ) that has diversified into other markets to stem maturing growth in its primary business.

Don't get me wrong, ADP is a dominant firm in its own right, with impressive cash flow generating capabilities, and its industry is still growing in excess of 5% per year. We'll see if it can return to its former glory of double-digit returns, both in terms of the business and stock price. But right now, I'd prefer a wait-and-see approach.

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Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.


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