Both are likely to have equally compelling margins, with operating margins of above 30%. Both are sitting on near-equal piles of cash (over $600 million) and lack long-term debt. Both have strong free cash flow (in the past 12 months, Paychex's free cash flow was 30% of sales, eBay's was 20% and rising). Beyond the numbers, both are in industries that promise to continue growing in the long term, and both, as we've seen, can be highly profitable even during economic slowdowns.
In short, the financial potential at both companies looks impressive.
Now we want to compare these companies on subjective matters -- which company do we understand better? Which has stronger sustainable advantages? Which fits better with our existing holdings? We'll tackle these considerations in the old-fashioned way, the way that mom used to advise: We'll list the pros and cons of each company. Doing this, we might be able to determine which, if either, is best suited for us.
- Network effects and scale provide eBay a strong sustainable advantage over competitors; eBay is positioned to be the leading consumer and small business e-commerce platform, period;
- Less than six years old, but in an ancient industry, eBay should have substantial growth ahead;
- We clearly understand how eBay makes money (hosting commerce), how it makes more money (host additional commerce), and how it makes more money than that (add more services, increase fees periodically, expand to new markets, etc.);
- Management has shown prudence in execution the past five years, even during (and especially during) the halcyon days of the Internet, when "get big fast" led to the fast demise of new companies;
- Management is aiming for 50% annualized sales growth through 2005, to $3 billion in sales; and
- Performance metrics (free cash flow, operating margins, ROE, etc.) are improving quickly and should for several years.
- eBay does not offer a Drip plan. We'd need to buy it through a pseudo-Drip and pay fees to do so;
- Given its short history, we don't know how large eBay's market might be, though we assume much larger; however, it might stop growing much sooner than we think; and
- We suspect that eBay's pricing power is ultimately limited; people will slow or stop their selling on eBay if commissions start to take too large a bite of each sale.
On the opposite side of the ring, about five times older than eBay, but weighing slightly less in market cap ($14 billion versus eBay's $15 billion), stands Paychex in the green boxers. (eBay is in the multicolored red, blue, yellow, and lime boxers.)
- Paychex is the leading payroll, benefit, and HR services provider for small- and medium-sized businesses, with brand recognition providing it an advantage in landing new customers, and a large, experienced sales force doing the rest;
- Paychex has an incredible thirty-year operating history that includes 30% annualized earnings growth the past ten years, on 20% annualized sales growth;
- Paychex's largest competitor, Automatic Data Processing (NYSE: ADP), demonstrates how a payroll service business can grow at a market-beating pace for nearly 50 years, and with 40 straight years of annual sales and net income growth;
- We understand how Paychex makes money (provide payroll services), how it makes more money (add more customers than are lost each year), and how it makes more than that (add new related services each year, use payroll withholdings to create additional income, etc.);
- We have seen how high its margins can be on a sustainable basis;
- The company offers a fee-friendly Drip, with free optional stock purchases; and
- It pays a dividend yield of nearly 1%, and the dividend has grown 54% annualized the last five years.
- Its biggest growth days are almost certainly behind it; from here, we can aggressively hope for earnings growth closer to 20% rather than 30%, and then that number will slowly decline, too;
- The largest payroll company, ADP, is starting to compete for the small- and medium-sized business market;
- Paychex's sustainable advantages are less entrenched than eBay's, because it is not very difficult to switch payroll providers and companies will often switch, especially in harder times, if it'll save them money; and
- Paychex's margins are unlikely to improve from this point, and could decline modestly;
We haven't mentioned the valuation of either company this week, though we eyeballed each last week. Both fetch premium valuations, but not unbelievably unreasonable ones, in my opinion, given the business and advantages that each possess. Since valuation is secondary to us given our 16-year "average-in" approach, we'll consider valuation after we've considered the businesses.
Drip Port specific concerns
Paychex is a financial and human resource services firm. We own Mellon Financial (NYSE: MEL), which is a financial services firm; granted, they're in very different businesses (money management versus payroll administration), but they're still more similar to one another than anything in our portfolio is to eBay. Thus, eBay likely presents superior diversification to our portfolio, being substantially different from all our holdings.
Yet, eBay doesn't have a Drip, so we'd need to pay a low-cost broker -- such as the Drip Port sponsors linked above -- to buy it every few months. If we did so, we'd likely buy it in an IRA account, to avoid taxes.
As to the businesses: eBay has stronger sustainable advantages, which are very important to us and should be to all investors. How does a company make more money every year? Other than smart management, it must have advantages that keep other companies from copying or compromising it. Paychex does have sustainable advantages, and ones that are certainly strong enough to attract us (its 30-year history isn't a fluke), but on the surface they're not as strong as eBay's appear.
That said, Paychex is the more stable, or we might go so far as to say "certain," business (as certain as things can be in business anyway). It has a history that eBay lacks, as does its largest brethren, ADP. For Drip Port, a history in its holdings is important. We're not interested in rolling the dice on something that may or may not grow most of the next 16 years, or might only growth for five years, for example, and then stagnate.
It's with these thoughts that we approach next week. Please continue to share your thoughts on the eBay, Paychex fight on the Drip Companies board. Next week we could have a purchase decision.
P.S. Our September $100 investment is being saved, as was our August investment, to presumably invest in our new company. This means we'll have $200 in cash as of this month.
Of companies mentioned here, Jeff Fischer owns shares of Mellon and eBay. By the way, he also owned shares, bought as a teenager, in a Florida real estate company that went bankrupt around 1990. The Motley Fool has a progressive disclosure policy.