Paychex Inc (PAYX) provides payroll and human resources services to small and medium sized business, and the tough employment market has obviously put a drag on results for the past year. The company serves more than half a million businesses around the globe, but experienced declining revenue recently due to small businesses not hiring and in some cases going out of business. However, many economists have become bullish on the labor market as the weather gets warmer and the economic recovery continues ahead, and it’s not just because of the temporary hiring of census workers (so they say). We make no predictions about the labor market, but if you agree with the optimistic outlook on jobs that is permeating much of Wall Street then Paychex would be a smart way to play this trend.
The company reported third quarter earnings on Wednesday afternoon that came in 1 cent ahead of consensus expectations with EPS of $.34 excluding one-time charges, which trails last year’s results by 2 cents per share.
However, the stock is indicated slightly lower in after hours trading because revenue of $508 million was just shy of analysts’ expectations, falling 3.9% from a year ago. Their client base declined by 2.1% thus far in fiscal 2010. Given the continued bleed of jobs that occurred over the last year, it is not hard to imagine that comparisons to last year could have been much worse. Despite the decline in fundamentals, we think the stock represents attractive value for investors looking to take advantage of improving employment trends.
The stock currently trades at a multiple of cash earnings of only 18.7x, which is well below the historical range for PAYX of 21.0x to 31.1x. Furthermore, price-to-sales over the last ten years has ranged between 6.87x to 10.61x, but currently trades at a discount to that with a current price-to-sales multiple of 5.88x. Management has been pretty successful at protecting the company from the downside considering very difficult operating conditions, and has been able to keep profit margins and ROE relatively consistent throughout the business cycle. Paycheck pays out a substantial portion of its earnings in dividends with a yield of nearly 4%, but with the payout ratio currently as high as 92%, this may be a warning sign if earnings do not improve as expected in the year ahead. The company reaffirmed their outlook for the remainder of fiscal 2010, but analysts are anticipating a better showing in fiscal 2011. Based on the fundamentals, we have believed PAYX to be Undervalued compared to historical valuations for quite some time.
One other note to be aware of, Paychex will almost certainly benefit in an environment of rising interest rates. They have absolutely no long term debt, and by nature of their business model have a natural interest free float. Because they collect payroll from employers prior to their actual employee pay date, they are able to invest that money short term in very low risk instruments. The government has kept interest rates extremely low for quite some time, and as the economy continues to recover, inflationary concerns will eventually manifest. Rising rates would give Paychex a better return on their investments and will almost certainly translate to a better bottom line.
In conclusion, Paychex’s valuation remains appealing as the stock has fallen out of favor with the market, while fundamentals remain pretty much intact as management minimized the impact of job losses. Potential tailwinds for the company include an improving employment picture (at least perceived), and additionally, general economic improvement will almost certainly demand higher interest rates. Paychex is uniquely positioned to benefit from both of these possibilities, and long term investors will be compensated with a 3.8% yield while they wait for price appreciation.
