Paychex Still Muddling Through

By Stephen D. Simpson, CFA | June 27, 2013 AAA

It has been about a year since I last wrote on Paychex (Nasdaq:PAYX). Back in 2012, I suggested that the Fed's actions to stimulate the economy weren't going to have a tremendous impact on employment, nor lead to a big turnaround in Paychex's fortunes. A year later that prediction seems to have worked out, as the company continues to muddle through a weak payroll growth environment in its core small/medium-sized business (SMB) market. While efforts to build up the HR services side of the business should pay off, and payroll will recover at some point, it still would seem that the Street is much too willing to price a strong recovery into these shares. A So-So Close To A Challenging YearAll things considered, 6% revenue growth for Paychex in fiscal Q4 was not a bad outcome and it was in line with sell-side expectations. Payroll service revenue rose more than 3%, though checks per payroll growth slowed to less than 1%. Revenue in the HR services business jumped almost 13% (and is now one-third of the total), while interest from client funds declined about 7% as rates remain low. Despite the less-than-perfect revenue growth environment, Paychex is executing pretty well. Gross margin improved two points from the year-ago period, and though the company lost some of that in operating expenses (operating margin was up about one point), operating income was still up 8%. SEE: Paychex Earnings & Revenue Miss Estimates In 4QCan Paychex Still Drive Meaningful Growth In The Face Of Competition?On one hand, Paychex's performance doesn't look so bad relative to the overall SMB environment. While the company did see higher payroll revenue due in part to higher pricing, the company does still continue to recruit clients for its services. Trouble is, Intuit (Nasdaq:INTU) has gotten into this business and seems to be executing well. Intuit has a strong cross-selling platform based upon the success of its QuickBooks business accounting software, and its payroll services business has been growing by double-digits. It's only about one-third the size of Paychex's business, but I don't think Paychex investors should underestimate the potential threat of a motivated, integrated service provider in the SMB space. Likewise, Paychex is going to find ample competition in the HR services space. Intuit has chosen to focus more on the marketing side (as opposed to HR), but Paychex is increasingly competing with companies like Oracle (Nasdaq:ORCL), SAP (NYSE:SAP), and smaller SaaS-based software companies as the worlds of software and services converge. Theoretically Paychex will have a built-in cross-selling advantage and an edge with its focus on the SMB market, but more and more larger software companies are devoting meaningful resources to this market. I also wouldn't completely rule out that Amazon's (Nasdaq:AMZN) efforts to make AWS “all things to all businesses” eventually turn it into a rival down the road. A Trusted Name In A More Complex WorldGiven the feedback management has given the Street in regards to client retention, I would posit that the success of companies like Intuit is coming more from the pool of businesses that don't use Paychex than direct share loss. To that end, I think Paychex has built a solid reputation for its services. I also think that increasing complexity in the business world could help Paychex recruit and retain more customers. The Affordable Care Act is going to make payroll more complicated for small businesses, and that should make the value proposition of Paychex's services more appealing to businesses. Likewise, there's the more traditional thesis that the company will benefit if, when, and as hiring and job growth improve. SEE: Earnings: Quality Means EverythingThe Bottom LineWhile I would agree with the basic premises that Paychex can benefit from an improving economy and successfully add and cross-sell additional services to its client base, I think the Street is already in tune with that notion. I expect the company to generate long-term growth in the mid-to-high single digits, and I believe the shares are worth about $32 on that basis. As that is below the current price today, I do not find these shares very compelling at today's price or valuation.

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