Paychex is a Good Dividend Play, but is there More to it?

Earnings from small business service provider Paychex (NASDAQ: PAYX  ) are usually closely followed for three reasons.

First, it's a payroll services segment is a good barometer of current conditions in the small and medium size business market. Second, its results provide good color on the increasingly competitive market for payroll and HR services. Third, and I suspect this is what most of you will be interested in, it's one of the go-to dividend stocks for income seekers.

Paychex gives small businesses some reliefThe company typically generates two-thirds of its services revenue from payroll services, and one-third from its faster growing HR services segment. In general, the first-quarter recent results were positive and tracked quite well against Paychex's full-year guidance.

	Full-Year Guidance	Q1 Results
Payroll Services Growth	3% to 4%	2.4%
HR Services Growth	9% to 10%	11.3%
Total Services Growth	5% to 6%	5.2%
Net Income Growth	8% to 9%	6.3%

Revenue growth matters a lot, because its operating income margins are close to 42%. Superficially, the payroll numbers were weak compared to what Paychex is expecting for the full year, but relatively speaking, they were good.

Going back to its last set of results, Paychex had stated that its key checks per payroll metric only grew 0.9% in the quarter. Furthermore, management had noted that the the number had moderated in the quarter, and the trend was downward. With this in mind, investors would have been right to be fearful of what Paychex would report for Q1.

In the end, checks per payroll grew 1.6% in the quarter, and the weakness in the fourth quarter was put down to a "timing issue." The overall payroll services growth rate was only 2.4%, but Q1 was affected by one less trading day than last year.

In a sense, this is a sigh of relief for commentators watching the small business sector, especially as it mirrors Automatic Data Processing's (NASDAQ: ADP  ) unchanged forecast for its "pays per control" to grow at 2% to 3% this year. Small businesses aren't growing as strong as they have in previous recoveries, but conditions aren't as bad as Paychex's Q4 numbers had previously intimated.

Are conditions getting tougher for Paychex?On the other hand, in Q4, Paychex argued that its full-year outlook for 3% to 4% payroll services growth was mainly predicated on revenue per check rising (rather than checks per payroll) thanks to price increases passed onto customers. However, on the Q1 conference call, Paychex stated:

Revenue per check grew modestly as a result of price increases partially offset by discounting.

To be fair, its revenue per client did increase, so any discounting did not totally takeaway any gains from price increases. However, the modest nature of the net increase, and the need to discount, could be a sign that competition is increasing payroll services.

ADP's forecast (reiterated in August) of 2% to 3% growth in pays per control is higher than employment gains in the overall economy, and ADP argues that its clients have been hiring faster than the national trend. So is Paychex's lower growth rate related to its client base?

Moreover, the payroll services space is getting crowded. ADP, Paychex, and Intuit (NASDAQ: INTU  ) are all trying to develop their software as a service-based offerings. Paychex claims that its SaaS-based SurePayroll solution is growing in the double-digits, and ADP is accelerating sales of its Vantage product, which will integrate HR management, payroll services, and benefits administration.

Meanwhile, Intuit can generate growth for its online payment solution by cross-selling it within its small business group solutions. In fact, Intuit continues to generate mid-teens growth with its payment solutions. In addition, Insperity has launched a SaaS-based payroll solution.

Is the dividend enough to buy the stock?The answer to this question partially lies with your desire for the near-3.5% dividend yield that Paychex currently generates for you. It's certainly a lot higher than the current 2.65% yield on a 10-year U.S. Treasury bill, but is it as safe over the next 10 years? The payroll services market is getting crowded, and it's not clear who will be the long-term winner out of the move to SaaS.

Moreover, Paychex paid out around 83% of its free cash flow in dividends last year, so it's difficult to see much scope for strong dividend increases in the near term.

In conclusion, the stock will continue to attract dividend seekers in a low interest rate environment. However, for long-term investors, paying 25 times earnings for a highly cyclical stock within increasingly competitive markets might appear a bit rich.