Wide-Moat Paychex Remains Immensely Profitable--And Overpriced

Wide-moat

Management’s guidance for revenue growth strikes us as somewhat conservative. Over the last decade, Paychex’s annual growth in payroll has been about 90% correlated to the previous year’s growth in U.S. employment. At the end of May, 12-month U.S. employment growth was 1.9% while Paychex grew payroll revenue by 1.7%. For fiscal 2018, investors should be modestly disappointed revenues did not grow more given the favorable winds from a growing labor force. At this point in the cycle, we would expect higher growth and better guidance than 2%-3% sales growth in payroll services, which includes the benefit from Lessor. During the call, Paychex management mentioned retention was greater than 81%, which we estimate is slightly higher than retention achieved during fiscal 2017. In addition, Paychex ended May with approximately 650,000 payroll clients, and this is about 7% greater than the previous year. Given improvements in retention, growth in client count, and the U.S. labor force, we have to believe that Paychex’s revenue within payroll will start accelerating. However, if it doesn't, it possibly suggests that Paychex is having issues with pricing and increasing competition. Though Paychex mentioned that it has seen no new entrants, that doesn’t mean that competition is placid.

The bright spot for Paychex continues to be HR services. Though federal regulation may be easing, at the state level it is increasing. Prior to this quarter, we cannot find Paychex ever using the word "harassment" during a conference call, but now it appears customers are seeking Paychex's assistance in adopting new harassment policies in order to mitigate risk. As long as risk related to employment is increasing, employers will want to outsource which why Paychex will continue its double-digit growth in the segment.

Paychex's Specific Services Do Pay Off Paychex's niche of providing payroll solutions to small businesses remains immensely profitable. With revenue growth that is routinely in the mid- to high single digits and EBIT margins just below 40%, this company continues to benefit from its expansive scale and the low incremental costs of providing payroll and new offerings to customers. This profitability has attracted competitors. We've become impressed with increasingly capable do-it-yourself software solutions and younger competitors in Paylocity and Paycom, which may represent a growing threat in the years ahead. We do not believe Paychex will benefit from increasing employment as it historically. In order to maintain its edge, we believe Paychex will need to increase its capital spending, improve its capabilities, and expand its service offering. The company has increased its level of service without increasing customer fees, which suggests to us that the company has limited ability to improve operational margins.

In recent years, much of the company’s growth has been attributable to human resource services. Revenue in this segment has compounded at more than 14% over the past five years, and much of this growth has been attributable to companies that are seeking to outsource parts of their HR department or access other cost savings. In addition, many small businesses have used Paychex’s professional employer organization to assign new and existing employees to Paychex as if these employees were really employed by Paychex, in order to gain better pricing on healthcare and employee benefits.

Finally, we do anticipate that interest rates will serve as a significant tailwind over time. Paychex generates interest income on all employee withholdings. In the precrisis period, Paychex had realized yields of nearly 3.5% on these cash balances. In fiscal 2018, Paychex realized yields on cash balances of 1.6%, we believe yields will eventually reach 2.5%, providing an additional $50 million in earnings that will fall directly to Paychex's bottom line. Without this benefit, Paychex may struggle to meaningfully increase margins in the years ahead.

HR Helps Paychex Dig Its Moat Paychex has constructed a wide economic moat through onerous switching costs and cost advantages resulting from the scale the company has amassed within its niche over the years. Through the end of 2018, Paychex served 650,000 clients. This captive list of clients has enabled the company to expand its product offering from employee payroll to record-keeping for retirement plans, health benefits, and workers' compensation. As tax, labor, and workforce regulations have grown in complexity, established providers such as Paychex have benefited by offering additional products and services. Small changes in labor regulation can result in significant increases in the reporting requirements that small and midsize business must provide the IRS and government. Small and midsize businesses often do not have HR departments and are reliant on Paychex to guide them through these changes.

Unlike rival ADP, which services a lot of midsize businesses, Paychex specializes in serving small businesses. In fact, the average client employs only 17 people. We believe Paychex maximizes its margins at 15-50 employees. Here, clients do not require a lot of service, but cannot entirely rely on a do-it-yourself software solution. In addition, we believe Paychex is partly insulated from competitors in this segment of the market. In order to succeed in this segment, one must invest in a large customer service apparatus. Thus, it does require a large initial fixed investment and significant scale to service small businesses. However, the typical Paychex customer is more sensitive to the overall economy. Paychex’s retention rates are typically in the low 80s and client losses generally result from bankruptcies and acquisitions. Retention rates also fall during recessions. At the end of fiscal 2009, retention dipped to 77%.

Generally, Paychex charges customers a flat rate plus an additional fee for employees enrolled in the platform. Increasing employment can provide a significant tailwind during economic expansions, while hurting the company during recessions. Between 2008 and 2010, revenue in Paychex’s Payroll Service business fell about 4%.

The company also has a Human Resource Service business. In some cases, companies outsource some of their HR functions to Paychex through its administrative services organization, or ASO, offering. This deepens a customer’s relationship with Paychex while increasing the switching costs for customers. In addition, Paychex serves as a professional employer organization. PEOs differ from ASOs in that it is a co-employment model. Paychex’s customers will hire employees for their HR departments; however, the employee will actually be technically employed by Paychex. This way, smaller employers can access better rates for insurance and health benefits that Paychex can access as a larger employer. The ideal PEO customer is a small or midsize business that may not need a full HR department. The Affordable Care Act has served as a significant catalyst for this business, as benefit costs have increased for employers. As employers grow, these services are often taken back in house.