Fool Covers PAYX Short
March 31, 1995

Friday, March 31 we're closing out our short in. . .

Paychex, Inc. (NASDAQ: PAYX)
TYPE: Darling/Highflyer
Phone: (716) 385-6666
Closing prices, August 4th, 1994: Bid $45 1/2, Ask $45 3/4

Trailing 12-month revenues: $273 million
Trailing 12-month EPS: $1.02
Last quarter reported: March, 1995 (3Q 1995)
Next quarter report date: About June 14th
Consensus EPS estimate for quarter: $0.33e vs. $0.25

FOOL ratio: 1.40

-------> TRADE: Buying back 150 shorted shares

Today marks the end of our short position in Paychex (NASDAQ:PAYX), national provider of payroll processing and corporate tax services for small-companies. We borrowed shares and shorted them last August at $32.72, post commission and spread, and tomorrow we'll venture out on the open market to buy back those shares and return them to our discount broker.

We'll be purchasing them nearly 40% higher than where we sold them. This one hurts, but don't we all know well, that no pitcher ever threw all strikes, no program is bugless, no juggler never drops a ball.

CASH STASHED. This past month Paychex announced third quarter earnings for fiscal 1995 coming in with $0.31, or 7% above analyst expectations. This marked a third outperformance of quarterly estimates in as many quarters, stacked on top of increasingly more sturdy financial crutches. Paychex now has $79 million in cash and cash equivalents and a mere $730,000 in long-term debt. Their current assets sit at $114 million with current liabilities at $25.6 million, making for a quick ratio of 4.45, up from 4.41 at the end of last quarter. Profit margins are also on the rise, creeping to 13.6%, up from 11.5% for the same period last year. There's the sort of financial stoutness that warrants a high PEG valuation. Cash, cash, cash, quarterly outperformance and no long-term debt. Fools know that's an excellent screen for long-term investment success.

For the record, here's the financial table for Paychex's performance through nine months of fiscal 1995:

           9 Months 1995      9 Months 1994 
Revenues   $195,330,000       $165,210,000
Earnings $28,540,000 $20,670,000
EPS $0.95 $0.69 Profit Margins 14.6% 12.5%
Costs-to-Sales 29.2% 30.6%
SG&A-to-Sales 51.3% 52.8%

RUNNING THE PEG. The truth is, no matter how we Fools slice or dice it, Paychex looks overpriced today at $45 3/4 per share. With $1.25 projected for year-end 1995, $1.55 for fiscal 1996, and a five-year estimated earnings growth rate of 24.5%, we don't see cause for the stock to be trading at 39X trailing earnings per share. The annualized growth rate generated by the numbers above sits at 23.5%, and even when you push things forward 1.25 years to $1.55 in fiscal 1996, you're looking at a stock fairly priced in the mid-$30s, not the mid-$40s. Did you catch all that number crunching above? 23.5% growth rate, therefore a P/E multiple of 23.5. If we give them the $1.55 projected for 1996 and run 23.5X it, the fair price sits in the mid-$30s. That's an awfully generous valuation, too, even for a financially-sturdy structure.

So why in tarnation would we close out our position now. . . what about the principle of The PEG? There are a handful of convincing reasons for cashing out now: Estimates have been upgraded; the load of cash supporting operations is getting larger; the dividend was increased earlier this fiscal year; the company has consistently outperformed projections in fiscal 1995. Paychex's first quarter saw a thrashing of estimates by 10%; in their second quarter, they came in 3% above projections and this, their third quarter, showed a 7% outperformance. In this light, those $1.55 estimates for 1996 begin to look conservative.

LOOKING BACK. It's always a good idea to look back when you close out an investment, particularly a loser. We've opened a new folder on our Talk with The Editors board entitled "My Dumbest Investment", which is there to help us all look back and learn from our mistakes.

