Time to Cash In on Paychex?


By Sam Jaffe Like many companies, Paychex (PAYX) is taking less to the bank lately. It just reduced revenue and earnings forecasts for 2001, and watched its stock drop from a high of $61 a share last October to a close of $39.21 on Aug. 16.

Still, on the fundamentals at least, Paychex, which outsources payroll management for small companies, is still an excellent business. Its revenue forecasts, after all, decreased just 1% -- to 20% annual growth -- and the company still expects to see earnings grow by at least 30% for the next several years. It earns 75 cents in gross margin on every dollar in sales. And its return on average invested capital (ROAIC) -- a measure of how well the company invests its cash flow -- is a stout 59%. "It's an extremely well-run business in an extremely profitable line of business," says Brandt Sakakeeny, an analyst with Deutsche Banc Alex. Brown.

Then why does Sakakeeny have a neutral rating on Paychex shares? He's not alone in liking the company but avoiding the stock. Of the 18 analysts who follow Paychex, eight give the stock a neutral rating and only one ranks it a strong buy, according to First Call. The reason: Paychex is an out-of-favor, old-fashioned growth stock. Despite its 36% drop in price, it still sells at a price-to-2001-earnings ratio of 41.3, or nearly double the forward p-e of the Standard & Poor's 500 stock index.

BIG NAME IN SMALL BIZ. Go back in time a couple of years, and this would have been considered a value stock. But in these days of declining economic growth, Federal Reserve interest-rate cuts, and deflated stock-market bubbles, the idea of paying a high price for a high-growth stock is about as passé as a Regis Philbin shirt-and-tie combo. Still, investors might be wise to remember that quality companies are essential parts of any stock portfolio. They will always be worth more than the broader market. They just won't always be as cheap as Paychex in the eyes of receptive investors.

Underlying Paychex' tremendous growth prospects is its business model. While the company's typical client has only 14 employees on average, Paychex is king of this field, holding close to a 70% share of the small businesses who use such services. Although there are plenty of payroll processors, most notably industry giant Automatic Data Processing (ADP), Paychex is the only large-capitalization company to focus exclusively on mom-and-pop outfits.

The market itself has plenty of room to grow. Only 25% of small businesses outsource their payroll process. The other 75% choose to handle the time-intensive and complex business of calculating wages and taxes and printing out paychecks themselves. But a good number of them will conclude sooner or later that, while outsourcing the pay process costs extra money, it usually proves advantageous to entrepreneurs, whose most valuable asset is their time. "There's an incredible demand for the type of service Paychex offers," says Rob Maina, an analyst with CIBC World Markets, who has a neutral rating on the stock. "That's how it was able to grow at a 25% clip every year for the past five years."

MORE SERVICES? Maina wonders how long such growth will continue. "The law of large numbers has to come into play at some point," he says. He points out that the company already has a 75% gross profit margin, and that it won't be able to push that any higher than 80%. "When gross margins max out, then revenue and profit growth will be the same, and that's going to hurt this stock." Paychex couldn't be reached for comment, despite repeated calls to the company.

Still, there's reason to believe that revenue and profit growth aren't close to maxing out yet, says Deutsche Banc's Sakakeeny. He thinks the company will be successful in selling other services to the existing customer base, such as management of workers compensation and 401(k) funds. "The ancillary sale is an easy one, and has a much higher profit margin than the initial payroll sale," says Sakakeeny. "You already have the customer, all you need to do is pick up the phone."

Paychex' salesforce has already demonstrated that it can successfully sell other products. In 1997, fewer than 29% of its customers paid for services other than direct payroll. By the end of fiscal 2001, which ended June 30, that figure had increased to 53%. "There's no doubt that it can deliver on its strategy of selling other products," says Andrew Jeffrey, an analyst with Robertson Stephens, who has a buy rating on the stock.

UPBEAT EXPECTATIONS. If Paychex can follow through selling other services to existing customers, while adding new clients at the same rate it has in the past, its profit growth forecasts can be achieved. Analysts expect the company to earn 98 cents a share in fiscal year 2003, vs. expectations of 81 cents in 2002.

Assuming that happens, Paychex' current stock price might look cheap a year from now. Hoak Breedlove analyst Kevin Dyches, who also has a buy rating on the stock, thinks it will outperform the broader market over the next few years. "Any time you have a stock that increases earnings 25% a year while the market as a whole can only improve 10%, you're going to get a nice premium," he says. "A stock like that is just going to get more and more valuable to investors in the coming years." To investors who aren't scared by the term "growth stock," that could sound pretty inviting in this barren market environment. Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

Questions or comments? Please visit our Ask Sam Jaffe interactive forum


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