Will The Third Round Of Quantitative Easing Give Paychex More Than It Takes Away?

By Stephen D. Simpson, CFA | September 25, 2012 AAA

When you're in the business of processing payrolls for small employers, a weak job market is a definite limitation on growth. Paychex (Nasdaq:PAYX) has been muddling through this period of weak job creation, and now there is a new Federal Reserve stimulus program specifically targeting job growth and employment. It's an open question as to whether this stimulus will succeed, but it's a near-certainty that low rates will continue to pressure Paychex's ability to wring profits from its float. That sets up Paychex for a high-quality but growth-poor play on improved employment, and an expensive one at that.

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Weak Growth in Fiscal First Quarter
Paychex continues to struggle to post much growth in its core payroll services business. While overall revenue rose 3%, payroll service revenue rose just 1% (down from 5% organic growth in fiscal fourth quarter) on a 2% improvement in checks per client. HR Services growth was more robust at 7%, but still down from 9% in the prior quarter.

Paychex absolutely deserves credit for improving its profitability during such a sluggish period. Gross margin improved more than a full point this quarter, with operating income rising 4%.

SEE: Understanding The Income Statement

Expectations Seem Ahead of Reality
It's a little curious to me that the stock has been strong since June - climbing about 14% and outperforming the S&P 500. Although there have been a few surprises in the job numbers over that time, it's not as though there has really been any sustained improvement in the job/payroll situation. In fact, a lot of the improvements seem to be due more to statistical factors such as births/deaths and discouraged workers than any fundamental change in the underlying circumstances.

I'm also a little disappointed that the company is not seeing better share growth. The company's management indicated during a recent analyst day that it believed Paychex had about 5% share of its addressable market. Judging by the numbers from this quarter and the last report we had from Intuit (Nasdaq:INTU), it just doesn't seem that Paychex is grabbing that available business. While I can understand investors being optimistic about the company's investments into IT and plans for expanding its SaaS capabilities, it still looks like there's more optimism than execution right now.

SEE: Stock-Picking Strategies: Value Investing

Forget the Float
While the markets had largely been expecting another round of monetary stimulus (quantitative easing) from the Fed, I do believe there was some surprise that it is specifically targeting higher employment as the objective of this new QE3 effort. Ostensibly, that should be good news for Paychex ((and its larger rival Automatic Data Processing (Nasdaq:ADP)).

I have my doubts, however. For starters, I think there are structural issues to the employment situation that a new flood of cheap money won't help. Consequently, I think the employment recovery is going to be a long, slow one. In the meantime, I have no doubt that the Fed will succeed in keeping interest rates very low for a few more years. So this leads to a situation where the benefits to Paychex (higher employment, translating into more payroll and HR business) are uncertain in timing and scope, but the costs (a feeble float) seem quite real and immediate.

SEE: What Does Q3 Mean For The Market?

The Bottom Line
While I think Paychex is a top-notch company, I don't like it today as a stock. Intuit and Cintas (Nasdaq:CTAS) are cheaper plays on job growth, and Intuit also has the advantage of being more aggressive in offering multiple avenues of exposure to small business growth. While I applaud Paychex's management for sticking to what it does best, I do wonder if they've been too conservative about expanding into additional services. I'm not suggesting that the company needs to be another Vistaprint (Nasdaq:VPRT) or a small business version of Xerox (NYSE:XRX) or IBM (NYSE:IBM), but I do think there are unexploited opportunities here.

I believe that Paychex still has long-term cash flow growth potential in the mid-to-high single digits (around 7%). Unfortunately, that only points to a fair value in the low-to-mid $30s. While Paychex's high dividend yield (3.70%) is appealing, I do think that the stock looks expensive on both long-term cash flows and near-term metrics such as P/E (22.40) and EV/EBITDA (12.62).

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

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