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The February quarter is normally a stronger quarter for Paychex ( PAYX), as the company generally benefits from yearend items, such as bonus checks and new contracts, which start with the beginning of the calendar year. So it's no surprise that revenue estimates for the quarter have crept slightly higher over the past few weeks, indicating that the Street is expecting a solid report.

PAYX is scheduled to report its third-quarter 2006 earnings results after the market closes March 28. The company will host a conference call to go over the results at 10:30 a.m. EST March 29. The current consensus estimates call for the company to produce EPS of 31 cents on revenue of $426 million.

The company reports revenue along three distinct segments:
    1. Payroll, which comprises about 80% of the revenue and includes functions such as processing payroll checks, tax filings, etc., is expected to post growth around 10%.
    2. Human resource services represents about 10% to 15% of the company's overall revenue. This segment has experienced solid growth in the 20% to 30% range as small businesses outsource this function to PAYX.
    3. The interest on funds held (investment portfolio) segment only represents about 5% to 10% of the company's overall revenue but has experienced very strong growth due to increasing rates.

Advice for the Stock

Recently, management has made some presentations suggesting that January was strong and the company was able to attract a number of new contracts. Management has also expressed comfort in its ability to retain current customers -- something the company has done a good job of for some time now. Also, the company continues to benefit from the Fed's decision to keep raising short-term rates, which allows the company to generate higher returns from the float in its investment portfolio.

With all these tailwinds, you can probably expect a decent quarter out of PAYX. Therefore, the key to the call will be management's guidance and commentary on the outlook. We shouldn't expect the interest rates to increase much further, so growth here might be leveling off. While the human resource segment should continue growth above 20% for a while, it is slowing somewhat as it becomes a more important piece of the revenue mix. Finally, the payroll segment is dependent on the overall strength of the economy and growth in the job markets.

I would characterize the valuation as fair. At about 30 times forward estimates, the stock is not cheap. However, the company has pretty strong fundamentals and will probably provide upside guidance, so I wouldn't be a seller just yet. But given the slowing growth rates in some of the company's key segments over the next six to nine months, I would be hesitant to initiate a new position here and would advise current holders to put this issue on your list of stocks to sell at the appropriate price.
At the time of publication, Thomas held no positions in Paychex.

Ben Thomas, CFA, is the portfolio manager for a technology oriented mid-cap hedge fund. Prior to this, Ben was a portfolio manager and senior equity analyst for Invesco. There, he was responsible for managing the firm's Midcap Growth portfolio as well as the firm's technology research efforts. Prior to Invesco, Ben worked for Banc One Securities and Prudential Securities. Ben graduated from the University of Kentucky with a degree in finance and went on to earn his MBA from Indiana University. He serves on the board of directors for the CFA Society of Louisville and is a member of the CFA Institute.