weiwentg (98.34)

Paychex: another undervalued, predictable, wide-moat business

November 18, 2008 – Comments (1) | RELATED TICKERS: PAYX

Continuing with my new theme of predictable businesses, I'd like to highlight Paychex, a payroll outsourcing company that primarily targets small and medium businesses. The value proposition that such firms offer is undeniable, especially for Paychex's customers, because it allows companies to focus on their core business.

I think Paychex has an economic moat for the following reasons. Switching costs are high. Paychex has relatively low capital requirements. As a bonus, Paychex generates a float from operations - companies pay it lump sums, and it gets to hang onto them for a short time. Paychex has been a very conservative investor.

In addition, Paychex generates strong cash flows and has no debt. Margins have been in the high 30%s, probably driven by their considerable pricing power. And I still think there's room for growth in the industry. 

Although small and medium businesses are less stable than larger ones, Paychex still seems to have done OK. Its Gurufocus business predictability grade is 5 stars, meaning that it has grown EPS very steadily. The company's free cash flows have also shown steady growth. As I mentioned in a previous post, I think there are several ways where EPS can be distorted. However, I don't think that's the case here. Management has taken opportunities to grow the company outside of its core business, but I see no reason to believe they're being aggressive with their numbers. Paychex is a very steady business, and I think its undervalued today.

Josh Peters of Morningstar owns this stock in the Dividendinvestor builder portfolio. Josh Peters owns it in the Hare portfolio. This means that Morningstar, for what its worth, also has a high degree of confidence in the stock. They expect it to grow faster than the S&P 500, and to steadily grow its dividend as well. Oddly enough, none of the investors tracked by Gurufocus have been buying Paychex. The last trade they record was by Primecap, and they sold out in the quarter ended 6/30. ADP runs a similar business for larger corporations. Although they only get 2.5 stars for business predictability, I think investors could also do well with ADP.