Paychex Comes Up Short

To say that Paychex's (Nasdaq: PAYX  ) fourth-quarter earnings release was a disappointment would be like saying that Howard Stern's open-miked radio career is in jeopardy. Both statements are grounded in truth but have serious future implications.

When Paychex short-changed the investment community's fourth-quarter expectations by a nickel, the company's shares instantly dropped nearly 5% in after-market trading. Paychex pointed to expense charges relating to a recent lawsuit against the company, which reduced earnings by $0.04 a share in the fourth quarter. Last Friday, a Los Angeles Superior Court awarded a Texas firm named The Payroll Partnership LP $6.4 million in a judgment against Paychex and one of its wholly owned subsidiaries. The jury ruled that the company was liable for "breaching software licensing agreements" against a payroll processing system named Rapid Pay.

While this decision alone put a marginal dent in the company's current earnings, the realistic threat of 19 additional Rapid Pay licensing agreement breach lawsuits against Paychex could be quite damaging. Not only could the judgments against the company be material, the costs associated with these lawsuits could be the wrecking ball that obliterates the company's earnings potential for some time to come.

Investment guru Warren Buffett sold all of Berkshire Hathaway's (NYSE: BRK.A  ) (NYSE: BRK.B  ) shares of Paychex rival Automatic Data Processing (NYSE: ADP  ) last month, which puts the top two companies plus Administaff (NYSE: ASF  ) in a position of weakness as an industry. The bottom line is that when Mr. Buffett makes a move, the investment community listens.

Paychex shares are trading at 38 times the company's expected fiscal year 2005 earnings of $0.96. This hefty P/E ratio, combined with the company's messy legal situation, makes me think that investors should avoid the shares until further notice.

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Fool contributor Phil Wohl spent over 12 years on Wall Street and now concentrates his writing on more fictional characters. He has no stake in any firm mentioned above.