Paychex Should Keep Cashing In

Screen No. 2: Sustainable Competitive Advantage

The reason Paychex has authentic earnings power is that it enjoys at least four sustainable competitive advantages (my second screen). And the more sustainable competitive advantages, the better. They are:

High switching costs. Once a company becomes a Paychex client, it's a hassle to switch to a competitor.

Pricing power. Because Paychex has "sticky" clients, management can raise prices without losing lots of customers. (In contrast, many airlines and gas stations lose customers when they raise prices.)

Financial muscle. Paychex has a long operating history, a positive net worth and a debt-free balance sheet, and it generates lots of defensive profits (free cash flow) and earns a high return on capital (enterprising profits).

Management. Paychex was founded by Thomas Golisano in 1971 with just $3,000 and one employee. Today, CEO Golisano owns 10% of the company, which is worth about $1 billion. Because Golisano owns such a large slug, it's unlikely he'll do something stupid. (I like that last year's deals were paid in cash, rather than diluting current stockholders by issuing additional shares.)

Screen No. 3: Reasonable Valuation

My third and final screen is the Croesus Test. This tells me how fast earnings have to rise for me to get a 15% total rate of return every year. (To learn more about the Croesus Test, click here.)

The math goes like this. At the close of business yesterday, Paychex had a market value of $12 billion. Therefore, if I buy the entire company today and want to earn a return of 13.6% a year (with the other 1.6% coming from dividends), then Paychex's market value in year 10 must be $43 billion. If I then sell the company to another Croesus for, say, 17 times earnings, then year 10 accrual profits (net income) must be $2.5 billion. In 2003, Paychex earned $293 million. That means earnings have to go up 8.6 times, or 24% a year, for the next decade.

Can this happen? Perhaps. In the last decade, Paychex's earnings went up 15 times. Also, the company still has lots of room to grow. In a CNBC interview this summer, Golisano said Paychex has just 6% of the market.

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Of course, the company will eventually outgrow its natural market. All companies do. Also, for a variety of factors, it'll be hard for Paychex to continue to do so well. If you study many highflying companies from earlier periods, you'll find they almost always "regress to the mean."

What to Do?

If you own Paychex, stay put. If you don't own Paychex but want to, then consider making a "starter" position. This will force you to keep studying the business. Then buy more stock a year from now. If it's down without any deterioration in the underlying business, you'll be happy, because you're getting a better price. If the stock price is up, you'll be happy, because you have some capital gains. Either way, you're happy.

(A confession: I read Williams' book several times when I was a kid, and I still sat on the bench!)

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman didn't hold any securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].

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