Paychex: A Hidden Gem
Christopher is a member of The Motley Fool Blog Network -- entries represent the personal opinions of our bloggers and are not formally edited.
Paychex (NASDAQ: PAYX) has carved out a niche in the small business segment of payroll processing, human resources, and benefits industry while the large company segment of the market is served by its bigger rival Automatic Data Processing (NASDAQ: ADP). At fiscal year end 2011, about 99% of Paychex's clients were businesses of fewer than 100 employees while its competitors operate throughout the full range of business sizes. Other players in the space are the smaller Ultimate Software (NASDAQ: ULTI) and Insperity (NYSE: NSP). These companies are focused on human resources outsourcing and software with relatively lesser exposure to direct payroll processing services offered by Paychex and Automatic Data Processing. This arrangement has worked well for both Paychex and Automatic Data Processing as each dominates their segment with average annual returns on invested capital above 20%, dividend growth about 13% annually since 2001, gross margins above 51% and operating margins above 20%. However, Paychex sets itself above its competition by its cash flow generating capability and revenue growth. Its annual free cash flow growth rate has been about 9.5% long term compared to Automatic Data Processing at about 1.3% while free cash flow to revenue has averaged about 29% for Paychex since 2002 compared to about 16% for Automatic Data Processing. Revenue has grown annually at about 9% for Paychex since 2002 compared to Automatic Data Processing at only about 4% annually during that time span.
Paychex's strong results are driven by its competitive advantages over its existing and potential rivals. These advantages include high barriers to entry, inherent scalability, pricing power due to high customer switching costs, lowest cost structure in the industry, and a respected brand image. Barriers to entry in the payroll business are high because a large infrastructure is needed to process a large number of employees. However, once the infrastructure is in place, the company enjoys a high level of scalability which comes from its ability to add incremental recurring revenue without material capital expenditures as demonstrated by its industry leading free cash flow to revenue ratio of about 29% long term. The company garners incremental revenue through adding new customers and offering additional services. Paychex uses its pricing power to raise prices annually, even through the last recession. Gross and operating margins for Paychex also are best in the industry due to the company's superior cost structure. The company's brand image is an intangible asset that is not reflected directly on its financial statements but is nonetheless a significant competitive advantage for the company as it competes for new small business customers and retains existing ones.
Investors have not missed the very appealing characteristics of Paychex and have bid up its relative price accordingly. Paychex has a forward price to earnings ratio of about 20x which is comparable to Automatic Data Processing's 20x but its projected earnings growth rate at about 7% lags Automatic Data Processing's at about 8.7%. As a result, Paychex has a less attractive price to earnings to growth ratio of about 2.9x compared to Automatic Data Processing's at about 2.3x. However, I believe this premium is worth paying to own Paychex's shares because of the strong stability of its cash flows, profit margins, returns on invested capital, and revenue growth compared to Automatic Data Processing. I agree with analysts estimates of Paychex's forward earnings and revenue growth at about 7% each because the company has initiated price increases and expanded its product offerings since 2010 and I expect margins to remain stable. These actions will boost revenue and earnings but their impact will be moderated by low interest rates through 2013 which hurts Paychex's interest income, typically about 4.6% of revenue but only 2.3% of revenue last year.
The two smaller players in the field both carry considerably lower price to earnings to growth ratios than either Paychex or Automatic Data Processing. Ultimate Software has a ratio of about 1.2x while Insperity has a ratio of about 0.6x. I believe a large premium compared to these two smaller rivals is worth paying to own Paychex's shares because of the reliability of its cash flows, profit margins, returns on invested capital, and its market niche dominance.
Another reason that Paychex is preferable to its competitors is its dividend. Paychex has a current dividend yield of about 4.1% which easily beats Automatic Data Processing's yield of about 2.9% and Insperity's yield of about 2.0%. Ultimate Software does not pay a dividend. Paychex's current payout ratio of about 84% is about 29% higher than its historic average of about 65% but I believe it is temporary until earnings growth moves back toward the historical average of about 9% after three years of below normal growth. The company should increase dividends going forward, but at a slower rate than earnings growth to allow the payout ratio to revert to its mean. Automatic Data Processing also has a high current payout ratio of about 55%, which is about 38% above its long term average of 40%. Like Paychex, I believe Automatic Data Processing will revert to the normal payout ratio once earnings growth returns with the economy. Insperity is similarly positioned with a current payout ratio of 54% compared to a long term average payout ratio of 40%.
Paychex's focus on the small business market allows the company to dominate the niche and enjoy its many competitive advantages but this strategy does expose it to greater instability inherent with small business clients. Paychex is fundamentally a play on the U.S. economy and with recent signs of a turn around in the job market, revenue and earnings growth are poised to improve, taking the share price beyond the estimated current intrinsic value of about $38 per share on a discounted cash flow basis. And should the economy take longer than expected to turn around, investors can be highly confident that the 4% dividend yield will be there to sustain them as they wait.
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