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Payroll processor Paychex (NASDAQ:PAYX) has a wonderful business model that benefits from scale and network advantages. It plays second banana to industry giant Automatic Data Processing (NYSE:ADP), but it's double the size of the next largest competitor, Ceridian (NYSE:CEN).
But being second banana here is an advantage for investors, because Paychex has much more room to grow. In fact, over the past five years, Paychex has grown revenues at around 14%, while ADP has struggled to grow at all. Better still, the expectation that we're heading into a weaker labor market has dropped the share price by more than 30% since its high last August. Now the stock is significantly undervalued, and it's easy to see what the rebound will look like once we head out of the recession.
Paychex raises
Everyone loves a pay raise, and naturally, investors like raises, too. So here's what makes Paychex a compelling pick to give you that financial boost:
- The company has fabulous returns on equity and capital, achieved without the use of debt.
- It has no need to raise capital during the credit crunch, because it has a fortress-like balance sheet.
- It requires minimal capital expenditures to grow its business.
- It has growth opportunities, both by increasing penetration in the payroll market and by using its vast network of established client relationships to sell additional services. Analysts polled by Reuters -- a part of Thomson Reuters (NYSE:TRI) -- expect 14% growth over the next five years.
- It pays a dividend yielding 3.8% and has used excess cash to buy back shares.
- Founder and Chairman B. Thomas Golisano owns 10.6% of shares outstanding.
Paychex deductions
No company is a perfect employer or a perfect investment, and Paychex is no exception. So here are the risks:
- Paychex concentrates on small and mid-size businesses, and in the short term, a prolonged recession tends to hurt smaller businesses disproportionately. The current environment makes it unlikely that the company will achieve that 14% estimated growth.
- It earns significant amounts of interest on the payroll float (interest income makes up 17% of operating income) and is therefore at risk to lower short-term interest rates. Conversely, the company benefits if those rates rise.
- In a recession, companies cut payroll. Lower-than-expected payrolls and a long recession could see the shares get cheaper.
Foolish Paychex
The Motley Fool's mission is to educate, amuse, and enrich, and that's precisely what this article is about. Ignore my attempts at humor if you will, but don't ignore the opportunity to educate yourself about Paychex and enrich yourself by buying its shares. We almost always get more opportunities to buy cheap shares, but don't wait too long, because this company is bound to be a leader coming out of a recession.
Before you make a buy decision, check out what our CAPS community of more than 110,000 investors thinks. And don't stop there. Chime in with your own CAPS call on whether Paychex will outperform or underperform.
