The last two weeks, we looked at the business of Paychex (Nasdaq: PAYX) and considered several of its risks. After discussing risks, most readers -- by a ratio of about four-to-one -- wrote to say that they've had good experiences with Paychex's customer service, which was one of our early concerns.
So far, the company successfully meets our high-growth criteria. In addition, Paychex has three decades of operations behind it, which is much more history than we expected to find in any of our high-growth contenders. This past allows us to look at the company's current financials and know they are not just a flash in the pan.
Next Monday, June 25, Paychex will announce fourth-quarter and year-end results. The average earnings estimate is $0.18 per share, up 28% from the same quarter last year. Today, we'll view recent results and run the company's financials through our high-growth criteria.
Recent financial results
Paychex's numbers make a sunny, breezy, 82-degree day at the beach look bad. In other words, they're near ideal. The most recent nine-month and three-month results are:
($ in thousands) 9 mos. 9 mos. ended 2/01 ended 2/00 Payroll revenue $509,496 $437,044 ENS* invest. rev. 60,671 40,595 Total payroll rev. 570,167 477,639 HRS-PEO** revenue 71,070 53,294 Total revenue 641,237 530,933 Operating cost 147,398 126,686 SG&A costs 244,706 215,152 Operating income 249,133 189,095 Operating margin 38.8% 35.6% Investment inc. 18,733 11,554 Net income 187,108 138,448 Net margin 29.1% 26.0% Diluted EPS $0.50 $0.37
3 mos. 3 mos. ended 2/01 ended 2/00 Payroll revenue $177,842 $155,466 ENS invest. rev. 25,905 16,355 Total payroll rev. 203,747 171,821 HRS-PEO revenue 25,509 20,362 Total revenue 229,256 192,183 Operating cost 54,376 45,964 SG&A costs 87,998 78,316 Operating income 86,882 67,903 Operating margin 37.8% 35.3% Investment inc. 7,234 4,012 Net income 66,352 49,621 Net margin 28.9% 25.8% Diluted EPS $0.18 $0.13(*ENS revenue is earned on money withheld for taxes, also called "float.")
(**HRS-PEO revenue is related to employee benefit services, including 401(k).)
These results show a high margin business that has been increasingly profitable and has been growing earnings around 35% year-over-year. (For more historical financials and a great explanation of the business, see the 2000 annual report (Adobe .pdf file)). All together, are the company's other numbers good enough?
Financial qualities that we seek
We want our high-growth company to meet the following qualities:
- The business should become more profitable per dollar of revenue the more that it grows, meaning that it scales;
- The business should be self-financed with positive cash flow, and the balance sheet should show cash at more than 1.5 times long-term debt;
- Some income must be reinvested back in the business with demonstrated effectiveness and the promise that that will continue;
- The business should have a Cash King Margin of 20% or higher and generate strong free cash flow, and a Foolish Flow Ratio below 1.4;
- The higher the gross margin, operating margin, and return on invested capital, the better;
- We must be able to logically estimate an annual five-year sales growth rate of at least 20%;
- Likewise, we must be able to logically estimate annual five-year earnings per share growth of at least 25%;
- Following five years of rapid financial growth, we must logically be able to estimate naturally slowing growth afterwards, rather than a sharp dropoff in growth.
Taking the list point by point, Paychex has indeed become more profitable per dollar of revenue earned, partly because it grows its client base at a faster rate than it adds to its sales team and other costs. This has been the case for years, and won't likely change dramatically. That said, the company has lost about 21% of its clients annually the past few years, while adding 32% more clients annually, so its client turnover is far from low. Part of this is due to smaller companies failing, but we'd rather see the turnover number at 15% or lower.
This profitable business is self-financed and cash flow positive. For the nine months ended February, Paychex had free cash flow of approximately $228 million. Its balance sheet had $106 million in cash and $506 million in corporate investments, with only $5.1 million in long-term debt. Clearly, some annual income is reinvested back into the business successfully, with more growth resulting all these years.
The company's Cash King Margin was a giant 35.5% for the nine months ended February, well above our 20% hurdle and even higher than Paychex's 29% net profit margin. Our only other high-growth contender that may eventually match or top this Cash King Margin is eBay (Nasdaq: EBAY). Paychex also manages its working capital well. Its Foolish Flow ratio was recently 1.26, below our 1.40 hurdle, and the Foolish Flow was actually only 1.0 if we include corporate investments in Paychex's cash and equivalents. (It's unclear whether they should be included or not.)
Finally, the company's operating margin (38%) and net margin (28%) are world-class, ranking in the top 1% of all public companies, and are in fact higher than those at Intel (Nasdaq: INTC) and Johnson & Johnson (NYSE: JNJ).
This leaves just growth rates to consider. Paychex has lately grown sales 22% annually and earnings per share 38% annually, but it is doubtful that sales can grow 20% annually the next five years, too. Something closer to 15% is more likely, and even that is an aggressive rate to ask. The good news is that asking for earnings per share growth of around 25% for the next five years, while equally aggressive, is in the realm of possibility and reason. Plus, after the next five years, continued double-digit earnings growth in the teens is equally possible given this industry and lessons from the past at older companies such as Automatic Data Processing (NYSE: ADP). Overall, we're comfortable expecting impressive long-term growth rates from Paychex that are near or at our goal.
It's a strong, high-growth company with strong prospects
Add it all together, and Paychex appears to be an excellent long-term investment prospect for us, especially as we're a portfolio that dollar-cost averages. We're left to discuss its competition in more detail, its management as much as we can, and its valuation. However, given what we already know about each, those subjects are not likely to change our long-term opinion on Paychex, which is very favorable.