Paychex, Inc. (NASDAQ:PAYX) is a leading provider of payroll, human resource and benefits outsourcing to over 567,000 small to medium sized business. Needless to say, this business is largely dependent on the economic recovery and unemployment rate. In the last couple of years, lower employment growth and interest rates have been headwinds for the company. However, just like the economy, Paychex, Inc. (NASDAQ:PAYX) is moving ahead slowly, corroborated by its 3Q12 results. In my opinion, it can be considered a good long-term investment with several years of growth ahead, as the economy and unemployment rate improve. Let me quickly go through five points that support my thesis.
Future Growth
Payroll is an integral part of any company; as the economy improves businesses grow and there is an increasing urge to outsource the payroll duty so that companies can focus on growth.
Paychex, Inc. (NASDAQ:PAYX)’s core business, payroll service, just like the economy, has been witnessing slow growth. In 3Q12, the segment’s revenue grew 2% vs. 1% in the previous quarter. This was mainly due to an increase in checks per payroll of 2.3%, higher than 1.8% in 3Q11. As the unemployment rate falls and the overall economy improves, this segment will definitely be poised for future growth.
Its smaller business, human resource services (30% of total income), grew 10% in 3Q12 and 13% in FY11. This segment has been witnessing strong growth in the last few quarters due to new business lines, and I believe it will continue be a strong driver of future profits.
Another inconspicuous factor that affects Paychex, Inc. (NASDAQ:PAYX)’s business are the current interest rates. Let me explain – Paychex withholds money, which is yet to be remitted to tax or regulatory agencies or client’s employees. As it holds this money, it earns interest on these reserves. Currently, interest rates are at an all time low, resulting in flat interest onclients’ funds in 3Q12. As interest rates rise, this can prove to be another revenue generating opportunity.
Focus on Small Business
Paychex, Inc. (NASDAQ:PAYX) is considered to be the bellwether of small and midsized companies. It caters to businesses with less than 100 employees and is a well-known payroll processor for these businesses. One may consider this as a hindrance, but Paychex can stand to gain as small businesses generally grow at a higher rate. Further, the Affordable Care Act, which requires small and midsized businesses to have ready access to payroll data, will prove to be a good opportunity for Paychex.
Dividend
Currently, Paychex has a strong dividend yield of 4% with a payout ratio of 84%. This is supported by its pristine balance sheet and strong cash flow generation.
Balance Sheet
Paychex’s balance is debt-free with $570 million cash. Further, it has been able to increase its free cash flow in eight of the last 10 years, which has enabled it to increase its dividend in seven of the last 10 years (lower cash flows and flat dividends were witnessed during the recessionary period of 2008-2010).
Competitive Advantage
Paychex faces strong competition from Automatic Data Processing (NASDAQ:ADP) and Intuit, Inc. (NASDAQ:INTU).
Automatic Data Processing is a much larger company and handles companies with size and revenue 10 times that of Paychex. It also has a strong dealer services segment, which caters to automotive and truck dealers across the world. Despite the recession, both companies have been able to increase their earnings, but Automatic Data Processing has outperformed Paychex. Paychex’s dividends have increased by an average 4% in the last five years whereas Automatic Data Processing’s dividends have increased 10% (it also paid a special dividend of $4.9 in 2007). The reason for this dividend growth is the strong growth in its EPS from $2.34 in FY08 to $2.82 in FY12, partly on account of share buybacks.
But I do not consider Automatic Data Processing a serious threat to Paychex, mainly due to its target customers. Automatic Data Processing generally caters to bigger companies, while Paychex is well known among the small and midsized companies. Further, competition in the small and midsized business is relatively lower, and Paychex is already a market leader. Paychex also has a competitive advantage with respect to its margins. Despite its higher revenues, Automatic Data Processing has a much lower operating margin (18% in FY12) vs. Paychex (38% in FY12) and Intuit, Inc. (28% in FY12).
The latest and strongest threat to Paychex is from companies that develop do-it-yourself payroll software and equipment. Intuit, Inc., which is the largest provider of online payroll service with their QuickBooks Payroll solution, is one of them. The online software is available for just $20 on a monthly basis and is used by over 1 million companies. It has increased its revenue in the last five years by CAGR of 6% vs. Automatic Data Processing’s 4% and Paychex’s 1.5%. But I believe Paychex has a competitive advantage, as there will still be some companies that will outsource their payroll requirements due to increasing compliance and regulatory requirements.
Conclusion
Given the fact that changing from one processing vendor to another is a burdensome process, Paychex’s market share remains intact. Further, Paychex has a strong retention rate (80% in FY12), which gives it pricing power over its customers as well as a downside protection. This way it can make modest price increases during good times as well as maintain its pricing during recessionary periods.
As explained above, Paychex has many factors working in its favor, and its low PE is another feather in the hat. Hence, take advantage of the current run in the stock and hold it for the long run.
The article 5 Reasons You Will Like Paychex originally appeared on Fool.com and is written by Sujata Dutta.
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