Paychex — How to Play Tuesday’s Earnings Report

Small-business human resource and payroll staffing company Paychex (NASDAQ:PAYX) reports earnings for the quarter ending Aug. 31, 2011, after the market closes Tuesday. With the job market in the doldrums and the economy stuck in neutral, don�t expect much from the report.

Big companies are doing just fine in this economy. Balance sheets are strong. More importantly, big companies can borrow money at extremely low rates — and they are using the cash to buy back stock. The situation is quite different for smaller companies.

Regulatory hurdles, fierce competition and increased operating costs make it difficult for small businesses to keep their head above water, and companies like Paychex that cater to small businesses are likely to struggle in such an environment. Plain and simple, growth prospects are not very promising at the moment.

Paychex has managed to meet or slightly beat expectations during the past four quarters:

In looking at the company’s performance, one gets the sense that Paychex is hanging by a thread. Will this be the quarter when investors begin to see the company disappoint Wall Street? Estimates for the current period have been rock-steady during the past 90 days. There is no sign from analysts covering the company that a miss is forthcoming. For the quarter ending Aug. 31, the average Wall Street estimate for profits is 38 cents per share.

For the current fiscal year ending May 31, 2012, the average estimate for profits is $1.50 per share. In the following year, profits are expected to grow by 9% to $1.64 per share. At current prices, PAYX trades for 17.5 times current-fiscal-year estimated earnings.

Thanks to a steep drop in share price in 2011, Paychex is trading for less than prices reached 12 months prior:

Although shares of PAYX have sold off significantly since May, they still are overvalued considering valuation and current economic conditions. It is difficult to see how this stock will move higher after it reports earnings results Tuesday. If anything, the most likely outcome for Paychex is a sharp selloff.

Paychex trades at a premium, going for more than 17 times earnings with profit growth anticipated to be less than 10%. We have seen many stocks, including FedEx (NYSE:FDX) last week, trade lower after reporting results that included lower guidance for the future. The same is likely to occur for Paychex.

It would be in the best interest of shareholders for management to paint a more realistic picture for this company given the current economic environment. Jobless claims still are above 400,000. Such a number suggests hiring still is anemic. That does not bode well for Paychex and certainly is not conducive to strong profit growth.

This is one of those moments when a stock could decline by 10% or more after reporting results. That would be my expectation when Paychex releases its earnings report Tuesday.