Evaluation Of A Payroll Processing King: Paychex

Jan.21.14 | About: Paychex, Inc. (PAYX)

Investing can be a dangerous and yet rewarding occupation. An investor must make the right decisions on whether or not to invest in a security of a great business at a wrong price, or a great business at the right price. In this article, I will provide reasons why to invest in Paychex in the first portion of the writing. In the second part of this writing, I will provide reasons why not to invest in Paychex. Finally, at the end of the article, I will weigh the pros and the cons together and come to the concluding statement of if I would or would not invest in Paychex for the long haul.

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Company Overview

Paychex is a leading provider of payroll, human resource, insurance, and retirement benefits outsourcing solutions for small- to medium-sized businesses. As of May 31, 2013, they serviced approximately 570,000 clients, including approximately 2,000 clients through four offices in Germany. They maintain their corporate headquarters in Rochester, New York, and have more than 100 offices nationwide. Paychex was formed as a Delaware corporation in 1979.

Strong Economic Moat

An economic moat is defined as: A way of describing the competitive edge of a company. This protection against competition can be in the form of a strong brand, the inability of customers to switch to a competitor, a cost advantage e.g., through economies of scale, or protection through such things as patents or government regulation. I believe that PAYX has an economic moat for the following reasons. Once PAYX starts providing payroll services to a company, that company will most likely not change their payroll provider to someone else. If PAYX is doing a great job at providing payroll to their customers, then the customers would have no incentive to switch providers. Switching payroll providers would be like everyone switching from using Microsoft software to Linux. People do not like change. Switching payroll providers can also be pretty risky and costly for small businesses to do as well. If a company switches payroll providers they have the chance of messing up payroll for the following weeks in advanced. Missing payroll will have a really negative effect on the employees who work for the small business.

Growth in Earnings

In the past 10 years, PAYX has not had a single loss in earnings. Showing signs of continuous growth in EPS is a great sign for continuous optimistic growth. The historical past is not a 100% indication of what the future will look like, especially when it comes to security analysis, but it can help to tell what the future might look like. Using a compound annual growth rate (OTCPK:CAGR) formula, I have found that earnings have grown 7.62% each year. Looking at PAYX peers you can see that Automatic Data Processing (NASDAQ:ADP) and Insperity (NYSE:NSP) (As of 1/17/2014)

are they only companies that have not had negative earnings in the past 10 years. For the record ADP's CAGR for the past 10 years is 8.53% and NSP's CAGR is 12%.

Ticker

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

PAYX

1.51

1.42

1.32

1.48

1.56

1.35

1.22

0.97

0.80

0.78

ADP

2.80

2.50

2.39

2.61

2.20

1.83

1.45

1.32

1.18

1.34

TW

3.59

2.62

2.04

3.43

3.50

2.60

1.99

Nil

Nil

nil

KFY

1.15

1.27

0.12

(0.23)

1.46

1.24

1.32

0.90

0.13

(0.63)

KELYA

1.32

1.69

0.71

(3.00)

(2.37)

1.67

1.75

1.09

0.60

0.14

TBI

0.84

0.73

0.46

0.20

(0.10)

1.44

1.45

1.18

0.75

0.41

ASGN

0.89

0.64

(0.27)

0.13

0.53

0.26

0.39

(0.00)

(1.68)

(3.22)

NSP

1.56

1.16

0.86

0.65

1.76

1.74

1.64

1.12

0.72

0.55

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(Diluted EPS)

Cash Flow, Dividends, and Debt

PAYX's majority revenue comes from recurring fees for services performed in the payroll processing. No single client of PAYX has a huge impact on their revenue as well. For example, Dean Foods (NYSE:DF) has 20% of their revenue coming from Wal-Mart (NYSE:WMT). If DF loses that contract they will be down 20% revenue. For fiscal 2013 PAYX clocked in 675.3 million in free cash flow. PAYX uses this cash to do the following; fund operations, capital investment purchases, business acquisitions, and finally dividend payments.

