Nadeem Moulvi's  Instablog

The rate of unemployment is a well known lagging indicator of the economy.  For instance, many market experts have predicted that the stock market has already hit a bottom and is currently in a consolidation phase.  However, the rate of unemployment is still expected to inch higher in the coming months before stabilizing.  In contrast, the stock market is a leading indicator of the economy.  As a case in point, since the March lows, the S&P 500 index has rallied by approximately 30%. 

One way of betting on the unemployment rate is investing in small businesses.  They make up more than 99% of all US employers.  In this recession these companies suffered, among other reasons, owing to the credit freeze.  In March this year, President Obama set aside approximately $375 Million to bolster small business lending in the form of loan guarantees. It is expected that this program would help existing small business (not to be confused with small capitalization stocks) expand and grow. 

Since these companies are not publicly traded, an investor has to resort to an indirect method of gaining exposure to this sector and participating in its anticipated growth.  This can be accomplished by investing in Professional Employee Organizations (PEOs).  PEOs provide payroll, human resources, healthcare and other benefits to small businesses.  When a company hires a PEO, in effect, the PEO becomes the legal employer of the employees within this company.  Thus, the small business owner can concentrate on running and expanding his/her business instead of dealing with legal, administrative and other issues facing his company.

By aggregating the employees of many businesses, a PEO can often offer better rates on health and workers' compensation insurance, while giving employees big-business-style benefits.  (Source – Fortune Small Business)

In this article, I will compare two major PEOs operating in the US, namely Administaff, Inc. (ASF) and Paychex, Inc. (PAYX).  Administaff is pure PEO play and is one of the largest PEOs in the US.  Paychex is a larger company  (by market capitalization) and serves both small and medium sized businesses. The table that follows summarizes the basic information for these companies. It should be noted that a direct comparison of company fundamentals is not recommended as Paychex has other divisions in addition to its PEO division.

Company Fundamentals

The revenue and income generated by the PEOs is a function of the number of ‘worksite employees’ under its control. At the end of Financial Year 2008, Administaff had 116,957 worksite employees and it generated a net profit of $33 per employee per month.  According to Administaff, the operating income per worksite employee exceeds industry averages by approximately 151%.  The corresponding data for Paychex was not available.  With the reduction in unemployment rates and the growth in small businesses, the number of worksite employees for these companies would increase, thereby improving the net income of the PEOs. 

The EPS estimates for the two companies are shown the table that follows.

Valuation:

Relative valuation was performed for the two companies using the 2011 average analyst EPS estimates.  The fair value is presented in the table that follows.  It should be noted that the data from the last four financial years was taken in calculating the averages shown in the table.

The Call:

Administaff, Inc.

I am initiating coverage of Administaff with a HOLD rating and a conservative 12-month price target of $25 derived by applying a PEG of 1.2 to the 2011 average analyst estimates.  At these levels, ASF would be trading at a multiple of 18, below its historic averages.

Paychex, Inc.

I am initiating coverage of Paychex, Inc. with a HOLD rating and a 12-month price target of $29.   At these levels, PAYX would be trading at a P/E of 20 and a PEG of 1.66, modestly below its historical averages. 

I have a target entry point of $20 for ASF and $23 for PAYX.  Assuming that the current recession does not extend into the forseeable future, these companies appear safe bets to double in value in the next five years.  For example, the stock price of ASF can be expected to double in five years if ASF grows its EPS at an annual rate of 12%.  This growth rate is below the analyst average forecasted rate of 15%. 

Disclosure: The author currently has no positions in the companies listed in this article. His company (a small business) is an Administaff, Inc. client.