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A Tale of Four Stocks: There Will Be Winners and Losers

This week we review four stocks. First we review one of our stalwart blue chip holdings that is currently trading at a discounted price thereby providing an attractive entry point for long-term investors. Next, we provide a checkup on an attractive small cap growth company we own that provides cloud-based payroll processing services, and has the potential to easily double in price and/or get bought out at an attractive premium. And finally, we provide some additional insights on Yahoo and how the stock price of its eventual acquirer could first fall and then rise significantly.

The stalwart blue chip holding is American Express (AXP). AXP is this week’s investment idea (you can read the full report here). We believe the market is overly pessimistic on AXP following last years “challenges,” and now it trades at a significantly discounted price relative to its enormous long-term value. If you are a long-term investor that likes lots of price appreciation and a decent dividend yield (1.9%), now is a great time to consider initiating (or adding to) your American Express position.

The small cap company that we own that provides cloud-based payroll processing services is Paylocity (PCTY). This is a company that has been growing revenues over 40% per year, and it has the potential to keep growing at a rapid pace for many years to come. Currently revenues are only $210 million per year, but the company estimates the total market to be upward of $9 billion. For reference, Paylocity competes for payroll processing business from small and mid-sized companies, an there is no clear leader in the space. There is a handful of competitors all racing to gather as much market share as possible, as quickly as they can, because the customers are loyal (it’s a pain and expensive to switch your payroll once you’ve got it set up).  Eventually the companies in this space will stop spending heavily on new business, and their very high margins will essentially turn them all into cash cows.

One way we value Paylocity is based on its future price-to-sales relative to similar larger companies. For example, if Paylocity grows revenues at 40% for the next seven years then its revenues would be $2.2 billion (still a small percent of the addressable market cap), and it price (market cap) to revenues ratio would be less than one (0.94) which is in the range of larger peers such as Paychex (1.7) and ADP (0.89). What makes this even more compelling is that Paylocity has the potential to growth much beyond this revenue run rate suggesting the price could (and should) go much higher. And considering Paylocitys cloud based system is better for small- and mid-size companies than what ADP is able to offer, ADP may eventually look to acquire Paylocity as a means to grow. This would help Paylocity’s price rise even faster (because they’d get bought out at a premium).

Another way to value Paylocity is simply its high gross profit margins. Paylocity’s cloud-based software as a service (SaaS) solution has a over 60% gross margins. And once they stop spending heavily on sales (which they’re doing now to grow) they’ll turn into a cash generation machine. If Paylocity turns into a $2.2 billion company with 60% gross margins and 30% net margins they’d have $660 million of net income per year, and a small 12 price earnings ratio would make the company worth $7.9 billion thus giving the stock roughly 280% upside!

Paylocity doesn’t currently pay a dividend because it’s using all its cash to grow. And it also tends to be a more volatile stock. It was down then up quite a bit this year already. If you are a market-timer (which we don’t recommend) then you might want to wait for a pullback. But if you are like us, you know the stock price is already far too low relative to it’s intrinsic value, and if you buy now you’ll probably be very happy in 5 to 7 years.

*You can view our previous write-ups on Paylocity here.

Finally, we consider this week’s free stock of the week, Yahoo. As we wrote about here, we believe Yahoo’s leadership has been truly horrible stewards of shareholder capital and they’ve destroyed tremendous value. To make things worse, they seem to now be ready to sell Yahoo at a bargain basement price to either a private equity firm or someone like Verizon or AT&T.

The word on the street is that Yahoo is likely to go to Verizon. We believe this is a great fit because Verizon really needs the cash flow (to help grow its dividend), and Verizon management has what it takes to make the tough decisions in cutting costs to the bone (that’s what they already do at Verizon anyway, you can read our previous write-up about this here). We believe if Verizon acquires Yahoo, Verizon’s price will initially fall (as is usually the case when a bigger company acquires a smaller one), and we also believe this may provide an excellent entry point for long-term, dividend-hungry investors to buy Verizon. We believe Verizon has what it takes (leadership) to maximize Yahoo’s value. We’ll be watching closely in the coming weeks and months to see who “gets” Yahoo!

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