Paying Dividends Is a Priority for This Payroll Firm

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Paychex recently announced an 8.6% increase to its dividend. I'm here with Josh Peters--he is editor of Morningstar DividendInvestor and also our director of equity income strategy--to take a deeper dive into the company and see if it looks attractive at today's levels. Josh, thanks for joining me.

Josh Peters: Good to be here. It's fun to talk about one of my favorite companies today.

Glaser: Let's talk about this increase first. It was pretty sizable. What is driving Paychex's management to feel confident enough to continue to boost their payout here?

Peters: You have to put this dividend increase in context. There are lots of companies out there that might have a 10%, 15%, 20%, or 50% increase to the dividend because it was so small to begin with. Paychex is a company that, for years, has been paying out 80% or more of its annual income to shareholders. That has routinely been providing the stock with a yield of 3% or even 4%, depending on where the stock has been trading. This is actually a lot of generosity on top of a tremendous amount of generosity to get a dividend increase like this.

What that signals to me is that this is a business, first of all, that is able to grow without having to plow a lot of capital back into the business. They process payroll checks for small businesses, and then they provide other ancillary human resources services--like 401(k) administration, for example. If you want to grow a business like that, you hire some more salespeople, and they go out and get some accounts. You're not building new steel mills or oil refineries or laying railroad track or anything like that. It's people cost; it's all pay-as-you-go. So, they don't have to reinvest or redeploy a lot of capital into the business in order to grow.

Second, they aren't the only cash-cow business out there, but they're one of the very few that recognize that they can pay a tremendous amount of dividend income out to shareholders and still provide their growth without somehow feeling like they are taking a reputation hit. Microsoft, back in the day when the stock was still depressed, could have doubled or maybe tripled the dividend; the stock could have yielded 6% or 7%. But are they willing to do that even though they could? No, they haven't been willing to do that. Paychex, over many years, has demonstrated that the dividend is absolutely their number one priority for shareholders--making it big and then continuing to raise it.

So, the intersection of those two factors--not just this abundant capacity to pay a big dividend while continuing to grow the business but also the willingness to do so--really makes it a unique company in the universe for dividend investors.

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Glaser: If the company is already paying out over 80%, then how many more increases can you expect? How fast can they keep growing the dividend, given where the payout ratio is?

Peters: I think you can continue to look for high-single-digit dividend growth over a longer period of time--7%, 8%, or maybe 9%. One of the things you have to remember about Paychex is that it's based largely off of total employment, not unemployment. A lot of people conflate the two. They think, "If unemployment went from 5% to 10%, does that mean that Paychex fell by half?" No--the employment rate went from 95% to 90%. It isn't a business that has shown a tremendous amount of downside in a recession-type of environment.

With that on the upside, you are limited to how many new small businesses are being formed and how many employees are those businesses picking up as they're hoping to start and grow their businesses. So, Paychex is not especially fast to grow just on the basic payroll line, but where they've had the most success recently and grown the business faster is in adding these additional services to that core payroll relationship.

We think Paychex is a wide-moat company. People are reluctant to switch payroll service providers because it could be a tremendous hassle. You don't want to get your payroll wrong--you're really going to mess with your employees if you do that. When you add on the additional services, you are creating a wider and wider moat. When there are more and more services that are provided by just one company, it gets much harder to walk away from the relationship on the basis of price. Paychex does have pricing power. It has very high client retention. And so many of the costs of processing--whether it's paychecks or other services--are fixed. The computers and software are already in place. You have very high margins associated with that business as well.

Glaser: One of the big worries for dividend investors has been, "How are these stocks going to perform in a rising-rate environment?" When you look at Paychex, what is your take on what could happen if rates begin to move up?

Peters: Here's another instance where Paychex is such an ideal pick for many dividend investors. If the economy really takes off, utilities, REITs [Real Estate Investment Trusts], and consumer staples firms are not going to grow that much faster. But if the economy is doing a lot better and interest rates go up as a result, then these stocks see a lot of valuation pressure. At least that's the conventional wisdom. It doesn't always work out that way in practice, but that's the gut instinct. In the case of Paychex, though, you should expect to see faster growth for them in a faster-growing economy. With more jobs are being created, especially amongst small businesses, they're going to be able to grow faster. Secondly, as part of the payroll process, Paychex collects the cash from its clients before it's paid out to employees or tax authorities or insurance companies or whomever.

They earn, right now, almost no interest income on that flow. If short-term interest rates start to move up, then it's going to have a direct impact on their earnings. Their earnings will go up just because interest rates have gone up. So, you've got some pent-up earning power there that they should be able to realize over the next couple of years, if short-term rates ever start to move up off the floor. That's not something you'd expect to find in other companies. Typically, a lot of those higher-yielding stocks don't have the economic upside, and they have valuation sensitivity to higher interest rates. And they themselves might be refinancing shorter-term borrowings at higher interest rates. So, it's not just the discount rate that goes up; their income might also go down. Paychex--which has no debt and lots of cash in addition to what it's holding for its clients--has those positive links to a better economy. You didn't see them to get clobbered in the downturn, but they'll participate on the upside. You can't say that about most utilities that would, for instance, yield 3.6% like Paychex does right now.

Glaser: Looking at valuation, does the firm look cheap?

Peters: This is one of their two problems. I think one of the threats to the business, long-term, is whether or not there will be some cloud-based service provider that will push Paychex or even its big rival, Automatic Data Processing (ADP), into some kind of a bind. I don't really see that happening. You don't want to turn over the handling of your cash to just anybody. It's not just the software involved, it's also the people and the services that are provided around it. But the big hitch right now is valuation. The stock is not really cheap on a price/earnings ratio basis. Though, it certainly has a nice yield, which is largely a function of that high payout ratio.

I think it's worth holding at least on the basis of its mid-3% yield. Dividend growth for the stock, over a five-year outlook, should be in the high-single digits. I think that's pretty good from a total return standpoint. But our fair value is $36, which is a couple of dollars below where Paychex has been trading. I would hold out for that before I add to or start a position in the stock. So, even though it's not a buy right now, it's a name I think that just about any income investor ought to have their eye on and look for those opportunities to buy it when it's trading at a fair price or better.

Glaser: Josh, thanks for the analysis today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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