Sunday, July 21, 2013

Paychex Earnings Analysis

It’s always interesting to look at Paychex's (NASDAQ: PAYX) results, because the small business service provider usually gives good color on the economy. What do its latest results say about the small business environment, Paychex's own prospects, and can the company grow its relatively large dividend?

Paychex gives mixed commentary

Anyone hoping that Paychex would deliver an upbeat depiction of the economy would have been disappointed with the recent fourth-quarter results. The key metric to follow, in terms of analyzing the health of the small business sector, is its 'checks per payroll’. Unfortunately, it only rose 0.9% in the quarter, and analysts spent much of the conference call trying to find out why it was so weak. The commentary wasn’t good, with the management describing it as moderating in the quarter and then suggesting that the trend was downward.

In addition, this doesn’t even appear to be a Paychex-specific issue because its client retention was at an all-time high at above 81%. The payroll services market is competitive, with the likes of Automatic Data Processing (NASDAQ: ADP) and Intuit (NASDAQ: INTU) also active, but Paychex is holding its own for now. Indeed, it made bullish noises by predicting its client growth would come in at 1%-3% going forward.

Paychex seems to be competing quite well, and it's helped by strength in the housing sector. I note that in May, ADP kept its forecast for pays per control (within its employer services division) at 2%-3% growth. In light of what Paychex just said, will it have to reduce this figure?

In summary I think Paychex’s commentary -- it also highlighted weaker-than-expected new business formulation -- confirms the mild nature of the recovery, and you can see this in the National Federation of Independent Business (NFIB) data. I’ve broken out the current job openings data below.

The trend is favorable, but growth remains tepid, and Paychex’s results did little to assuage fears.

Paychex’s recent results

Paychex’s overall results were okay. In the last quarter, it had forecast full year growth of 1%-2% in payroll services, with human resource services forecast to grow at 9%-11% and net income up 5%-7%. In the end, these full year numbers came in at 2%, 10% and 6% respectively.

In its guidance for 2014, the company predicts:

  •  Payroll services revenue growth of 3%-4%

  • Human resource services growth of 9%-10%

  • Total service revenue growth of 5%-6%

  • Net income growth of 8%-9%

The forecast for the acceleration in payroll service growth is based on revenue per check rising for Paychex. This is thanks to price increases made to customers, rather than an improvement in the amount of checks per payroll. At this point, anyone would be inclined to ask whether it is worth paying 24 times current earnings for a business that is forecast to grow income by only 8%-9%.

One reason to make your answer "yes" is if you see some upside prospects to these forecasts. Paychex obviously has the potential to benefit if the economy does better. Furthermore, its management was keen to highlight the potential for its healthcare services to do well as companies grapple with regulatory changes. However, I think its most interesting upside driver could come from its technological investments.

Technology to the rescue?

In common with others in its industry, Paychex is making ongoing investments in software as a service (SaaS) offerings. The idea is to create an integrated management tool that allows its customers to use its human resource, employee management, and payroll services through one application. In fact, it’s such a good idea that ADP and Intuit have already been doing similarly.

I’ve discussed Intuit in more detail in an article linked here. Its recent results were disappointing, but that was mainly due to its core tax return business having a poor season. In fact, its small business group (which now makes up 35% of revenues) saw growth come in at 17% in the quarter. Its employment management services came in with 11% growth. Intuit is the poster boy for businesses shifting their offerings towards SaaS, and clearly, Paychex needs to embrace these industry changes.

With regards to Intuit, it will be a while before tax return season comes into investors' minds again. Provided it can keep up good growth in its small business group, I think Intuit's stock is well worth looking at.

ADP claims to be the "leading provider in the cloud" and is pushing its ADP Vantage HCM product. This product will integrate things like ADP’s human resource management, payroll services, and benefits administration. ADP described the products sales as "tracking very well against our expectations" in its latest conference call. Unfortunately Vantage is still a relatively small part of its sales, so investors can't expect too much of a contribution in the near term. ADP expects its employer services to grow at 7% this year, but is seeing its growth prospects held back due to its European exposure and ongoing low interest rates holding back investment income.

The bottom line

I think the main attraction of Paychex remains its dividend yield which currently stands at around 3.5%. By my calculations, it paid out nearly 83% of its free cash flow in dividends last year. Therefore, there isn’t much scope to aggressively grow dividends outside of bottom line growth, and, with income forecast to grow at 8%-9%, you shouldn’t expect too much of a dividend increase in future.

In conclusion, Paychex's commentary on the economy wasn’t great, but it is performing well in very competitive markets and has some upside drivers. On the other hand, there are others increasing investments in its core area of payroll services. On balance, it’s not a stock for me, because I don't chase dividends. But those looking for yield could do a lot worse than picking some up.