In order to remember and learn from Chexy, we spent last night reading back through the 300 hundred messages in this forum about Paychex. That's one of the beauties of the medium and our Foolish exploitation of it. There are permanent records here. We have a journal on Paychex, and on hundreds of other stock and investment approach folders. All we need do is click back through them to learn, to hold ourselves and others accountable, to give credit when it is due, and to learn from poor decisions. Here were some of the important headlines on Paychex noted in our folder, displayed below chronologically:

- Barrons Names Paychex "Overvalued"
- Smith Barney Upgrades Paychex to Outperform
- Paychex Insider Sells 200,000 shares at $37 1/4
- CEO Tom Golisano Announces Plans to Run for Governor in NY
- The Cry Goes Up: Why Don't The Fools Add to Their Short Position at $37?
- Paychex Raises Dividend from 6 Cents to 9 Cents
- Argus Research Names Paychex a $47 Stock in the Coming Year
- Rumors Fly: Will Paychex Be Restating 1st & 2nd Quarter Earnings?
- Paychex is Part of the New America Series in IBD
- Argus Restates Target, Calls Paychex a Buy Up to $43
- Paychex Up $2 on Positive Conference with Goldman Sachs
- Paychex Beats 3rd Quarter Estimates, the Stock Hits New Highs
- Paychex hits $45 1/2 and The Fool Closes Out

These twelve items sketch the outline of THE worst short position in the history of The Motley Fool, online, offline and in either of The Fool Editors' portfolios. Ouch.

LESSONS LEARNED.

Did we learn anything? We certainly did. For starters, we learned more about what makes for a great LONG investment. To repeat, Paychex has no debt problems; they have $79 million in cash reserves (for a company with less than $300 million in annual sales, that's a lot of cash); they have beaten up on estimates all year; they've been the subject of upgrades, and their profit margins have improved. They are spinning out cash and saving it for darker days; The Street loves that. . . and they should.

When you pile all of those together, you have a stock that will naturally trade higher than a PEG of 1.00, as investors look ahead. Wall Street accepts that financially-strong growth companies that beat estimates should be expected to, at the very least, MEET estimates going forward. And so The Street pushes the earnings numbers forward, applying multiples off longer-term growth rates. The same situation is alive and well with one of our long holdings, America Online (NASDAQ:AMER).

Of course, our short has not touched us up too badly. Why not? Primarily because we didn't add to our position. The temptation is always there to pour cash into your losers. "After all," the double-downer maintains, "I couldn't have been THAT wrong with my first valuation." Actually, you very well could have. More likely in situations like this, though, is that your first valuation wasn't terribly amiss; the situation simply changed. It did with Paychex. We're thankful that our ancestors have taught us never to throw good money after bad. And we're taking our lumps and moving on.

WHERE TO FROM HERE? As everyone in this forum knows, we aim to outdo 21% annual returns in every single position in The Fool Portfolio. Since Beating the Dow has compounded 21% growth yearly since 1973, Fools have to ask themselves, why invest anywhere else? The answer for us is: We aim to outperform Beating the Dow's 21% annual growth. We believe we can, while diligently reporting all commissions and spreads, a discipline to which so few in the financial world adhere. We'd have it no other way. If the public companies which newsletters invest in have strict reporting requirements, then the newsletters themselves should meet those same requirements. Virtually none do. That's a shame.

Here in Fooldom, we account. And our accounting software reminds us that what makes Paychex such a painful investment is knowing that we could've dumped this money into Merck, American Express, or Sears, and we'd be grinning today. Instead, Paychex has lost us as much money as we've profited off our investment in Merck. Darn. But that comes with the territory. If you're going to try to outdo your Dow holdings, you're going to have to be comfortable taking some losses with your gains. As long as the latter outweigh the former, and you can outperform your yield-plays over time, you haven't erred.

So, for The Fool Inc., we now have to make up $1900 in losses. We like to demand that that growth comes from work outside of the market. . . a great rule which helps limit the risk when investing. The dollars one loses from non-Beating the Dow investments have to be made up by work outside of your investment portfolio. We think that's an excellent way to run a personal portfolio, an investment club portfolio, a Foolish portfolio. So. . . back to work!

---David Gardner