Thursday, April 4, 2013

Paychex Offers a Good Dividend But What Else?

One of the most important parts of successful investing is to quickly discern the key drivers of a company’s stock price. Of course, it is easier said than done! It is a bit like deciding how an election is won. Different voters vote for different things. However, in the case of Paychex $PAYX I think I know what the campaign issues are likely to be.

Paychex Pays You Checks

In a low interest rate environment, income seeking investors are virtually being forced by the Federal Reserve into seeking high yielding stocks as a substitute for US Treasuries. Frankly I think PAYX’s near four percent yield is a compelling proposition.

In addition, consider that its earnings prospects are largely contingent upon the economy and the small and medium sized business market picking up hiring and employee payments. In other words, you are getting earnings that correlate with nominal GDP-like growth but with a higher yield and some prospect of growth.

It all sounds good for income investors, but there are a few questions over the company:

  • Will small and medium sized business start hiring this year after a few years of tepid growth?
  • Will competition in its core payroll service hold back pricing and erode market share so that the company decouples from its position as a GDP play?
  • Does PAYX have any other opportunities to generate margin expansion and/or growth?

I will try to shed some light on these questions in light of PAYX's and its competitors' recent results.

Paychex Sees Growth

I thought the recent results were pretty good, and the growth in the key payroll per checks number of 2.3% versus 1.8% last year was a stronger than anticipated number. This is a good sign for the US economy at large.

Indeed, plenty of small business indicators have been gradually improving in the last six months. As I argued last time around political events do have a short term effect on small business hiring plans, although they tend to bounce back provided they are resolved. It is no accident that the National Federation of Independent Business (NFIB) indicators tend to worsen over fiscal cliff worries and then bounce back afterwards. The economy is like a supertanker--it doesn’t just turn around that easily.

With the ongoing headline payroll numbers improving I would expect some improvement in small business formulation. Indeed, PAYX argued that since there hasn’t been the typical surge in small business start ups yet, there should be upside to come in the future. We shall see. On a positive note PAYX talked of strong bookings in its core payroll services division but mentioned that pricing increases would be at the low end of the range.

My view is that the economy is improving, but PAYX has more limited pricing power than in previous recoveries thanks to increasing competition. It is not only coming from its traditional sources like Automatic Data Processing $ADP but also from companies like Intuit $INTU. Both of these companies are strong in the online payroll via their Software as a Service (SaaS) offerings. Intuit is the poster boy of the movement towards SaaS based services to small business, and it has the opportunity to cross-sell its range of products to its existing customer base. Intuit is achieving teens growth in its total small business group, and I see the company as a formidable competitor.

As for ADP, its growth prospects are pinned to its professional employer organization (PEO) services group, which is also growing strongly. However, margin growth has been hard to come by in recent years, and the human capital management market is getting crowded.

All of which leads me to answer the third question with a reference to its plans to invest in its ‘market leading’ SaaS technology, although I have a feeling that it is a bit late to the party here, and ADP and Intuit have stolen a march. Nevertheless PAYX can expand margins if its SaaS sales expand.

Where Next for Paychex?

On balance I think the recent results were a net positive for PAYX. Operating margins increased even though the pricing outlook wasn’t great, and there should be upside to come from an improving economy. The SaaS investments make sense, even if the payroll service market (around 2/3 of revenue) is only forecast to grow 1-2% in the full year to May 2013. Human Resources Services are forecast to grow at 9-11% with net income up 5-7%.

In summary, income investors can probably enjoy some high dividends for a few years to come. On the other hand growth investors should probably look for better ways to play a cyclical economic recovery than PAYX.