Paychex Favored For Buy

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

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.

P.S. We'll send our July investment to Intel and Pepsi (NYSE: PEP), split 50/50, by the end of next week.

You can view the writer's holdings online, as well as The Motley Fool's full disclosure policy. Jeff Fischer doesn't own shares of Paychex, but owns the stocks held in Drip Port.