Employment Weakens, but Payroll Processors Are Cheap
Not all firms are impacted equally by deterioration in the employment situation.
For this installment of our quarterly employment Stock Strategist, we'll focus primarily on two payroll processors that have become cheap as the employment situation has deteriorated. To help make our point, we'll highlight a few developing macroeconomic trends along the way. (For additional background on the topic, we recommend reading our past employment Stock Strategist articles: Has Employment Peaked?, Our Picks for a Grim Employment Climate, and Weak Labor Market, Cheap Stocks.)
Automatic Data Processing (ADP) and Paychex (PAYX), the two largest payroll processors, are a couple of our favorite companies. These firms are highly profitable, they benefit from wide economic moats because of switching costs and scale, and they have large market opportunities ahead of them. Although the stocks have fallen out of favor as the employment situation has deteriorated, we still see bright futures for these firms.
To help demonstrate the long-term potential as well as the short-term head winds faced by ADP and Paychex, I'd like to step back from our usual bottom-up analysis and discuss some macroeconomic data from the Bureau of Labor Statistics. ADP and Paychex process over one third of outsourced payrolls in the United States, so we can assume that their experience (excluding price increases, cross-selling, and share gains) will roughly match the employment market in aggregate.
There's no denying that the employment situation has deteriorated. The year-over-year change in the seasonally adjusted employment level (represented by the green line in the chart below) is essentially zero year-to-date, including negative readings in March and June. Looking back over the last 60 years, this data series has never turned negative without a coinciding recession, indicating that significant downside risks may remain in the short term.
However, several long-term trends paint a much more favorable picture. First, note that the average trough decline in the employment level during prior recessions was about 2%. While job losses are never a good thing, the relative magnitude is hardly a business-model-destroying circumstance for payroll processors. Second, note that since 1948 the employment level has steadily increased at a positive 1% rate annually (the blue line in the chart above). If we assume a roughly stable labor force participation rate, this figure should continue to mirror population growth over time and help support growth for ADP and Paychex in the long run. When we add inflationary annual price increases, substantial cross-selling potential, and share gains, our high-single-digit revenue growth forecasts over the next 10 years for these companies seem very reasonable.
When looking at the employment data, it's important to differentiate between permanent employment and temporary employment. As can be seen in the chart below, these data series react very differently to economic cycles, which is why our ADP and Paychex forecasts are much more favorable than those for staffing firms, such as Robert Half (RHI), Manpower (MAN), and MPS Group (MPS).
The reason for this varying performance is that temporary employees often absorb the volatility associated with the hiring decision. In other words, when economic growth starts to appear on the horizon, employers use temps to avoid taking on the fixed cost of a permanent employee until the growth trajectory becomes clear. As the cycle progresses, managers begin hiring permanent employees as well as temps. Toward the end of the cycle, when earnings pressure is on the horizon, managers quickly release their temporary employees. Only when the situation deteriorates significantly will employers start reducing their core workforce. This dynamic is revealed not only in the volatility of temporary employment, but also in the fact that temporary employment tends to lead permanent employment on the downside. Temporary employment started shrinking in early 2007 and has been accelerating lower ever since with the direction of permanent employment lagging about a year behind. The bottom line for ADP and Paychex investors is that while the employment situation seems likely to deteriorate further, be sure to keep the potential deterioration in perspective. Don't confuse steady payroll processors with the much less predictable staffing companies.
Joel Bloomer does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.