Paychex, Solid and Primed for Growth

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Paychex (NASDAQ: PAYX), which has been in business since 1971, provides human resource, payroll, and benefits outsourcing solutions. In a slow global economy, Paychex has executed solidly. In fiscal year (FY) 2012 ended on May 31, 2012, Paychex increased its total revenue by 7% year over year to $2.2 billion and increased its net income by 6% year over year. In Q1 FY 2013, the company increased both its total revenue and net income by 3% year over year. Paychex CEO Martin Mucci stated, “Our client base continued to improve, checks per payroll continued to increase, and our client retention is near a historic high.”

Most of Paychex’s income comes from its payroll service. Payroll service provides delivery of employee paychecks, record keeping, and preparation of tax returns. In Q1 FY 2013, payroll service revenue accounted for 66.7% of the company’s total revenue. Human resource services accounted for 31.5% and interest on funds held for clients accounted for 1.7% of total revenue. Overall, the company has a broad set of products. In addition to payroll, it offers 401k services, employee benefits, eServices, insurance services, and others.

While susceptible to economic downturns, the payroll processing business is an excellent industry. Small and medium size businesses benefit greatly from outsourcing employee payrolls because it removes the task from the company and allows management to focus on making money. This increases efficiency. As a result, there is good demand for the industry. In addition, business customers are good customers to have because they are very loyal customers. As long as things are working, businesses tend to be content to keep things the same. In FY 2012, Paychex’s client retention was about 80% and its total client base increased by 0.5%.

Furthermore, Paychex’s businesses have high margins. As of May 31, 2012, the company had about 567,000 clients. This includes 2,000 clients in Germany, which it serviced through just four offices in Germany. In the US, the company services its customers with around 100 offices nationwide. In the trailing twelve months, the company has a 69.21% gross margin, a 38.41% operating margin, and a 24.6% net profit margin. Furthermore, the company has a return on assets of 10.32%, a return on equity of 34.57%, and zero debt. That is quality efficiency.

According to Paychex’s FY 2012 annual report, there are about 10 million employers in the US markets that it currently serves. More than 99% of these employers have less than 100 employees. Paychex’s focus on small and medium size businesses aligns perfectly with this market. In FY 2012, only 2% of Paychex’s client base had more than 100 employees. In addition, 42% of the company’s client base and 83% of the 10 million employers had one to four employees. Looking forward, the business process outsourcing (BPO) market in the US is projected to grow at a five-year compounded annual growth rate (CAGR) of 4.2%. It is projected to grow to $92 billion in 2016 (IDC). In FY 2013, Paychex projects its net income will increase by somewhere between 5% and 7%.

Looking at competition, two of Paychex’s biggest competitors are Automatic Data Processing (NASDAQ: ADP) and Intuit (NASDAQ: INTU). In terms of revenue, Automatic Data Processing is the largest US provider of payroll processing and human resource services. ADP has about 600,000 clients. Intuit competes in the same industry and sells popular do it yourself software, such as QuickBooks, TurboTax, and Quicken. Intuit’s QuickBooks software is the best selling small business financial software. These two companies are big threats to Paychex. In addition, Paychex has a smaller competitor in Insperity (NYSE: NSP). Insperity is focused on providing services to small and medium sized businesses. The company provides payroll, employee benefits, compensation, and other services. Insperity’s business solutions have around 100,000 clients.

Overall, the business services industry is highly competitive and fragmented. Comparing operating margins in the trailing twelve months, Paychex outperformed its peers. Paychex, ADP, Intuit, and Insperity have operating margins of 38.41%, 19.74%, 28.35%, and 3.22%, respectively. Overall, Paychex looks like a solid company. On top of its strong margins, the company has a dividend yield of 4.1%. At a payout ratio of 84.1%, management is passing a ton of earnings over to investors. The only thing that keeps Paychex from being a strong buy is that at a trailing PE of 21.2 the company looks fairly valued. Investors who like Paychex might want to wait for a pullback before jumping in. Regardless, Paychex is a solid company.

Alvin has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Automatic Data Processing and Paychex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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