Paychex (PAYX) was founded in 1971 and focuses on payroll solutions, human resources and benefits outsourcing for small to medium-sized businesses. The business is fairly sticky once clients are brought into the Paychex ecosystem due to high switching costs pertaining to payroll needing to be right and on time. Once a business gets brought in the risk of switching to a different provider is high due to not wanting to upset their employees with inaccurate paychecks.

It’s been nearly a year since I last analyzed and initiated a position in Paychex so it’s time to take another look at what I believe is an excellent company. When I last examined the business the business appeared on the high side of fair value and since that time shares have delivered a paltry 2.05% return.

Dividend History

The majority of my capital is invested in companies that have a history of paying and growing their dividend payments. That means I’m primarily invested in established businesses that generate ample cash flow, some of which can be passed on to shareholders via dividends. A lengthy dividend growth streak is far from a guarantee that the business will continue on in the future; however, I do believe that it helps to weed out some of the potential pitfalls that are out there.

Paychex Dividend HistoryImage by author; data source Paychex Investor Relations

Paychex is a Dividend Contender with 10 consecutive years of dividend growth. Their streak had been longer; however, growth was paused during the Great Recession in 2007-09. While I want to see the businesses I own grow their dividends each and every year, I am a bit more tolerant of freezes of dividend growth especially given the severity of the situation during that time coupled with Paychex’s aggressive cash return policy as can be seen later with their elevated payout ratios.

Dating back to 1994, the year over year dividend growth rate has ranged from 0.0% to 80.0% with an average of 18.7% and a median of 10.5%.

Of the 22 rolling 5-year periods over that time, annualized dividend growth has ranged from 2.2% to 50.0% with an average of 18.1% and a median of 14.0%.

There’s been 17 rolling 10-year periods over that time and annualized dividend growth has ranged from 6.0% to 30.0% with an average of 16.1% and a median of 11.7%.

The 1-, 3-, 5- and 10-year period dividend growth rates since 1994 can be found in the following table.

Year Annual Dividend 1-Year DGR 3-Year DGR 5-Year DGR 10-Year DGR
1994 $0.04
1995 $0.04 0.00%
1996 $0.05 25.00%
1997 $0.09 80.00% 31.04%
1998 $0.13 44.44% 48.12%
1999 $0.18 38.46% 53.26% 35.10%
2000 $0.27 50.00% 44.22% 46.51%
2001 $0.38 40.74% 42.98% 50.02%
2002 $0.44 15.79% 34.71% 37.35%
2003 $0.45 2.27% 18.56% 28.19%
2004 $0.49 8.89% 8.84% 22.18% 28.47%
2005 $0.55 12.24% 7.72% 15.29% 29.97%
2006 $0.69 25.45% 15.31% 12.67% 30.01%
2007 $1.02 47.83% 27.68% 18.31% 27.48%
2008 $1.22 19.61% 30.42% 22.08% 25.10%
2009 $1.24 1.64% 21.58% 20.41% 21.29%
2010 $1.24 0.00% 6.73% 17.66% 16.47%
2011 $1.25 0.81% 0.81% 12.62% 12.65%
2012 $1.29 3.20% 1.33% 4.81% 11.36%
2013 $1.36 5.43% 3.13% 2.20% 11.69%
2014 $1.46 7.35% 5.31% 3.32% 11.54%
2015 $1.60 9.59% 7.44% 5.23% 11.27%
2016 $1.76 10.00% 8.97% 7.08% 9.82%
2017 $1.92 9.09% 9.56% 8.28% 6.53%
2018 $2.18 13.54% 10.86% 9.90% 5.98%
2019 $2.42 11.01% 11.20% 10.63% 6.92%
2020 $2.48 2.48% 8.91% 9.16% 7.18%

Table and calculations by author; data source Paychex Investor Relations

*Dividends are growth rates are based off calendar year payouts.

When investing in dividend growth businesses, the dividend payout ratio is a quick way to gauge the safety of the dividend payout from a potential freeze or a reduction.

Paychex Dividend Payout RatiosImage by author; data source Paychex SEC filings

As I mentioned earlier, Paychex was forced to pause their dividend growth, although they did maintain their dividend level, during the financial crisis. The reason they had to freeze it is because of the elevated payout ratio that Paychex carries in normal times.

The average payout ratio based on net income for the last 10 years is 82% and for the most recent 5 years it’s 80%. The average free cash flow payout ratios are 71% and 70%, respectively.

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Quantitative Quality

When I invest my savings into a business I try to take the approach of being a partner in the business which means I’m looking to own the business for the long haul. As such, my perception of the business quality plays a big role in the investment decision process in conjunction with the valuation currently offered in the market. However, before looking forward I like to see how the business has done across a variety of metrics over prior years.

Paychex Revenue Operating and Free Cash FlowImage by author; data source Paychex SEC filings

Over the last decade Paychex has shown solid growth with revenues climbing 99% in total or ~7.9% annualized. Top line growth has materialized through a combination of organic expansion as well as through acquisitions.

