Steady Payout From Paychex By Vishnu Lekraj | 06-27-12 | 06:00 AM | Email Article Paychex (PAYX) is among the best businesses we cover. The firm has produced returns on invested capital that have averaged well above 70% during the last 15 years, with the triumvirate of high customer switching costs, solid scale advantages, and a respected brand image providing a wide economic moat. We believe the stock is currently undervalued, giving investors an opportunity to gain a powerful return from a top-tier business. Paychex faced some harsh headwinds during the recent recession, which slowed its usually stellar performance and sent its stock reeling. The stock price has since recovered from trough levels, and we believe there is still more upside. During the recent recovery, poor new business formation and disappointing new client sales execution hampered the pace of recovery for the payroll processor. These factors disappointed many market participants and have held Paychex's stock from recovering more robustly. The firm's equity currently trades at about 80% of our fair value estimate; combining this with a healthy 4% dividend yield gives investors an excellent potential return. We believe the confluence of a moderately recovering employment market, more robust new business starts, and a retooled salesforce will provide a strong catalyst for further stock price appreciation. Potential for a Robust Investment Return A few months before the beginning of the recent recession (December 2007), Paychex's stock price hit a five-year high of around $45. However, during the heart of the following recessionary period, the stock lost 55% of its value, falling to a trough of $20. It has since recovered and now trades around $32. Even with this dramatic recovery, we still believe there is significant potential for more upside. The firm carries no debt, produces robust free cash flows, competes in a large and growing market, and possesses significant competitive advantages that will allow it to thrive over an extended period. We believe these factors are a recipe for future stock price appreciation. Our $38 fair value estimate includes assumptions for a moderate near-term recovery in the firm's operating environment, better new client sales execution, an extended period of low interest rates for high-quality paper, and solid long-term top- and bottom-line expansion. We believe a major near-term catalyst for improving results will be growth in checks per client, as each additional check processed is more profitable than the last. The scale factor of processing more payrolls is a key variable for Paychex, as profitability tends to follow the total level of client employees. Combining this dynamic with moderate new job growth should lead to good operating margin expansion. We also expect the total number of payroll clients serviced to increase. Driving some of this expectation is the firm's recent investment in a retooled sales staff. The other main variable relates to the pace of new business formation, which has been lackluster to say the least. With the credit markets tighter than historical levels, it was tough for new small businesses to form over the last several years. We believe the operating environment has improved for Paychex, and indications point to solid near-term results. This dynamic also should serve as a catalyst for stock price appreciation. Adding to the potential for a good capital return is Paychex's robust dividend. The annual dividend yield currently stands at 4%, significantly higher than most high-quality fixed-income investments. This dividend yield also provides a floor, in our opinion, as investors may find a mid- to high-single-digit return too appealing to pass up. Combining the potential for solid capital appreciation with a robust dividend offers one of the best opportunities to gain an excellent return from a high-quality business.