Invest Like Buffett With This 'Free Money' Company

Nathan Slaughter's picture

Wednesday, March 10, 2010 - 2:39pm

by Nathan Slaughter

Most businesses hate to see rising interest rates. Higher rates make it more expensive to borrow money. Not every business though. This company welcomes and profits from increases in interest rates.

Paychex (Nasdaq: PAYX) collects payroll for its clients' employees, and sits on the money for a while before disbursing it to its rightful owners on payday. During this lag time, the company is free to invest that cash on its own behalf -- much like Berkshire Hathaway (NYSE: BRK-B) puts its insurance "float" to good use.

Paychex basically gets to invest with free money.

Unfortunately, abysmally low interest rates have eaten away at the interest income from these short-term investments. During fiscal 2009, the company's $3.3 billion portfolio of AAA-rated government agency bonds generated a yield of 2.2%, resulting in interest income of about $75 million. That's a steep -43% drop from what it earned in 2008 thanks to an unprecedented low federal funds rate of 0.25%.

Before the financial crisis hit, rates were sitting at lofty levels above 5.0%. With the economy back on its feet and inflationary pressures looming, rates should begin marching higher in the second half of 2011 -- potentially doubling that $75 million in interest income to $150 million in just 18 months.

That's just icing on the cake for Paychex.

Every day, millions of workers receive their wages, either via paycheck or direct deposit. The process may seem simple and straightforward, but there's more to it than meets the eye. Time sheets may need to be validated, payroll taxes have to be calculated, and deductions for health care premiums and retirement account contributions must be withheld.

Crunching the numbers and making sure employees are promptly and accurately paid can be an expensive and time-consuming undertaking. That's where Paychex comes in. The firm handles these outsourced operations for 540,000 businesses around the world -- reducing expenses, eliminating bookkeeping headaches, and giving companies more time to do whatever they do best.

There's another reason to love Paychex -- it holds the cards in negotiations. These smaller businesses, representing 98% of Paychex's client base, have little negotiating power and are conditioned to annual price increases. There is usually little incentive to switch vendors -- which gives Paychex a very sticky customer base.

And there's still plenty of business for Paychex to capture. Only 10% of the estimated 11.5 million businesses located where Paychex operates outsource their payroll.

As you might expect, the moribund labor market has dampened the firm's growth prospects lately. Last year, the number of clients from new business fell -19%, while the number lost to companies going out of business rose by a similar percentage.

Even under these difficult economic conditions, Paychex managed to grow revenue (albeit by just +1%) and produce record operating income, while dishing out 85% of its profits as dividends.

P.S. Anyone who bought Paychex when we recommended it for our "Growth Portfolio" is up +20.5%. If you liked my article and recommendation today, I encourage you to learn more about the rest of the stocks in that portfolio. Combined, the 11 stocks in that portfolio are up an average of +96.7%. I'll be making my next recommendation in the coming days, don't miss it.

Nathan Slaughter does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.