Slowly and maybe not entirely surely, business conditions are getting better. That's good news for Paychex (Nasdaq:PAYX), as this company needs a healthy small business environment to continue it growth plans. While results are decent and there are still growth opportunities for the company, oncoming competition and international expansion both look like increasingly relevant factors.

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Decent Q3 Results
Paychex reported that revenue rose 7% for the fiscal third quarter, with organic revenue growth of 5%. Payroll services revenue grew 5% (4% organically) as checks-per-client rose almost 2%. HR services rose 12% (10% organic), and the company continues to see good growth in services like employee health and benefits. Earnings from the interest carry continue to be limited by the low rate environment, as the average interest rate fell 30 basis points and interest from client funds declined 7%.

While the company did log higher SG&A expenses (which rose 10% this quarter), operating income still rose 6% for the quarter and operating margin erosion was limited to 30 basis points.

Competition From Above and Outside
For quite a long time, Automatic Data Processing (Nasdaq:ADP) split the market quite cleanly - ADP handled the big companies and Paychex took care of the small companies. Now, though, ADP is looking to build on its market leadership by slowly going down-market - not targeting the very small companies that still make up the core of Paychex's client base, but nibbling on the upper end of the range.

At the same time, Intuit (Nasdaq:INTU) seems pretty serious about getting into the business. Given how many small businesses use products like QuickBooks, it seems like a natural progression, and Intuit has not only signed up partners like Bank Of America (NYSE:BAC) and Costco (Nasdaq:COST), but has been seeing decent growth so far.

Conditions Getting Better ... Slowly
Data from the Bureau of Labor Statistics supports the idea that conditions are improving in Paychex's core addressed markets, as small businesses are not only seeing employment growth, but better relative growth than large businesses.

That said, companies are still nervous and the recovery is slow. Banks are only just starting to ramp up their commercial lending and reliable access to capital remains a concern for many business owners.

SEE: Commercial Banking

The Bottom Line
Paychex is an excellent example of why valuation matters. Paychex has been an incredibly successful company over the past decade - delivering better than 9% compound revenue growth, 11% free cash flow growth, and excellent returns on invested capital - but the stock has markedly underperformed the S&P 500 YTD. Perhaps some of this can be attributed to the ongoing malaise in small businesses, but I suspect more of it has to do with the sky-high multiples that the stock carried 10 years ago.

While multiples have come down markedly, Paychex is still not exactly cheap. The company would need to grow its free cash flow at a compound rate of at least 10% over the next decade to really seem meaningfully cheap here, and I'm not sure that's in the cards. While acquisitions like SurePayroll and ePlan do give the company some new growth options, cloud software service expansion is lowering the barriers for new market entrants.

What Paychex does have going for it is a strong dividend and a long history of returning ample amounts of cash to investors. That leads me to wonder whether Paychex might be something like a variable annuity for the small business sector - a way of translating the health and growth (or lack thereof) in the small business sector into a convenient income stream for investors.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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