Bet on the Unemployment Rate: Invest in Small Business Through PEOs

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The rate of unemployment is a well known lagging indicator of the economy. For instance, many market experts have predicted that the stock market has already hit a bottom and is currently in a consolidation phase. However, the unemployment rate is still expected to inch higher in the coming months before stabilizing. In contrast, the stock market is a leading indicator of the economy. As a case in point, since the March lows, the S&P 500 index has rallied approximately 30%.

One way of betting on the unemployment rate is investing in small businesses. They make up more than 99% of all US employers. In this recession, they suffered owing to the credit freeze among other reasons. In March this year, President Obama set aside approximately $375 Million to bolster small business lending in the form of loan guarantees. It is expected that this program would help existing small business (not to be confused with small capitalization stocks) expand and grow.

Since these companies are not publicly traded, an investor can gain exposure to this sector and participate in its anticipated growth by investing in Professional Employee Organizations (PEOs). PEOs provide payroll, human resources, healthcare and other benefits to small businesses. When a company hires a PEO, in effect, the PEO becomes the legal employer of the employees within this company. Thus, the small business owner can concentrate on running and expanding his/her business instead of dealing with legal, administrative and other issues facing his company.

By aggregating the employees of many businesses, a PEO can often offer better rates on health and workers' compensation insurance, while giving employees big-business-style benefits. (Source – Fortune Small Business)

In this article, I will compare two major PEOs operating in the US, namely Administaff, Inc. (ASF) and Paychex, Inc. (PAYX). Administaff is pure PEO play and is one of the largest PEOs in the US. Paychex is a larger company and serves both small and medium sized businesses. The table that follows summarizes the basic information for these companies. It should be noted that a direct comparison of company fundamentals is not recommended as Paychex has other divisions in addition to its PEO division.

Company Fundamentals

	ASF	PAYX
Market Cap (Millions)	$603.6	$9,700
Sales (Millions)	$1,730.3	$2,106
Income (Millions)	$40.54	$548
Net Profit Margin	2.5%	26%
Return on Equity	20%	45%
P/E	16	18
Projected 5 Year Growth Rate	15%	12%
Forward PEG	1.23	1.57
LT Debt to Cap	0%	0%
Current Ratio	1.3	1.12

The revenue and income generated by the PEOs is a function of the number of ‘worksite employees’ under its control. At the end of Financial 2008, Administaff had 116,957 worksite employees and it generated a net profit of $33 per employee. According to Administaff, the operating income per worksite employee exceeds industry averages by approximately 151%. This data for Paychex was not available since Paychex is comprised of several other divisions in addition to the PEO. With the reduction in unemployment rates and the growth in small businesses, the number of worksite employees for these companies would increase, thereby improving the net income of the PEOs.

The EPS estimates for the two companies are shown the table that follows:

	ASF	PAYX
TTM EPS	$1.59	$1.52
2009 Average EPS Estimate	$1.25	$1.50
2010 Average EPS Estimate	$1.38	$1.46

Valuation

Relative valuation was performed for the two companies using the 2011 average analyst EPS estimates. The fair value is presented in the table that follows. It should be noted that the data from the last four financial years was taken in calculating the averages shown in the table.

	ASF		PAYX
	Average	Fair Value	Average	Fair Value
P/E	23	$29	28	$42
(P/E) / (P/E – Peers)	0.79	$24	1.00	$37
(P/E) / (P/E – S&P 500)	1.08	$23	1.35	$34
PEG	1.38	$33	1.88	$34

The Call:

Administaff, Inc.

I am initiating coverage of Administaff with a HOLD rating and a price target of conservative 12-month price target of $25 derived by applying a PEG of 1.2. At these levels, ASF would be trading at a multiple of 18 below its historic averages.

Paychex, Inc.

I am initiating coverage of Paychex, Inc. with a HOLD rating a 12-month price target of $29. At these levels, PAYX would be trading at a P/E of 20 and a PEG of 1.66, modestly below its historical averages.

I have a target entry point of $20 for ASF and $23. These companies appear safe bets to double in value in the next five years. For example, the stock price of ASF can be expected to double in five years if ASF grows at an annual rate of 12%. This growth rate is below the analyst average forecasted rate of 15%.

Disclosure: The author does not own a position in the companies listed in this article. His company (a small business) is an Administaff, Inc. client.