Paychex Should Benefit From A Rising Rate Environment

Much like Automatic Data Processing (ADP) which I analyzed in this January 27 2022 post, Paychex should benefit from a rising rate environment. This is because it often holds over $4.5B in funds held for clients, cash and cash equivalents, restricted cash, and corporate investments. Management's FY2023 projection is for $85 - $95 million of interest income from funds held for clients!

I last reviewed Paychex (PAYX) in this January 22, 2022 post following the release of Q2 2022 results. Subsequently, a broad market pullback has enabled us to discover who was swimming naked when the tide receded.

As mentioned in numerous previous posts, an assessment of a company's risk should always be a vital component of any investment analysis. Regrettably, many investors disregard the risk component of an investment and subsequently learn that grief from a loss outweighs the joy of a gain of a similar dollar value.

Although the share price of many high-quality companies has taken a hit over the recent months, investors who restrict their investments to high-quality companies stand a better chance of generating reasonable long-term total investment returns. This is because, in the short run, the market is a voting machine, but in the long run, it is a weighing machine. In essence, stock prices in the short term may not accurately reflect the value of a company. The value of a company, however, generally becomes reflected in a company's share price over the long term.

After I reviewed PAYX's Q4 and FY2022 results and FY2023 outlook, I have increased my PAYX exposure within one of the 'Core' accounts in the FFJ Portfolio.

Business Overview

Please refer to my January 22, 2022 post in which I provide a Business Overview.

The FY2022 Form 10-K is scheduled to be released in late July. Until such time, I encourage investors unfamiliar with PAYX to read Part 1 of the FY2021 Form 10-K to get a good overview of the company.

Financial Review

Q4 and FY2022 Results

On June 29, 2022, PAYX issued its Q4 and FY2022 results and FY2023 guidance (Form 8-K).

 

• FY2022 operating cash flow of ~$1.506B (~$1.26B in FY2021) versus $0.555B during the first 6 months (~$0.431B in the first 6 months of FY2021).
• Free cash flow of ~$1.337B in FY2022 (~$1.118B in FY2021) versus $0.459B during the first 6 months (~$0.379B in the first 6 months of FY2021).

FY2023 Guidance

The following is PAYX's FY2023 outlook.

In contrast, the following is PAYX's outlook at the time of my previous analysis.

Risk Assessment

After investing in equities for ~35 years I know my risk tolerance. I will not invest in companies whose domestic unsecured long-term debt credit ratings are below investment grade. My rationale is that my risk exposure is the greatest as a shareholder. If a company's unsecured long-term debt is speculative then my degree of risk is all that much greater.

Being able to see how the major credit rating agencies rate a company's debt greatly simplifies the risk analysis portion of my review. Not all companies in which I invest, however, have debt that is rated. PAYX is one such company which is why I spend more time analyzing its financial statements.

PAYX's FY2022 Form 10-K is not yet available. Details of PAYX's credit arrangements, however, can be found on page 18 of 44 in the Q3 Form 10-Q.

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. Proceeds from the Notes were used to pay off $0.8B in short-term borrowings under its JP Morgan credit facilities used to temporarily finance the acquisition of Oasis; Oasis was the US's largest privately-owned professional employer organization (PEO) and an industry leader in providing human resources outsourcing services.

PAYX's financial position remains strong. At FYE2022, cash, restricted cash, and total corporate investments exceeded $1.3B (~$1.1B at the end of Q2 2022) and total borrowings amounted to ~$0.8B (the same amount at the end of Q2 2022).

The low risk of default meets my relatively conservative risk profile.

Dividends and Share Repurchases

Dividends and Dividend Yield

On April 29, 2022, PAYX declared a 20% increase in its quarterly dividend from $0.66 to $0.79.

At the time of my prior post, PAYX shares were trading at $118.67 and the $0.66 quarterly dividend yielded ~2.22%.

Shares are now trading at ~$114 so the $0.79 quarterly dividend yields ~2.77%.

In FY2022, PAYX paid cumulative dividends of $2.77/share totalling $1.0B, resulting in a dividend payout ratio of 72%.

PAYX's dividend coverage has improved to 1.3x FCF/dividend paid versus 1.2x in FY2021 and 1X in the first half of FY2022.

Share Repurchases

The weighted average number of shares outstanding (in millions) is 363, 365, 366, 365, 363, 363, 362, 362, 361, 362, and 363 in FY2012 - FY2022.

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.

During FY2022, PAYX repurchased 1.2 million shares of common stock for a total of $0.1452B. In comparison, PAYX repurchased 2 million shares ($171.9 million at an average price of $84.68) and 1.7 million shares ($155.7 million at an average price of $90.83) in FY2020 and FY2021, respectively.

Valuation

PAYX's FY2012 - FY2021 diluted PE levels are 20.19, 28.28, 26.08, 26.31, 28.32, 29.34, 23.44, 28.54, 31.80, and 38.78.

At the time of my January post, the following were the forward adjusted diluted PE levels using earnings estimates from the two online trading platforms I use.

• FY2022 - 16 brokers - mean of $3.63 and low/high of $3.59 - $3.68. Using the mean estimate, the forward adjusted diluted PE is ~33 and ~32 if I use $3.68.
• FY2023 - 18 brokers - mean of $3.89 and low/high of $3.70 - $4.08. Using the mean estimate, the forward adjusted diluted PE is ~30.5 and ~29 if I use $4.08.
• FY2024 - 10 brokers - mean of $4.20 and low/high of $4.05 - $4.42. Using the mean estimate, the forward adjusted diluted PE is ~28.3 and ~26.8 if I use $4.42.

I concluded that PAYX's current valuation was slightly high.

In FY2022, PAYX generated $3.84 in diluted EPS and $3.77 in adjusted diluted EPS. With shares currently trading at ~$114, the diluted PE is ~29.7 and the adjusted diluted PE is ~30.2.

Management's FY2023 outlook is for a 9% - 10% increase in adjusted diluted EPS (~$4.11 - ~$4.15). Using the current share price, the forward adjusted diluted PE range is ~27.5 - ~27.7.

I expect revisions to earnings estimates from the brokers which cover PAYX over the coming days. Based on current estimates, however, the forward adjusted diluted PE levels are:

• FY2023 - 19 brokers - mean of $4.13 and low/high of $4.03 - $4.17. Using the mean estimate, the forward adjusted diluted PE is ~27.6 and ~27.3 if I use $4.17.
• FY2024 - 17 brokers - mean of $4.43 and low/high of $4.10 - $4.62. Using the mean estimate, the forward adjusted diluted PE is ~25.7 and ~24.7 if I use $4.62.

PAYX is not a company in which investors should expect a forward adjusted diluted PE in the teens. Its current valuation based on earnings estimates is a level at which investors should consider reasonable. Naturally, investors might want to 'load up' if PAYX's share price is caught in a significant market downdraft.

Final Thoughts

PAYX's ~$114 share price is well below its ~$142 52-week high. I welcome this price decline since it has contributed to a more favourable valuation. Given this, I have acquired additional PAYX shares along with the purchase of shares in several other companies.

At the time of my January 2022 Investment Holdings Review, PAYX was not one of my top 30 holdings. A cursory review of all holdings in 19 investment accounts leads me to conclude that PAYX is still not a top 30 holding. Nevertheless, I like the company and intend to occasionally increase my exposure through direct purchases and the automatic reinvestment of quarterly dividends.

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 and ADP.

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.