As Steady a Paycheck as You'll Find

06/02/2009 1:00 pm EST


Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, and analyst Vishnu Lekraj say payroll processing firm Paychex offers reliable growth and a stable dividend.

Paychex (Nasdaq: PAYX) is one of the most successful human resources outsourcing firms in the US.

Paychex is the second-largest player in the payroll outsourcing market (based on revenue), and it can leverage its 572,000 clients to spread costs associated with its servicing infrastructure. The firm’s strong brand also plays a significant role, since clients are hesitant to entrust their critical HR functions and payroll cash to an unproven competitor. The combination of these factors has produced margins that have been well above 30% during the past five years.

High customer switching costs, inherit scalability, and a respected brand image [help keep the firm’s economic moat wide] and form a potent combination that will last for some time to come.

Switching from one payroll processing vendor to another is very difficult, and customers’ unwillingness to do so has allowed Paychex to build a relatively sticky client base, raise prices annually, and expand profits.

Contributing to these returns is the firm’s focus on servicing small and medium-sized businesses, having left the servicing of larger firms to Automatic Data Processing (NYSE: ADP). The focus on smaller client servicing does give more fluidity to the firm’s client base, but it also gives Paychex more pricing power and a greater ability to expand operating margins.

[Paychex and ADP] have left each other alone, for the most part, to exploit different parts of the payroll outsourcing market. This has been good, in our opinion, because excessive profit-draining competition has been avoided and both firms are able to reap the rewards. Providing other HR-related services to its customers is currently a main focus of the company, and we believe this strategy can add significantly to profitability.

Paychex [also] is one of the leading providers of 401(k) record-keeping services, and it also provides services in the workers’ compensation insurance and total HR outsourcing markets. Revenue for these noncore services has grown to be about one-fourth of total revenue. With very small incremental costs associated with these ancillary services, most of this additional revenue flows to the bottom line.

Paychex’s dividend payout ratio, currently in the low [80% area], could be a major concern if the company didn’t have such a strong balance sheet (no debt and more than one year’s worth of dividends in cash). It helps, too, that earnings and cash flows are only modestly sensitive to economic conditions.

Though Paychex has little room to expand its payout ratio further, we believe it remains committed to returning the bulk of its cash flow to shareholders through dividends. We expect five-year average revenue of 8% and operating profit growth of 9% and expect a similar pace of dividend growth.

From a yield of [around 4.5%], Paychex is priced for total returns in the low to mid- double digits, in our view. (It closed at around $28.50 Monday—Editor.)

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