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Paychex (NASDAQ:PAYX) has been a dividend income stand out for years. Paychex has been a wonderful business for income investors. The stock operates in a mundane but mandatory business segment to comply with state taxation regulations and Internal Revenue Service laws. The company excels at its services. The stock yields a stagnant 4% dividend yield. In this article I will focus on three core reasons to sell Paychex and focus upon better dividend paying stocks.

1. Paychex has failed to beat the SP500 (NYSEARCA:SPY) over the past five years and 10 years. In fact, the SP500 beat Paychex by a 2.7% total annualized rate of return over a 10 year period. This is not acceptable for income investors. Paychex did, however, beat the SP500 by a 3.5% total annualized rate of return over a 15-year window.

2. Paychex has increased its past two quarterly dividends to 32 cents per share. This is an annual dividend of $1.28 for 2012. The company did not increase the dividend from 2008 through 2010. The dividend payout ratio, in 2008 through 2010, was 84% of net income. Historically the payout ratio has been in the mid 50% range.

As employment has suffered in the United States, so has Paychex's ability to attract new clientele. In my opinion, employment growth is not increasing. There was seasonal hiring in the fourth quarter of 2011. If unemployment rates truly decrease, then Paychex could reap financial benefits due to increased revenue.

3. Investing requires focusing upon the right sectors. In a time when job losses are significant, investors should minimize their exposure to this sector. Paychex cannot excel if the sector is suffering.

Strong Sector Idea:

One sector that is very strong is the agency mortgage real estate investment trust. This sector benefits by low Treasury Bond yields. The company borrows money at short-term rates and invests this money in higher yielding Federal Guaranteed agency mortgage backed securities. One of the best performing companies in this sector is American Capital Agency (NASDAQ:AGNC).

The company offers a 17% annual dividend yield. American Capital Agency has returned a 27.5% total annualized rate of return for five years compared with Paychex's -.5% return over the same time frame.

American Capital is just one idea to replace Paychex in your portfolio. The right sector is essential to outperforming the market and increasing one's net worth.

Overview

Founded in 1971, Paychex is a Rochester, New York, based company that provides business services to small and medium enterprises - payroll and tax administration, human resource management, expense reports management, benefits administration, recruitment, and time and labor management. Most of its products are hosted online, easy to access anytime, anywhere, and significantly improve overall productivity. Paychex services over 564,000 clients from 100 offices nationwide.

Business Strategy

Paychex is a mature company with a stable business model and fairly regular repeat revenue because its solutions typically lock clients in for multiple years with high switching costs. For example, moving from one payroll administrator to another is something a company would rather not do unless there are very compelling reasons. Paychex has diversified over the years from its core payroll business into ancillary solutions such as human resources that make it more deeply entrenched with clients. In 2011 alone, Paychex acquired SurePayroll, Inc., and ePlan Services, Inc., as part of its revenue growth strategy. Moreover, by moving to a hosted online model, what's called "software-as-a-service" or SaaS, and by offering mobile access to its product suite, Paychex continues to innovate in line with key industry trends, thereby enhancing its competitiveness.

Financials

Paychex' financial year starts in June. For the twelve month period ended November 30, 2011, Paychex reported total revenue of $2.16 billion, operating income of 829.3 million and net income of 538.8 million, with a very healthy 24.9% net margin. Paychex ended its November 30, 2011, quarter with cash of $96.1 million, total assets of $4.9 billion, zero debt, $1.56 billion in shareholders' equity and $110 million in cash from operating activities. Revenue has been fairly stable over the past five years.

Dividends

Over the 12 months ended November 30, 2011, Paychex paid $1.25 in dividends (3.9% dividend yield). In its second quarter ended November 30, 2011, Paychex increased its quarterly dividend from 31 cents to 32 cents, on earnings per share of 39 cents, paying out fully 82% of earnings per share as its quarterly dividend. In fiscal 2011, Paychex had earnings per share of $1.42 of which it paid $1.24 or 87.3%, as cash dividend per common share. Such high payouts signify limited upside in near-term dividend increases.

Shares

As of February 2012, Paychex shares traded in the $32 range with a fairly tight 52-week range of $25.12 to $33.91, a market cap of $11.6 billion and a price-to-earnings ratio of 21.4x. The below chart shows analysts' growth projections for dividends and earnings. The dividend increases, in my opinion, appear to be overly enthusiastic.

Peer Group

Paychex serves small to medium businesses, a market that is fairly fragmented and serviced by local providers and leading national players. Leading national players include industry giant Automatic Data Processing (NASDAQ:ADP), Ceridian and Intuit, and by companies such as AccountantsWorld, CompuPay, Paycom, Payroll People, TimePlus Payroll and others.

Automatic Data Processing is the biggest entrant in the payroll processing field. The company is the country's largest provider of business outsourcing solutions. Automatic Data Processing has approximately 570,000 customers. The company has a market cap of $26 billion and yields a 2.8% dividend.

Action

Paychex is a conservative company with zero debt and a stable revenue stream. It serves a large market segment - small and medium enterprises - but has significant competition. It has been smart about expanding its product range and driving its grip deeper on each client account, about adopting cloud computing and Saas applications. In addition, Paychex has been developing mobile apps for the iPad2, and by selectively growing through acquisition. Paychex will continue to grow its revenue base over time, albeit slowly. With a stagnant dividend payout, this is a company to sell because Paychex is a good company operating in the wrong sector.

I would recommend selling Paychex. Identify stocks that are operating in the economy's strong sectors. These stocks offer higher yielding dividends and capital appreciation. In my opinion, Paychex's 4% dividend yield can clearly be beat with the right stock in the right sector.

Source: Paychex Has Lost Its Dividend Luster