Cloud Computing Stocks to Buy

There are no prizes for guessing that cloud computing is the IT sector's hot buzzword is right now. Blue chip tech companies like Google, IBM, Oracle  and Microsoft are all investing in offering infrastructure as a service, or IaaS, solutions to their customers. In addition, there is an ongoing trend of incumbent software companies shifting toward software as a service, or SaaS, based models. For example, Intuit, Adobe, and Autodesk are all making the change, but what is in it for them? Moreover, what are the tangible benefits of cloud computing for these companies?

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Intuit is more than just TurboTax

There are three main ways to invest in the cloud. One way is to invest in the infrastructural plays that help to create it. Another is to buy companies whose internal operations are benefiting from utilizing the cloud. The third option is to invest in software companies that are shifting into selling software as a service, or SaaS. The poster boy of the last option is Intuit. It's time to take a close look.

Intuit's two key growth drivers
Intuit's stock is peculiar because it has its very own trading dynamic. Most of its profit is made during the all-important tax season. Subsequently, investors are mainly focused on its tax software's fortunes during the spring quarter.

Source:company accounts.

After the tax season quarter, the attention turns toward its small business group (SBG) offerings. Attention shifts back once the tax season comes around again. Intuit isn't just about taxes, though.

In fact, in its last fiscal year, consumer tax only contributed 45% of full-year revenues. Furthermore, its guidance for 2014 implies that Consumer tax (consumer group) and pro tax will only make up 49% of revenue. Moreover its tax operations are only growing in low single-digits while, the SBG's growth is in the more impressive low-teens range.

2014 Guidance	Revenue	Growth
SBG	2290	10%-12%
Consumer Group	1778	3%-5%
ProTAx Group	413	0%-4%

 Source: Company presentations.

Moving into 2014, Foolish investors should be focused on two things with Intuit. First of all, they should look at its plans to ensure a solid tax return season. Secondly, they should watch the ongoing development of an ecosystem within its SBG.

Intuit's disappointing 2012 tax season
Unfortunately, Intuit's last tax season was somewhat disappointing for a number of reasons:

• Overall tax returns were lower than its internal expectations due to a difficult tax season

• The software category overall only took a 1% share from manual, when Intuit had expected 2%

•  Intuit didn't grow its online market share as expected, and smaller competitors took market share

Intuit's rival, H&R Block, also confirmed that the tax season was uniquely difficult this year:

"We expected...  ...the season would normalize to historical growth rates of 1% to 2%...  ...we had little reason to believe that growth levels this year would be different than average historical levels.

Instead, at season's end, IRS returns were down approximately 1%, a result no one was expecting."

In addition, investors in Intuit and H&R Block have some cause for concern in 2014. According to Intuit's management, the IRS is talking about "some delays to the start of tax season again this year." While this is likely to be a timing issue, there is a danger that it could indicate a more complex tax season.

Intuit is making some changes to its tax strategy this year. The company is trying to move away from heavy advertising during the tax season, and more toward simplifying its products and ensuring customer retention. This sort of strategy is very much in line with the advantages of SaaS. In other words, SaaS solutions help to reduce customer churn because they tend to involve more of an ongoing interaction than a one-off software sale does.

Intuit develops an ecosystem
Its second major strategic focus is to develop an ecosystem around its various offerings in its SBG segment. The idea is use the cloud in order to cross-sell its financial management, payment, and employee management solutions (which make up the SBG and account for 37% of segment profits.) Furthermore, its tax refund customers can plan how to utilize their refunds by using the lower end of Intuit's accounting and financial planning software, QuickBooks.

QuickBooks is also undergoing a refresh which is being rolled out to existing QuickBooks online and desktop publishers. Again, a big part of the plan is to encourage its desktop customers to convert to its online offering. Intuit outlined that it now had over 500,000 QuickBooks online subscribers, up by 29% from the previous quarter. This provides more power to Intuit's ecosystem.

A competitive market
One downside to all of this is that Intuit's markets are getting ever more competitive. Paychex has recently launched an online accountancy offering targeted at small business. While this a relatively late move, it still represents the principle of moving to the cloud in order to cross-fertilize its payroll and HR services. Automatic Data Processing's  also competes with both companies in online payroll, and its Vantage product is a cloud-based suite designed to integrate ADP's human resources, payroll services, and benefits administration in one package.

The bottom lineIntuit is facing stiffer competition, but it's an early mover in offering SaaS-based solutions. It's also being aggressive about developing its ecosystem, and it remains a prodigious generator of cash flows for investors. For example, Intuit generated $1.24 billion in free-cash flow last year, representing around 5.8% of its market cap. With analysts forecasting 11% EPS growth for the next couple of years, Intuit looks like a good value.

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.

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.

H & R Block a Structurally Challenged Business?

H & R Block HRB gave results on Friday and they appear to be confirming my feeling about this company. I think they are company that benefits from a cyclical upturn in employment (employees filing more tax returns) but who are structurally challenged by rivals such as Intuit.

In a sense H & R Block is the archetypal Warren Buffet type of stock. Indeed, he has formerly held large stakes in this company. It has a strong market position, holds a good competitive boat and generates lots of cash flow. A classic Warren Buffet ‘annuity’ type of stock, whose position in the heartland of America (via opening stores in Wal-Mart and such like) is assured. However, technology is no respecter of tradition or of Warren Buffet.

Intuit’s (do it yourself software based solution) has been eating into market share. Furthermore, the pick up in employment in this recovery-so far- has been noticeably behind previous recoveries. Moreover, employment gains have not yet compensated for the losses in employment during the recession.

So we have a business that is structurally challenged. They look set to benefit from a cyclically pick up, but I would prefer more pure plays on economic recovery than H & R Block.