Paychex, Inc.: Love The Company, Not The Price

| About: Paychex, Inc. (PAYX)

Summary

Paychex, Inc. reported total service revenue of $760 million (7% inc) for Q2 2017 and $1,533.5 million (8% inc) for six months ending November 30, 2016.

Adjusted diluted EPS of $0.56 (8% inc) for Q2 2017 and $1.12 (8% inc) for six months ending November 30, 2016.

While investors have been aptly rewarded over the years, Paychex is expensive with a forward P/E of just under 28.

Recommend “Hold” if currently long, and patience, if you’re interested in adding PAYX to your portfolio.

This post is longer than I would like to write. The reason for this, however, is that before I provide my thoughts on Paychex (NASDAQ:PAYX), I would provide some color as to my background and investment strategy. This is only my third post on Seeking Alpha and I suspect some readers have come away with the impression that I might be a "permabear" which is definitely not the case.

I am a Canadian resident who has recently had the good fortune of retiring at 56. After working many years in the Canadian banking industry (which I truly enjoyed 98% of the time), I realized that I had far fewer years of good health and energy than I had already enjoyed.

After years of diligently saving and investing, my wife and I have had the good fortune of building a portfolio which generates sufficient dividend income to support our lifestyle. Having said this, we are not yet at the stage where we are spending all our dividend income, and we continue to reinvest the same.

The day will soon come, however, where we will need to draw down on the funds within our retirement accounts. In Canada, we have what is known as Registered Retirement Savings Plan (RRSP). At some stage of the game, most people convert their RRSPs to Registered Retirement Income Funds (RRIFs). Since most Seeking Alpha readers are US residents, I won't go into detail on the terms and conditions of these plans. If you really have the urge to see what we Canadians have to go through, then go here. For all American readers, you probably have enough to worry about your IRAs, 401(k)s, etc.

While the vast majority of the Canadian population will wait as long as they can before converting their RRSP to a RRIF, we are in the position where if we don't start withdrawing from our RRSPs well before age 71, we will face a huge tax liability once we convert our plans (try close to 50% tax!). We must, therefore, strategically start withdrawing funds from our RRSPs well before the age of 71. A challenge we have, albeit good, is that the dividend income generated from our stock holdings within our non-registered and registered accounts is sufficient to more than offset the RRSP withdrawals we must start taking early.

Another good fortune we have had is that about a year before the economic meltdown, I became increasingly nervous about the stupidity that was going on in the real estate market in the US. While definitely not the wisest thing to do, I literally liquidated every single stock we held in our multiple accounts and sat on cash. It certainly was frustrating for the following year as stock prices kept creeping upwards but when the meltdown happened, I started deploying our cash. This was not done all at once but rather in drips and drabs. I also lucked out when, for the first time in ages, our Canadian dollar was almost at parity with the US dollar and was briefly above parity. That is no longer the case as we now need roughly $1.34 Canadian to purchase $1 US dollar.

Some readers might point out that we are being silly having 60-65% of our portfolio in US stocks since we get hit with a 15% withholding tax on all dividends generated from US-based companies (more than 15% on the ADRs we own) held in non-registered accounts (there is no withholding tax on dividends from US companies held within registered accounts), but I just HAD to buy shares in US-listed companies. You see, for those of you who are unfamiliar with the companies listed on the Toronto Stock Exchange (TSX), pickings are pretty slim; it doesn't really take long to go down the list of companies based on market cap to go "Ugh, are you kidding me?". Once you get past the major banks, the telecoms, and a handful of other companies, there are few companies that meet my investment criteria.

Another thing I would like you to consider is that at my stage in life, I will not invest in anything remotely speculative. I see several posts on companies that are far too risky for me. I need to be able to put my head on the pillow at night and get a sound night's sleep.

I also see several posts written by people who appear to be far brighter than me. They go into all sorts of technical analysis. This is wonderful because I learn a lot. While I don't mind reviewing 10-Ks, 10-Qs, proxy statements, investor presentations, etc., I just don't have the technical skill, nor the desire, to perform any form of technical analysis that would make members of the SA community proud.

Given my profile, this is why we invested in PAYX and intend to hold it for the long term.

Company Overview

Paychex, Inc. was founded in 1971, 22 years after Automatic Data processing (NASDAQ:ADP), its largest publicly-traded competitor, was founded. The founder's intent was to make payroll outsourcing easy and affordable for small businesses.