In millions

2013

2012

2011

2010

Net Income

569.0

548.0

515.3

477.0

Non-Cash Adjustments to Net Income

183.3

175.1

166.5

161.3

Cash (used in)/provided by changes in operating assets and liabilities

(77.0)

(16.5)

33.5

(27.4)

Net cash provided by operating activities

675.3

706.6

7.15.3

610.9

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PAYX pays a handsome 1.40 (annual) dividend. This equates out to a nice 3.20%. Dividends are 84% of net income or 466.7 million of 2013s net income. 84% of net income is quite a lot of income paid out to shareholders but, PAYX also has no long term debt at all on its balance sheet. Below you will find a graph that depicts how PAYX has performed as a whole compared to its peers, and the S&P 500.

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Back in 2008-2010 Paychex and the peer group that Paychex is in have outperformed the market as a whole. As of now Paychex is performing just as good as the market is, but the peer group has been making better stock returns overall. The graph shows a five-year comparison of the total cumulative returns of investing $100 on May 31, 2008, in Paychex common stock, the S&P 500 Index, and a Peer Group Index. All comparisons of stock price performance shown assume reinvestment of dividends.

Huge Dividend Payout Ratio

PAYX pays out 84% of their net income in dividends. I believe that you really need a margin of safety, when looking at the dividend payments a company makes. 50% and below is a great margin of safety in my opinion. Is paying out an 84% of net income in a dividend, really sustainable in the long run? Earning may fluctuate, making an 84% payout ratio impossible to pay in the future. One can only speculate on how the earning may grow, and in my opinion 84% is not a conservative payout ratio. Finally dividends that are received are taxed as income and some long term investors may not want that.

Bad Customer Reviews

"I interviewed several payroll companies to handle my 2013 payroll and HR functions. I ended up choosing Paychex and couldn't be more disappointed."

This is an actual review and it's just one of the many bad reviews that I found floating across the internet. The average review of PAYX on Yelp.com was 2 stars out of 5 total stars. Seeing how a lot of customers are disappointed with the service they have received from PAYX, makes me hesitant to put money into a business.

Overvalued

PAYX has a nice free cash flow, they have been paying a dividend since 2004 which has increased in payout ratio by 192% overall, but they are also an overvalued company at the price that the market has given them at the moment. By having no debt, an astoundingly high net margin, and return on equity, you are not going to get this cash cow for cheap. I have provided a table of PAYX getting compared to its peer competitors below. As you can see PAYX has a higher P/B and PEG ratio than all of its peers. It also has a higher net margin and ROE as well which is a good thing, and may be why the price is high. I believe that this price is too high to buy PAYX at. There is not a good margin of safety in this security at the price the market sets for it as of right now.

Ticker

Price

Market Cap

Trailing P/E

Dividend Yield

Net Margin

P/B

ROE

PEG Ratio-5 year expected.

Total Debt

PAYX

44.10

16.06B

27.39

3.20%

24.59%

9.09

34.09%

2.59

0

ADP

79.97

38.50B

27.20

2.40%

12.41%

6.21

22.27%

2.52

2.83B

TW

128.84

9.14B

26.22

0.10%

9.64%

3.17

12.87%

2.18

273.75M

KFY

25.32

1.25B

36.17

N/A

4.10%

1.78

5.15%

1.11

0

KELYA

25.00

933.88M

18.80

0.80%

0.94%

1.16

6.61%

1.68

58.0M

TBI

26.66

1.05B

28.64

N/A

2.42%

2.80

10.79%

1.29

32.52M

ASGN

33.17

1.79B

27.14

N/A

3.94%

2.96

9.92%

1.88

357.81M

NSP

33.23

849.69M

23.74

2.00%

1.62%

3.47

14.22%

1.63

0

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Conclusion

From what I have learned from researching PAYX, is that this is an incredible business. There are many reasons why PAYX is an incredible business, but my favorite reasons are, having a higher net margin and ROE than all of their peers, not having a single loss in 10 years, a strong economic moat, and finally not a single penny of debt. This could be a company that you can buy and hold for many years without losing sleep at night. There are also some negative reasons why you might want to wait for Mr. Market to give you a better price. Obviously this is a very overvalued stock at the moment. Buying at a high price can be very dangerous for an investor. You may buy at a record high of a stock thinking the stock will go higher, and it might, or it might not. I will leave you now with a chart of the DJIA from 1928-1954. Remember this chart for it might save you from making irrational unintelligent decisions in the future.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.