Update With New Trade Sept 25th, 2012: Last night PAYX reported Q1 results that appeared to be mixed as they missed on sales, but beat on earnings due to tight cost controls, leading many analysts to label the quarter of poor quality.
Citi downgraded the stock this morning from Neutral to Sell, lowering their 12 month price target to $30.50…….here are some highlights from their note to clients:
-Key Takeaway(s) — Following PAYX’ mixed 1Q13 results (lower revs, better margins) and the recent rally in the stock (+17% since early June), we are downgrading the stock to Sell from Neutral. PAYX appears on track to report another year of mid-single digits revenue and EPS growth, yet the stock has reattained its premium valuation of ~21.5x FY13E P/E. While we appreciate PAYX’ high quality business model and attractive dividend, the company has had difficulty attracting new clients (the main driver of long-term growth) and the outlook for the two key external contributors (US employment, interest rates) remains poor. Lastly, recent results and trends indicate that PAYX will continue to make its EPS number through better margins as revenue may continue to disappoint – we expect this could impact the multiple investors are willing to pay. Therefore, we are downgrading PAYX to Sell while maintaining our $30.50 price target.
-Mixed 1Q13 Results, Steady Guidance — PAYX reported 1Q13 revenue of $578 mil, which was ~1% below consensus ests. Organic service revenue growth slowed to ~3% from ~5% sequentially due to overall client growth constraints, lower PEO growth and tough comparisons. Margins improved vs. last year and were ahead of expectations – ex-interest margins topped 40% for the first time ever as expense growth was just ~2%. EPS of $0.42 split Citi/consensus of $0.43/$0.41 as the better margins offset the weak top-line results. EPS grew ~3% y/y, down from ~4% last quarter. Following the results, PAYX maintained its service revenue growth guidance of 5%-6%, though the low end of the range seems more likely after this quarter. Net income growth of 5%-7% seems safer given the better margins.
-Pushback to Our Call — As our call is partly valuation based, the argument that PAYX’ stock has never been cheap is valid. That said, we see limited near-term catalysts for the stock given our expectation for meager job growth and low interest rates. A dividend increase in October is likely also expected. A buyback is possible long-term, but unlikely near-term based on management comments recently.
Volatility, which was fairly low going into the earnings event has fallen a few points in October and November but stayed around the same level in December, which catches the company’s next earnings. If the stock continues to see selling pressure, or if the December earnings become a highly anticipated event for the company, some of these options will appear to be priced too cheaply in hindsight.
MY VIEW: Given the poor quality of the results, my strong feeling is that another consecutive quarter of similar results could cause a reversal of much of the stocks 12% ytd to gains. With options cheap I want to buy Dec Put Spreads to position for future disappointment predicated on their Q2 results due Dec 20th. To be fair, given the results and the 2 downgrades (UBS downgraded from Buy to Neutral), the stock acts pretty well, SO I want to look for a low premium way to have this exposure over the next 2.5 months.
TRADE: PAYX ($33.67) Bought the Dec 32 / 30 Put Spread for .35
-Bought 1 Dec 32 Put for .61
-Sold 1 Dec 30 Put at .26
Break-Even on Dec Expiration:
-Profits btwn 31.65 and and 30, make up to 1.65 or 4.7x my money, max gain of 1.65 at 30 or below, down about 11%.
-Losses of up to .35 btwn 31.65 and 32, and max loss of .35 at 32 or higher.
Trade Rationale: My sense is that this stock is up for all the wrong reasons in the last few months. With the company so exposed to U.S. jobs growth, I see potential risks to the ytd performance with the stock so near 52 week highs on any signs of further stagnation on the employment front. I was already leaning to have short exposure prior to last night’s report, and to be frank, Citi’s downgrade doesn’t add much to my decision, as much of their reasoning is on valuation.
Original Post Sept 24th, 2012 at 2:20pm: Quick Earnings Preview: PAYX
Event: PAYX: report fiscal Q1 after the close tonight.
-Implied move in the options market is only about 2% vs the 4 qtr & 8 qtr avgs of only about 2%.
-Stock is up about 14% ytd, trailing the SPX by a little less than 2%, but trading within 1% of new 52 week highs.
-Stock is also quickly approaching a level that it has not traded above since Sept 2008.
-Sentiment in the stock is fairly mixed with only 6 Buys, 17 Holds and 5 Sells with an average 12 month price target of about $32.30 (below where the stock is trading).
-Balance sheet fairly solid, with no debt
-While the company’s exposure to the U.S. employment woes would be an obvious investor concern, the stock’s 3.6% dividend yield has clearly buoyed the shares. This demand by yield investors has pushed the valuation, at least on a simple PE basis to possibly stretched levels at about 22x 2013 earnings on expected growth in the mid to high single digits for the next 2 years.
Volatility: PAYX has historically had cheap options from an implied vol perspective. Even going into earnings the options only trade in the high teens. Meaning any outside moves in an event can be bought fairly cheaply. Below is a graph showing the IV and HV graphed against a yearly average of the IV and HV.
The yellow and pink lines represent the IV360 and HV360 which average in the low 20’s. Monthly IV and HV (red and blue)get as low as mid teens during quiet times, but rarely trade above the 20 mark for extended periods.
MY VIEW: I don’t have any particular insight into PAYX’s business, as stated above, with the sort of earnings growth expected and the obvious sensitivity to U.S. employment, the stock would not be where it is without that Dividend yield. But with Vol where it is, it is not expensive to take a directional view, and certainly not expensive to hedge stock. I guess the vol market is telling you that there is no reason to hedge your stock.
With the stock nearing some long term resistance, I would suggest that it would take a meaningful beat and raise print tonight to get the stock through such levels. Selling the move seems bit silly though, as it is cheap. SO that leaves me with having to pick a direction, which given my quick look at the story it would likely to be a bit contrarian. A friend of mine whom with I discussed the name earlier (a very smart options trader at a big institution), who also knows little about the company agreed that the move looks cheap given where the stock is, and the macro backdrop, but it his inclination to stick with what is working in a situation like this. I couldn’t argue one way or the other, but most of you know I am usually looking down in situations like this.
Looking at trades into the close, will update the post and send out if anything sticks out to me. As far as today’s activity, there appears to be a buyer of the Oct 35 calls for .40, 3300 have traded so far today, the most active option in all expireys for the stock[/private]