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Improving Jobs Situation Brings Upside Potential to Paychex

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Rising employment rates should help boost the shares of PAYX as businesses begin to expand spending again.

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Paychex (NASDAQ:PAYX) offers a wide range of services for business, including payroll processing and tax services and outsourced human-resources solutions.

Major drivers for growth are business creation and labor expansion-areas that have been constricted in recent years. Paychex has managed to show growth in per-share profits in the last two years despite tough conditions in its markets, and earnings growth should continue in fiscal 2013 ending in May.

Paychex has not been the most dynamic stock in recent years. These shares fell 2.6% in 2011 and rose only 3.3% in 2012. In fact, the stock has been locked in a trading range for the better part of the last four years.

To be sure, the yield of 4% has helped take some of the sting out of the sluggish price action. But 2013 should be a better year for the stock.

I expect employment numbers to take a turn for the better this year, a major plus given the company's payroll processing and human-resources services. And I think the interest-rate environment, especially in the second half of 2013, will be a bit more to the company's liking.

I'm probably in the minority, but I think you will see surprisingly strong economic activity this year, which should help drive better labor numbers. That works to the advantage of Paychex, as it will increase the number of checks processed.

Another trend I see happening-and, yes, I'm in the minority on this one as well-is an increase in interest rates. Why are higher rates helpful for Paychex? Because of the firm's payroll and tax-paying services, Paychex holds lots of funds for clients. The interest on these client funds accrues to Paychex.

The problem is that the extremely low interest rates of recent years have limited the interest income. For the three-month period ended November, Paychex had an average balance of more than $3.2 billion in client funds held. For the quarter, it earned only 1.2% on those funds, down from 1.4% in the year-earlier period.

While I don't expect interest rates to skyrocket in 2013, I do think better-than-expected economic growth will provide some upward pressure on rates in the second half of year (which coincides with the first two quarters of Paychex's fiscal year). And given the volume of funds held by Paychex, even a small increase in rates would have a meaningful impact on the bottom line.

The other bullish side to the story is the company's dividend yield. The firm typically pays 33 cents per share quarterly, giving the stock an indicated dividend yield of 4.1%.

However, it is important to note that Paychex, like a lot of firms in 2012, accelerated 2013 dividend payments into 2012. Thus, Paychex shareholders will not receive dividends in the February and May quarters of 2013.

The good news is that the combination of an improved bottom line and strong balance sheet-the firm has no long-term debt-should fuel a modest dividend increase in the second half of 2013.

Paychex is not a cheap stock-the shares trade at 20 times the fiscal 2013 estimate of $1.60 per share-but I do believe there is upside potential if a few things fall in place in 2013. I think downside risk is cushioned a bit by the dividend yield.

Please note that Paychex offers a direct-purchase plan whereby any investor may buy the first share and every share directly from the company.


Editor's Note: This article was written by Charles Carlson of DRIP Investor.

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No positions in stocks mentioned.
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