Description

If you are looking for a high quality US business with a strong balance sheet trading at a reasonable price, then Paychex should be right up your alley.

Most VIC readers are probably quite familiar with the company. Paychex is the leading provider of payroll, human resource, and benefits outsourcing for small and medium-sized businesses. Payroll services consist of payroll processing, payroll tax administration, and employee pay services. Human resource services include 401(k) plan recordkeeping, health insurance, workers’ compensation administration, section 125 plans, a professional employer organization, time and attendance solutions, and other administrative services for business. Paychex benefits from helping small and medium-sized businesses reduce administrative burden and compliance risks. Paychex brings technical capabilities, knowledge, and operational expertise to the increasingly complex and changing administrative requirements and federal, state, and local tax regulations.

Paychex was founded in 1971 and came public in 1983. The company has 572,000 clients and over 100 offices nationwide and in Germany. It is headquartered in Rochester, New York.

Paychex’s financial results are stellar. The company has grown revenues, net income and earnings per share for 18 consecutive years. Unlike so many large companies today, Paychex’s financial statements are clean and easy to understand. The company currently generates over $2 billion sales and over $800 million in operating income. The operating margin is nearly 40%. More than 80% of revenue is recurring.

After-tax returns on invested capital are north of 60% and returns on equity are in the mid-40% range. Free cash flow tends to run slightly in excess of net income. Historically, Paychex has paid out well over 50% of net income to shareholders via dividends. Last year, the company returned $442 million via dividends and $1 billion via share repurchases (at prices above today’s quote), which combined totaled 250% of net income. In general, shareholders could expect to receive roughly 100% of net income per year through dividends or repurchases unless the company makes acquisitions to further growth.

Paychex is conservatively capitalized. The company has $479 million of cash and $0 of debt. It is built to withstand turbulent times. Paychex’s broad portfolio of ancillary services and products increases growth potential and client stickiness. Moreover, during difficult economic times, there tends to be a greater trend toward outsourcing. 

On the latest conference call from December 17, Paychex indicated that Payroll Service revenue will grow by 3-5% and Human Resource Services Revenue will grow by 12-15% in 2009. Total Service Revenue is expected to grow 5-7%. While these growth rates are down considerably from historical levels as well as from predictions made by management earlier this year, they are still positive – which is a lot better than most companies these days.

Where Paychex’s profitability has really taken a hit is on the interest income component of earnings. Interest on Funds Held for Clients will plummet 40-45% from 2008 since interest rates on high-quality short-term paper are nearly zero. In addition, Corporate Investment Income will fall 70-75% due to the low absolute interest rates available today. The good news is that rates cannot fall meaningfully lower from here! And if rates rise, so will Paychex’s interest income.

Concerns in the next few years include the rising unemployment trends and more small business bankruptcies as well as continued credit market disruptions. But Paychex is going to be around for years and years to come. For investors willing to own the stock for the long-term, it is reasonable to assume that Paychex will resume Service Revenue growth of 12% and Operating Income growth, net of certain items, of 15%.

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