Automatic Data Processing (NYSE:ADP) is known primarily for its dominance of the payroll services market, but the company's dealer management systems business was grabbing all the headlines earlier this month. ADP fans should be encouraged by the company's announcement of its $300 million acquisition of U.K.-based Kerridge Computer.
ADP is already the dominant provider of inventory management and customer relationship management systems for automotive, truck, and recreational vehicle dealers in the United States. ADP's DMS franchise accounted for 12% of the company's $8.5 billion revenues in fiscal 2005, but only 9% of its earnings. The Kerridge acquisition will add to the unit's scale of operations, expanding its presence from 14 countries to more than 40.
So far, the DMS business has not been revving investors' engines. It's been growing more slowly than ADP's Employer Services franchise and requires more capital while producing weaker operating margins. So what about this deal should make investors happy? I think ADP's management sees the opportunity to give its DMS unit the same competitive advantages the company enjoys in Employer Services.
Payroll processing has significant barriers to entry for aspiring competitors. ADP uses its huge infrastructure of hardware, software, and back-office expertise to process payrolls for other companies. It's not a flashy business; ADP essentially keeps records, files tax forms, administers benefits, and performs other related functions. But it does so with greater reliability, and at lower expense, than its customers could achieve on their own. Consequently, ADP and smaller rival Paychex (NASDAQ:PAYX) largely control the market.
The DMS market is more fragmented, but it has similar characteristics to the payroll processing market. DMS companies provide the same sort of back-office technology to manage dealers' vehicle inventories and facilitate sales. As ADP consolidates its position in the DMS market, economies of scale should allow it grow, expand operating margins, and improve returns on invested capital.
Over time, ADP's DMS division could be the kind of cash cow that makes the Employer Services unit such an attractive franchise.
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Michael Leibert welcomes your feedback. He owns shares of Automatic Data Processing. The Fool has a disclosure policy.
