As I've said recently in relation to McDonald's (NYSE:MCD), Coca-Cola (NYSE:KO) and Nestle (OTCBB:NSRGY), top-notch companies are a mixed blessing for investors - great to hold for years at a time once you own them, but very hard to ever buy at a notable discount. Automatic Data Processing (Nasdaq:ADP) fits that bill as well, as even the most negative or bearish analysts still seem to go out of their way to affirm their respect for the company, its strategy and management.
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Good Quarterly Results in a Challenging Environment
While the private sector employment situation is gradually getting better (and ADP has minimal public sector exposure), it's still not exactly a white-hot market. Nevertheless, ADP managed to surpass expectations with a 7% revenue increase in the fiscal third quarter.
Revenue growth was supported by solid retention, 1% pricing growth and same-store "pays per control" was up 3%. The core employer service segment saw 7% reported revenue growth (6% organic), while PEO grew 15% and dealer services grew at identical rates with employer services.
Weakness in the interest carry continues to take a toll on margins. Gross margins stayed flat and operating income rose 6% (leading to a 30 basis point decline in operating margins), despite a 10% decline in that high-margin interest revenue.
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ADP has been smart about building its business, and using incremental transactions here and there to enter new market segments. It paid an undisclosed amount back in January to acquire PhyLogic and enter the medical billing market - a market where athenahealth (Nasdaq:ATHN) has shown solid growth. I would expect the company to continue this strategy, especially given that ADP can use its huge infrastructure to quickly leverage even small transactions into meaningful market opportunities.
The 800lb Gorilla
ADP continues to be one of the relatively few great companies with minimal direct identifiable competition. As the company moves down market (in terms of client size), it will encounter Paychex (Nasdaq:PAYX) and Intuit (Nasdaq:INTU) more often, but that ought to worry the latter two more than ADP.
At this point, the biggest competition still left for ADP are those companies that continue to choose to keep their payroll or human resource services in-house. Although new business additions decelerated a bit (12% versus 14% in the last quarter), double-digit growth is still impressive for a company this size.
The Bottom Line
ADP seems to be managing that sweet spot between embracing new service opportunities (like SaaS or cloud) and going too far away from its core competencies. Moreover, the company does what it does well enough that large business service providers like IBM (NYSE:IBM) and Accenture (NYSE:ACN) aren't eager to move into this market.
The downside to this story is that everybody knows about how well run ADP is. Although the company's free cash flow is a little more erratic than you might assume, the company posts solid returns on capital and has an enviable record of client retention.
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Assuming that ADP can grow free cash flow at about 6% over the next decade, a rate faster than the U.S. economy is likely to grow, the shares are only very slightly undervalued. It may be a case where investors can feel more at ease in paying fair value, but these shares are not a bargain right now.
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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.