By Vishnu Lekraj
Paychex (PAYX) is among the best businesses we cover. The firm has produced returns on invested capital that have averaged well above 70% during the last 15 years, with the triumvirate of high customer switching costs, solid scale advantages, and a respected brand image providing a wide economic moat. We believe the stock is currently undervalued, giving investors an opportunity to gain a powerful return from a top-tier business.
Paychex faced some harsh headwinds during the recent recession, which slowed its usually stellar performance and sent its stock reeling. The stock price has since recovered from trough levels, and we believe there is still more upside. During the recent recovery, poor new business formation and disappointing new client sales execution hampered the pace of recovery for the payroll processor. These factors disappointed many market participants and have held Paychex's stock from recovering more robustly. The firm's equity currently trades at about 80% of our fair value estimate; combining this with a healthy 4% dividend yield gives investors an excellent potential return. We believe the confluence of a moderately recovering employment market, more robust new business starts, and a re-tooled sales force will provide a strong catalyst for further stock price appreciation.
Potential for a Robust Investment Return
A few months before the beginning of the recent recession (December 2007), Paychex's stock price hit a five-year high of around $45. However, during the heart of the following recessionary period, the stock lost 55% of its value, falling to a trough of $20. It has since recovered and now trades around $32. Even with this dramatic recovery, we still believe there is significant potential for more upside. The firm carries no debt, produces robust free cash flows, competes in a large and growing market, and possesses significant competitive advantages that will allow it to thrive over an extended period. We believe these factors are a recipe for future stock price appreciation.
Our $38 fair value estimate includes assumptions for a moderate near-term recovery in the firm's operating environment, better new client sales execution, an extended period of low interest rates for high-quality paper, and solid long-term top- and bottom-line expansion.
We believe a major near-term catalyst for improving results will be growth in checks per client, as each additional check processed is more profitable than the last. The scale factor of processing more payrolls is a key variable for Paychex, as profitability tends to follow the total level of client employees. Combining this dynamic with moderate new job growth should lead to good operating margin expansion.
We also expect the total number of payroll clients serviced to increase. Driving some of this expectation is the firm's recent investment in a retooled sales staff. The other main variable relates to the pace of new business formation, which has been lackluster to say the least. With the credit markets tighter than historical levels, it was tough for new small businesses to form over the last several years.
We believe the operating environment has improved for Paychex, and indications point to solid near-term results. This dynamic also should serve as a catalyst for stock price appreciation. Adding to the potential for a good capital return is Paychex's robust dividend. The annual dividend yield currently stands at 4%, significantly higher than most high-quality fixed-income investments. This dividend yield also provides a floor, in our opinion, as investors may find a mid- to high-single-digit return too appealing to pass up. Combining the potential for solid capital appreciation with a robust dividend offers one of the best opportunities to gain an excellent return from a high-quality business.
Unyielding Competitive Advantages
High customer switching costs, inherent scalability, and a respected brand image are the main drivers of Paychex's steep competitive advantages, which we believe form a potent combination that will last for some time to come. Switching from one payroll processing vendor to another is very difficult, as revamping a critical aspect of a business' human resources process is an arduous activity. This in-elasticity has enabled the firm to raise prices annually and expand profits. Strong scalability also has allowed the firm to be price-competitive without feeling margin pressure. Capital expenditures are minimal, and automation helps keep a lean operating structure. The firm's strong brand also plays a role as clients are hesitant to entrust their critical HR functions to an unproven competitor. Competition in the payroll processing industry is minimal, and we foresee no erosion to the firm's competitive position.
One explicit example of Paychex's competitive advantages is its ability to raise payroll services prices annually. Revenue per client employee per month has increased every year apart from 2011, when the firm faced some sales execution issues. These issues seemed to be resolved, and we expect the usual pricing growth to resume.
The cost of rolling over a critical part of a firm's back-office operations most likely far outweighs any pricing benefit a competitor could offer. The security of entrusting payroll processes and funds to a proven and trusted partner is also a very compelling factor working in Paychex's favor.
In terms of revenue, Paychex is the second-largest payroll processor behind
Automatic Data Processing (ADP). Despite its dominant position, we believe there is a good growth runway for Paychex, as we estimate it has captured only about 9% of the small and medium-size business market, a niche we believe will grow at a solid clip over an extended period.
In addition to new client growth, cross-selling also will drive a material amount of expansion for Paychex. The firm is able to offer a plethora of ancillary HR services, including 401(k) administration, benefits administration, and compliance tracking. Paychex also has the capability to offer a professional employer organization service, with which the firm is able to take total responsibility for all HR activities (operationally and legally).
Other ancillary HR services have grown from about 11% of total operating revenue (revenue excluding float) to about 30% of total operating revenue since fiscal 2000. We believe this percentage will continue to grow as Paychex is able to more efficiently cross-sell these ancillary products and clients demand a more all-encompassing HR outsourcing process. In our opinion, this dynamic is highly positive, as each additional service sold to a client contributes a material amount of profitability and also further locks the client into the firm's grasp. The combination of a growing target market and increasing cross-sells provides a smooth runway for growth.
We Believe This Wide-Moat Business Provides an Advantageous Opportunity
Like most employment services firms, Paychex's stock price fell significantly during the last recession. However, we believe market participants unduly lumped this stalwart business in with less formidable players. Despite its employment-related services, Paychex's results do not fluctuate nearly as much as a typical HR outsourcer. Instead of relying on the marginal growth in employment (which can vary enormously during an economic cycle), operations are driven by the aggregate level of employment (which does not vary greatly during an economic cycle).
In addition, Paychex stumbled slightly during the recent recovery, as it was unable to execute its sales operations on par with expectations. Exacerbating this dynamic was a poor market for new business formation market. These factors have kept the firm's stock price from recovering to 3-star territory like that of main rival ADP. Accordingly, we believe investors have an opportunity to gain excellent capital returns and a robust dividend yield from a wide-moat business that is able to continually churn out returns on invested capital around 70%.
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