How to Play the Data Processing Sector

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Paychex (NASDAQ: PAYX), one of the leading providers of payroll services in the United States, specializes in small and medium sized companies and serves almost 600,000 clients. Lately the company has performed well, with solid growth so far during the current fiscal year and strong stock performance. What caught my attention about Paychex was the company’s completely flat revenue numbers for the past five years or so, after incredible growth during the five years before. A quick glance at the revenue chart looks like Paychex ran out of gas once the economy went sour, and it is taking longer to get its mojo back than it has for most other companies. Let’s look a little closer to see if this one is worth owning or if there is a better play in the sector.

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About Paychex

Paychex provides a variety of payroll accounting services to its customers including payroll checks, earnings statements, payroll tax returns, and more through their tax filing and employee payment services segments. Additionally, their Human Resources/Professional Employer Organization (HRS/PEO) segment offers employee benefit services, HR services, and more. To combine all of their services, Paychex offers the Paychex Administrative Services (PAS) product, which bundles all of the mentioned services together. 

As mentioned, almost all (99%) of Paychex’s client base is made up of small and medium size companies, which is defined by 100 employees or less. Paychex and its share price are very reactive to the national employment rate (more employees = more money spent on payroll services) as well as interest rates, since the company holds funds in its accounts before paying employees or the IRS and those funds earning interest is a very significant source of income for the company.

As optimism has increased about the U.S. employment situation, along with speculation that interest rates may rise sooner rather than later, Paychex has risen to the point where it commands a premium valuation of about 24 times TTM earnings, which strikes me as a bit high considering the company’s so-so history of earnings growth. The consensus of analysts calls for just over 6% annual earnings growth over the next few years, so it doesn’t appear to me that the high multiple is justified.

Competition

Since Paychex seems a bit expensive, let’s see if there is a better play. The leader in payment processing is Automatic Data Processing (NASDAQ: ADP), so let’s take a look at that one. Also worth considering is Intuit (NASDAQ: INTU), which isn’t exactly an apples-to-apples comparison, but they do make the software for businesses that want to do their payroll and accounting on their own, such as QuickBooks and TurboTax.

Automatic Data Processing, known simply as ADP, is the largest payroll and data processing service provider in the world, serving about 570,000 customers all over the world. ADP has a very similar pattern of revenue growth to Paychex in that it had been stagnant for a while, and is just now beginning to show real growth. ADP is also projected to grow its revenues quicker than Paychex in the near future, with 6.5% growth next year (FY 2014) as opposed to about 4% for Paychex. ADP trades at a very similar P/E of 23.3, and is expected to grow earnings at a slightly quicker pace of 8% annually due to the expected revenue growth combined with higher margins.

Intuit is one of the most well-known makers of accounting and personal finance software, with QuickBooks being almost a requirement for small businesses. Intuit also makes TurboTax, which I personally rely on each year as a do-it-yourself tax filer. Intuit seems like the best bargain in this group, at just under 20 times TTM earnings, but with a much better 12% forward growth rate projected, due to the increased success of small businesses in the improving economy, as well as the increasing number of people who decide to do their own taxes.

Buy, Sell, or Hold?

As I mentioned, Intuit is the best bargain in the group, and although it is not a direct comparison to the other two, it does merit consideration if you are considering an investment in the payroll small business services space. As far as Paychex (and ADP) goes, with shares up about 15% so far in 2013, I would need for the stock to pull back to a more reasonable valuation in order to be a buyer. 

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Automatic Data Processing, Intuit, and Paychex. The Motley Fool owns shares of Intuit. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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