Paychex Is Slightly Expensive But Has Hidden Growth Potential

| About: Paychex, Inc. (PAYX)

Paychex (NASDAQ:PAYX) provides outsourced payroll and human resources services to small and medium size businesses in the United States. PAYX also has operations in Germany and Brazil, but these are currently insignificant (although offer potential future growth). PAYX offer a variety of different products / services designed to reduce the customer's administrative overhead. This overhead can be a significant drain on the growth of small businesses and on the profitability of all businesses so there is a clear market need.

PAYX operate on a service model - clients pay every month for the services they subscribe to. Subscription based businesses usually have more predictable revenue streams than business that only generate up-front revenue. Subscription based software businesses are particularly appealing as it is time-consuming and expensive to change software providers (especially when it is for something as important as making sure your employees are paid on time). Obviously you should look for businesses that retain customers positively (by offering a good service) but it is nice to have a negative backup (customers want to avoid the pain of changing).

PAYX is the second largest payroll processor in the US behind Automatic Data Processing (NASDAQ:ADP). Both firms have approximately 10% market share in payroll processing (estimate based on the firms' publicly reported client numbers and census data for the number of firms with employees in 2004). The only other national competitor for outsourced payroll is Ceridian (a private company) who appear to have about 2% of the market. PAYX therefore gain the benefits of being a market leader while still having expansion possibilities. ADP's focus is more on medium and larger companies, leaving PAYX facing only small (local payroll processors) and or non-specialized (bookkeepers / accountants) competition.

Less than 20% of small (<100 employee) business have outsourced payroll services, so there is still considerable potential market here. The big question in terms of market share / market growth is whether Intuit's (NASDAQ:INTU) QuickBooks software will continue to gain customers (they currently claim over a million users (about 20% of the potential market used above). To some extent Intuit is targeting a different market than PAYX (the DIY approach is most appealing to companies that have an in-house bookkeeper) but there will be some overlap.

PAYX has also begun to expand in Germany and Brazil. The German operation is about eight years old accounted for <1% of company revenues in 2013 so it has been little more than an interesting curiosity. However, PAYX are looking to expand the German operations and recently doubled their client base through an acquisition so we may see noticeable growth in the near future. The Brazilian joint venture is very new (launched January '13) so there are no meaningful results yet. There is significant potential though - there are five million small or medium business and the regulatory environment recently became much more complex. At the moment, the overseas operations are merely interesting curiosities, however there is real potential in Brazil as it is a growing and modernizing economy. If PAYX were to achieve the 10% penetration they have in the US this would be another ~50,000 customers (about a 9% growth on the current customer base).

PAYX is well placed to benefit from two possible macro-economic trends. The obvious source of potential growth is from increases in employment, especially in small businesses. The US unemployment rate has been falling steadily over the last four years but is still significantly higher than before the 2008 crash. Additionally, the number of small businesses continues to grow in both absolute terms and as a percentage of total jobs. These suggest PAYX's target market will continue to grow for the next few years.

The second macro trend that PAYX may benefit from is rising interest rates. PAYX make payments on behalf of some employers. These employers send PAYX the money before PAYX pay the employees. During the time between receiving the money and paying it out PAYX collects interest on it. In 2013 only 1.8% of company revenue ($41m) was from interest on this float. In 2007, when the overnight bank rate was 5.25% (compared to 0.25% at the moment) 7% of revenue ($134m) came from interest on client funds. An increase in interest rates would effectively be free money for PAYX as it does not have any debt so would not face increased interest payments. PAYX currently hold approximately $4B of client funds so if interest rates rise by 1% that would be an extra $40m in profit (about a 7% improvement in the bottom line).

The numbers in the following section are from GuruFocus and Paychex investor relations.

PAYX have almost doubled revenue over the last 10 year from $1.3B to $2.3B. There was a slight (4%) dip in 2010 due to the effects of the financial crisis but otherwise, we see consistent growth in revenue. Earnings per share have also nearly doubled since 2004 ($0.80 to $1.56) although they only grew at 3% last year.

One of the reasons I like software businesses (in addition to being a software guy) is that they can have excellent margins because software is very scalable (once it is written you can sell it multiple times). PAYX's Gross Margin was 72.9% MRQ (it has risen fairly steadily from 64.2% in 2012). Net Margin was 26.8% (up from 23.4% in 2012). Consistent and rising margins are a sign of a good business. Consistent, rising, and high margins are a sign of a great business. PAYX also display a pleasing downward trend in accounts receivable. In 2006 they had an average of 49.7 days sales outstanding. In 2013 it was just 26 days. This suggests some combination of less bad debt and improved collection terms.

PAYX have no long term debt and $500m in cash and short term investments (not including client funds which obviously cannot be spent). This is almost one quarter's revenue or two quarters of real expenses (cost of goods sold plus selling general and administrative). This is a nice cushion and is further boosted by another $370m in long term investments.

A history of acquisitions mean that PAYX is carrying $533m of goodwill but the balance sheet is strong enough even without this "asset". Capital expenditure for fiscal year 2014 is expected to be $100m to $110m which is fairly consistent with the last 3 years and well covered by cash on hand and expected cashflow.

PAYX has authorised up to $350m of share repurchases for the upcoming year. During Q1 2.1M shares were repurchased at a cost of $84M (about $40 each). Share repurchases suggest that management are not acquisition crazy and recognize the value of giving pare money back to shareholders. PAYX currently yield 3.25% with a payout ratio of 88% from earnings. The payout ratio is on the high side so the dividend looks somewhat risky. However, PAYX have a good history of earnings growth and plenty of cash at the moment so it should be safe. Net Income is projected to grow 8-9% over 2013-14.

PAYX is currently on a slightly expensive P/E of 27. ADP is trading on the same multiple so this suggests investors are bullish on the sector. PAYX's 1 year forward P/E is 23.5 which is better but still on the high side. PEG is 2.5 at the moment which suggests that future growth is completely priced in and possibly that the market is being too optimistic about PAYX.

PAYX has a solid balance sheet, a profitable highly cash generative business, and a relatively strong competitive advantage. When you add in a relatively high yield and some attractive macro factors and expansion possibilities it is not surprising that this is a popular stock. I would like to own PAYX but I am not quite convinced I should pay 27x earnings for it. For now, I am putting PAYX on my watchlist for either a price drop or when interest rates look more likely to rise.

One thing to note (depending on when you are reading this article) is that PAYX goes ex-dividend on 10/30, so it may be worth waiting till after that date if you are considering a purchase and do not have access to a DRIP (I do not). Doing this means you will get slightly more shares for the same initial investment.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PAYX over 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.

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