Anyone who has either owned or worked for a small/medium sized business has probably at least heard of Paychex (NASDAQ:PAYX): the behemoth within the payroll processing space. Along with Automatic Data Processing (ADP) and TriNet (TNET), Paychex is considered one of the market leaders in the industry. With a name that resembles "pay checks", it's quite common for one to think of the company as solely a payroll processor. However, people are generally not aware that PAYX also offers HR, retirement, and insurance services as well.
Along with the competitors mentioned above, Paychex creates a one-stop-shop of administrative services that millions of clients require on a weekly basis. Since the market is mostly fragmented past the few main competitors, these giants within the space receive the majority of the market share. So, if they do ultimately the same things, what makes Paychex stand out from ADP and TriNet? For a start, it's their target market. ADP's clients are generally huge companies with many employees like IBM (IBM), Ford (F), and Xerox (XRX). For that reason, ADP is touted as the biggest in the industry. On the other side of the spectrum, Paychex targets small- to medium-sized businesses, of which there are over 28 million in the U.S. alone. TriNet's claim to fame is its HR services, not payroll.
Businesses with payroll-intensive needs often stumble upon Paychex one way or another, and end up adding the other ancillary services. For those reasons, PAYX has effectively developed a niche for itself: small- to medium-sized businesses with a full spectrum of administrative needs. It's no doubt all three companies are incredibly well positioned for a bright future. With that being said, in our eyes, Paychex is special. We believe the company is a quality company with superior financial ability, solid managerial execution, favorable macroeconomic conditions, and potential to be a profitable long-term investment.
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Basic Data
(1) Proven ability to create consistently strong cash flows year after year. Paychex operates on a subscription-based business model with which a company can customize its subscription based on its needs. The services offered by the company include: payroll, tax services, 401(k)s and employee benefits, HR administration and compliance, and time and labor solutions. That being said, PAYX enjoys handsome revenues with relatively low associated cost of revenue. As shown in the following graph, Paychex's 10-year average gross profit % floats around a very attractive 70%.
- In thousands
Historical Income Statement Excerpts
The source of Paychex's revenue is reportedly changing. Since 2005, Paychex cited nearly 100% of its revenues based on subscriptions of payroll service. However, according to its most recent investor presentation (as of May 31st, 2015), the company attributes roughly 39% of its yearly revenue to its growing HR service platform… but more on this later.
Along with consistent revenues, Paychex reports growth in yearly net income, as well as EPS, as shown by the graph below. Consistent revenues, different sources of revenue, and annually increasing net income and EPS offer the kind of financial strength that one hopes for in any company.
"With product expansion and technology innovation as our foundation for growth, it's our sales and service execution that leads to consistently strong financial results. I'm really pleased with how Paychex employees performed over the past year, which in turn powered the company's performance… Our core payroll, SurePayroll, retirement services, and HR solutions sales teams generated strong new business revenue." - President and CEO Martin Mucci in 2013 Annual Report
(2) Lack of short- and long-term debt. Paychex has zero debt in an industry where the average debt-to-equity ratio is 13.9x, which gives it a measurable advantage over competitors. With its Software-as-a-Service or "SaaS" business model, Paychex is capable of operating with a neutral balance of debt. SaaS companies typically do not accrue debt through their low capex-intensive natures; therefore they have a certain dimension of financial stability that many other companies cannot replicate. That being said, Paychex has the ability to keep a healthy current ratio (always at least 1).
Because its business is Internet-based, PAYX operates with a low fixed cost structure while adding an important, but often overlooked advantage: customer convenience. Since the company is all Internet-based, clients have the ability to access the majority of Paychex's services 24/7. The accessibility is a huge competitive advantage against boutique firms that may not have an automated system or be able to offer one with twenty-four hour capabilities.
Although this point about debt is quite straightforward, it is very crucial to the overall health of the company. After all, a safe company is often more desirable than a risky one.
(3) Record client retention rates and high (tangible and intangible) associated switching costs. According to the 2013 annual report, Paychex reported an 81% level of client retention from its beginning client base; in its words, a "record level of client retention." Notably, in 2013, they also received the highest rates of client satisfaction in their history, which they, "believe is a result of [their] focus on providing high-quality service to [their] customers utilizing leading-edge technology to maximize client retention." The company notes its dedication to customer satisfaction and acknowledges that in the past it has received less-than-perfect reviews for some of its services.
Paychex has a huge advantage that value investors should pay attention to: high switching costs. Microsoft (MSFT) has consistently profited from this simple concept since its start. In the face of switching payroll and HR services, a customer faces the burden of (1) learning how to use a completely new user interface, (2) switching all of the internal payroll processes (bank account routing numbers, employee accounts in which money is transferred to, etc.), and (3) the tangible cost of the new software/service from a local brick and mortar payroll service company. When the customer considers all of the tangible and intangible costs involved, they often find the hassle/costs of switching prohibitive.
