Contents
Paychex, Inc. (PAYX) is currently experiencing challenges because of the low interest rate environment and because its primary target market (small businesses with ~17 employees on average) has been hard hit because of COVID-19.
I have mentioned in several previous articles that the valuation of many companies has become detached from the underlying fundamentals and PAYX is a good example. Although the company continues to have strong working capital and is generating strong free cash flow, the free cash flow being generated is lower than prior recent years. The company has also kept its quarterly dividend constant at $0.62/quarter for 8 consecutive quarters.
Summary
- Paychex (PAYX) specializes in serving small businesses with its average client employing ~17 people.
- On December 23, 2020 the company reported Q2 2021 results which comfirmed the company is facing headwinds as a result of its customer base having been hard hit by COVID-19 and because of the low interest rate environment.
- Although PAYX continues to generate positive Free Cash Flow YTD, it has generated less than in the first 6 months of the prior fiscal year.
- The company's dividend has not changed from $0.62/quarter for the last 8 quarters.
- PAYX's bottom line remains positive but results are weaker than in recent prior years.
- Shares appear to be overvalued ~20% and a share price in the low $70s based on FY2021 earnings estimates seems more appropriate than the current $89.40.
Introduction
I am continually on the lookout to increase my position in high quality companies when my analysis suggests shares are undervalued/fairly valued. Unfortunately, it has become increasingly difficult to find such companies. Case in point...Paychex, Inc. (PAYX), a leading provider of integrated human capital management solutions for payroll, benefits, human resources, and insurance services.
I initiated a position on July 8, 2009 when I acquired shares for our daughter's Registered Education Savings Plan (RESP). Although I knew the dividend would incur a 15% withholding tax I envisioned shares appreciating in value to such an extent that this 15% haircut would not be 'material'. When I sold PAYX shares in late 2017 to fund some of our daughter's education expenses, PAYX's share price had appreciated to ~$65.
It was my intent to reacquire PAYX shares following this sale but I did not do so until late March 2018 when I acquired 400 shares for one of the 'Core ' accounts within the FFJ Portfolio at which time shares were trading at ~$60. Unfortunately, I had to sell 100 shares mid-October 2019 at ~$84/share and another 100 shares early May 2020 at ~$68/share. I did, however, purchase 300 shares at ~$73 in March 2020 for one of the 'Side' accounts within the FFJ Portfolio and disclosed same in this article.
Following the March 2020 purchase, PAYX's share price dipped to the high $40s but subsequently went on a tear and almost reached $100/share in December. The share price has subsequently pulled back to the current $89.40 and while the most recent financial results are for the end of Q2 (November 30, 2020) I thought I would revisit PAYX.
Business Overview
A comprehensive overview of PAYX's business can be found commencing on page 5 of 89 in the 2020 10-K. Additional details can be found here.
PAYX specializes in serving small businesses with its average client employing ~17 people. Its rival, Automatic Data Processing (ADP), services a lot of midsize and larger businesses.
PAYX maximizes its margins at 15-50 employees and companies of this size generally do not require a lot of service but cannot entirely rely on a do-it-yourself software solution.
It is somewhat insulated from competitors because in order to succeed in this segment of the market a large customer service apparatus investment is necessary. Essentially, it does require a large initial fixed investment and significant scale to service small businesses.
A drawback about PAYX's customer base is that these customers are generally more sensitive to the overall economy than much larger companies. PAYX's retention rates are typically in the low 80% range and client losses generally result from bankruptcies and acquisitions. Furthermore, client retention rates also fall during recessions as evidenced by the retention rate having dipped to ~77% at the end of fiscal 2009.
Q2 and YTD2021 Results and FY2021 Guidance
PAYX's Press Release regarding Q2 and YTD 2021 results can be found here and its Q2 2021 10-Q can be found here. We can clearly see that PAYX's results have been negatively impacted by COVID-19 which is not surprising given that PAYX is a leading provider of integrated human capital management solutions for human resources, payroll, benefits, and insurance services for small-to medium-sized businesses. Many of PAYX's customers have undoubtedly been negatively impacted by COVID-19 which would naturally lead to PAYX feeling the impact.
In addition, pressure has come from the lower interest rate environment. PAYX generates income from client funds held on deposit and we see from the income statement that in the first 6 months of FY2020 and FY2021 this source of revenue dropped from $40.4 million to $29.7 million. This is mainly a margin issue as this revenue passes almost completely to the bottom line so if you are wondering what type of businesses are negatively impacted by a low interest rate environment....this is one of them.
While PAYX provided an update to its outlook for the second half of FY2021, management has indicated changes in the macroeconomic environment could alter this guidance. PAYX is certainly facing some headwinds but based on my experience as a shareholder since 2009 I am reasonably confident that management is closely monitoring the situation and is taking appropriate actions to ensure the company remains profitable and continues to have ample liquidity.
Free Cash Flow (FCF)
If we look at PAYX's financial position we see that as at November 30, 2020 it had working capital of ~$1.1B (Current Assets minus Current Liabilities on page 4 of 38 in the Q2 2021 10-Q).
