One Stock The Extremists Can Agree On

We're a divided crowd these days. Right now, two intense groups command attention. The extreme optimists say we're in the early days of a "V" shaped recovery, where everything goes right, the economy surges, and prosperity abounds. Another, the extreme inflationists, say the trillions of dollars of federal largesse dumped on the economy will soon ignite rampant inflation, soaring interest rates, and, worse, a Greek-like fiscal apocalypse. (Most of us are somewhere in the middle.)

Both sides can make rational arguments to support their views. Either side could be spot on, I'd say at equal odds, which has led most investors to be overwhelmed with the feeling of what do I do now.

Hedge your bet and cross your fingers
Luckily, there's an industry that is probably better hedged between both outcomes than almost any other. I'm talking about the payroll processors, dominated by ADP (NYSE: ADP) and Paychex (Nasdaq: PAYX). Since it's smaller and has more potential, I'm going to focus on Paychex today. Let me tell you why this company could dominate no matter which side is right.

Paychex is in a simple industry that's easy to understand. The bulk of its business is processing payroll data and distributing paychecks. Businesses send Paychex the data, and it makes two Fridays per month everyone's favorite days. Simple. Making money on this comes from two areas: Each of Paychex's customers is charged a set fee per payroll period processed, and an additional fee per paycheck that's cut.

From the structure of this business model, it's obvious that as the economy recovers and companies start to hire, Paychex stands to benefit. This is already happening to some extent. March added 162,000 jobs nationwide, the biggest one-month gain since 2007. If you're in the optimistic camp and think this trend will continue, the benefit to Paychex is really straightforward: more employment means more profits.

And in this corner ...
Why Paychex could dominate in a high-inflation world isn't as obvious, but it's just as powerful. For one, the company has tremendous pricing power. And two, it earns money on funds it temporarily holds for customers, where higher interest rates lead to higher profits.

Let's start with the first. All pricing power means is that you can raise prices without your customers running away. One way to see this is by looking at Paychex's payroll service revenue over the past three years:

Source: Company filings.

In 2008 and 2009, years when unemployment shot through the roof, Paychex was actually able to grow revenue. And this is specifically payroll revenue we're talking about. If you add in ancillary revenue from its side businesses like human resource management and retirement services, total "service revenue" grew from $1.7 billion in 2007, to $1.9 billion in 2008, to $2 billion in 2009. Considering, as Paychex's annual report states, "Our client base declined 3.1% for fiscal 2009," this is a mighty impressive feat. And it's all because of pricing power -- the best defense against inflation.

The second inflation weapon is a little sneakier. When customers do business with Paychex, they forward the cash used in payroll disbursement to the company in advance. That turns Paychex into a quasi bank: It holds onto other people's money, and earns interest on those funds. At the end of last year, Paychex held $3.3 billion of its customer's cash.

Interest rates are pitifully low right now, so this area isn't a large source of income. But in year's past, it's been a nice boost:

Source: Company filings.

This segment could turn into a cash cow if inflation suddenly took off, as the extreme inflationists portend. In any inflationary environment -- or even just in cases of government finances getting out of control -- interest rates invariably rise. When you're a company like Paychex just milking interest payment off your clients' cash, higher interest rates mean bigger profits. If inflation really explodes and interest rates rise to 10% or 20% -- where they were in the early 1980s, mind you -- this would become a major source of income for Paychex. And since Paychex holds most of this cash in short- and mid-term duration debt securities (the average duration is 2.5 years), it isn't terribly prone to getting crushed on its existing positions when interest rates do rise.

Some might counter: Aren't higher interest rates typically bad for banks? Yes, but there are fundamental differences between banks and Paychex's bank-like operations. First, banks have to pay for their capital, either through interest payments to deposit holders, or through the cost of debt. That means when interest rates rise, margins are often squeezed.

But Paychex's clients simply hand it cash and call it even. So the cost of Paychex's funds stays pegged at zero regardless of what interest rates do. Second, banks are subject to bank runs, where creditors demand their money back all at once. But Paychex knows exactly when it needs to remit the cash it holds to its customers' employees and various tax agencies. That gives it more control over its cash than most banks have.

Of course, there are several companies that can do well in both recovery and inflationary worlds. Coca-Cola (NYSE: KO) and Philip Morris International (NYSE: PM) are two good examples of companies with huge pricing power that also stand to gain from a consumer revival. But for Paychex, the benefits from either outcome are really accentuated: In a recovery, payroll revenue will gain quickly without being tied to any single industry; in high inflation, the twofold advantages of pricing power and interest on client funds compound profits for shareholders in real terms. And at some outcome in between, Paychex is still a highly profitable company with a 4% dividend. I like it all.

Talk me down
The Motley Fool has a disclosure policy, prohibiting writers from buying or selling a stock within 10 days of writing about it. Unless someone can talk me out of it in the comment section below, I'll be a happy new Paychex shareholder in 10 days. Go.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.