Operating income has grown 98% over the same time or ~7.9% annualized. Cash flow from operations rose 101% in total or ~8.1% annualized. Meanwhile, free cash flow grew 114% or approximately 8.8% annualized.

Paychex Margins Image by author; data source Paychex SEC filings

Paychex has maintained excellent gross margins with the 10-year average sitting at 70.2% and the 5-year average at 69.7%.

With operating and free cash flow both outpacing revenue growth over the last decade, it should come as no surprise that margins have increased. My preference is to see a free cash flow margin greater than 10% which Paychex has easily surpassed with a 10-year average of 29.8% and a 5-year average of 31.0%.

My profitability metric of choice is the free cash flow return on invested capital which represents the excess cash that could theoretically be pulled from the business based on the capital currently invested in the business.

Paychex Free Cash Flow Return on Invested Capital Image by author; data source Paychex SEC filings

Paychex has managed excellent FCF ROICs over the last decade with every year being greater than 30% which is well above my preference of at least 10% FCF ROIC. The 10-year average FCF ROIC sits at 41.8% with the 5-year average at 43.4%. Paychex’s FCF ROIC took a hit in FY 2019 due to the Oasis Outsourcing acquisition.

To understand how Paychex uses its free cash flow, I calculate three variations of the metric, defined below:

  1. Free Cash Flow, FCF: Operating cash flow less capital expenditures.
  2. Free Cash Flow after Dividend, FCFaD: FCF less total cash dividend payments.
  3. Free Cash Flow after Dividend and Buybacks, FCFaDB: FCFaD less cash spent on share repurchases.

Ideally, the business would be generating plenty of cash flow through its operations to support the entire capital allocation process including capital expenditures, dividends, buybacks and acquisitions. That means I want to see a positive FCFaDB over time; although, I’m not concerned about any year any particular that could be in the red since opportunities can be short-lived.

Paychex Free Cash Flows Image by author; data source Paychex SEC filings

Over the last decade, Paycheck has generated $8.77 B in cumulative FCF. That’s allowed management to return $6.17 B to shareholders through cash dividend payments and puts the cumulative FCFaD at $2.60 B.

With that $2.60 B in FCFaD management has further returned $1.08 B of cash in total via share buybacks. That puts the cumulative FCFaDB at $1.52 B for the entire decade.

When funded with internally generated cash flows, buybacks can be a wonderful way for companies to return cash to shareholders. Unfortunately, the $1.08 B Paychex has spent on share repurchases hasn’t done much to reduce the share count. Diluted weighted shares outstanding have only declined 0.4% in total over the last decade or ~0.04% annualized.

Paychex Shares OutstandingImage by author; data source Paychex SEC filings

Considering that’s ~12% of the cumulative FCF that Paychex has generated that’s pretty disappointing. The lackluster share repurchases suggests dilution from either stock-based compensation, $336 M in total over the last decade, or the various acquisitions that Paychex has completed.

As an investor in the equity portion of a business, the balance sheet is of crucial importance to protecting your investment. The reason being that debt introduces a level of risk.

Paychex had eschewed debt in their capital structure up until FY 2019 with the Oasis Outsourcing Acquisition accounting for much of the debt that is currently on the balance sheet.

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Paychex Debt to CapitalizationImage by author; data source Paychex SEC filings

Additionally I like to examine the debt ratios across EBITDA, operating income and free cash flow to see how quickly debt could be reduced if need be. Paychex’s debt-to-EBITDA, debt-to-operating income and debt-to-free cash flow ratios are at 0.5x, 0.6x and 0.7x, respectively, for the most recent fiscal year.

Paychex Debt RatiosImage by author; data source Paychex SEC filings

Valuation

For valuing potential investments, I use several methods to determine what I believe is a fair value range. The methods I use are the minimum acceptable rate of return, “MARR,” dividend yield theory and a reverse discounted cash flow analysis.

The MARR analysis requires you to estimate the future earnings and dividends that a business will generate, apply a reasonable terminal multiple on those earnings and then determine whether the expected return exceeds your hurdle rate.

On average, analysts expect Paychex to show earnings per share for FY 2021, ending May 2021, of $2.82 with FY 2022 EPS to be $3.06. Analysts also expect Paychex to show 3.4% annual EPS growth over the next 5 years. I then assumed that Paychex could manage 4.0% annual earnings growth for the following 5 years. Dividends are assumed to target an 80% payout ratio.

I like to use history as a guide to determine what the future multiple could be for Paychex. As you can see in the following YChart, market participants have typically valued Paychex’s TTM EPS between ~15x to 30x.

ChartData by YCharts

The following tables show the potential internal rates of return that an investment in Paychex could provide across the various terminal multiples given that the assumptions laid out above are reasonably close to how the future plays out. Returns include forecast dividends taken in cash and are calculated with a purchase price of $83.73, Friday’s closing price. Returns are run through the end of calendar year 2025, “5-Year,” and calendar year 2030, “10-Year.”

