Paychex: No Good Deed Goes Unpunished

| About: Paychex, Inc. (PAYX)


Paychex is an impressive secular growth story, more than doubling in five years and posting a 43% increase in its dividend over 5 increases.

Wednesday saw the stock knocked down 5% post earnings, which is the most heat the stock has felt during that time.

The company's steady expansion and high margins have typically commanded a premium and this stock does not go on sale too often.

I assess if this is a good opportunity to add this blue chip on weakness.

Paychex (NASDAQ: PAYX) is one of those stocks that you wish you bought last year every year. It's not an explosive growth tech or pharma story- everyone knows the downsides of those. Rather, its a stock that steadily rises, year after year, with rising earnings and dividends, and management who seemingly know what they are doing to make this happen. In other words, real value creation. It sounds so simple, and yet it is so rare in the market. Many household name blue-chips have become such crowded trades that they now have to resort to financial engineering in the form of buybacks to keep the party going. Paychex, at just under $21B market cap, remains small enough not to be swept up with the P&Gs and Colgate-Palmolives of this world.

On a five year basis, this stock has outperformed the SPY by 42% with less volatility, currently sporting a beta of 0.82. Are we too late to the party?

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It turns out there is a downside to things going so swimmingly for a company, and that is sky-high expectations. We know that earnings are a wild-card and sometimes a stock can get bid up on a loss, but today the truly irrational happened. The company was literally batting 1.000 on earnings as far as the eye could see, not posting one miss since before 2012. Today they announced that net income was up 3%, and revenues were up 9% overall, in line with consensus estimates. Of that 4% in services and 15% in HR/admin services. The only wrinkle in the announcement was that guidance was revised down from 4% earnings growth next year to between 3% and 4%. Investors responded by sending the stock down almost 5% on over 4 times average daily volume.

Remember that this stock has no negative news to deal with and has not faced much adversity in 5 years. In fact, you can probably find an article by someone making a great case for adding it when it was at its all time high last week. Let's look at some metrics vs Paychex's two main competitors, which I have identified as Intuit and ADP, to see if anything is out of whack from a metrics perspective. Intuit does have a suite of offerings that compete with Paychex's services even though they are more known for tax software. There are other companies in this space but none of them come close to the size of these three.

First, on ROE, Paychex consistently generated the highest of the group until about a year ago when Intuit took over. Whether that spike of Intuit's can be sustained remains to be seen. Paychex has been the most consistent generator of high ROE so they command a premium here.

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Turning next to the payout ratio, as all three companies in this stable, high margin business are dividend payers, we see Paychex is returning the highest amount of its profits to shareholders. Not necessarily a good thing. It's a little high at 80%, but, this is one metric I think we can give the benefit of the doubt to management on.

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Is it sustainable in this industry? Competitor ADP is bigger, has been around longer, and has some debt on its balance sheet (unlike Paychex). ADP have been quite active on the buy back from. Paychex also authorized up to $350M of buybacks at the beginning of July, and you have to hope they would save these for when the price drops a little (like now) and not at its all time highs (last week). Limited buybacks are a good tool for the arsenal, since the earnings are not very diversified and rapid margin expansion appears unlikely at this point. Investors have been well served by the slow and steady approach, and this high payout is part of the deal: slow, boring, and consistent.

On the earnings growth chart below, you can see that revenues have consistently grown between 4.5 and 9 per cent for 5 years. Intuit's earnings growth has been more volatile, swinging from almost none to 10. ADP has provided roughly the same consistency in earnings growth except for a blip in 2013. That is really the other direct competitor here and there is very little on the horizon at the moment that disrupts either of these incumbents' space. Differentiation must come mainly from service and user experience since I could glean very little substantive difference in product offering from the company websites. Of course, Intuit is a Silicon Valley company and you can picture them targeting these markets harder so that is a risk. As is the ever present threat of disruption to comfortable, high-margin business models in this age of rapid rechnological change.

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So why choose Paychex? Better track record and less leverage for one thing, but also a rare opportunity to score some stock on sale. If you look at the long term price action, you would have waited a long time, maybe forever, for a "pullback", if you're one of those people. This earnings non-event may be a quick "on sale" event. If the good economic news continues and the post-election bump occurs, this company could be at $65 or $70 in the next two years.

To get an idea of the likelihood of that, I also took a look at the option market to see what kind of moves market makers are pricing in. Paychex is not active enough for weekly options yet so I looked at March 2017. The market is pricing in about a 70% chance of an up to $6 move in either direction right now with an ever so slightly bias to the downside. This drop may represent an opportunity to be a contrarian and scoop up some Paychex under recent highs, or, as I did, write some puts. Wanting to wait always seems sensible, but when quality businesses get knocked down (think American Express and Wal-Mart earlier this year), which often happens after a tepid earnings report, the bargains usually don't last long. I would not buy calls in a slow-moving stock like this but $95, or 1.9%, or 3.8% annualized, could be collected for committing to buy the stock in March 2017 for $50. I probably wouldn't bother with this since its not much of a premium over the current yield of 3.2%, but I am a big advocate of cash secured puts for people who don't want to pony up for a stock today.

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I think it's too early to call dead money on Paychex. This is not a risk-free stock by any means but its has shown incredible resilience through all economic cycles. And dips today's like have, up until now, continually been met by new highs.

Disclosure: I/we 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.

Additional disclosure: I am short the October 57.50 puts