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Wide-Moat Paychex Remains Immensely Profitable--And Overpriced

The company continues to benefit from its expansive scale and the low incremental costs of providing payroll and new offerings to customers.

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Wide-moat  Paychex (PAYX)  finished its fiscal 2018 modestly ahead of our expectations in part due to the inclusion of revenue from acquisitions. Total service revenue grew by more than 8.8% from last year’s fourth quarter, while growing sequentially by 0.5%. Paychex’s payroll continues to pressure top-line growth, growing only about 1.5% from the previous year organically. The company’s paid employer organization offset much of the slower growth within payroll. Payxchex’s HR Services segment continues to grow in the midteens, generating 16.7% year-over-year growth during the quarter. The company gave guidance that was modestly below what many were expecting. Management is forecasting that payroll services will grow between 2% and 3% and HRS revenue by 10%-11% for total revenue growth of 6%-7%. These numbers strike us as conservative, and we think revenue will be higher. Investors expecting margin expansion in 2019 were likely disappointed by the company’s expectation that operating margins will be 37%, lower than in 2018. After incorporating full-year guidance and making a few updates to our model, we are increasing our fair value estimate to $58 per share from $56. We’re modestly increasing our forecast for sales over the next two years, while fine-tuning a few expense items.

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.

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Colin Plunkett does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.