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Paychex (PAYX) and Automatic Data Processing (ADP) are both in the business of providing outsourcing solutions to businesses mainly for human resources, payroll, tax and benefits. ADP is the bigger player and the industry leader, and it mostly serves companies above 50 employees, while PAYX specializes in small companies below 50 employees. So while both in the same market, they are not direct competitors, but have in a way "split customers in half", with both of them generating great returns without having to fight for them all the time.

This situation exists mainly because both companies have carved "a strong moat" around them using two great durable competitive advantages:

  • High switching costs

The services they provide are so integrated to their client's processes that clients are more likely to accept higher prices and bad customer care before considering to change providers. This is due to the hurdle the client will probably face if he decides to leave, plus the fear of having his business functions disrupted while moving to a competitor.

This competitive characteristic keeps market share changes in this industry quite slow and difficult for existing firms.

  • Economies of scale

Since PAYX and ADP have their systems up and running, the cost of adding a new customer for them is essentially zero. Since they have big customer bases to spread fixed costs at, they can outspend any potential entrant in their market in terms of R&D, Advertising, Recruiting etc. This means that if a company wants to enter this market and compete it would have to spend HUGE amounts of money for a very long time in order to develop competing systems, software and company structure. The entrant would also have to tolerate great losses for many years due to the fact that gaining existing market share is extremely difficult (remember switching costs?) and gaining new customers would also be a problem since the existing players could match any price he might offer while he generates losses and they stay profitable.

So, in fewer words, this competitive advantage keeps possible entrants away from the market.

In the following table you see the comparison of both companies in various areas.

Indicator

PAYX

ADP

Price 12-Oct-2012

$32.63

$58.32

Market Cap.

$11,861,005,000

$28,238,544,000

No. Shares end of Q2

363,500,000

484,200,000

Operating Prof. Margin

38.29%

19.90%

Net Profit Margin

24.58%

13.02%

EPS (after taxes) TTM

$1.52

$2.87

P/E - TTM

21.47

20.32

Operating Cash Flow TTM

$737,100,000

$1,910,200,000

Oper. Cash Flow / Share

$2.03

$3.95

RoA

11.24%

4.5%

RoE

34.15%

22.71%

NAV / Share

$4.41

$12.63

Operating Leverage (Assets / Equity)

3.45

5.04

Dividend / Share

$1.28

$1.60

Dividend Yield

3.92%

2.7%

As you can see, PAYX enjoys better margins and returns from ADP, mainly due to a mix of better management and smaller size. In addition, PAYX is less leveraged and has a greater dividend yield than ADP. Nevertheless, ADP earns 2.47 times its dividend in cash compared to PAYX's 1.6, which means that ADP is better positioned for a future dividend raise. Both companies are financially strong being essentially debt-free and have enough cash for management to sleep well at night.

The weak spot for those 2 great companies is the state of the U.S. economy. As long as the economic recovery remains sluggish and unemployment doesn't fall significantly, ADP and PAYX may purse growth only by gaining market share from smaller players. Moreover, if the U.S. slips back into recession and unemployment goes through the roof then both companies are due for a slowdown in earnings. That sluggishness is clearly shown in this chart from Google Finance, in which we see both companies following but underperforming the S&P 500 (NYSEARCA:SPY) Year to Date.

I believe that PAYX's fair value is between $15 and $20 and ADP's is between $28 and $39. As a result, both companies are a bit expensive at current valuations, so waiting for a 30% pullback or more before buying would probably be a good idea. And with growth slowing around the world, politicians in Washington bickering and the eurozone still trying to figure out if it wants to exist, a pullback may not be that far away.

Source: A Thorough Look At Paychex And ADP: Buy Or Wait?