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.

Does Buying Intuit Make Tactical Sense?

Investing is often about weighing the possibilities of various outcomes and then trying to assign a value to the stock on a balance of probabilities. With Intuit , I think investors are getting a fundamentally cheap company that has disappointed in its core activity this year but is performing very well in its fast-growing non-core businesses. Furthermore the question marks over its core activity (tax returns) won’t be at the forefront of investors’ minds until next year. Time to pick some up?

Intuit explains itself

Having previously been rather positive over its prospects for its core tax-return business this year, the company managed to disappoint the market by announcing that it would only grow 4% this year. This is below the 8-10% analysts had penciled in. For an idea of how important tax returns are to its full year, readers can take a look at the charts in the article linked here.

Naturally, investors will want to focus on why and how its tax-return revenues came in lower than expected. Here are the reasons cited.

• Overall tax returns were 1% lower this year against Intuit’s previous expectations of 1-2% growth. The IRS has not yet come to a clear conclusion as to why this was so, therefore it would be remiss to expect Intuit to have a clear view either at this time. Obviously this is an industry issue which could normalize in future years.

• More worrisome, the software category only took 1% market share from manual when it had expected it to come in at 2%. This could be an indication of a slowing of growth in this secular trend or it could be a reflection of issues with Intuit’s software.

•  Intuit claimed that it didn’t grow its online share as it had expected (although it did well with mobile and retail) and smaller competitors took some share. With 60% of the market Intuit is obviously vulnerable to future erosion. 

In summary, it wasn’t as good as expected. But the reasons for this are a combination of structural and company-specific issues. Nevertheless there were some plus points. Mobile is performing very well and Intuit has clear leadership in developing mobile-app solutions. In addition it is competing well against H & R Block . In addition its main rival reported in its press release that the industry had "experienced unprecedented delays and changes to the timing of taxpayer filings this tax season which created significant challenges."


It then went on to argue that it was essentially flat in terms of overall market share of tax returns. So while H & R Block is pleasing investors because it has managed to fight back against Intuit by developing its own online operations, this is not really a story of Intuit notably losing market share. Moreover if there are some structural reasons why manual tax returns can stabilize their market share then H & R Block is going to be a relative winner out of this.

Intuit's Small Business Group continues to grow

If tax returns disappointed, then there was no such let down with its Small Business Group (SBG) results. This group made up 35% of revenues in 2012 and is growing in the mid-teens. A graphical depiction of its ongoing growth is shown below.

These results have been achieved in an otherwise weak environment for small business and they attest to the cost-effectiveness of their offerings. In addition, Intuit has the capability to cross-sell solutions across its customer base. There is a natural correlation between financial management solutions (QuickBooks, etc.) and HR services

Indeed, this space is getting somewhat more competitive now with Paychex  and Automatic Data Processing chasing growth in order to offset slow growth in their core offerings. I’ve discussed these companies in more detail in an article linked here.  Paychex’s payroll service market is only growing in low single digits but its human resources services operations are growing in double digits. Paychex's key attraction is its dividend yield, and even though it has more limited pricing power than in previous recoveries, it still has upside from the jobs recovery working its way down into small businesses. Meanwhile ADP’s growth prospects come from its professional employer organization services group. The environment is clearly getting more competitive, but for now Intuit is performing well.

Where next for Intuit?

I think investors need to keep things in perspective here. Intuit is a huge cash generator and is on a good cash-flow yield. This hasn’t been a good year for its core tax revenues but it still recorded 4% growth while growing its SBG in the mid teens. If it only replicates this performance next year, then I think the stock is a good value. Indeed, there is some upside potential from some of the structural issues (falling tax returns) being resolved.

By my calculations Intuit has generated over $1.2B in free cash flow on a trailing year basis and as I write. That puts the stock on a free-cash-flow yield of 6.8%. In other words, if you buy the stock now and it keeps generating this kind of cash then in 14 years (and this is conservatively assuming no real growth) it will have generated its evaluation in cash. I think that is attractive for a business that – despite slowing growth in its core activity – is still capable of revenue growth in the high single digits.  In addition, the market's focus is largely going to be on its SBG until the next tax season comes around.