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Employment Weakens, but Payroll Processors Are Cheap--Page 2

Not all firms are impacted equally by deterioration in the employment situation.

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The final chart we'd like to discuss is a comparison of the unemployment rate and the duration of unemployment. In our opinion, a spike in the unemployment rate won't necessarily translate into a reduction in demand for payroll processing services, at least not in the same magnitude. To make our reasoning clear, we first have to define the unemployment rate. According to the BLS Web site, unemployed persons are defined as "people aged 16 years and older who had no employment during the reference week, were available for work, except for temporary illness, and had made specific efforts to find employment sometime during the four-week period ending with the reference week." The last part of that sentence is key: If you don't have a job but haven't looked for work in the last month, you are not considered unemployed according to the unemployment rate. The impact of this definition is portrayed in the chart below.

As you can see, the median duration of unemployment (in weeks) was coincidentally about equal to the unemployment rate for many years, but it has diverged significantly since the mid-1990s. The 20-year moving averages (represented by the dashed lines) show that the duration of unemployment has steadily ticked up while the unemployment rate has ticked down. In other words, the unemployment rate has been falling partially because people are finding jobs, but also because it's taking longer for many people to find work. This brings us to an important attribute of the unemployment rate that is often overlooked: It's driven by both demand and supply. If the supply of aggressive work-seekers increases (let's define aggressive as active in the last four weeks) but the number of jobs stays the same, the unemployment rate increases.

Given falling asset values (such as real estate and equity markets) and rising prices on basic needs (such as energy and food), consumers are starting to appear short on cash. It stands to reason that eventually the unemployed are going to become more aggressive in their search, possibly causing the dashed lines in the chart above to converge, increasing the unemployment rate. Of course, we're not suggesting that this will be the only impetus for a higher unemployment rate: If the country goes into recession (assuming we're not already there), employers will lay off workers, reducing the number of jobs available. Rather, the point of this discussion is to help you, the reader, know the drivers of the unemployment rate, so that you don't make a hasty decision to sell your ADP and Paychex positions if the unemployment rate rises. In fact, we could argue that the current situation may increase the labor force participation rate as low-paying, undesirable jobs that were once passed over must now be accepted. This would be a benefit for payroll processors because they get paid per paycheck processed and not by the size of the paycheck.

In sum, when making our micro call on ADP and Paychex, we're not oblivious to the current macroeconomic environment, nor to the possibility that the situation could worsen materially. In fact, we've modeled significantly reduced revenue growth and profitability over the next few years under the assumption that a recession is imminent or presently occurring. To conclude that ADP and Paychex are not undervalued, we would have to believe that the core workforce will be sharply reduced, that a disruptive technology will unseat these industry leaders, or that interest rates will remain permanently lower (which would impact float income). The latter two scenarios are beyond the scope of this article, but we're confident that the long-term risks are minimal.

See the table below for our current valuation opinions on employment stocks in our coverage universe.

 Permanent Employment
Company Industry Moat Uncertainty
Rating
Star
Rating
P/FV 1-Year
Perf.
ADP (ADP) Payroll Wide Low 5 0.78 -5%
Paychex (PAYX) Payroll Wide Low 5 0.75 1%
Administaff (ASF) PEO Narrow Medium 5 0.71 -19%
Gevity (GVHR)  PEO Narrow High 4 0.69 -35%
             
 Temporary Employment
Company Industry Moat Fair Value Uncertainty
Rating
Star Rating P/FV 1-Year
Perf.
CDI Corporation (CDI) Staffing None High 3

1.35

-8%
Cross Country (CCRN) Staffing None Medium 3 1.16 -5%
Heidrick & Struggles (HSII) Staffing Narrow High 3 1.11 -35%
Hudson Highland Group (HHGP) Staffing None High 3 1.27 -22%
Kelly Services (KELYA) Staffing None High 3 0.99 -6%
Korn/Ferry International (KFY)  Staffing Narrow High 3 1.12 -19%
Kforce (KFRC) Staffing None High 2 1.29 -25%
Manpower (MAN) Staffing Narrow Medium 4 0.81 -32%
MPS Group (MPS) Staffing None High 2 1.23 -10%
Robert Half (RHI) Staffing Narrow Medium 2 1.24 -16%
Spherion (SFN) Staffing None High 3 1.01 -36%
Trueblue (TBI) Staffing Narrow High 3 1.30 -23%
Volt Information Sciences (VOL) Staffing None High 3 1.12 -6%

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Joel Bloomer does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.