With unemployment figures rising each week as corporations downsize operations to reflect declining demand, investing in a payroll processing company might appear counterintuitive. But a solid balance sheet and pricing power give this firm a sustainable dividend at an attractive yield regardless of near-term headwinds. And when the economy turns, this stock should return to its high-flying ways.-The Editors

 

Pays Off Despite Layoffs

 

There’s no question that Paychex (NSDQ: PAYX) has been hit by the economic slowdown: Sales to new business starts declined 13 percent for the six months ended Nov. 30; customer attrition levels increased 12 percent as smaller companies ceased operations; and checks per client decreased 1.5 percent as layoffs and a lack of new hires cut into payrolls. And if the economic environment didn’t present enough of a challenge, historically low yields on high-grade fixed-income instruments have likewise weighed on earnings growth. Paychex has long followed a conservative investment policy predicated upon maximizing liquidity and preserving principal; this philosophy applies to both its own cash holdings as well as the payroll funds that the firm holds and disburses for its clients. During the first half of fiscal year 2009, interest generated by fund held for clients declined by $19 million (30 percent), and management expects this figure to decline 45 to 50 percent on the year.

 

The combination of a weakening economy and lower investment yields knocked net income down 5 percent for the quarter and 3 percent for the first half. At the same time, with interest rates at record lows, there’s little downside risk to the investment portfolio going forward.

 

Despite these obstacles, Paychex managed to grow its total revenue by 4 percent over this six-month period, while total service revenue grew 7 percent. Because the company targets primarily small to medium-sized businesses and faces little competition from Automatic Data Processing (NSDQ: ADP), it was able to offset declining business by raising prices. In fact, service margins improved slightly during the quarter from 37.5 percent a year ago to 38.1 percent.

 

In addition to pricing power, Paychex has also benefitted from ongoing efforts to introduce and cross-sell ancillary services to its client base. The company’s retirement services segment has continued churn out impressive growth, bolstering revenues generated by its basic payroll processing business. Paychex currently services roughly one out of every ten 401(k) plans in the US, and the firm is seeking to leverage its size and reputation to increase the number of its clients that opt for this service. Over the first half of fiscal year 2009, the number of customers adding retirement services grew by 10 percent.

 

The firm has also ramped up efforts to expand its health and benefits offerings as well as workers compensation services: Revenues generated by the former segment in the first half nearly doubled from a year ago, while the latter’s client base increased 11 percent to 75,000.

 

Management has admitted that 2009 will be a rocky year for the company; it expects that net income will total 5 to 7 percent less than a year ago. However, the company’s bulletproof balance sheet, operational efficiency and established reputation put it in a strong position to weather these headwinds and thrive when the economy recovers.

 

At the end of its second quarter, Paychex had cash and total corporate investments of $479 million, and its cash flow from operations over this period totaled $328 million. A recently opened one-year revolving credit facility offers an additional $400 million in liquidity. This places the firm in a solid position to continue to meet its dividend obligations, and with the stock currently yielding slightly less than 5 percent, these payments will smooth over any gyrations the share price might experience.

 

In short, Paychex is a quality company whose pricing power and expanding menu of services offer considerable upside once the US economy rights itself.

 

WHY TO BUY
Paychex (NSDQ: PAYX, $25.32)
*Rising unemployment already priced in
*Pricing power and strong reputation position stock to rebound with the economy
*Attractive yield