Paychex is less than half the size of ADP from a market capitalization perspective ($22.05B vs. $46.35B) as I compose this post on December 22, 2016. Despite being much smaller than ADP, PAYX is still formidable and has grown to more than 12,000 employees serving in excess of 1 million small to medium-sized businesses nationwide as per a December 1, 2016, news release. Another impressive statistic is that it pays one out of every 12 American private sector employees.

PAYX's operates from more than 100 locations in 40 states. This is a major difference between PAYX and ADP in that PAYX's business is almost exclusively in the US, whereas ADP has operations in multiple countries.

While PAYX has operations in Germany (four locations) and long-lived assets in Germany, the level of business it conducts in Germany is immaterial. It also has a joint-venture arrangement to provide payroll and human resource services in Brazil but, once again, revenue from these operations is not material.

Services offered by PAYX consist of:

  • Payroll processing
  • Human Resource Services
  • Accounting and Financial Services
  • Integrated human capital management (HCM) solutions for payroll
  • Retirement and insurance services

On December 22, 2015, PAYX completed its acquisition of Advance Partners, a leading provider of integrated financial, operational, and strategic services to support independent staffing firms. It offers customizable solutions to the temporary staffing industry, including payroll funding and outsourcing services.

PAYX generates revenue from its Payroll Services (PS) and Human Resources Services (HRS) lines of business.

Analysis

The following analysis has been prepared using PAYX's December 21, 2016, news release and second quarter highlights and financial results FY 2017 presentation as well as data from Morningstar, Inc.

Q2 Fiscal 2017 Results

PS revenue was $440.9 million, a 3% increase from the same period FY 2016. Advance Partners contributed approximately 1% to this growth.

HRS revenue was $319.1 million, an increase of 12% compared to the same period in the previous fiscal year. HRS revenue growth was primarily driven by increases in client base across all major Human Capital Management services, including comprehensive human resource outsourcing services, retirement services, time and attendance, and human resource administration. Advance Partners contributed approximately 2% to the growth of HRS revenue in Q2.

Source: PAYX's second quarter highlights and financial results FY 2017 presented December 21, 2016.

PAYX benefited from slightly higher interest rates, which resulted in interest earned on funds held for clients increasing 2% to $11.4 million in Q2 relative to Q2 FY 2016. This came about even though average investment balances held for clients were down 1% for the second quarter. Although there was client base growth, the lower average balances were more than offset by the impact of the timing of certain remittances to taxing authorities.

PAYX was negatively impacted by a 1.2% increase in the effective income tax rate from 32.9% to 34.1% (same six-month period FY 2016 and FY 2017).

Cash and short-term investments as at November 30, 2016, totaled $725.1 million, with normal business operations being the primary source of cash. Short-term borrowings amounted to $103.1 million. Cash flows from operations were $413.4 million for the first six months of FY 2017, which represents a 2% decrease from the same period in FY 2016. This decrease resulted mainly from fluctuations in working capital, partially offset by higher net income adjusted for non-cash items. Working capital fluctuations contributed $147.0 million of cash outflows for the first six months of FY 2017 compared with $111.5 million of cash outflows for the same period in FY 2016.

In the first six months of FY 2017, PAYX repurchased 2.9 million shares of its common stock for a total of $166.2 million. This represents an average purchase price of $57.31/share. During the same six-month period in FY 2016, it repurchased 1.3 million shares for $62.9 million for an average purchase price of $48.38/share.

Outlook For Remainder Of Fiscal 2017

PAYX provided the following outlook for the fiscal year ending May 31, 2017. This is based upon current market, economic, and interest rate conditions continuing with no significant changes. In addition to what is not reflected below, the effective income tax rate for fiscal 2017 is expected to be approximately 35%, which is slightly higher than that incurred YTD and the previous FY.

Source: PAYX's second quarter highlights and financial results FY 2017 presented December 21, 2016.

P/E Ratio

PAYX's historical P/E for 2008 - current is as follows:

2008: 16.74

2009: 22.37

2010: 22.73

2011: 20.21

2012: 20.19

2013: 28.28

2014: 26.08

2015: 26.31

Current: ~29.17

Dividends

Dividends have historically been paid to common stock shareholders in August, November, February, and May. On October 12, 2016, the Board of Directors declared a regular quarterly dividend of $0.46 per share which was paid November 22, 2016, to shareholders of record November 1, 2016.

