Leading payroll and human resource (HR) service firm Paychex (Nasdaq:PAYX) reported solid first-quarter results. The full year isn't likely to be as strong, though, and the firm's valuation isn't overly appealing given business remains challenging in a tough economy. However, that may not worry investors interested in income, and Paychex remains impressively profitable despite economic malaise in the U.S.
Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.
First Quarter Recap
Total revenues advanced 9% to $563.1 million. The flagship payroll service business, where Paychex handles the preparation and delivery of employee payroll checks, accounted for 68% of the total top line. The increase was quite respectable at 6%, given the company's focus on small and medium-sized businesses (it serves more than 500,000 clients), many of which are struggling to grow and keep employees in the current economic environment. Archrival Automatic Data Processing (NYSE:ADP) focuses on serving larger businesses.
The other service segment consists of HR functions where clients use Paychex for help in running and administering core HR activities including benefits administration, risk management and related hiring and firing activities. ADP is also a rival in this business, as are other larger firms including Accenture (NYSE:ACN) and Aon (NYSE:AON), which acquired Hewitt Associates in 2010, and even financial services firm Marsh & McLennan (NYSE:MMC) via its Mercer consulting arm. HR services grew an impressive 17% during the quarter to account for 30% of sales. The remaining 2% of sales consisted of interest earned on payroll funds held for client,s and fell 9% as interest rates continued to decline. (For related reading on payroll, see Small Business Tax Obligations: Payroll Taxes.)
Operating income jumped up 14% to $229.7 million as management was able to hold total expense growth well below sales growth at 5%. Slightly higher income tax expenses meant net income rose slightly lower than 13% to $148.9 million. Earnings per diluted share reached 41 cents.
For the full year, Paychex expects total service revenue to advance between 7% and 9% as payroll service revenue should rise in the mid-single digits, and HR services should advance in the mid-teens. It projects earnings growth between 5% and 7%. Analysts currently project full year sales growth of 7%, total sales of $2.2 billion and earnings of $1.51 per share.
The Bottom Line
Paychex is impressively profitable. The quarterly net margin exceeded 26% and free cash flow came in at $167 million, or approximately 46 cents per diluted share, which exceeded reported net income. This leaves more than enough capital to return to shareholders in the form of a 4.7% current dividend yield.
The two primary drawbacks to the investment story are growth and valuation. Over the past five years, Paychex has managed only 4.5% annual sales growth, and profit growth of only about 3%. The three-year numbers are even worse, with annual sales growth about flat and profits down more than 3% annually. The forward P/E is currently above 18, which is quite high for a firm that is struggling to grow. (For related reading on the P/E, see How To Use The P/E Ratio And PEG To Tell A Stock's Future.)
The growth challenges are not surprising given the high unemployment levels in the U.S. and stagnant economic growth. Paychex appears to be gaining market shares in HR services, even though the overall market isn't expanding that much. Some investors may be fine receiving the high dividend coupon and getting paid to wait for economic conditions to improve further, while others may want to wait for tangible signs of growing employment, or a lower valuation and share price closer to $20.
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!