Paychex Should Appeal To Risk Averse Investors

Paychex (PAYX) should appeal to risk-averse investors given its strong recurring revenue, and operating and free cash flow.

I last reviewed it in this September 28 post at which time it had just released Q1 2024 results and raised its FY2024 outlook for the adjusted diluted EPS and Interest on Funds Held for Clients metrics. At the time of that review, I concluded shares were attractively valued.

On December 21, PAYX released its Q2 and YTD2024 results thus prompting me to revisit this holding.

Business Overview

I have provided a Business Overview in prior PAYX posts. However, it is preferable if you read Part 1 of the FY2023 Form 10-K to gain a good understanding of the company.

PAYX benefits from an increasingly complex regulatory environment, a tight labour market, and a growing adoption of hybrid work models which should drive demand for its offerings; this includes add-on human capital management modules and human resources outsourcing solutions. It does, however, operate in a highly competitive market. As a result, PAYX must ensure the functionality of its product suite is comparable with peers and meets client demands.

PAYX's customer base consists of 740,000+ small- and medium-sized businesses across the U.S. and parts of Europe. Many could go out of business if the economies in which PAYX operates slip into a recession. The risk of significant credit losses, however, is minimal because:

• it typically receives funds before it must disburse funds; or
• it has a Standby Letter of Credit (typically from a reputable financial institution) which can be drawn upon in the event the client is unable to fund its payroll.

Alterna Capital Solutions Acquisition

On July 31, 2023 (one day prior to the start of Q2), PAYX closed the purchase of Alterna Capital Solutions (ACS) for $0.208B. This small company has a team of senior-level sourcing professionals across several offices nationwide. This specialty finance company offers a range of financing solutions to small business clients including:

• invoice financing;
• asset-based lines of credit;
• term loans; and
• other complimentary financing solutions.

It purchases outstanding accounts receivable from its customers under a non-recourse basis. This acquisition is a good strategic fit with Paychex Advance which purchases accounts receivable for temporary staffing clients.

This acquisition will provide an opportunity for PAYX's small business clients to manage working capital challenges.

The acquisition should have no material impact on PAYX's FY2024 financial results.

Financial Review

Q2 and YTD2024 Results

PAYX's Q2 and YTD2024 results and FY2024 outlook are accessible in Form 8-K and Earnings Presentation.

It has reported total revenue growth of 6% and diluted EPS and adjusted diluted EPS growth of 10% in the first half of FY2024.

This pace of growth, however, has been hurt by lukewarm spending by businesses and a slower pace of hiring. The U.S. Labor Department reported on December 21 that the number of Americans filing new claims for unemployment benefits increased moderately in the week ending December 16.

Furthermore, an uncertain macroeconomic environment has dampened demand for PAYX's HR platform among small and medium businesses. Its client base continues to struggle in both the cost of and access to growth capital and finding quality talent in the current labor market.

Despite a slower pace of growth, PAYX continues to generate strong Operating Cash Flow (OCF) and Free Cash Flow (FCF).

PAYX benefits from higher interest rates because is has client funds on deposit from which it can generate additional income. A rising interest rate environment benefits PAYX's short-term investments as seen from the average rate of returns reflected below. The rising rates, however, harm the longer-term component of the investment portfolio which explains the unrealized net loss on a mark-to-market basis. This, however, is an unrealized net loss as PAYX has not sold and crystalized these losses. If these investments are held to maturity, PAYX will incur no loss.

FY2024 Outlook

When PAYX released its FY2024 outlook in June, the outlook took into account some uncertainty surrounding future interest rate changes. Management stated it would have better visibility into the remaining quarters as the year progressed, and therefore, quarterly adjustments were likely.

Management revised the FY2024 outlook when it released Q1 results and it has once again raised some of its FY2024 projections.

PAYX's outlook assumes the current macro and competitive environment, particularly as it relates to future interest rate changes in the economy.

Total revenue is expected to grow 6% - 7% but management now expects growth to be more in the middle of the range.

Operating income margin is expected to be 41% - 42% but more likely at the upper end of this range.

Revenue retention remains above pre-pandemic levels. Client retention has improved over last year, and retention in its HR outsourcing solutions remains at record levels.

While PAYX has not seen any normal signs of a recession in its data, it is starting to see some softening in seasonal hiring. This is particularly evident it PAYX's large client segments, including the HR outsourcing businesses, many of which typically add seasonal employees at this time of the year.

Small and medium sized businesses remain challenged with access to capital, the high cost of capital, inflation and macro uncertainty.

Risk Assessment

No rating agency rates PAYX's debt. Looking at the consolidated Balance Sheet (page 12 in Form 8-K), however, we see that PAYX's risk is low.

It had current assets before funds held for clients of ~$3.484B of which ~$1.398B was cash, cash equivalents, and corporate investments and ~$1.627B was Accounts Receivable, net of allowance for credit losses and professional employer organization (PEO) unbilled receivables, net of advance collections.

At the end of Q2 2024, PAYX's Current Assets before funds held for clients were more than 2.14x Current Liabilities before client fund obligations.

Total short-term and long-term borrowings of ~$0.812B are similar to prior recent quarters.

On March 13, 2019, PAYX completed the private placement of Senior Notes, Series A in an aggregate principal amount of $0.4B due on March 13, 2026, and Senior Notes, Series B in an aggregate principal amount of $0.4B due on March 13, 2029.

Details of PAYX's financing arrangements commence on page 26 in the Q3 2023 Form 10-Q.

I see nothing on the horizon which suggests PAYX will have difficulty in retiring these senior notes at maturity.

