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Time to Cash Your Paychex

March 25, 2009 | About:
Paychex, Inc. [NDQ:PAYX] March 25, 2009: $23.62

52-week range: $20.31 (March 3, 2009) - $37.47 (May 2, 2008)

Dividend = $0.31 quarterly = 5.25% current yield


Paychex provides computerized payroll-accounting, salary deposit, payroll tax payment, and tax return filing services to over 572,000 small and mid-size businesses in 36 states plus the District of Columbia. They also provide human resource product and services which account for about 24% of their top line revenues of about $2.1 billion.

This fiscal year’s earnings (years end May 31) are likely to show the first ever year-over-year decline in the company’s history due to the slow US economy and its accompanying decrease in total employee count among their customers. The share price has reflected this interruption in growth by falling about 50% from a 2007 high of $47.10 to today’s close of $23.62.

Paychex reported February quarter results today. They hit their estimate on the button at $0.36 this year versus $0.39 in 2008. FY expectations for the 12 months ending May 31 are now at $1.50 or down about 4.5% from last year’s figure of $1.57/share. While it represents their first down year ever that’s not a bad performance in such a poor environment.

The company has zero debt. Value Line rates their financial strength as ‘A’ and notes their stock price stability and earnings predictability are in the 90th and 95th percentiles respectively (with 100th being best). Their dividend yield of 5.25% is better than what’s available on bank CDs or long term treasuries.

At first glance the trailing P/E of 15.8x may not seem cheap. When you look backwards at the historical valuations for Paychex it looks like an absolute bargain. The 10-year median P/E is 41x and prior to this year the lowest multiple in the past 16 years was 2008’s 24.6x.

Here are the last six year’s numbers to illustrate the per share growth that led investors to pay premium prices for Paychex shares:

FY …...…. Rev …… C/F ...….. EPS ….... Div ….. B/V ….. Avg. P/E

2002 ….. 2.54 ….. 0.81 ..…. 0.73 ….. 0.42 …. 2.46 ……. 24.6x

2003 ….. 2.92 ….. 0.89 ..…. 0.78 ….. 0.44 …. 2.86 ……. 28.4x

2004 ….. 3.42 ….. 0.95 ..…. 0.80 ….. 0.47 …. 3.17 ……. 30.7x

2005 ….. 3.82 ….. 1.14 …... 0.97 ….. 0.51 …. 3.66 ……. 33.0x

2006 ….. 4.40 ….. 1.40 …... 1.22 ….. 0.61 …. 4.35 ……. 44.0x

2007 ….. 4.94 ….. 1.54 …... 1.35 ….. 0.79 …. 5.11 ……. 35.0x

2008 ….. 5.73 ….. 1.82 …... 1.56 ….. 1.20 …. 3.32 ……..24.6x

Once the economy shows even a hint of bottoming I expect these shares will revert back to at least an 18 – 20 multiple on what should be higher earnings. With just minor growth forecast for FY 2010 though I’m going to present a quite conservative way to play that doesn’t assume much reversion to the mean over the next 9- 10 months.


Here’s my buy and write combination for Paychex:

……………………………….................….…….. Cash Outlay …….............…. Cash Inflow

Buy 1000 PAYX @ $23.62 ………..........….. $23,620

Sell 10 Jan. 2010 $25 calls @ $2.15 ……………………….....................…... $2,150

Sell 10 Jan. 2010 $22.50 puts @ $2.95 …………...................…………….. $2,950

Net Cash Out-of-Pocket ………......................………....... $18,520


On the January 15, 2010 expiration date…

If Paychex shares are $25 or higher [up $1.38 or + 6% from today’s price]:

The $25 calls will be exercised.

Your shares will be sold for $25,000.

The $22.50 puts will expire worthless (a good thing for you as a seller).

You will have collected $930 from three $0.31/share dividends.

You will have no shares or any further option obligations.

You will hold $25,930 for your original outlay of $18,520.

That’s a profit of $7,410 or 40% cash-on-cash over less than ten months on shares that only needed to go up by 6% from trade inception.


On the January 15, 2010 expiration date…

If Paychex shares are unchanged from today’s price:

The $25 calls will expire worthless.

You will still hold 1000 shares worth $23,620.

The $22.50 puts will expire worthless.

You will have collected $930 from three $0.31/share dividends.

You will have no further option obligations.

You will hold $24,450 in cash and stock for your original outlay of $18,520.