IRR
P/E Level 5-Year 10-Year
30 7.4% 7.2%
25 4.0% 5.5%
22.5 2.1% 4.6%
20 0.0% 3.6%
17.5 -2.3% 2.5%
15 -4.9% 1.3%

Alternatively, I calculated the required purchase targets in order to generate the returns that I desire from my investments, once again if the assumptions laid out above are reasonably close to what comes to pass. My baseline hurdle rate is a 10% IRR, but I will also examine 8% and 9% levels as well.

Purchase Price Targets
10% Return Target 9% Return Target 8% Return Target
P/E Level 5-Year 10-Year 5-Year 10-Year 5-Year 10-Year
30 $75 $67 $78 $72 $82 $78
25 $64 $59 $67 $64 $70 $69
22.5 $59 $55 $62 $59 $64 $64
20 $54 $51 $56 $55 $58 $59
17.5 $48 $47 $50 $50 $53 $54
15 $43 $43 $45 $46 $47 $49

Dividend yield theory is built on the concept of reversion to the mean. The idea behind this valuation method is that stable businesses can deviate from fair value, but over time will revert towards a fair dividend yield level. I’ll be using the 5-year average dividend yield as the proxy for the fair value of Paychex.

Paychex Dividend Yield Theory Passive Income PursuitImage by author; data source Paychex Investor Relations and Yahoo Finance

Paychex shares currently offer a dividend yield of 2.96% compared to the 5-year average yield of 3.16%.

I use a reverse discounted cash flow analysis as a reality check to see what the current share price implies about investors’ growth expectations. It’s a way to reverse engineer the expected cash flows that would be needed to support the current share price. I use a simplified DCF built on revenue growth, a static EBIT margin of 38.0% and one that increases by 10% over the 20-year period to 41.8%, a tax rate of 24% and a 4% terminal growth rate. I use both a 10% and an 8% hurdle rate to discount the cash flows back to the present.

In the 8% hurdle rate scenario with the static EBIT margin, Paychex needs to manage 4.5% annualized revenue growth to support the price. The required revenue growth drops to 4.2% to justify the current price for the 8% hurdle rate and 10% EBIT margin improvement. The required revenue growth for the 10% hurdle rate scenarios are 7.2% and 6.7%, respectively.

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Conclusion

Paychex is an excellent business with gross margins around 70% and free cash flow margins around 30%. That leads to gobs of excess cash flow that can be returned to shareholders and which management has been more than willing to do with a target of paying out 80% of net income.

Dividend yield theory suggests a fair value range between $71 and $87. The fair value based on the MARR analysis with a 10% IRR hurdle rate appears to be in the $50 to $60 range. While the fair value with an 8% IRR hurdle rate would be in the $60 to $70 range.

The reverse discounted cash flow analysis isn’t throwing up any red flags with 8% returns easily justified on what I believe would be low expectations. The possibility of 10% returns aren’t out of the ordinary either if growth can continue on at slightly lower rates as it has over the last decade.

A back of the envelope calculation for the compounding rate of the business using ROIIC and the reinvestment rate puts the business compounding its value by ~7-8% annually over the last decade.

What’s really amazing considering how hard small-to-medium sized businesses were hit during the COVID-19 lockdowns is that Paychex showed an increase for Q1 year over year from ~670,000 clients to >680,000. It’s not a huge increase, but it does show solid client growth when many businesses were forced to shutter.

The question then becomes what are the reinvestment possibilities. The payroll solutions and HR space is highly fragmented which is where the growth possibilities reside. According to the US Small Business Association, there are 31.7 M small to medium-sized businesses. Paychex is the 2nd largest player in the HR/payroll outsourcing space with 680,000 clients at the end of Q1 2021 or ~2.1% of the SMB’s out there.

In the Q1 2021 investor presentation, management is now expecting a bit of a rebound compared to their initial FY 2021 guidance. That’s good to see, even if expectations are still for declines across the board.

FY 2021 1st Quarter Investor Presentation

There’s obviously a risk that the small-to-medium sized businesses will struggle if the COVID-19 risks inflate during the fall and winter and of course those businesses will also be more sensitive to swings in the direction of the economy. However, this business formation statistic from the Census Bureau does give hope that the worst could be behind us.

Census Business Formation StatisticsCensus Bureau Business Applications

Given the current valuation of Paychex, I’m hesitant to significantly increase my position. However, I do feel comfortable enough with the valuation to continue on with my dollar-cost average approach.

Interested investors could sell put options if they have cash earmarked for an investment in Paychex. Selling puts is a way to be the insurance company wherein you collect premium upfront in exchange for the potential liability of having to purchase the shares at some point in the future.

The $77.50 strike option looks intriguing at the current mid-point of $1.98. Writers of the contract would take on the potential risk of having to purchase 100 shares per contract sold at a price of $77.50, but receive $198 per contract. That works out to either purchasing shares at $75.53, ~10% lower than current levels, or receiving a 2.5% return in approximately 2 months’ time which works out to a 16% annualized return. In my opinion, that’s not a bad tradeoff.

Disclosure: I am/we are long PAYX. 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.

Additional disclosure: I am not a financial professional. Please consult an investment advisor and do your own due diligence prior to investing. Investing involves risks. All thoughts/ideas presented in this article are the opinions of the author and should not be taken as investment advice.



Via SeekingAlpha.com