“The wonderful aspect of investing during economic downturns is that to find bargains you needn’t ferret out dinged up companies that have alienated investors. Instead you have your pick among excellent companies with strong futures. This month’s selection, Paychex, Inc. (PAYX, Nasdaq) is as good as they get: a dominant player in the payroll services sector, a debt-free balance sheet, loads of potential for future growth and a 4.6% yield. Why is a deal like this just sitting there? Any idiot could answer that: the most corrosive aspect of this recovery from recession is the lack of job creation. ... In this environment, why own shares in a company that is a proxy for employment levels? From our perspective, what better time could there be to buy them?
“Automatic Data Processing (NYSE: ADP) is the big dog in payroll services. With a $20.6 billion market cap and $8.9 billion in sales, ADP markets primarily to medium and especially to large size companies. Paychex, which has a market cap of $9.9 and $2 billion in sales, plays a similar role for small businesses. Of its clients, 41% have 1-4 employees, 41% have 5-19, 12% have 20-49, 4% have 50-99 and 2% have 100 or more employees. Though both companies will prosper in any recovery scenario, Paychex, because it focuses on smaller companies, the most dynamic portion of the business world, has a greater potential source of clients. ...
“The more time we spend looking at how the payroll services business operates, the more impressed we are by what a profit-generating machine it is. The costs for running an efficient operation are modest and the incremental costs for adding new clients and services are also small. Capital expenditures for Paychex over the years have never been more than 5% of sales. Paychex is a cash cow, and management has never been reluctant to distribute it to shareholders. From 1994 until 2009 Paychex had increased its dividend from 1 cent to $1.24. [Furthermore, Paychex generates interest income from funds held for clients.] But with a slack economy, the amount of funds held for clients has declined and cut into interest revenue. The real problem, however, has been the low interest rate environment that is normal during economic slowdowns, but which has Paychex—like the rest of us—watching interest income collapse. ...
“Paychex’s share price (adjusted for splits and dividends) peaked in late 2000 at $47.39 along with what was the greatest bull market and economic expansion of our lifetime. During that boom, PAYX’s revenues had rocketed averaging 18.6% annual growth—and that included the 1990-1991 recession. Since that peak, the adjusted share price has been as low as $16.62 in August 2002 as the economy and market were heading for a bottom, and as high as $40.91 just before the market began its decline in late 2007. When the market did bottom in March 2009, PAYX closed just over $19, which is to say that investors sour on Paychex during and in the immediate wake of recessions. What we are seeing with Paychex is a pattern defined by the business cycle.
“PAYX has come back with the rest of the market, but has lagged. The S&P 500 since March 9, 2009 has risen almost 70%, while PAYX has advanced 40%. It’s hardly rocket science (nor is it damning) that a company whose revenues are inextricably tied to business vitality and expansion would shed accounts, revenues and shareholders during tough times, nor is it surprising that most investors would remain wary until they had unequivocal evidence that robust growth had returned. After the economic drubbing we’ve absorbed since late 2007, investor skepticism is at its deepest. ...
“But for value-oriented investors who understand the business cycle, even at its current price, PAYX is trading at very attractive valuations. Going back to 1990, every standard price ratio currently is well below its historical average: Price/Sales is at 4.9 versus an average low of 6.4. Price/Cash Flow is at 17.5 versus an average low of 24.8. Price/Earnings is at 20.6 versus an average low of 30.7. Price/Book is at 7 versus an average low of 8.8. ...
“This is a classic ‘buying-straw-hats-in-winter’ opportunity that offers considerable potential for capital appreciation as well as a yield nearly twice that of the 10-year Treasury. We recommend buying shares up to $32.”
Gray Cardiff, Sound Advice, 10/8/10