(4) High growth potential within its emerging HR segment.
As shown in the pie charts above, Paychex's revenue streams are fundamentally changing y/y. Because it started out as a payroll outsourcing company, the company is often thought as a leader within only that space. However, we can see from the 2014 chart on the left to the 2015 chart on the right that its HR segment is starting to grow at a more robust rate than the already mature payroll processing segment.
"Our ancillary services provide services to employers and employees beyond payroll, but effectively leverage payroll processing data and, therefore, are beneficial to our operating margin. eServices ancillary services are often included as part of the SaaS solutions for mid-market clients. The following statistics demonstrate the growth in certain of our HRS ancillary service offerings:
The combination of our market-leading SaaS solutions combined with our service model allows us to offer a unique value proposition in the market." - Martin Mucci - Quotes from Annual Report '13 and graphs from Investor Relations Presentation '15
Macro Trends?
The growth in the HR segment, coupled with the record high client retention rates, offers a new horizon for Paychex. It can also be speculated that with higher financial and healthcare related regulatory measures instituted by the Obama administration and the "Affordable Care Act," Paychex has the potential to further increase its growth.
The reasoning is as follows:
With added regulation from the government in the financial and healthcare sectors, there is more of a hassle for small- to medium- size companies (which also happens to be the target market for Paychex) to operate in congruence with these regulations. Companies will most likely look to outsource these complexities because the opportunity cost of invoking the services of a company such as Paychex is much lower than that of hiring a team of experts. Large companies may opt to employ the latter strategy, as they have many more employees to worry about; however, companies with 1-1,000 employees will most likely seek a service to which they can outsource the looming headache that goes along with said regulations.
Note: Companies with 50 or fewer employees will not be financially responsible for healthcare or healthcare-related costs of its employees.
(5) A seasoned management team capable of maintaining attractive returns.
Paychex's management team is dedicated to raising money for its stockholders. Over the history of the company, PAYX has consistently brought in impressive ROE, ROC, and FCF/S in good times and bad (including the 2008 recession)
Paychex has:
- Generated $34.00 of earnings for every $100 of shareholders' equity
- Created $18.88 for every $100 invested
- Maintained a 9.58% average ROA over the past 5 years
- Created positive annual free cash flow for the trailing 10 years
(6) Solid dividend payout rates on a quarterly basis. Paychex has paid cash dividends since 1988. Dividends are normally paid in August, November, February, and May. The company has been able to increase its cash dividend on a regular basis for the trailing 10+ years (disregarding the anomalous $0.66 payout in 12/2012). In 2013, dividends of $476.7 million were paid to stockholders, representing 84% of net income.
In 2012, Paychex's board of directors authorized the purchase of up to $350 million of its common stock expiring on May 31st, 2014. The company reported the purchase total of $249.7 million of common stock (approx. 6.2 million shares) over the 2-year period. In May 2014, the board approved a new stock repurchase program that authorizes the purchase of up to $350 million of common stock (expires May 31st, 2017).
(7) Fair valuation given its financial ability and opportunity for healthy growth. It is important to highlight one very important fact: Paychex has sustained incredible financial strength over its lifetime of existence. Revenues have risen nearly every year for the last 10 years while the margin has remained consistently within 3% of 70%. EPS has only decreased on an annual basis 2 out of the last 10 years while FCF/S has remained positive for all of those 10 years.
Paychex is a premium company that is selling at a somewhat premium price, but the underlying value of the company lies in its consistency and growth potential. The company is predicting a great potential for growth in its HR segment. On top of the financial stability and upside potential, the current consistent dividend growth should be factored in as well. Stocks of this caliber should be included in portfolios in order to dilute risk. In a recession, a heavy dividend payer such as Paychex can offer some shelter as it has in the past (keeping its steady quarterly dividend of $0.31 throughout 2008 and the following few months). Should the company maintain its forward EPS growth and continually generate positive FCF yields, the management team should be able to create future value for its stockholders. In short, Paychex is a winner.
To Recap:
Paychex is a quality company with (1) a proven ability to create consistently strong cash flows year after year, (2) lack of short- and long-term debt, (3) record client retention rates and high (tangible and intangible) associated switching costs, (4) high growth potential within its emerging HR segment, (5) seasoned management team capable of maintaining attractive returns, (6) solid dividend payout rates on a quarterly basis, and (7) fair valuation given its financial ability and opportunity for healthy growth.
