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Paychex (NASDAQ:PAYX), the payroll giant, sporting a sporting a trailing PE of 20, has been a steady performer even in bear and sideways markets. After ADP (NASDAQ:ADP), it's well entrenched as the leader in the small business (below 100 employees) segment. Paychex has a lot of positives going for it.

Year End July 2011

PAYX

ADP

Market Cap $B

11.25

27.28

Employees:

12,400

51,000

Qtrly Rev Growth (yoy):%

7.20

7.40

Revenue TTM $B

2.2

10.35

Gross Margin %

69.24

49.65

Operating Profit : $B

0.938

2.2

Operating Margin : %

38.20

18.17

Net Income : $B

0.543

1.34

EPS

1.5

2.71

P/E

20.69

20.52

Revenue per employee

177,419

202,941

Net Profit / Employee

43,790

26,275

Net Profit Margin %

24.68

12.95

Best industry margins -- Paychex has the highest profit per employee compared to its peers and its net profit margin of 24.35% is almost double of ADP's. Paychex keeps a tight lid on expenses, allowing it to gross an average of 38% revenues; even in a terrible 2010, Paychex managed an operating margin of 36% and net margin of 23.5%. In one of its best years -- 2008 Paychex had an operating margin of 40% and net margin of 28%.

Generates gobs of cash - Paychex has no long term debt, yields 4% and pays out about 80% of its profits as dividends to shareholders.

Steady for a cyclical -- Even as a cyclical, Paychex has never been subject to wide swings; in its worst year in 2010, revenues dropped a mere 4% and net income dropped 10%. It is very nimble and has managed operations beautifully even in the second worst recession in the last 100 years when unemployment hit 9.9%

In spite of these positives, I still feel that the stock is overpriced relative to earnings and here are the reasons why:

Broker estimates call for earning growth of 7 to 10% for the next two years each. Unless there is a dramatic change in the economy, it should be difficult to achieve anything higher. Paychex, like many other payroll services is totally dependent on employment improving and higher interest rates to make more interest income from the float it keeps. Paradoxically, if interest rates increase, employment takes a dive and if the Fed continues to keep interest rates low to revive unemployment, Paychex makes a negligible return on its investment income. A yield, which used to be 2.1% in 2010, is now down to 1.2% in 2012. In 2008, when Paychex made a whopping $576 M net or 28% of revenue, $132 M of that was interest alone! In 2011 it made a paltry $49 M!

There are few growth catalysts and no moats. This is a simple cookie cutter business with a lot of substitutes - CPAs, online payroll services, payroll modules from accounting software such as Intuit (NASDAQ:INTU)'s QuickBooks, banks and self processed payroll. Paychex saw revenue growth from both its insurance and HR divisions of about 10% last year, but these are very small pieces and are not likely to have any impact on the bottom line for the next three to four years. Paychex also rightly acquired an online service to add to its product line, but this too will be a very small part of the overall business.

This is not a sticky business - Paychex has a retention rate of 79% and besides price there is very little to distinguish service providers.

Earnings growth of 7 to 10% doesn't justify price/earnings multiples of 20. At this price, unless earnings consistently surprise over the next two to three years it's difficult to see the stock not move sideways. Paychex has averaged high PEs of 16 to 20 relative to its 5 year earning CAGR of 2.3%.

Paychex did throw up two good entry prices in 2010 and 2011 -- In August 2010 it dipped to $24.97 and again in August 2011 to $25.35 (during the great Washington gridlock and credit downgrade). These are opportunistic entry prices, which offer a lot more than the current dividend yield of 4%.

Source: Paychex: Overpriced For A Cyclical