By Brian Lund (TMF Tardior)
March 16, 2000

Instead of watching Ronin for the third time last weekend (and it wasn't very good the first time), I could have spent that time writing about today's third-quarter earnings report from Paychex, Inc. (Nasdaq: PAYX). I could have told you then that revenues at the payroll-processing company for small and mid-sized businesses would rise 21% over the year-ago quarter, led by a 43% increase from the relatively new Human Resource Services and Professional Employer Organization segment. I also knew that net income would increase 37% -- that's right, 16% more than revenue -- to $49.6 million, or $0.20 per diluted share, beating analysts' estimates by a penny.

How could I have known it would be thus? Because Paychex always has results like this. The company has reported net income increases in excess of 36% for eight consecutive years. That's a long time to be producing growth of that magnitude. The consistency is amazing, too -- look at the revenue and income growth numbers for the last four years and this past quarter:

                      1999  1998  1997  1996  2000 (YTD)
Revenue growth (%):   21.0  23.5  20.0  22.5    20.5
Income growth (%):    36.1  36.0  35.6  36.3    36.8

How boring can you get? Does anything at the company ever change?

Well, yes, in fact, its margins are volatile: They get better every year. Gross margins rose from 74% to 76% over last year, operating margins swelled from 30% to 35%, and net margins hit 26%, well above 1999's 23%. That's not the only stuff heading in the right direction. The company has boosted its return on equity to 37%. It has steadily improved its cash conversion cycle to 18 days, mainly through increases in its payables outstanding. Finally, its Cash King margin has exceeded 31% for the year, up from an already outstanding 25% in 1999. Oh, and the company has $65 million in cash and no debt.

As far as I can tell, Paychex's financials are above reproach. Maybe there's something wrong with their business model -- a big-time competitor on the horizon, perhaps? Didn't I read that Intuit (Nasdaq: INTU) was getting into online payroll services? Are they going to undercut stodgy, old Paychex through an Internet strategy?

That certainly was the thinking last year, but it hasn't played out that way. Paychex saw its payroll client list expand 9.2% over last year and 2.4% over last quarter. The Internet hasn't really changed the payroll-services industry significantly, since it already had a payment infrastructure in the ACH Network and Fedwire. Paychex will soon offer products to facilitate data entry, including a general ledger interface that can import data from accounting products -- like Intuit's QuickBooks. Intuit may find a competitive advantage, but it hasn't damaged Paychex yet.

One problem Paychex has faced in the past is turnover in its sales force, which has averaged in the low-30% range. The cause appears to be the stress associated with Paychex's stringent requirement that a salesperson must sell 150 payrolls annually. Turnover becomes expensive, because of the cost of finding a replacement and the associated drop in productivity. Nevertheless, Paychex hasn't suffered substantially from this cost. As income growth outpaces revenue growth, operating margins continue to rise, a testament to management's efficiency.

The stock doesn't come cheap, of course; it currently trades at about 66 times estimates for 2000 and 53 times 2001 projections. For a company that has proven over and over again that its profits can grow a rock-solid 36% a year, with 31% free cash flow and a dividend to boot, that may well be a price worth paying.

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