A Payoff for Payroll Services


By Jonathan Rudy The addition of 57,000 nonfarm jobs in the September employment report released on Oct. 3 was the first positive figure in that vital labor-market gauge in seven months. And while that doesn't necessarily mean the job market is in full turnaround mode yet, we at Standard & Poor's Equity Services believe employment should improve over the next year. And we expect that to be good news for leading providers of payroll services, as a workforce recovery leads to increased demand for their offerings. Therefore, we raised our investment outlook for the group on Oct. 7 to positive from neutral.

Payroll-services companies perform a number of back-office functions for their customers, including the preparation and generation of payroll checks and journals, employee earnings statements, departmental earnings and deduction summaries, quarterly and annual Social Security and income tax withholding reports and statements, and employee earnings histories. They also provide tax-filing services and generate pension-fund and profit-sharing reports.

A JUMP TO 5 STARS. These companies have been hurt by the economic slowdown, which has led to a higher unemployment rate and a decline in the number of payroll checks that are processed. Still, we view the market for payroll outsourcing as not fully realized, providing opportunities for future earnings growth for these concerns.

On Oct. 7, we upgraded our recommendations on two of the leading payroll-services outfits. We raised Automatic Data Processing (ADP

; recent price, $39) to 5 STARS (buy) from 3 STARS (hold), based on its valuation as calculated from our

discounted cash-flow analysis.

ADP's balance sheet is strong with $2.3 billion in cash and little debt. Moreover, we believe the stock is trading at a discount to peers on an enterprise value to sales basis (see BW, 10/6/03, "A Better Way to Size Up a Company"). However, on a price-earnings-to-growth (PEG) basis, it trades in line with its industry peers, due to its growth rate. All in all, we believe the shares deserve a premium valuation to the rest of the industry, based on ADP's market-share leadership, healthy balance sheet, and strong cash-flow generation. We have a 12-month target price of $48 on the shares.

ADDITIONAL LEVERAGE. We also raised our opinion on Ceridian (CEN

;$21) to 4 STARS (accumulate) from 3 STARS. It, too, should benefit from an improving job market, in our opinion. Additionally, its Comdata unit, which provides transaction processing and information services to the transportation industry, give Ceridian additional leverage in an economic recovery, in our view. We have a 12-month target price of $24 for Ceridian, based primarily on our discounted cash-flow analysis.

S&P has a 3-STARS (hold) recommendation on the other major player in the field, Paychex (PAYX). While this highly profitable company trades in line with its peers on a PEG basis, due to a faster growth rate its shares are at a notable premium to the rest of the group on a price-to-sales basis. Nonetheless, we believe its shares are worth holding. Analyst Rudy follows application software stocks for Standard & Poor's Equity Services


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