For Paychex (NASDAQ:PAYX), the second quarter of 2007 was business as usual. Report stellar financial results? Check. Reinvest in additional business lines that will help dig the economic moat? Check. Implement a fat increase in the dividend payout? Check. (You get the idea.)
Company snapshot
Paychex provides 543,000 clients, mostly small businesses with less than 20 employees, with payroll, payroll tax administration, human resources, employee benefits, and other outsourced services. Its primary competitors include Ceridian (NYSE:CEN) and ADP (NYSE:ADP); the latter serves larger businesses, although the lines are blurring somewhat.
For the second quarter, Paychex increased sales 14%, operating income 15%, and net income 18%. The company's core payroll services, which account for nearly three-quarters of its business, increased 9%, and the faster-growing human resource services increased 24%.
In addition, when a client makes a direct deposit or tax payment, Paychex gets to hold (and invest for its own benefit) those funds for a very short period of time; those funds averaged $2.9 billion for the quarter, an increase of 6%. Thanks to increases in the federal funds rate, the company's investment yield increased 100 basis points to 4%, expanding total interest revenue 43%. In the conference call, management also noted that it hasn't yet seen any fallout from Bank of America's (NYSE:BAC) recent free offering of payroll administrative services.
It shouldn't be a surprise that Paychex stock, at more than 30 times trailing earnings, reflects shareholder optimism. I'm personally waiting for the next economic downturn, when business gets worse and the company's stock tends to sag, to hopefully grab some shares. After all, Paychex simply creates a platform for processing payroll and other outsourced business services. That platform is primarily a fixed cost, so the more customers it gets, the more that fixed cost gets spread around. Thus, natural scale advantages allow winners like Paychex to keep winning. And since most of its business is based on referrals, Paychex and other incumbent winners become even more successful.
Checks and balances
Although Paychex is investing in new and existing growth areas such as 401(k), health insurance, workers-compensation insurance, and recruiting-process management services, it's hard for the company to reinvest its prodigious cash flow at a high rate of return. In 2005, a tantalizing 30% of the company's $1.6 billion in sales translated into free cash flow. For a finely tuned machine like Paychex, a lot of that cash is excess.
What to do? Rather than orchestrating a "shareholder-friendly" buyback to snap up executives' stock options and line their pockets, Paychex management decided to increase the company's dividend 31%. The move will raise the company's dividend yield to a not-too-shabby 2%. It probably helps that the company's chairman owns 10% of the firm. Shareholder-friendly management, I salute thee.
Here's some related news about Paychex:
Foolanthropy is celebrating its 10th year! To learn more about our five Foolish charities or to make a donation, visit www.foolanthropy.com.
Bank of America is a Motley Fool Income Investorrecommendation.Discover our entire portfolio of dividend dynamos with a free 30-day trial subscription.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.
