At first glance, pitting the payroll services leader against the online commerce giant seems like putting a cat and a dog in a boxing ring to have at it. They're very different creatures. Yet, on closer inspection, these two companies share many of the same qualities and traits, making our pending buy decision even more interesting.
Both companies have grown largely by word-of-mouth. Paychex serves thousands of businesses, mostly small- to medium-sized, and clients that are pleased recommend the company to other businesses. The network effects at eBay are much larger in size, but operate in the same manner -- word of mouth. Word of mouth is the most effective form of marketing, and, ironically, a company usually doesn't pay anything for it.
Both companies serve markets that could theoretically continue to grow for decades and decades, granting for the usual ups, downs, and slowdowns. As long as the economy in the United States doesn't collapse (and even if it does), new businesses are born every year that are in need of payroll services, and most existing businesses don't yet use Paychex or any payroll service.
Meanwhile, the business of eBay is commerce, the oldest business in the world. If anything is here to stay and grow, commerce is, and eBay is arguably the most financially attractive broadbase commerce platform in the world, not handling inventory and serving more than 30 million people.
So, we have two strong businesses in two promising long-term growth industries -- industries that also promise to be stable, because demand should remain fairly constant even if demand isn't always growing.
Let's compare some key numbers side-by-side:
Past 12 Months Paychex eBay Gross margin 77% 81% Operating margin 38% 18% Profit margin 29% 14% Revenue $869M $588M Operating cash flow $304M $157M Free cash flow (FCF) $259M $117M Return on Equity 38% 8% Sales/employee $147,000 $302,000 Share price $39.50 $59.50 Market value $14.7B $16.1B Cash & equiv. $614 million $686 million Enterprise value $14.1 billion $15.4 billion EV to FCF ratio 54.4 131.6 2001 earnings est. $0.81 $0.45 2002 earnings est. $0.98 $0.72 Est. '02 EPS growth 21% 60% P/E on 2002 EPS 40.3 82.6 Dividend yield 0.94% N/A 5-year Div. Growth 46% N/A
Those are several numbers to eye, and there is additional context to consider. For example, currently Paychex has much higher operating and net profit margins than eBay, but it is a 30-year-old business while eBay is only five years old. Management at eBay forecasts operating margins of 30% to 35%, so, in fact, the two companies are likely to have similar margins eventually. As we can see, eBay already has the higher gross profit. Likewise, eBay's return on equity should rise sharply over time.
So, while Paychex is likely seeing its optimal performance numbers today, or very close to them, eBay is still very much on the rise. (Rule Breaker wrote last week that eBay looks stronger than ever.)
Another consideration: It's interesting to me that eBay is at 82 times next year's earnings per share (EPS) estimate while expected to grow 60%, and Paychex is at 40 times an estimated 20% growth rate. This gives Paychex a considerably higher valuation premium, even though eBay is the much faster grower. This may be, in part, because Paychex has such a long history of consistent growth.
Paychex grew sales 19% in fiscal 2001, which just ended, while its EPS rose 34%. The numerous reductions in interest rates this year will negatively impact its 2002 business, but management still expects sales to rise 16% to 18% in its new business year just started. Given this, the 21% EPS growth estimate for 2002 is probably somewhat conservative.
Over the past 10 years, Paychex's sales have grown at a 20% compound annual growth rate (CAGR), while net income has grown at a 39% CAGR. (Paychex's 2001 annual report, with 11 years of past results, is now available online as a .pdf file.) By pushing and pulling some "levers," Paychex should be able to turn even 16% sales growth into net income growth of more than 21% next year.
Working in Paychex's longer-term favor, interest rates are more likely to rise in the next few years rather than continue falling. Rates have been lowered seven times this year, a record since the early 1990s. Rates are now near historic long-term average lows, so the most likely eventual direction from here is up. In that case, Paychex will earn more net income on its float -- or the tax withholdings that it maintains for several weeks before paying it to the government -- sooner rather than later.
Overall, on a numbers basis, these two companies are more similar than different. Even their long-term terminal growth rates will likely prove similar. Next week we need to consider the pros and cons of each business and each investment, side by side. In the meantime, what are your thoughts on this competition? Share on the Drip Companies board.
Jeff Fischer enjoys a good, clean fight (Is there such a thing?). That's probably why Dueling Fools is one of his favorite weekly columns on the Fool. (Catch it every Wednesday!) He owns shares of eBay. The Fool has a progressive disclosure policy.