In the first 6 months of FY2021 it generated ~$0.38B of FreeCash Flow (FCF) which is calculated by taking 'Net cash provided by operating activities' deducting 'Purchases of property and equipment' and adding 'Proceeds from sales of property and equipment' found on page 7 of 38 in the Q2 2021 10-Q versus $0.505B in the first half of the prior fiscal year. Even if PAYX were to generate $0.809B in the second half of the current fiscal year, which is what it generated in the second half of the prior fiscal year, PAYX would end up generating just under $1.2B which is less than what it generated in FY2020. This is still a solid number but I think PAYX might be hard pressed to generate $1B in FCF in the current fiscal year.
For comparison purposes, in FY2011 - 2020, PAYX generated FCF of 615, 617, 577, 797, 792, 921, 866, 1,122, 1,148, and 1,314 (in millions).
Credit Ratings
PAYX is not rated by the major ratings agencies because for the longest time it never had any long-term debt which needed to be rated.
On March 13, 2019, however, PAYX and its Paychex of New York LLC subsidiary 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 repay $0.8B in short-term borrowings under PAYX's credit facilities with JP Morgan Chase that were used to temporarily finance the acquisition of Oasis.
PAYX does not have any long-term debt due for several more years and with the liquidity this company has and the FCF it generates, I am satisfied the level of risk I have assumed by investing in PAYX is acceptable even if none of the ratings agencies have rated PAYX's long-term debt.
PAYX does not have a section on its website where you can access its dividend history. Its dividend history can, however, be accessed here on NASDAQ's website.
A few comments about PAYX's dividend history:
The December 28, 2012 $0.66 dividend stands out from previous and subsequent dividend payments which were in the mid $0.30 range. This is because PAYX accelerated the payment of its February and May 2013 dividend payments. This was NOT a 'special' dividend.
We also see there were several quarters in which the quarterly dividend remained constant. PAYX distributed a $0.31/quarterly dividend from August 2008 - August 2011 and most recently, its $0.62 quarterly dividend has been in place since May 2019; the February 2021 dividend is also $0.62.
While I do not think the dividend is at risk, the mere fact PAYX has held its quarterly dividend steady at $0.62 for 8 consecutive quarters is a strong signal from the company that there are far more pressing priorities than increasing the quarterly dividend.
I do not envision the quarterly dividend increasing any time soon even though recent history suggests a dividend increase happens around August. I think investors should expect the dividend to remain at $0.62 until business conditions stabilize/improve. On this basis, therefore, the $2.48 in annual dividend payments provides investors with a ~2.78% dividend yield on the basis of the current $89.40 share price.
When I wrote my December 23, 2016 article Paychex Stock Analysis: Love the company, not the price, shares were trading at $61.39 and the quarterly dividend was $0.46/share or $1.84/share/year giving investors a 3% dividend yield. I didn't like PAYX's dividend yield at the time and the dividend yield back then was higher than it is today!
Looking at PAYX's weighted-average common shares outstanding (assuming dilution) we see 361.6 million shares for the first 6 months of the current fiscal year. In FY2011 - 2020, PAYX reported 362, 363, 365, 366, 365, 363, 363, 362, 362, and 361 million shares outstanding. Share count has certainly not changed much over this timeframe.
Valuation
In FY2020, PAYX generated $3.04 in diluted EPS and as at the end of Q2 2021 PAYX has generated diluted EPS of $1.34. Given current market conditions I strongly suspect PAYX will not generate $3.04 in diluted EPS for the current fiscal year and even somewhere close to $2.90 might be a stretch. Using $2.90 and the current $89.40 share price the diluted PE is ~30.8.
In FY2020, PAYX generated $3.00 in adjusted diluted EPS and FY2021 guidance provided December 23, 2020 calls for adjusted diluted EPS to be in the range of 1% - 4% lower than FY2020's results. This should come as no surprise as for the first 6 months of FY2021, PAYX generated $1.36 in adjusted diluted EPS versus $1.42 for the same period in the prior fiscal year. Currently, 20 brokers have provided low/high adjusted diluted EPS estimates for FY2021 of $2.90 and $3.00 with a mean of $2.94. Using $2.94 and the current $89.40 share price the diluted PE is ~30.4.
If I thought shares were richly valued when I wrote my December 23, 2016 article at a forward P/E of 27.65 then the current valuation is even less appealing to me.
PAYX is certainly facing headwinds so I would want its adjusted PE to drop to ~24 which, using $2.94 in FY2021 adjusted earnings, would give us a price of ~$71. This means PAYX's share price would need to retrace ~20%.
Final Thoughts
As I have indicated in several previous articles I continue to believe the share price of many companies has become detached from the underlying fundamentals.
In my opinion, PAYX is a good example of a company whose share price has become detached from the underlying fundamentals...and not in a good way. In PAYX we have a company whose share count has not changed much in years, the dividend yield has dropped relative to the yield when I previously purchased shares, the bottom line has suffered and yet the share price has ballooned over the past year.
With shares currently valued at a lofty level it will be difficult for investors acquiring shares today to make a decent rate of return and investors would be wise not to acquire shares until the share price retraces ~20% from the current $89.40.
While an argument can be made that I should sell my shares, I very rarely sell shares (the PAYX shares I indicated earlier in this article which I sold were because the funds invested in PAYX shares were for a specific purpose) unless my underlying thesis for having made the investment has changed. PAYX is certainly experiencing challenges as a result of the impact COVID-19 has had on its customer base and target market and because of the low interest rate environment. I do, however, continue to have confidence management is doing what is required during these difficult times.
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.
