Friday, November 16, 2012

Stocks Exposed to Favorable Small Business Trends

I want to take a check on what is happening with the environment for small businesses in the US and see if there are any identifiable trends worth investing in. I’ll start with the most recent company in the sector to give results and that is Paychex Inc (NASDAQ: PAYX).  Then I will compare some industry surveys with what companies are reporting.

In summary, the results and guidance were slightly ahead and there were no major surprises here. However, there are a few trends that can give clues as to other stocks and sectors that might prove attractive. With regards Paychex itself, the stock’s dividend will interest income seekers but its single digit earnings prospects won’t turn on growth junkies.  Each to his own!

Paychex Results

The results were slightly ahead in terms of revenues and the company reaffirmed full year guidance so nothing new here. As for the specifics, payroll services (67% of revenue) increased by 1% and human resource services (32%) increased by 7%.  The key takeaway here is that checks per payroll continue to increase albeit at a slower pace with 2% growth this year versus. 2.4% growth last year.

 This is consistent with a slowing economy and anyone looking for upside surprise would have been disappointed. It pretty much confirms what the key industry surveys have been saying. Moreover, Paychex predicted that checks per payroll would experience lower growth going forward while revenue per check would see a modest increase. Again this is confirmation of a slowing economy that doesn’t have much traction.

It is a ‘steady as she goes’ type of earnings report. Yield chasers will love the stability of the dividend and this is true attraction of the stock. Of course in an environment where growth is a lot weaker than it traditionally is in recoveries we can expect increased competitive pressure as companies fight for a piece of a smaller cake. Indeed, the likes of Automatic Data Processing (NASDAQ: ADP) offer stiff competition. ADP is doing a bit better than Paychex in terms of generating growth. Its employer services division recorded 5% organic growth in the last quarter and the company forecasts 6-7% revenue growth along with some margin expansion. It is predicting a modest 2-3% growth in pays per control which tallies closely with what Paychex is seeing too.

Industry Surveys?

While according to what Paychex and ADP are reporting, small business conditions appear sluggish at best, is this what the industry surveys are saying?

I think the answer is yes.

The National Federation of Independent Business (NFIB) surveys have tended to be a bit on the weak side this year but August saw a slight uptick. With regards employment here is the NFIB small business job openings data. This measures the percentage with positions not able to fill right now.

So a slight tick up in August but it has been a very sluggish recovery and the numbers are still far from pre-recession levels. Nonetheless the trend remains positive.

It is a similar story with NFIB capital expenditure plans. This measures the percentage planning a capital expenditure in the next three to six months.

So we seem to be having a decent August following a tough couple of months and it’s amazing how the market seems to be pricing this in.

Opportunities in the Small Business Market?

Aside from Paychex, ADP and the other obvious beneficiaries of a pickup in small business sentiment there are other companies that could benefit. I want to focus on what Wells Fargo said in July with its Wells Fargo/Gallup small business index.  In line with the NFIB data (for June/July) it was predicting weaker capital spending plans but as August has rebounded with the NFIB it is fair to assume that the capital spending trends identified in the Wells Fargo index will strengthen in August.

Interestingly new technology is very high on the capital spending agenda of small businesses. Here are the movements in purchase rates for technology over the last year.

Smart phones and tablets are replacing traditional cell phones and desktop computers in importance and if the mini recovery in August is sustained then companies exposed to these themes will do well.

Stock Ideas

There will be winners and losers in this kind of shift in spending and the clearest losers are Dell and Hewlett-Packard (NYSE: HPQ). Both are seeing pc sales collapse and mobility revenues challenged. Moreover Hewlett Packard’s printing division has been under pressure for a long time now and the company’s debt puts it in a tricky position. It’s hard to see an easy turnaround for either of these companies but HP looks in particular difficulty.

On a more positive note Aruba Networks (NASDAQ: ARUN) looks like a beneficiary of this shift.  Incidentally, there is a more detailed article linked here on Aruba. The company is a good play on companies rolling out smart phones and mobile devices across their workforce. It is also exposed to the trend of bring your own device (BYOD) in corporate mobile. A trend that is increasing as Blackberry continues to lose market share as the device of choice for corporations. Aruba did make some positive noises in the last report but I am a bit concerned with the evaluation. Nonetheless, it is a great stock to monitor.

Another SMB focused business that will do well out of new technology spending is Fortinet (NASDAQ: FTNT). I am a bit of a fan of this IT security company and think it is performing very well this year. Its unified threat management (UTM) solutions provide SMBs with their IT overall security needs and the company is also winning business from mid-market firms that are increasingly moving to its solutions. Whether this is ‘trading down’ or not doesn’t really matter, it still ends up in its bottom line.

The Bottom Line

In conclusion, small businesses are doing ok. The recovery is slow and not offering great upside to the traditional plays but there are trends within small business spending that can be capitalized on and I hope this article has created some ideas for you.