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Given the successful IPO on Oct. 12 of cloud-based HR software provider Workday (WDAY), soaring 74% in its debut, and the continued growth of ADP, the giant worldwide player in business outsourcing software (HR, payroll processing, and benefit administration), one has to wonder what the future holds for Paychex (PAYX). Paychex has held the No. 2 position in United States human resource and benefit administration client count for over 30 years.

A review of fiscal year-end (May 31, 2012) results taken from the company's annual report indicates record performance for Paychex and its 12,400 employees. Paychex delivered a 7% increase in revenue year over year to $2.229 billion. Earnings per share increased 6% to $1.51 from $1.42 in 2011. Most importantly for future growth, client employees served with Paycheck's HR solutions grew 8% to 615,000.

Paychex has carved out a niche with small and medium-sized businesses served from over 100 offices across the United States and Germany. Large corporate clients are more likely to be with competitor ADP. This is not a negative for Paychex; instead, Paychex cements its relationship with small businesses using a direct sales force presenting mobile solutions and the latest technology to make payroll, insurance and benefit administration simple. In September 2012, Paychex launched a special 401(k) sales force solely dedicated to building relationships with financial advisors and plan sponsors.

Paychex Has a Substantial "Moat"

The "moat" for this business is the difficulty and headache involved in a client changing providers. Why is it difficult for an employer, especially a "mom and pop" operation, to change paycheck and benefit providers? All year-to-date cumulative information for income, taxes, health insurance deductibles, and 401(k) contributions for each employee are in the hands of the benefit administrator, such as Paychex. In addition, funds are held by the administrator for payment of federal tax withholdings and Social Security contributions. This is private and sensitive information and won't be moved without a compelling reason.

Paychex is priced at $32.63 as of the close on Oct. 12, 2012. The stock is up 16.2% over the past 52 weeks, below the 18.9% growth of the S&P 500. It is selling below its 50-day moving average of $33.58.

Paychex pays an attractive dividend yielding 3.9% annually. The dividend growth rate is 7.16% on a five-year average. A cautionary note is that the dividend payout ratio is at 84%, higher than the industry average.

Competitors

Automatic Data Processing (ADP): The company is the oldest and largest provider in the space of business HR outsourcing including payroll and benefit management solutions, tax, and compliance. The company has a suite of human capital management systems and a worldwide network of service centers. Revenue exceeded $9.9 billion in 2011 with a client count in excess of 600,000.

Insperity (NSP): The company provides HR support through its Workforce Optimization solution, which encompasses a range of functions including payroll and employee benefits, workers compensation, government compliance, expense management, training, and employee performance goals. Its client count includes over 100,000 small and medium-sized businesses with over 2 million employees served from 56 offices. Revenues in 2011 exceeded $2 billion.

Workday: The company provides cloud-based applications for businesses in the United States and internationally. It offers applications for customers to manage business functions that help them optimize their financial and human capital resources. The company was founded in 2005 and went public on Oct. 12, 2012.

Paychex

Automatic Data Processing

Insperity

Workday

Year Launched

1971

1949

1986

2005 (IPO 2012)

Employee count

12,400

57,000

2,100

1,452

Market Cap

11.8B

28.2B

660M

N/A

Dividend Yield %

3.9

2.7

2.7

N/A

Dividend pd since

1988

1974

2005

N/A

5 yr Div Growth

7.1

11.7

8.8

N/A

Trailing P/E

21.5

20.7

19.4

N/A

Operating Margin

38.4

22.9

3.0

(-44)

Return on Equity

34.5

22.9

13.6

N/A

PEG ratio (5 yr est)

2.14

2.17

0.70

N/A

Source: Yahoo Finance.

Conclusion

The business of business outsourcing appears healthy and each of the above companies serves a specialty niche. Investing over the long term in any of these examples is a play on continued business growth. The fact that these companies survived and prospered during the downturn means there may be real upside as the economy improves. Imagine if, over time, 5-10 million new jobs are created how these payroll processing and employee benefit companies will profit.

As a retiree with an interest in dividend income, I like each of the three listed above as they all pay dividends -- but particularly PAYX, with its 3.9% yield. I am impressed with the return on equity and operating margin performance of the two largest players, PAYX and ADP. The fact that NSP is a small-cap and has a very attractive PEG ratio 0.70 will cause me to put it on my watch list. You may want to do the same.

Source: Paychex Is A 3.9% Yield Dividend Heavyweight