Last week we introduced Paychex (Nasdaq: PAYX) as the leading contender in our high-growth company study. We have five other finalists to consider, but given Paychex's long history of greater than 30% annualized earnings growth, its understandable business, and its free Drip plan, it may prove difficult to beat.
Paychex does have weaknesses, however, and those are what Fool readers focused on when they discussed the company on the board last week. The main concerns raised were:
- Economic weakness leading to weakness in employment and payrolls could lower Paychex's income and growth potential.
- Changes in tax laws could decrease Paychex's tax withholding and "float" income.
- Paychex's customer service quality may cause it to lose customers, because some clients have had poor experiences as the company has grown.
- Paychex operates in a commodity service business because changing payroll providers is not that difficult. Thus, its sustainable advantages are questionable.
All these are good points, but some are worth more attention than others. The first point -- the potential for a weak economy that slows Paychex-- is not a threat exclusive to Paychex. Such a macro-event could slow all companies, and, without great luck, would not be avoidable by investors. Therefore, long-term stock owners shouldn't sweat this. In fact, we would favor a slowdown if it allowed us to buy more stock in otherwise strong companies at lower prices.
Lower taxes hurt Paychex?
The second concern, that of lower taxes, has direct implications for Paychex. In the most recent nine months reported, revenue from the company's Electronic Network Services (ENS) grew to about 9% of sales, clocking in at $60 million. This is revenue earned by investing, for one to 30 days, money that is withheld from paychecks for taxes. Paychex holds the money and invests it before sending it to the IRS.
If tax rates decline, Paychex must withhold less money per paycheck, and therefore it earns less on that money. Overall, however, the tax cut signed into law probably would not affect total revenue by more than one or two percentage points, and that's at least a few years from now. By then, new revenues could compensate for those lost. Also, I believe that if the stock market were concerned about this, it would have punished Paychex and other payroll service companies the day that President Bush raised his pen to sign the tax law. So, I believe this is relatively minor in the grand scheme.
What are its sustainable advantages?
The third and fourth concerns listed above intertwine. A few Fools wrote to say that their companies were not happy with the customer service received from Paychex. Some switched to smaller, more personal payroll providers. Others haven't switched, but are considering it. On the flip side, other Fools wrote to say how happy they are with Paychex's services. Some then suggested that customer service is uneven at the company, being better in some parts of the country than others. This leads to the question of sustainable advantages.
Paychex's best sustainable advantage is its reputation. Across the country, Paychex and Automatic Data Processing (NYSE: ADP) are the best-known payroll and employee benefit service providers. ADP leads in serving large clients, while Paychex leads in small to medium-sized clients, but both are edging into each other's markets. In general, the product offered is nearly identical -- universally needed payroll and human resource services -- so what differentiates a company is its customer service and the quality and accuracy of its payroll service. With that service comes a reputation, and through word-of-mouth, a reputation leads to more or fewer new customers.
Because ya gotta have faith, faith, faith... (argh, sorry)
Both ADP and Paychex have been adding new customers at record rates over the past five years; not surprisingly, both companies have strong reputations. Short of a crystal ball, we can't predict that this will change for the worse. Paychex's 30-year history of good service argues that it won't change, although as the company has grown, its service challenges have grown. We expect growing pains and challenges within customer service, but overall we must have faith that the company will continue to improve its customer service as it grows if we're going to be investors.
Unfortunately, when investing in a service business, after you've read all the customer surveys, it comes down to faith -- faith that your company's management will continue to provide clients with great service. Meanwhile, the best research that we can do now on Paychex is to ask readers: Does your company have experience with Paychex? Share your knowledge of its service quality on the Drip companies board.
Required business qualities
Satisfied for now regarding those stated weaknesses, let's start to run Paychex through our high-growth criteria, starting with business qualities. We said that we desired the following:
- The product or products sold must deliver value to a growing customer base, and should do so on a recurring basis.
- The existing business(es) must have an attractive, quantifiable long-term growth opportunity.
- There must be many new, related business opportunities, or what some call "option value."
- Perhaps most importantly, the company must possess a sustainable competitive advantage over competitors and potential innovations, meaning there must be a protective "moat" around the business that we can describe, explain, and validate.
- Related to sustainable advantages, a logical argument supporting 16 years of significant growth for the company itself, not just the industry, must exist.
Paychex meets all of these. The first two qualities above are obvious in Paychex. As for the third, recall from last week that Paychex is growing revenue in new opportunities by a few percentage points annually. Fourth and fifth, the main sustainable advantages are the brand, the reputation, and Paychex's size, which gives it economies of scale, i.e., it can provide services for a lower price than many competitors. We'll have more on this, but so far, so good. Next week we'll continue this thread and then look at financials.
Intel and Campbell Soup
A reader on the discussion board, "msurel," asked us for an update on Campbell Soup (NYSE: CPB), pondering why we still held it. I posted a response (a column in itself) that serves as our update on our Campbell holding.
For millions of families around the world, what is more important than that bi-weekly, life-sustaining paycheck? Yet, Jeff Fischer doesn't own shares of Paychex. (Idiot!) You can view his holdings online, as well as The Motley Fool's full disclosure policy.