Evaluating Total Return Prospects For Paychex

Mar.27.13 | About: Paychex, Inc. (PAYX)

An Overview

Paychex, Inc. (NASDAQ:PAYX) processes payroll and offers human resource and benefit services to companies in the United States and Germany. They collect fees for these services, and also earn interest on funds held for their clients. The most similar publicly-traded company is Automatic Data Processing (NASDAQ:ADP).

Paychex seems fully valued today at around $34/share and 20X earnings, but when I run the numbers it looks like a buy to me. I only buy stocks that offer an attractive total return profile of 9-11% annually over the next 5 years. Obviously you want stocks that will continue to gain after 5 years, but trying to do any analysis more than 5 years out includes more guessing than I am willing to do. I view Paychex as being of the highest quality, so my threshold for buying would be the lower 9% hurdle.

So where does Paychex need to be 5 years from now to earn 9% annually? The short answer: $43.50/share

Now, let's take a brief glance at how that number is calculated:

Looking forward, we can expect the next full years worth of dividends to get 4% of the return. Given Paychex' history of keeping a somewhat steady payout ratio, and thus raising their dividends in line with earnings, over our next five years we will assume that 4% annual dividend return will hold. That means the stock price will have to make up for the other 5% a year.

$34/share * (1.05) ^5 = $43.50/share

We know what share price we need 5 years from now to earn our 9% annually, now let's figure out what we would expect the share price to be. With a company as stable as Paychex, there is one number we need to know five years from now to figure out a likely stock price: earnings per share. Let's start the process of figuring out what Paychex' 2018 earnings per share number will be.

Here is a quick chart of what I view to be the key metrics for Paychex' business. Service Revenue, Average Client Funds Held, Net Income, and Interest Earned were pulled from Paychex 2012, 2011, and 2010 annual reports. The other data points are numbers I calculated from that data, and are not specifically listed by Paychex in their financial statements.

Fiscal Year (Ended May 31)

2007

2008

2009

2010

2011

2012

Service Revenue

1752.9

1934.5

2007.3

1945.8

2036.2

2186.2

Service Income

381.3

444.3

458

440.7

467.2

504.4

Service Income Margin

21.75%

22.97%

22.82%

22.65%

22.94%

23.07%

Average Client Funds Held

3408.9

3323.3

3167.9

3350.3

3584.3

Interest Earned on CFH

134.1

131.8

75.5

55

48.1

43.6

% Earned on CFH

3.87%

2.27%

1.74%

1.44%

1.22%

Net Income

515.4

576.1

533.5

495.7

515.3

548

Click to enlarge

2010 includes one-time expense charge of $18.7 million added back into net income, all non-percentage values listed in million USD

As I noted above, Service Income and Service Income Margin are not numbers given by Paychex. So how did I calculate them?

First off, we need to make some assumptions about the Interest Earned on Client Funds Held (CFH), and the effect that has on Net Income. I assumed that Interest Earned on CFH translated 100% to Net Income. This seems a bit simplistic, but most of what Paychex invests these funds into is Municipal Bonds. Listed in their annual report is a benefit to their effective tax rate of 2.7%, 2.2%, and 1.8% for the years 2010, 2011, and 2012 from owning Municipal Bonds. Some quick calculations (which are not shown here) makes their tax rate on Interest Earned on CFH immaterial/negligible.

Additionally, I assume that operating expenses are essentially zero for earning this income. This takes more assumptions. However, Paychex and most other companies invest their current assets in these types of funds anyway, and therefore I assume there is zero/immaterial marginal cost to investing Client Funds Held. Lastly, I ignore investment income on Paychex' current assets as it has been trending around 1% of net income, and thus I consider immaterial for my analysis.

So:

Service Income = Net Income - Interest Earned on CFH

and

Service Income Margin = Service Income / Service Revenue

So what is the point? I feel like knowing the Service Revenue, Service Income Margin, Average Client Funds Held, and the % Earned on CFH in any given year will give you an accurate calculation of Net Income for that year.

The Projections

So what are these numbers going to be over the next 5 years? Let's take them one at a time.

Service Revenue:

Here is the last 10 years of Service Revenue for Paychex, 2002 Service Revenue numbers were used to calculate the 2003 Year-over-Year change but are not listed.

Fiscal Year 2003 2004 2005 2006 2007
Service Revenue 1046 1240.1 1384.7 1573.8 1752.9
% change Y/Y 17.24% 18.56% 11.66% 13.66% 11.38%
Click to enlarge

Fiscal Year 2008 2009 2010 2011 2012
Service Revenue 1934.5 2007.3 1945.8 2036.2 2186.2
% change Y/Y 10.36% 3.76% (3.06%) 4.65% 7.37%
Click to enlarge

(Service Revenue listed in millions of USD)

Service Revenue growth comes from a variety of sources. A growing population (more importantly a growing workforce) can lead to more business clients and more employee checks per business client. Existing payroll clients opting to use Paychex for benefits and/or other human resource needs also grows this revenue. Taking market share from competitors or buying smaller competitors also grows this revenue. Additionally, Paychex is able to raise prices at a rate equal to or above inflation given their sticky relationship with their customers.

