Is Paychex, Inc. (PAYX) Destined for Greatness?

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Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does Paychex, Inc. (NASDAQ:PAYX) fit the bill? Let’s take a look at what its recent results tell us about its potential for future gains.

What we’re looking for

The graphs you’re about to see tell Paychex, Inc. (NASDAQ:PAYX)’s story, and we’ll be grading the quality of that story in several ways:

1). Growth: are profits, margins, and free cash flow all increasing?
2), Valuation
: is share price growing in line with earnings per share?
3). Opportunities
: is return on equity increasing while debt to equity declines?
4). Dividends
: are dividends consistently growing in a sustainable way?

What the numbers tell you

Now, let’s take a look at Paychex, Inc. (NASDAQ:PAYX)’s key statistics:

PAYX Total Return Price Chart

PAYX Total Return Price data by YCharts.

Passing Criteria 3-Year* Change Grade
Revenue growth > 30% 14.6% Fail
Improving profit margin 10.4% Pass
Free cash flow growth > Net income growth 16.1% vs. 19.7% Fail
Improving EPS 18.9% Pass
Stock growth (+ 15%) < EPS growth 43.1% vs. 18.9% Fail

Source: YCharts. *Period begins at end of Q1 (Feb.) 2010.

PAYX Return on Equity Chart

PAYX Return on Equity data by YCharts.

Passing Criteria 3-Year* Change Grade
Improving return on equity 0.2% Pass
Declining debt to equity No debt Pass
Dividend growth > 25% 112.9% Pass
Free cash flow payout ratio < 50% 91.3% Fail

Source: YCharts. *Period begins at end of Q1 (Feb.) 2010.

How we got here and where we’re going

Paychex, Inc. (NASDAQ:PAYX)’s five out of nine passing grades are a little disappointing considering its rather solid position in the American employment chain. However, these results do reflect the anemic nature of America’s recovery, as Paychex seems to be only barely ahead of inflation (these are three-year metrics, after all). What does the future hold for Paychex as it struggles to grow in a difficult jobs market against several muscular payroll-processing competitors?

Paychex, Inc. (NASDAQ:PAYX)’s quarterly report — scheduled for tomorrow — should shed more light on its progress. The company’s small- and mid-sized business target market is getting increasingly crowded. Automatic Data Processing (NASDAQ:ADP) pushes in from above (it typically works with larger companies) with the option to deposit paychecks into a prepaid Visa card. Intuit Inc. (NASDAQ:INTU), maker of TurboTax and other small-business software, is pushing up from below with cloud-based payroll software that allows really small businesses to manage employee paychecks with a greater degree of control.

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