Strong Cash Flow, Superb Operation Back Paychex Dividend

The stock of Paychex (PAYX) the nation’s leading payroll processor and H.R. services supplier to small businesses, took a swift beating a couple of weeks ago.

PAYX’s earnings met estimates but investors were disappointed overall, generating at least one negative analyst comment and pushing the stock 7% lower over a couple of stumbling days for the market generally.

One worry about PAYX has been the sustainability of its heavyweight dividend, which results in a chunky 4.3% that is barely covered by earnings.

PAYX just announced it will maintain its dividend at the same rate this quarter. That means there was no increase at all in 2009, and doesn’t soothe investor jitters about the direction of future dividends.

So here’s another way of looking at it. Show me the money. And when I say money, I mean the real Benjamin Franklins: cash money, not accounting department earnings.

For the most recent quarter, PAYX’s dividend outlay totaled 60% of cash flow from operations. This is actually an improvement from higher payout levels for the past two full fiscal years, and not nearly as historically out-of-line as the payout ratio on earnings.

During the last business downturn, the 2002 cash payout spiked to 52%, a big jump from the 33% and 40% payouts the prior two years, and not exactly a moon-shot from the current, and improving, 60%. PAYX’s typical recent payout on operating cash flow has been 40% to as much as 48% due to some large dividend increases in 2005-2007.

Just like now, PAYX held its dividend steady for 2002. The company then resumed annual increases in October 2003, racking up a 5-year dividend-growth record of over 21% annually, according to Reuters. As noted above, that included some atypically large increases, so it’s reasonable to expect less generous dividend growth going forward, even when business conditions improve.

To be fair about the cash flow analysis, the 2002 dividend payout on net income also “spiked,” but at just 57% it looked like cookies and milk compared to where it is now. Still, it was a jump from the roughly 40% net income payout ratio in 2000 and 2001, and PAYX managed through it.

Three more reasons for optimism: first, some fundamentals. PAYX has virtually no long-term debt to service, and with relatively low capital expenditures the company actually punched-up far more free cash flow during FYs 2008 and 2009 than during the good years before the current economic downturn. Return on Equity is marvelous at 39% and valuation ratios are still sweet, all based on Morningstar data.

Second, we already saw a summer sneak–peak of this mud-wrestling melee. When PAYX was taking a pounding for its June earnings release, Barron’s stepped into the ring, saying that despite the merciless labor market, the company is well-positioned for a recovery, generates “astonishing” free cash flow, and its dividend would likely remain “unscathed.”

And third, a Morningstar analyst just did a deep dive into the newest quarterly numbers, concluding they “point to the beginning of a solid recovery” in 2010 for this well-managed company that Morningstar gives its highest “Wide Moat” rating for sustainable competitive advantages, as well as its highest “Five Star” stock rating.

Don’t get me totally wrong, though. Like many dividend-growth investors, over the long run I want to see a manageable earnings payout ratio; earnings increasing at a clip that supports dividend increases; revenues growing to support earnings; and cash flow that assures me everything’s backed up by green paper with pictures of presidents on it, not just paperwork from the accounting department.

But over a cyclical short-run, a high quality company with a healthy balance sheet can pay dividends from cash flow and still have the resources to run the business. And that’s a key point. PAYX is not the latest busted business model or some financial zombie buried under a mountain of reserve requirements. No doubt they are in a tough fight, but the cash is flowing and their business metrics seem to be signaling a 2010 recovery.

And in addition to the 4.3% cash dividend, if the market decides PAYX isn’t a knockout loser after all, the capital returns from this S&P technology-sector company could be worthwhile.

Coming off the March bottom, the stock shot past both the S&P 500 and the Technology Sector ETF (XLK) for the first two months of the rally, though it has since fallen behind both.

And despite its recent troubles, PAYX has rewarded long-term investors. Over the trailing 1-year, 2-year and 5-year periods the stock price has roughly tracked the S&P 500, but lagged the lower-yielding technology sector.

The downside? PAYX could send investors a ‘Rochester raspberry’ and cut the dividend next year. How much of that likelihood is already priced into the stock is anyone’s guess, but there’s some risk here, certainly.

And so, some dividend-growth investors will no doubt want to stick to their discipline and avoid PAYX: its payout ratio on earnings has skyrocketed and it failed to raise its dividend this year. Meanwhile, economic bears who are particularly skeptical about the job market might be more comfortable looking for yield in other sectors.

But patient investors willing to take a reasonable risk on a superb company, and pocket a nice dividend while they wait and see? Those investors might not want to show PAYX the back of their hand, as long as PAYX can keep showing them the money. And when I say money, I mean the real Benjamin Franklins.

Finally, for readers clicking in from Yahoo Finance or other outside sites, and who might not be familiar with Seeking Alpha, if you hit the “Follow” button (under that handsome photo) then register, the site will send an e-mail that warns you every time I publish an article here. Additionally, there are lots of good authors on the site, so look around, especially if you like dividend articles.

References and Links

Associated Press, “Shares of Paychex Fall After 1Q Earnings Drop,” September 24, 2009

Morningstar, Paychex Financials: 10-year Cash Flows, 2009

Yahoo Finance, Paychex Historical Dividends, through 2009

Barron’s, “Why Paychex Will Pay Off,” June 25, 2009.

Morningstar Stock Analyst Notes, “Weak Economy Continues to Challenge Paychex,” September 24, 2009

Disclosure: Long PAYX

Comments

[Brad Castro:]

Good analysis. I agree that PAYX is one of those truly superior businesses, incredible ROE and incredible balance sheet. They focus on small to midsize businesses in an economy with nearly 10% unemployment, and yet they're still highly profitable.

On the negative side, I think it's much more likely that the dividend would remain frozen rather than ever be cut.

Oct 14 10:37 AM

[Low Sweat I...:]

Thanks for your comment.

I think you make a good point that the more probable risk for PAYX might be an extended period of dividend maintenance (and perhaps a dead-money stock price with it) rather than the more severe risk of a dividend cut that I noted in the article.

Even more optimistically, PAYX has increased its dividend something like 19 of the last 21 years, usually in October, so perhaps by this time next year there will be enough cyclical turnaround to restart the increases, and the freezes of 2002 and 2009 will remain the exceptions in the company’s dividend history.

Oct 14 10:24 PM