Paychex – Waiting For Further Pullback

Summary

• PAYX released Q2 results on December 19^th and provided an update on the Oasis Outsourcing Acquisition which was announced on November 26^th.
• Investors may be concerned about the 80+% dividend payout ratio but management has reiterated on several occasions that the company’s positive cash flows have historically allowed it to support its business and to pay substantial dividends.
• Despite the ~14.55% pullback from the 52 week high I still view it as slightly overvalued.

Introduction

When I last wrote about PAYX (NASDAQ: PAYX) shares were trading at $66.89 (June 27 close of business) and management was projecting ~$2.66 diluted EPS and ~$2.83 adjusted diluted EPS for FY2019. The share price subsequently rose to ~$75 toward the end of September but has since retraced to the ~$65 level.

On December 19^th PAYX released its Q2 results and revised FY2019 outlook. I now take this opportunity to revisit PAYX which is held in the FFJ Portfolio.

PAYX stands to benefit somewhat from a rising interest rate environment in that it consistently maintains several billion dollars in ‘funds held for clients’ on which it is able to generate investment income.

Source: PAYX Q2 2019 Highlights and Financial Results

More detail on the nature of these investments can be found in Note F - Funds Held for Clients and Corporate Investments found on page 54 of 82 in PAYX’s FY2018 10-K.

Naturally, there is always some interest rate ‘tipping point’ at which time further rate increases start to have a detrimental impact on PAYX’s client base and then PAYX suffers. I think we are a few hundred basis points away from this occurring.

Oasis Outsourcing Acquisition

On November 26^th, PAYX announced that it had entered into an agreement to acquire Oasis Outsourcing Acquisition Corporation for $1.2B with closing anticipated to occur in Q3; Oasis is the largest privately owned professional employer organization (PEO) in the US.

Financing will be through a combination of cash on PAYX’s balance sheet and borrowings under existing credit facilities and/or new debt.

Source: PAYX Q2 2019 Highlights and Financial Results

PAYX is acquiring Oasis since it views it as a good fit with its professional employer organization (PEO) growth strategy. Oasis will add to PAYX’s scale, will expand relationships with new insurance partners, create up-sell opportunities into the existing Oasis customer base and the addition of the experienced Oasis leadership team will augment PAYX’s leadership talent.

The Oasis acquisition is expected to have a $155 - $175 million incremental impact on revenue for the balance of the current fiscal year. It is anticipated that ~45% of this incremental revenue will occur in Q3 and the remainder will occur in Q4.

Excluding one-time acquisition related costs, PAYX anticipates that Oasis will have minimal impact on FY2019 diluted EPS; it is anticipated that the acquisition will be ~$0.03 dilutive for FY2019.

Q2 FY2019 Results and FY2019 Guidance

PAYX’s Q2 results can be found here and here.

At the time of my June 27^th article PAYX had provided the following guidance.

Source: PAYX Q4 2018 Highlights and Financial Results

This guidance has been revised as follows.

Source: PAYX Q2 2019 Highlights and Financial Results

The following guidance has been tightened:

• Interest on funds held for clients is anticipated to grow 20% - 25%; it has been assumed there will be no further rate increases subsequent to the recently announced rate increase by the Fed prior to PAYX’s May 31^st fiscal year end.
• Net investment income is anticipated to be in the range of $10 - $15 million.

Valuation

PAYX’s historical PE based on diluted EPS has been in excess of 26 from 2013 – 2018. During 2008 – 2012, PAYX’s PE was in the mid teens to lower 20s.

At the time of my June 27^tharticle, PAYX has just reported diluted EPS of $2.58, adjusted diluted EPS of $2.55, and had forecast a ~3% increase in diluted EPS and a ~11% increase in adjusted diluted EPS for FY2019. Using these forecasts we arrived at projections of ~$2.66 diluted EPS and ~$2.83 adjusted diluted EPS for FY2019.

PAYX was trading at $66.89 as at the close of business on June 27^th which resulted in a forward diluted PE of ~25.15 and a forward adjusted diluted PE of ~23.64.

With the recently revised guidance we now arrive at projections of ~$2.68 diluted EPS (~4% growth) and ~$2.84 adjusted diluted EPS (~11.5% growth) for FY2019…essentially minimal change.

PAYX is now trading at ~$65 thus given us a forward diluted PE of ~24.25 and a forward adjusted diluted PE of ~22.89….somewhat better than late June.

Dividend, Dividend Yield, Dividend Payout Ratio and Stock Splits

I am unable to locate PAYX’s dividend history on its website and have had to resort to this site for historical dividend information. PAYX’s stock split history, however, is readily available on PAYX’s website.

In mid-January PAYX will declare its 4^th consecutive $0.56/quarterly dividend. I then anticipate PAYX will raise its quarterly dividend by $0.04 commencing with the May payment meaning PAYX will have distributed 3 quarterly $0.56 dividend payments and one $0.60 quarterly dividend payment for a total annual dividend of $2.28 in FY2019 for a yield of ~3.5%.

This $2.28 in FY2019 dividend distributions is ~85% of the $2.68 in projected diluted EPS which is somewhat higher than PAYX’s ~80% target payout ratio. I have no issue with this high payout ratio and draw to your attention the following comment extracted from PAYX’s December 19^th Earnings Release:

‘Our positive cash flows have historically allowed us to support our business and to pay substantial dividends (targeting approximately 80% of net income) to our stockholders. It is anticipated that cash and total corporate investments as of November 30, 2018, along with projected operating cash flows and available short - term financing, will support normal business operations, capital purchases, share repurchases, and dividend payments for the foreseeable future.’

Final Thoughts

Based on my review of PAYX’s historical valuation of the last 10 years, PAYX is not yet ‘on sale’. In my opinion a price closer to $55 giving us a forward PE in the low 20s (similar to 2011 and 2012) is where I would be inclined to add to my position.

I wish you much success on your journey to financial freedom.

Thanks for reading!

Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I am long PAYX.

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