Payroll Processing Pays Off

While

Paychex has other factors working in its favor, however. Its growth in recent years has come mainly through cross-selling ancillary services centered on human resources, employee retirement plans, and insurance. Further, we think the company's professional employer organization services, a model that helps small businesses better negotiate employee benefit plans, is positioned to expand as health-care costs rise. We expect the company's growth to continue to shift in this direction and believe that its small-business focus is a benefit as the limited resources available to small businesses should make them more likely to look for bundled solutions like those offered by Paychex, as opposed to searching for best-of-breed applications. Paychex, with its broad product portfolio and dominant position in the small-business space, is best positioned to exploit this trend. As such, we think the company can maintain healthy earnings growth even as the addition of new payroll clients diminishes.

Paychex should have another factor working in its favor in the coming years, although the timing is difficult to predict. Its payroll business generates float income, and the low-interest-rate environment has hampered profitability on this side. Although its float income is small in relation to total revenue, it drops almost completely to the bottom line, and we estimate that a 1-percentage-point increase in the yield on the portfolio would increase operating income about 4%. For comparison, yields in the pre-crisis period were about 2 percentage points higher than current levels.

Scale Provides Cost Advantages Paychex has a wide economic moat as a result of high customer switching costs and cost advantages due to scale in its small-business niche. Paychex is the second-largest player in payroll outsourcing (based on revenue), and its scale has allowed the firm to leverage its 580,000 clients to spread out costs associated with its servicing infrastructure. Switching from one payroll processing vendor to another is a difficult task, and a customer's hesitancy to do so has allowed Paychex to build a sticky client base. Annual client retention rates are about 80%, with most attrition due to client failures. Paychex's retention rates are similar to those experienced by ADP ADP in the small-business space.

Paychex is dwarfed by ADP, which generates about 5 times as much revenue in the payroll area, but we think Paychex's small-client focus is a positive from a moat standpoint. More than 80% of its clients have fewer than 20 employees, which lowers their bargaining power, and Paychex holds a leading market position in the small-business segment (employers with fewer than 50 employees). The difference can clearly be seen in operating margins, with Paychex generating margins close to 40%, compared with high teens for ADP. Although ADP has a scale advantage across the entire payroll processing market, we think Paychex has dug out a strong position in the most profitable area.

Paychex's competitive position in services outside payroll processing is weaker and the company is seeing higher growth in these areas, but we believe there are substantial synergies in bundling these services. The company's historically high growth hit a wall during the recession and client growth has remained very modest since. We view this more as a function of the increasing maturity of the business as opposed to deterioration in the company's competitive position. Historically, ADP and Paychex have segmented the market to some extent and avoided profit-draining competition. ADP has shown more of an interest in the small-business space over the past couple of years and could take some share as a result. Still, we think Paychex can maintain its position, and we have not seen any signs that competition between the two has become irrational.

Macroeconomic Exposure Is a Risk Paychex is exposed to macroeconomic conditions. Its results can take a hit during periods of high unemployment, and its concentration in the small-business market exposes it to increased client failures during recessions. The management of client funds could create problems if the company were to experience material impairments in its portfolio. The company handles sensitive information and its brand could be damaged if its systems were breached. Regulatory changes could also pressure margins and revenue.

Paychex is conservative in its balance sheet structure and historically has carried no debt. We don't expect this to change. The firm is also cautious in its investment of client funds, with a little more than half of the portfolio invested in money market funds, other cashlike instruments, and general obligation municipal bonds. Paychex has avoided the temptation to wring more yield out of the portfolio by taking unnecessary risks with its investments.

Paychex has been disciplined in returning cash flow to shareholders, primarily through its hefty dividend. The average payout ratio of 86% over the past five years looks aggressive at first glance, but we think it is sustainable, given the low capital intensity of the business. Paychex has been able to make some small tuck-in acquisitions and still build its cash balance during this period.