A Mixed Outlook for Outsourcing Firms

By Lee Samaha - July 5, 2012 | Tickers: ADP, NSP, PAYX | 0 Comments

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Paychex (NASDAQ: PAYX) has a lot of interesting qualities that could appeal to an investor. Aside from a 4% yield it has minimal European exposure and is primary a play on US growth. It is also heavily exposed to US employment and small business growth. Despite the gloomy data recently there are grounds for optimism as things appear to be improving. In summary, I think Paychex’s weak growth numbers are not so much a function of the overall economy but rather that the market is still not strong enough to allow competition from companies like Automatic Data Processing (NASDAQ: ADP) and Insperity, Inc (NYSE: NSP) to not eat into sales growth and margins.

For example, on the macroeconomic front, a quick look at the National Federation Independent Business (NFIB) survey reveals that although the headline index is still way below numbers last seen in 2008, the trend is still upward. This confirms the ‘slow grinding recovery’ thesis and looking at the detail of last survey, a net 6% of firms expect to increase employment whilst a net 24% expect to make capital outlays. Conditions are not as bad as they may seem.

Checks Per Payroll

One key metric which serves as a useful indicator for Paychex and the US economy is checks per payroll. In other words, this is the average number of checks issued per client payroll run. It has been growing for nine straight quarters. Whilst it is growing, the moderation in growth (to 2%) in Paychex’s fiscal 2012 is a concern and the guidance for further moderation in growth in 2013 is worrying. However, management stated that the moderation in 2012 was slower than they had expected, so perhaps this is a case of overly cautious guidance for 2013? We shall see. Ultimately, the management will have no better idea than we would have over the state of the macro economy, so as investors we need to take our own view.

Of course, much of the narrative around the checks per payroll number must focus on what is happening internationally. The US is certainly not an isolated economy, however to see this kind of impact on guidance –so early in the Chinese moderation and the current flare up in Euro Zone difficulties- is concerning. It suggests that Paychex is not quite the US centric play that it appears to be.

Another explanation is that the US market is highly competitive and the company finds it difficult to generate strong revenue or margin growth as a consequence. Indeed, the payroll client base was flat this year although, this beat a three year run of declines. Client retention remains historically strong and client satisfaction scores are at all time highs, so Paychex appears to be executing successfully.

Competitive Market?

So if the macro environment is moderate but growing, and Paychex i executing well, why is the guidance so tepid? I suspect the answer lies in the competitive landscape, especially amidst a low interest rate environment which will hold back income earned from client funds.

In fact, key competitor ADP gave its last results in May and at the time was expecting 8-9% EPS growth this year. It also stated that it expected a $50-55m decline in pre-tax earnings thanks to a decline in yield on the client fund portfolio. Low interest rates are starting to hurt these companies in the same way that they are forcing other companies to increase pension provisions thanks to shortfalls caused by low yields.  Similar to Paychex, ADP saw growth in its ‘pay per control’ metric across the board, with the only weakness coming in the public sector.

Turning to Insperity, it too, has been issuing changes in guidance in the light of a sluggish labor market and overall weak economy. For example in the last results, the company stated that average paid worksite employees would be slightly lower than initially forecast, but gross profit per worksite employee per month would be higher than initially expected.

Putting these three companies outlooks and guidance together creates a picture of an overall US economy which is seeing growth but also a marked reluctance to expand hiring. The good news is that this suggests some pent up hiring which could be released if the macroeconomic environment improves.

Where Next for Paychex?

The company is faced with the headwinds of low interest rates and a sluggish hiring environment in an uncertain macro-economy. On the other hand much of this is already in the price of these stocks. Paychex pays a 4% dividend yield and although low earnings growth signals low dividend growth, it will have to be a pretty drastic scenario that sees Paychex get down to the kind of yields that long term US treasuries are on right now. In a sense, this conundrum is a common one across the stock market, but I suspect growth orientated investors (and risk averse for that matter) might prefer a company with a bit better competitive positioning than Paychex.

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