Dividends and Share Repurchases

Dividends and Dividend Yield

PAYX's currently does not reflect its dividend history on its website; the dividend history is accessible here.

In 2020, PAYX froze its quarterly dividend at $0.62/share given the uncertainty the COVID pandemic would have on its business. Other than this brief period, PAYX has consistently rewarded its shareholders with attractive dividend increases (post 2013).

In mid January, PAYX will likely declare its 4th consecutive $0.89/share quarterly dividend for distribution in late February. In late April, I expect an $0.11/share increase in the quarterly dividend to $1.00. If this happens, the next 4 quarterly dividend payments will total $3.89. With shares currently trading at ~$120, the forward dividend yield would be ~3.2%.

Share Repurchases

The weighted average number of diluted shares outstanding (in millions rounded) is 363, 365, 366, 365, 363, 363, 362, 362, 361, 362, 363, and 362.3 in FY2012 - FY2023. The weighted-average diluted common shares outstanding in Q2 2024 was 362.1.

PAYX repurchased no shares in FY2023 and in Q1 2024. However, it repurchased 1.5 million shares for ~$169.2 million in Q2.

In comparison, PAYX repurchased:

• 1.2 million shares for a total of $145.2 million in FY2022;
• 1.7 million shares for a total of $155.7 million at an average price of $90.83 in FY2021; and
  
• 2 million shares for a total of $171.9 million at an average price of $84.68 in FY2020.

PAYX maintains a program to repurchase up to $0.4B of common stock, with authorization expiring on January 31, 2024. The purpose of this program is to manage common stock dilution. Much like many other companies, PAYX issues shares under its employee compensation structure. This explains why there is very little change in the weighted average number of shares outstanding despite the repurchase of shares outstanding.

Valuation

PAYX's FY2012 - FY2022 diluted PE levels are 20.19, 28.28, 26.08, 26.31, 28.32, 29.34, 23.44, 28.54, 31.80, 38.78, 28.53, and 28.97.

At the time of my September 28 post, PAYX had generated $1.14 of adjusted diluted EPS in Q1 and management's FY2024 outlook was for 9% - 11% growth from FY2023's $4.27 adjusted diluted EPS. Using the 10% mid-point, PAYX's FY2024 adjusted diluted EPS was expected to be ~$4.70. Using the current ~$116.50 share price, PAYX's forward adjusted diluted PE was ~24.8.

In addition, the following were the forward-adjusted diluted PE levels using current broker estimates.

• FY2024 - 19 brokers - mean of $4.70 and low/high of $4.60 - $4.75. Using the mean estimate, the forward adjusted diluted PE was ~24.8.
• FY2025 - 18 brokers - mean of $5.01 and low/high of $4.91 - $5.15. Using the mean estimate, the forward adjusted diluted PE was ~23.3.
• FY2026 - 6 brokers - mean of $5.39 and low/high of $5.30 - $5.48. Using the mean estimate, the forward adjusted diluted PE was ~21.6.

Management now forecasts FY2024 adjusted diluted EPS to grow 10% - 11%. As noted above, PAYX generated $4.27 adjusted diluted EPS in FY2023. Using the 10.5% mid-point, PAYX's FY2024 adjusted diluted EPS is likely to be ~$4.72. With shares currently trading just under ~$120, PAYX's forward adjusted diluted PE is ~25.4.

Brokers currently forecast the following but their forecasts are likely to be adjusted slightly within the next few days:

• FY2024 - 19 brokers - mean of $4.70 and low/high of $4.64- $4.74. Using the mean estimate, the forward adjusted diluted PE is ~25.5.
• FY2025 - 19 brokers - mean of $5.02 and low/high of $4.93 - $5.15. Using the mean estimate, the forward adjusted diluted PE is ~24.
• FY2026 - 9 brokers - mean of $5.37 and low/high of $5.21 - $5.49. Using the mean estimate, the forward adjusted diluted PE is ~22.3.

Final Thoughts

PAYX has just reported its slowest increase in quarterly revenue in over two years leading to a decline in PAYX's share price. If you are a long-term investor, however, you should welcome temporary weakness in a great company's share price and valuation.

The nature of PAYX's business is such that it generates recurring revenue. The company is not capital intensive which leads it to consistently generating strong OCF and FCF. In FY20214 - FY2023 it generated FCF (in billions of $) of 0.797, 0.792, 0.921, 0.866, 1.122, 1.148, 1.314, 1.142, 1.372, and 1.556. In the first half of FY2024, it generated 0.925.

PAYX should have ample cash on hand to retire its long-term debt when due in March 2026 and March 2029. Unless it makes a major acquisition between now and these maturity dates, PAYX could end up being like some other holdings in the FFJ Portfolio where its cash, cash equivalents, and corporate investments greatly exceeds TOTAL debt.

Regrettably, share repurchases is not a top priority from a capital allocation perspective. This is borne out from the relatively stable weighted average number of diluted shares outstanding over the past decade. Nevertheless, PAYX's average annual total return (with dividend reinvestment) has been ~14.4% over the past 10 years. While past performance is not indicative of future performance, I am happy to accept a low double digit investment return while exposed to minimal risk.

I have been a PAYX shareholder since July 8, 2009 and have periodically added to my exposure. Based on my current analysis, I consider low-risk PAYX to be attractively valued. However, my PAYX exposure now consists of 725 shares (285 and 440 shares in a 'Core' and a 'Side' account, respectively) and I am looking to increase my exposure in other holdings. I, therefore, do not intend to acquire additional PAYX shares at this point.

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

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long PAYX.

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your own research and due diligence. Consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.