Published: August 6, 2010
unemployment rate in the United States has only recently
experienced some moderately good news, dipping back into the
single digits to 9.5% -- a slight
downtick from 9.7% in May. A 9.5% unemployment rate is still
a far cry from 2007 the when the jobless rate was only 4.6%, and
as David Sterman
noted, we need to see about 200,000 new jobs
created every month to significantly bring that number down
Fortunately, the United States has yet to not recover from a
recession, which means that hiring trends should eventually pick
up. This is great news for payroll firms.
These companies facilitate the transfer of funds from corporate
coffers into the checking accounts of the gainfully employed. So
it stands to reason that as corporate hiring picks up, these
firms should garner more and more business.
The payroll industry is dominated by two firms: Automatic
Data Processing (NYSE: ADP), and Paychex (Nasdaq: PAYX).
Both stocks can be seen as a recovery play, particularly on
declining unemployment, but I like Paychex more.
A recent count put ADP's client base at 455,000 and Paychex's at
534,000, which doesn't seem that different until noticing that
ADP logged almost $9 billion in revenue during the past 12
months compared to $2 billion for Paychex. This is primarily
because ADP rules the roost for larger corporations, while
Paychex has made its name serving smaller businesses.
In terms of past growth, ADP's size and market focus have put it
at a disadvantage against Paychex. ADP must add nearly $1
billion in revenue to grow +10%, while Paychex only needs a
couple hundred million to grow the top line into the double
Also, small businesses greatly outnumber large businesses, which
are Paychex's sweet spot, with 41% of its client base stemming
from businesses with only one to four employees. Another 41%
stems from businesses with 5-19 employees, while only 6% of
revenue comes from businesses with more than 50 employees.
Catering to small businesses has worked out nicely for Paychex.
Prior to the onset of the credit crisis, revenue had grown
nearly +18% on average during the previous decade while
earnings grew more than +23% a year in this period.
Unfortunately, growth plateaued in 2006 and has fallen steadily
since and reached negative territory last year as sales fell -4%
and earnings more than -10% as small businesses found it
difficult to obtain credit to run and grow their operations.
Despite the near-term malaise, Paychex remains fantastically
profitable. Net margins remain over 20% and returns on equity
still exceed 30%. A service
business model also means lots of excess
cash flow, which the company uses to support a current
dividend yield of 4.8%. The company hasn't repurchased
shares in a couple of years but likely will when economic
conditions fully recover.
There is undeniable upside in the shares as employment levels
continue to improve. And as a nice bonus, higher interest rates
will also juice Paychex's profits. My colleague Nathan Slaughter
calls it "playing with fee money." That's because as business
funds are transferred to Paychex, it earns interest on that
money before it's disbursed to employee bank accounts. Right
now, Paychex only earns 1.5% on this cash, compared to 4.0% in
2007, but that rate of return should climb in the coming years
as interest rates gradually climb higher.
Shares of Paychex are not a steal. They currently trade at a
P/E of just under 19, while the trailing
free cash flow multiple is also lofty at just over 17.
Leading firms rarely trade at bargain-basement levels, however.
Action to Take ---> Looking
at the growth baked into the current stock price, I estimate
that the market expects profits to expand at a +13% annual clip
for the next five years. Given the historical growth trends and
upside that exists when employment and interest rates rise, this
is a hurdle that Paychex should easily handle.
It won't happen smoothly, but I expect profits to grow at an
average rate of +15% through mid-2016, which implies the stock
is undervalued by more than -50% from current levels. Look for
the stock to double within 3-5 years, which equates to
double-digit annual returns for shareholders. Better yet,
investors are getting paid to wait and collect an above-average
dividend yield as they wait for growth to pick back up.
-- Ryan Fuhrmann