I would peg a realistic Revenue growth estimate for the next five years at 6% per year. This includes a mix of additional revenues from cross-selling services, price increases, market share gains, and growth through acquisitions.

Service Income Margin:

Fiscal Year

2007

2008

2009

2010

2011

2012

Service Revenue

1752.9

1934.5

2007.3

1945.8

2036.2

2186.2

Service Income

381.3

444.3

458

440.7

467.2

504.4

Service Income Margin

21.75%

22.97%

22.82%

22.65%

22.94%

23.07%

Click to enlarge

(Service Revenue and Income listed in millions of USD)

Paychex' Service Income Margin has held remarkably stable over the last five years. This speaks to their business model. They have very low overhead, and are able to match increases in business volume with the appropriate level of personnel. The biggest outlier of the last 5 years was fiscal year 2010 which contained the most challenging employment market and still clocked in at 22.65%. For this reason I feel comfortable approximating this margin to be 23% for the next five years.

Average Client Funds Held:

Fiscal Year

2008

2009

2010

2011

2012

CFH

3408.9

3323.3

3167.9

3350.3

3584.3

% change Y/Y

(2.51%)

(4.68%)

5.76%

6.98%

Click to enlarge

(CFH listed in millions of USD)

With a limited window to look at, I will be content to conservatively estimate that the average Client Funds Held will grow in tandem with, but slightly less than Service Revenue. I will use a growth rate of 5.5%/year over the next five years.

% Earned on CFH:

Fiscal Year

2008

2009

2010

2011

2012

Interest Earned on CFH

131.8

75.5

55

48.1

43.6

CFH

3408.9

3323.3

3167.9

3350.3

3584.3

% Earned on CFH

3.87%

2.27%

1.74%

1.44%

1.22%

Click to enlarge

(Interest Earned on CFH and CFH listed in millions of USD)

This number is the real crapshoot. Paychex holds both short-term and intermediate-term (3-5 years) bonds, so changes in interest rates have an immediate, though somewhat diluted effect. Over the next 5 years I would expect interest rates to head back towards where they were in 2008, but not reach quite reach it. The % earned on CFH would remain below that until the portfolio fully cycled into higher yielding assets. I view my guess as good as any other so I will use 1.15%, 1.25%, 1.5%, 1.8%, 2.2%,and 2.6% for the years 2013-18.

Putting all of this into a chart:

Fiscal Year

2012

2013

2014

2015

2016

2017

2018

Service Revenue

2186.2

2317.4

2456.4

2603.8

2760

2925.6

3101.2

Service Income Margin

23.07%

23%

23%

23%

23%

23%

23%

Service Income

504.4

533.0

565.0

598.9

634.8

672.9

713.3

avg Client Funds Held

3584.3

3781.4

3989.4

4208.8

4440.3

4684.5

4942.2

% earned on CFH

1.22%

1.15%

1.25%

1.50%

1.80%

2.20%

2.60%

Interest Earned on CFH

43.7

43.5

49.9

63.1

79.9

103.1

128.5

Net Income

548

576.5

614.8

662.0

714.7

776.0

841.8

Click to enlarge

(all non percentage values listed in millions of USD)

Using a share count of 365 million (my estimate) for 2018 gets you $2.31/share of earnings for 2018. Valuing earnings at 20X would get a share price of over $46 for 2018. This would meet my 9% threshold.

Alternate Scenarios

There are certainly alternate scenarios that could play out with this stock to consider. In my analysis a full 14% of 2018 Net Income comes from Interest Earned on CFH. A lower available interest rate and/or changes in the climate that affects CFH could bring this number down considerably.

Looking at Service Revenue Year-over-Year changes shows that Paychex is resilient to a down-turn in the economy, but certainly not immune from it. A recession could slow or even turn Service Revenue growth negative and greatly undermine my valuation thesis.

Another scenario deals with a lower market-place valuation. While I believe 20X earnings to be an appropriate price for Paychex, a lower market valuation in the future could limit your ability to realize gains from owning Paychex.

There is also more upside potential in Paychex to consider as well. An acceleration of economic growth and Paychex' growth to a mid 2000's-level would lead to much higher earnings growth than what I have projected. Additionally, wage growth acceleration (which has been quite stagnant) could lead to a double-positive of both faster CFH growth and higher interest rates.

Conclusion

I consider what I have outlined to be a base-case (and a conservative one at that) scenario for Paychex hinging on a slow-growth US economy over the next five years. The total return prospects of owning Paychex are favorable and meet my 9% annual return threshold. I own Paychex and feel like at $34/share it presents an adequate if not compelling total return prospect over the 5 years.

Anything to add? Would you like to poke holes in my calculations, estimates or projections? Leave a comment.

Disclosure: I am long PAYX, ADP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.