Paychex reported a strong Q3 today, but that's nothing new. Investors should be mindful of the Electronic Network Services division's investment income growth, which has begun to play a larger role in the company's fiscal performance. Also, while Paychex appears pricey, the company may be able to appreciate two times in five years.
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Paychex (Nasdaq: PAYX), which provides payroll, tax, and human resource outsourcing services to small and medium-sized business, turned in a strong fiscal third quarter yesterday, as net income and revenue grew 34% and 19%, respectively. The company has consistently delivered strong sales and earnings growth, as Brian Lund noted earlier this year. Check out these stellar results over the past five years: As for its Q3 operational results, net income was $66.4 million, or $0.18 per share, compared to $49.6 million, or $0.13 per share, in the year-ago period. That beat the Street's estimate by a penny. Total revenue was $229.3 million, versus $192.2 million in the same period last year, and slightly ahead of the Street's $228.1 estimate. Net profit margins also increased to 29%, compared to 25.8% in the year-ago period. Investment income increases In Paychex's latest 10-Q, released today, management said, "The increases in ENS investment revenue are due to growth in the utilization of Taxpay and Employee Pay Services by new and existing clients, higher comparative rates of return, and net realized gains on the sale of available-for-sale securities. ENS investment revenue included net realized gains on available for sale securities of $3.4 million and $3.1 million in the third quarter and nine months of fiscal 2001 compared with net realized losses of $.8 million and $1.6 million in the respective prior year periods." While the increase in ENS revenue has benefited the company of late, interest rate volatility could eventually hurt its top line. The recent trend has been interest rate reductions, which increases the market value of investments. But if interest rates were to increase, the value of Paychex's available-for-sale securities would fall. Paychex mitigates this exposure to interest rate volatility by investing in high-credit-quality and tax-exempt securities. This increase is not necessarily bad, but certainly something investors should be mindful of. Investment revenue has contributed significantly to the company's 20%-plus revenue growth and better-than-expected earnings expectations. In fact, Banc of America research said yesterday that the company's increase in interest income contributed nearly a penny and a half of EPS upside to the quarter. The biggest thing to remember: Volatility in interest rates could have a negative impact on revenue. Is Paychex overvalued? In order to appreciate two times in five years, Paychex would have to post $2.4 billion in revenue in year five, growing its top line 23% annually. Of course, that's assuming Paychex will have a P/E ratio of 40, which seems reasonable considering its more mature competitor and closest comparable Automatic Data Processing (NYSE: ADP) has a current P/E ratio of 37. With those assumptions, at least, a double for Paychex over five years doesn't seem out of the question.
1996 1997 1998 1999 2000 2001(YTD)
Revenue growth (%): 22.5 20.0 23.5 21.0 21.9 20.6
Income growth (%): 36.3 35.6 36.0 36.1 36.6 35.2
Investment income from Paychex's Electronic Network Services (ENS) division, which contributes to total sales, continues to increase as a percentage of sales and at a faster rate than sales. ENS represents the part of the company that handles the float: When money is taken from your paycheck, the payroll services provider (Paychex) invests the cash before giving it to the IRS. The money is usually invested in securities like cash and bonds. Here's a look at the company's ENS revenue growth. 1998 1999 2000 2001(YTD)
Percentage of Sales: 8.8 8.8 8.1 9.5
YOY* ENS growth (%): 24.6 20.5 12.3 49.4
*Year-over-year
Paychex has been handsomely rewarded for its performance, trading at roughly 47x next year's expected earnings. Using the Rule Maker Portfolio's valuation "ground rule" for leading companies, it's worth asking whether Paychex can appreciate two times in five years. Let's assume 5% dilution because of stock options, which translates into a market cap of $25.3 billion. The company's trailing 12-month profit margin is 28%, so we'll hold that constant.Projected P/E 40 30 20
Year 5 Earnings ($B) 0.67 0.89 1.33
Year 5 Revenue ($B) 2.38 3.17 4.75
Growth Rate for 2x5y 23.17% 30.47% 41.49%
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