Note: PAYX's Board of Directors decided to accelerate the distribution of its February and May 2013 dividend and same were distributed in December 2012. The above-noted dividends were obtained directly from the 10-K reports.

PAYX's historical dividend for 2008 - current is as follows:

2008: $1.20

2009: $1.24

2010: $1.24

2011: $1.24

2012: $1.27

2013: $1.31

2014: $1.40

2015: $1.52

2016: $1.68

Current: $1.84

Diluted EPS

PAYX's diluted EPS for 2008 - current derived directly from its 10-K and Thomson Reuters I/B/E/S Estimates report dated December 21, 2016, for the 2017 estimate:

2008: $1.56

2009: $1.48

2010: $1.32

2011: $1.42

2012: $1.51

2013: $1.56

2014: $1.71

2015: $1.85

2016: $2.09

2017 est.: $2.22 (22 brokers with a range of $2.20-2.24)

What is to like about PAYX?

  • It has a long-term track record of paying dividends, which implies that management is committed to paying a dividend regardless of the economic conditions.
  • It has a pristine balance sheet and a history of profitability and strong cash flow. If I were a business owner handing over my money to a third party to pay my employees, I would insist that the company be on solid footing. I don't want a payroll service provider that is loaded with debt.
  • It has negligible exposure to exchange rate and political risk and no exposure to environmental risk.
  • It is a well-known player in the industry and is third in size to ADP and Ceridian (privately-owned).
  • It is in a non-cyclical industry.
  • It does not have a huge dividend yield which, in my opinion, would be a "red flag".

What is to dislike about PAYX?

  • It is expensive relative to historical P/E and dividend yield levels.

Potential Covered Call Options Strategy

I do not profess to be an options expert and have restricted my options trading to the occasional covered call.

If I wanted to augment my return on the PAYX shares we own, I might write an out-of-the-money $65 June 2017 call, which is being bid at $1.05. The likelihood of me doing this, however, is remote. I am just happy to sit on our PAYX shares with no worry about our shares being called away if I am off doing something far more enjoyable than monitoring stock prices.

Conclusion

PAYX is a wonderful business and I highly recommend it as an investment... just not at the current valuation. I am very reluctant to invest any more money in PAYX at current levels and a forward P/E of 27.70 (current price $61.50/$2.22 EPS estimate from 22 brokers).

I recognize the new US President has promised job creation, which would be a huge positive for PAYX. In addition, if interest rates trend up, PAYX will generate additional income on client funds held on deposit.

I, however, sense an element of euphoria somewhat similar to the high tech bubble in 1999-2000 (although not to quite the same degree). I have witnessed the repercussions when people are willing to pay 30Xs earnings (and more). Some readers may say this time it is different. If this time it is different, so be it. If it is not different, then at least I have not stepped on a landmine.

An argument could be made that I should perhaps sell our PAYX shares if I feel they are overvalued. Very valid point considering they are held in a Registered Education Savings Plan (RESP) so the sale of same would attract no capital gains tax; the dividends do attract a 15% withholding tax. I, however, have no interest in parting ways with this company much like Warren Buffett and Charlie Munger had no intention of parting ways with Coca-Cola (NYSE:KO) when it was grossly overvalued in 1998. I don't even intend to sell these shares to fund our daughter's education although I will inevitably have to sell our PAYX holdings as there is a deadline by which I must liquidate the RESP. When this happens, I will just turn around and repurchase the same number of shares in a non-registered account.

I will patiently wait to add additional PAYX shares to those currently held and acquired at an average cost of $23.2771. Should PAYX experience a correction, which brings its shares to a more reasonable P/E multiple of 25 (or lower), I would consider buying. Using the consensus projected EPS of $2.22 provided by 22 brokers, I would be prepared to add additional PAYX shares if the price drops to about the $55 level (25 * $2.22).

Using a price of $55 and the current annual dividend of $1.84, I end up with a dividend yield 3.35%, which comes closer to the five-year trailing dividend yield of about 3.2%.

On a final note, I don't have any intention of posting any more articles until 2017. I would, therefore, like to wish everyone a Merry Christmas. Should you not observe Christmas, I still wish you the very best during the upcoming holiday season.

Here's hoping to a wonderful and prosperous 2017!

Disclosure: I am/we are long PAYX, ADP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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