A muddle-through economy and a legacy of high valuation continues to weigh on shares of small business payroll and human resource (HR) service provider Paychex (Nasdaq:PAYX). While the large amount of sell-side skepticism on this stock might appeal to investors with a contrarian streak, the lack of growth and momentum are legitimate concerns. Paychex's above-average yield and strong potential for dividend growth makes it a worthwhile hold, but it's hard to get excited about this combination of growth and valuation today.

Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers.

Closing the Year In-Line
Paychex didn't really surprise for good or ill with its fourth quarter results. Revenue rose 6% as reported and 5% on an organic basis. While the smaller HR services business continues to grow at a double-digit clip (up 12%), the larger payroll services business grew just 3% on an organic basis. The nearly 2% growth in checks per client (the Paychex version of "same store sales") was nice, but the 1% growth in clients was not as encouraging.

While revenue growth is pretty flaccid, margins are still quite strong. Gross margin improved a full point, while operating income rose 7%. Excluding the interest Paychex earns on client funds, operating margin improved by 80 basis points this quarter.

SEE: Understanding The Income Statement

On that latter point, interest from client funds dropped 12% from last year and about 2% from the prior quarter. With interest rates so low, it is a struggle for Paychex to earn a significant return on these short-term deposits.

The Hunt for Growth Continues
While it seems unlikely that analysts will find too much to quibble about with Paychex's reported earnings, the guidance is going to cause some trouble. Not only is Paychex looking for less growth in 2013 than originally hoped, but growth is now becoming a central bear thesis on the stock.

Some of Paychex's growth trouble is out of its hands; companies like Automatic Data Processing (Nasdaq:ADP), Accenture (NYSE:ACN) and IBM (NYSE:IBM) have benefited from the fact that hiring activity and service demand among large corporations have recovered, but the recovery in small- and mid-sized businesses (SMB) has been more uncertain.

Competition is also a threat, though. Intuit (Nasdaq:INTU) has specifically targeted this SMB market, as have a host of other smaller companies that are building around software-as-a-service (SaaS) models. And then there are companies like Heartland Payments (NYSE:HPY) trying to build its payroll card businesses (though Paychex does service payroll cards as well).

What this all mean is that Paychex needs to figure out new avenues for growth. Acquisitions could add a point or two of growth on a year-to-year basis, but it seems that the company needs to add new lines of business to really change its trajectory - and that represents execution risk that the company management just may not see as worthwhile.

SEE: Analyzing An Acquisition Announcement

The Bottom Line
Paychex is another one of those classic examples of how not every great business is a great stock. Paychex posts incredible returns on capital and generates a very compelling amount of free cash flow from its revenue. What's more is it's a leveragable business model where each incremental customer is more profitable than the one before it.

SEE: 5 Must-Have Metrics For Value Investors

All of that said, the numbers just don't point towards value. Even if Paychex can stave off competition and enjoy a rebound in SMB hiring, it's just hard to see where the company is going to generate double-digit growth without a bold (and risky) expansion plan into new businesses. I completely understand investors willing to hold this for the dividend and dividend growth potential, and I see relatively limited down-side risk, but it's hard to get excited about the price-value tradeoff today.

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

Related Articles
  1. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  2. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  3. Investing

    Don't Freak Out Over Black Swans; Be Prepared

    Could 2016 be a big year for black swans? Who knows? Here's what black swans are, how they can devastate the unprepared, and how the prepared can emerge unscathed.
  4. Investing News

    Today's Sell-off: Are We in a Margin Liquidation?

    If we're in market liquidation, is it good news or bad news? That party depends on your timeframe.
  5. Investing News

    Bank Stocks: Time to Buy or Avoid? (WFC, JPM, C)

    Bank stocks have been pounded. Is this the right time to buy or should they be avoided?
  6. Stock Analysis

    Why the Bullish Are Turning Bearish

    Banks are reducing their targets for the S&P 500 for 2016. Here's why.
  7. Stock Analysis

    How to Find Quality Stocks Amid the Wreckage

    Finding companies with good earnings and hitting on all cylinders in this environment, although possible, is not easy.
  8. Stock Analysis

    Analyzing Sirius XM's Return on Equity (ROE) (SIRI)

    Learn more about the Sirius XM's overall 2015 performance, return on equity performance and future predictions for the company's ROE in 2016 and beyond.
  9. Stock Analysis

    Will Virtusa Corporation's Stock Keep Chugging in 2016? (VRTU)

    Read a thorough review and analysis of Virtusa Corporation's stock looking to project how well the stock is likely to perform for investors in 2016.
  10. Stock Analysis

    Analyzing Porter's Five Forces on JPMorgan Chase (JPM)

    Examine the major money-center bank holding firm, JPMorgan Chase & Company, from the perspective of Porter's five forces model for industry analysis.
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  3. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  4. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ... Read Full Answer >>
  5. How do you calculate working capital?

    Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining ... Read Full Answer >>
  6. What is the formula for calculating the current ratio?

    The current ratio is a financial ratio that investors and analysts use to examine the liquidity of a company and its ability ... Read Full Answer >>
Trading Center