Shares of Paychex Inc. are poised to outpace the broader market as the prospect of higher interest rates and more job creation will buoy the payroll-service provider.
The company generates income from the interest earned on money it holds for clients, a so-called float, so rising Treasuries yields are “pure gravy” to its net income, said David Yucius, who oversees $250 million in assets as president of Aurora Investment Counsel Inc. in Atlanta. Paychex stock has lagged behind the Standard & Poor’s 500 Index, amid a backdrop of low rates and slow job growth for small- to medium-sized business in the past five years, he said.
Shares of the Rochester, New York-based company have risen 51 percent since April 3, 2009, trailing the S&P 500’s 119 percent increase. The yield on 10-year U.S. Treasuries -- at 2.6 percent as of 5 p.m. in New York yesterday, according to Bloomberg Bond Trader data -- is down from as high as 4 percent in April 2010.
Paychex manages about $4 billion in client funds as well as approximately $800 million in its own corporate investments, Chief Financial Officer Efrain Rivera said in a phone interview. About half that total is invested in longer-term securities and approximately $400 million to $500 million in this portfolio matures and re-prices each year, so if the yield on 10-year Treasuries increases by 25 basis points, or 0.25 percentage point, that translates to an additional $1 million in annual income, he estimated.
By year-end, the yield will be 3.4 percent, according to the median forecast of economists surveyed by Bloomberg. Such an increase, driven in part by the Federal Reserve tapering its bond-buying program, would serve as a tailwind for Paychex, Yucius said, adding that central bank Chair Janet Yellen’s Feb. 11 testimony to the House Financial Services Committee underscored her plans to continue reducing asset purchases.
A boost from higher rates will coincide with an improving economic backdrop marked by more hiring, according to Walter Todd, who oversees about $950 million at Greenwood Capital Associates LLC in Greenwood, South Carolina. These are “positive dynamics” for certain stocks like Paychex, which his firm doesn’t hold, though it does hold Automatic Data Processing Inc., another payroll-service processor, he said.
Gross domestic product grew at a 2.4 percent annualized rate in the fourth quarter, marking 11 consecutive quarters of gains, though the increase was less than the government’s first estimate of 3.2 percent, data from the Commerce Department show.
February hiring, scheduled to be released March 7, rebounded to 150,000 from 113,000 in January and 75,000 in December, according to the median estimate of economists surveyed by Bloomberg and Labor Department data.
All this is making Paychex’s valuation more compelling for some investors, Yucius said. The stock currently is trading at a multiple of about 14 times on a price-to-earnings basis before interest, taxes, depreciation and amortization, he said. That’s below the 10-year average of about 16.
In addition to benefiting from its cyclical exposure to the labor market, this “very solid” company also is expanding offerings to existing clients, said Jeff Silber, an analyst in New York at BMO Capital Markets. Paychex’s fastest-growing business segment is professional employer organization, he added. This allows businesses to have Paychex handle some or all of their human-resource and staff-benefit operations.
These new services have lower margins than Paychex’s core business, which is growing at only about the same pace as GDP, so this could “impinge profitability” for the company, said Matthew Beesley, who helps oversee about $125 billion as head of global equities in London at Henderson Global Investors Holdings. This creates a dilemma because Paychex is trying to expand in less-profitable areas while facing increased competition in payroll-service processing, he said.
Analysts’ consensus estimates for Paychex earnings have lagged behind their forecasts for companies in the S&P 500 Index. In fact, the Paychex estimate has been “dead in the water” for the past 12 months -- basically unchanged at $1.70 a share for the fiscal year ending in May, Beesley said. This will need to change for Paychex stock to outpace the market.
Silber maintains a market-perform recommendation on the company, partly because the impact of rising long-term rates on Paychex’s longer-term securities already is built into its valuation, he said.
Meanwhile, the balance of its client and corporate investments are in a short-term portfolio, which probably won’t see a boost until the Fed starts raising its benchmark federal funds rate, Silber said. Economists forecast the rate on overnight loans among banks will remain unchanged at 0.25 percent through the end of 2014.
Even so, Yucius and Todd agree investors may be wise to consider Paychex stock now, before it’s obvious that rates are going higher. In the meantime, the company also pays a “juicy yield” of about 3.4 percent on an indicated annualized basis, Yucius said, adding that “investors are being paid to wait for a change in the macroeconomic drivers.”
Paychex’s cash dividend of 35 cents a share for the quarter ended Nov. 30 was up 6 percent from the year-ago period, company data show.
Paychex also has protected its margins by maintaining market share in a mediocre environment, which is attractive to prospective investors, Yucius said.
“If you’re of the opinion that interest rates are going to rise along with small-business hiring, this is a company that’s exposed to that,” he said. “For the valuation and the yield, it’s a bet that probably will pay off.”
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