- They've made a lot of people fabulously wealthy.
- They've each got a rare trifecta of durable competitive advantages.
Scale advantages, valuable intellectual property, and high switching costs. Individually, any one of these can lead to market-drubbing success. The rare bird that possesses this trio of competitive advantages, though, has all the makings of a corporate ATM machine. That's why each of these names is on my watch list. That's also why Motley Fool Inside Value recently doubled down on our recommendation of Paychex (Nasdaq: PAYX ) , possibly the best business you don't know a thing about.
Livin' it up
Paychex is a human-resources solutions provider for small- and medium-sized businesses, with its bread-and-butter being payroll processing. Rather than meddle with this complex, time-consuming administrative task, businesses line up to let Paychex handle it for them. More than 500,000 businesses, in fact, with more than 75% sticking around from year to year.
Payroll processing is like the Hotel California: You can check out anytime you like, but you can never leave. The switching costs associated with changing who handles your payroll are extremely high. It takes lots of time to evaluate competitors, manage the logistics of a transition, and train employees on a new system. As if that's not enough of a deterrent, Paychex also cross-sells a host of ancillary human-resource services, making a full-on switch all that more difficult. That's a pity if you're a customer, but that's music to this shareholder's ears.
The gravy train
Thanks to the toll-booth nature of the payroll business, processers like Paychex and fellow industry big dog Automatic Data Processing (NYSE: ADP ) practically rake in cash. Not only do these guys collect fees for each check cut and cross-sell their myriad ancillary services -- payroll tax administration, 401(k) plan offerings, etc. -- they also collect interest on the funds they temporarily hold for clients. That interest historically makes up more than 13% of Paychex's operating profits and is virtually 100% margin, meaning only the tax man stops that gravy from dripping to the bottom line.
Paychex and ADP are the clear alpha dogs of payroll processing, with each boasting client logs with more than 10 times the number of clients as their next-biggest rival. You'd think that would mean Paychex's growth days are behind it, but the peppy truth is that only 10% to 15% of businesses in its target markets even outsource payroll processing. In other words, there's plenty of room left on this runway. And given Paychex's large sales force, strong brand, and breadth of support services, there's every reason to believe that Paychex will gobble up a larger slice of the growing market pie.
At Inside Value, we peg Paychex at $40 a stub, making for about 30% upside from recent prices. And this isn't some "value is its own catalyst" jive, either. Paychex is looking at a double-barreled catalyst: falling unemployment and rising interest rates. A rebound on the jobs front will equate to more checks cut, better pricing power, and higher customer retention rates -- all great news for Paychex.
The shares aren't without risk, of course. Unemployment won't turn overnight; nor will interest rates bounce upward until the Fed takes its foot off the gas. For that matter, there's always the chance competitors could invent a better widget or start pushing aggressive price cuts in response to the recession.
Then again, I'll put it this way: I own Paychex shares, and we at Inside Value rate them among our top eight Best Buys Now. You can try our service free for 30 days. There's no obligation to subscribe.