Paychex

Paychex (PAYX) provides payroll, and related human resource and employee benefits outsourcing for small- to medium-sized businesses in the United States. As of May 31, 2008, the company served approximately 572,000 clients in the United States. Paychex was founded in 1971 and is headquartered in Rochester, New York.

Payroll is probably the oldest outsourced function. There are several good reasons for this: all the different withholdings make it complicated, penalties for making mistakes are severe, the cost of outsourcing is low (dare I say cheap) and payroll is not close to a core function for most businesses. So Paychex’s core business is well established and doesn’t seem to be at any risk of being supplanted by either new technology or tax simplification. The company has used payroll as an entry point to offer a variety of additional services from 401(k) plans to insurance to HR functions. So the company has two ways to grow – find new customers and sell additional services to existing customers.

At a price of $21/share, Paychex trades at 14x expected earnings and yields over 5.9%. The company has no debt. The business is not capital intensive. If Paychex generates $600 million of free cash flow this fiscal year (less than FY08) it has a free cash flow yield of 8%, most of which investors receive through dividends.

Paychex is also an interesting play on short-term interest rates. The company collects money from clients every payroll period but holds cash for payroll taxes until the taxes are due. Rising short-term interest rates benefit Paychex as it earns more on this float. Float was over $3.5 billion at 11/30/08. So a 1% increase in short term interest rates increases earnings and free cash flow by approximately 3.5%.

We think Paychex represents an attractive business offered at an attractive price.

(Disclosure: Harvest Financial Partners owns Paychex in its client portfolios. The author owns Paychex in his personal portfolio. Positions may change at any time.)