That’s a profit of $6,030 or 32.5% cash-on-cash over less than ten months on shares that did not go up from trade inception.


What’s the downside?

On the January 15, 2010 expiration date…

If Paychex shares are below $22.50 [down $1.12 or – 4.8% from today’s price]:

The $25 calls will expire worthless.

The $22.50 puts will be exercised.

You will be forced to buy another 1000 shares for $22,500 more cash.

You will have collected $930 from three $0.31/share dividends.

You will now hold 2000 shares of Paychex.

You will have no further option obligations.

Your break-even on the trade would be calculated as follows:

On the original shares you bought it’s $23.62 less the $2.15 call

premium = $21.47 /share.

On the second batch of shares it’s the $22.50 strike price less

the $2.95 put premium = $19.55 /share.

Your overall cost per share would be the average of

$21.47 + $19.55 = $20.51 [not counting dividends received].

While I can’t guarantee that Paychex shares won’t be below $20.51 through next January 15th I can tell you that they’ve only traded below that price on one day since late 1999. In fact your break-even price would be lower than the lows in any year from 2000 right through 2008.

This combination play on this very high quality company offers a best case total return of 40%, a static return of 32.5% and a margin of safety of over 17% even if Paychex should decline by over $4/share.


Disclosure: Author is long Paychex shares and short Paychex options.

About the author:

Dr. Paul Price
http://www.RealMoneyPro.com
http://www.gurufocus.com/peter_lynch.php
http://www.TalkMarkets.com
http://www.MutualFunds.com

Visit Dr. Paul Price's Website


Rating: 3.4/5 (10 votes)

Comments

Dr. Paul Price
Dr. Paul Price premium member - 5 years ago
THURSDAY, JUNE 25, 2009

BARRON'S TAKE





Why Paychex Will Pay Off

By TIERNAN RAY - Barrons Online

The payroll and personnel services provider's earnings disappointed. But with a 4.8% dividend yield, the stock is a buy at current levels.

PAYCHEX (TICKER: PAYX) is having a tough time today.

Shares are 6% lower after the payroll and personnel services provider said last night that it missed estimates for its fiscal fourth quarter, ended in May.

You'd figure that investors would realize that a company that handles payroll will see things get worse before they get better with unemployment rising to a quarter-century high of 9.4%.

That said, the stock, despite looking somewhat pricey at about 18 times this fiscal year's expected earnings, can realistically rebound, especially considering that the stock's generous and rock-solid dividend provides a floor of sorts.

Despite a decline in its payroll business, the company generates massive amounts of free cash flow, after subtracting its investment in the business, which should ensure that its delectable 4.8% dividend yield remains unscathed.

With today's news from the Bureau of Labor Statistics that new claims for unemployment were higher than expected last week, it's no surprise that Paychex missed the $511 million revenue estimate for its fourth quarter and the 34-cent profit estimate. Sales fell 5% from a year earlier to $496 million and earnings came in at just 32 cents.

It's no surprise, either, that Paychex's outlook has dimmed considerably. The company expects its payroll-service revenue, which is three-quarters of total revenue, to decline 1% to 4% this fiscal year and net income to fall 10% to 12%, compared to expectations for a 1% increase in revenue and a 2% decline in profit.

Some investors clearly got ahead of themselves in their expectations for a rebound, with some analysts pumping up estimates for this year in recent weeks. But volume for June 27.50 puts was high in the middle of last month, which strongly suggested that many people knew the stock's rise from $20 in March couldn't last.

Despite the disappointment, the company managed to add 111,000 new clients last year even though the total client base declined 3%. Moreover, the company generated an astonishing $624 million in free cash flow on $2.1 billion in sales last year, a 30% yield.

The company paid out the vast bulk of that, $447.7 million, as a dividend. Even if the company sees revenue decline by 5%, as expected, it wouldn't have to cut much fat to maintain the dividend given that Paychex has no long-term debt and $473 million in cash and equivalents.

And when growth returns in the client base, there's a lot of leverage in the business. Margins are taking a hit this year, as indicated by the drop in net income, because fewer checks mean the gross profit on processing each check is lower for the company. In an upturn, that scenario should reverse itself.

And so we're back where we were when we wrote about Paychex in January at $25, which is that it's a real business with real customers paying a very attractive dividend that should fare well when labor markets eventually rebound. (See Weekday Trader, "Three Tech Stocks That Pay," Jan. 26, 2009.)

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