Although large American firms were able to post a strong rebound in sales after the financial crisis, top-line growth for many firms has recently slowed considerably. More rapid profit gains are partially attributable to rock-bottom interest rates, which have helped lower interest expenses.
In the new paradigm of low sales growth, companies are cutting costs and seeking to increase operating efficiency.
The trend has provided a strong tailwind for companies in business outsourcing services as corporations look to outsource jobs that can be handled more cheaply by someone else. Research firm IDC estimates sales growth for the industry at a compound annual rate of 5.6%, to $209 billion, over the five years through 2017.
In fact, shares of Automatic Data Processing, Inc. (Nasdaq: ADP), have surged 45% over the last two years. There is strong demand for the payroll services of this outsourcing market leader, which is reflected in strong investor sentiment.
However, ADP is almost entirely focused in payroll management, where IDC forecasts annual growth of just 4% a year to 2017. ADP has booked just 3.1% growth of earnings before interest, taxes, depreciation and amortization (EBITDA) over the last five years and may have trouble growing from such a large base.With a market capitalization of roughly $40 billion, twice the size of the next largest competitor, ADP dominates business payroll services and holds nearly 7% of global market share with 2014 revenue of $12.2 billion.
While the market favorite may have provided strong gains recently, a pricey valuation and a lack of diversity in its business model could become the impetus for a sharp selloff.
Another company in business services, one about 1/16th the size of ADP, offers a much more attractive valuation and offers a suite of services.
Smaller Size But Twice The Value
Convergys Corp. (NYSE: CVG) provides a more diversified portfolio of services than ADP, from agent-assisted call services, technical support, revenue management services and social interaction solutions in the fast-growing field of social media communications. The company closed its $820 million acquisition of Stream Global in March 2014, to add 56 service centers in 22 countries.
Convergys is much smaller, with a market value of $2.5 billion and revenue of $2.85 billion last year. On strong margin improvement and acquisitions, Convergys has booked compound annual EBITDA growth of 49% over the last five years.
After strong gains, shares of ADP are now valued at 30 times trailing earnings, a 39% premium on the five-year average of 21.6 times trailing earnings. Analysts are expecting $2.95 per share in 2015 earnings on a 10% drop in revenue to $11 billion. (That's a bit misleading as the company spun off a dealer services division a few quarters ago -- sales are growing organically at a 7% pace.)
By comparison, shares of CVG trade for just 14.1 times trailing earnings. Profits are expected to grow 7% this year, to $1.75 per share in 2015, on sales growth of 5.2% to $3 billion.
Shares of Convergys jumped 3% on May 6, when the company beat Q1 earnings estimates by 17%.
While ADP may enjoy scale economies in its segment of the business services industry, Convergys is a stronger buy in my book. My price target of $73.75 on shares of ADP, based on a multiple of 25 times expected 2015 earnings is 13.7% lower than the current trade. My price target of $29.75 on shares of Convergys, based on a multiple of 17 times expected 2015 earnings, is 19.3% higher than its recent price.
Risks To Consider: An eventual decline in the business cycle will hit revenue for outsourcing business service providers. While CVG should be relatively safer due to valuation and a more diversified business model, the shares could struggle until the business cycle picks up again.
Action To Take --> Position in shares of Convergys on its strength in a diversified portfolio of services and a valuation that is half that of peer Automatic Data Processing.
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