2023-06-14 01:33:11 ET
Summary
- Paychex is a steady company with consistent growth and an increasing yearly dividend, but its current valuation is slightly high.
- The company benefits from a strong job market, HR outsourcing trend, and higher interest rates, but faces competition and potential economic risks.
- Paychex is rated as a "Hold" with a preference for Paycom in the HCM space.
Paychex ( PAYX ) is a solid holding for investors that like steady results and an increasing yearly dividend. However its current valuation is a little on the high side.
Company Profile
PAYX is a human capital management [HCM] services and software firm. It offers solutions for payroll, human resources, benefits, and insurance service for small to medium sized businesses.
The company reports its revenue in two segments: Management Solutions and PEO & Insurance Solutions. Within Management Solution the company offers a number of services including payroll processing, payroll tax administration services, and employee payment services. It also has regulatory compliance services that help with things like complying with the Affordable Care Act, and HR solutions to help manage benefits, recruiting, onboarding, and other HR functions. The segment also has retirement solutions that include 401K and other retirement plan options such as SIMPLE IRAs.
Within the PEO and Insurance Solutions segment, PAYX offers a PEO solution to its clients. For its PEO solution, PAYX acts as a co-employer to its clients where it is able to pool clients together while taking on some of the risks and rewards of certain workers’ compensation insurance and health insurance offerings. PEO clients also get payroll, employer compliance, HR and employee benefits administration, risk management outsourcing services. PAYX self-insures the deductible portion of its insurance exposure. For its insurance solutions, the company has a licensed insurance agency that provides insurance through various carriers.
Opportunities and Risks
PAYX is currently riding the wave of a solid job market and the trend of HR outsourcing. The HCM market is generally forecast to growth at between a 7-9% CAGR by most outlets, and while a legacy player, PAYX is still seeing its share of growth. This can be seen in its 7% service revenue growth in Q3 and 8% service revenue CAGR since its fiscal year 2018. If anything, the company has been consistently steady in its growth.
Product development and increasing product penetration remain a key for the company. While long known as a payroll company, PAYX is still seeing good upselling of its HCM and retirement products to existing clients. It's also been able to take price as well.
Discussing fiscal 2024 on its FQ3 earnings call , CFO Efrain Rivera said:
“The first is obviously what we expect from a client growth perspective … The second part is what do you expect from a pricing standpoint, too early to talk exactly what we're going to do. But those 2 components, both client growth and also pricing are part of our assumptions going into next year. You want to get the right level of product attachment, continued growth on the ancillary products in the bundled suite including time and attendance, HR administration. And then increasingly, within Management Solutions, retirement and HR drive a lot of growth. And we're assuming strong years within both of those products, partly on the return side based on what John said. So you put all those together, and that forms the basis of our thought process around Management Solutions. And then PEO and insurance, we expect to grow faster than we've seen this year in part because of some of the headwinds we feel will abate as we get into next year, although that may still be evident in Q1.”
Another place where PAYX has benefited from is higher interest rates. The company holds funds for clients in interest bearing accounts before they are paid out to employees. The surge in interest rates has seen its float income explode higher, including being up 144% to $35.3 million in fiscal Q3. This all drops right to the bottom line and as free cash flow, so it’s a nice beneficiary to the current hawkish Fed.
PAYX also expects some headwinds from its PEO and insurance businesses to dissipate in FY2024. It saw some lower healthcare insurance attachments in FY23, and will look to reset on this side of the business during the next open enrollment period in what ultimately is a low-margin, mostly pass-through type of offering.
When looking at risks, competition is a big one. While PAYX is a large company that continues to show growth, nimbler HCM and payroll companies such as Paycom ( PAYC ) and Paylocity ( PCTY ) have been taking share away from legacy players like PAYX and ADP ( ADP ). While the legacy players will have a place and continue to grow, I’d expect this trend to continue.
The economy and jobs are also another potential risk. Despite some well publicized layoffs in the tech space, jobs growth in the U.S. has continued and unemployment remains low. That has certainly been a boost to all the HCM companies. However, the tide can certainly shift, which undoubtedly would be bad for a company like PAYX.
PAYX also takes on insurance risk in its PEO segment. If it misjudges its risk assessment, it can certainly impact results. This is more impactful for a pure PEO company like TriNet ( TNET ), but PAYX also has some risk exposure here, as well, and it will need to be careful to maintain its discipline in the face of a tough insurance attachment year in fiscal 2023.
One recent area the company has been doing well with is its Employer Retention Tax Credit (ERTC) service. The company warned last fiscal year growth in this area would slow but that did not happen. Given that this is a Covid-related tax credit, it should indeed go away and be about a 1% headwind in FY2024.
Valuation
PAYX stock trades around 16.6x the FY2024 (ending May) consensus EBITDA of $2.39 billion and 15.3x the FY2025 consensus of $2.58 billion.
It trades at a forward P/E of 24.7x the FY24 consensus of $4.60. Based on FY25 analyst estimates of $4.96, it trades at 22.9x.
PAYX trades at similar valuation to rival ADP, at a higher valuation compared to PEOs, and at a lower valuation compared to faster-growing payroll and HCM firms.
Historically, the stock is trading at higher level than it was trading at pre-pandemic.
Conclusion
PAYX is a solid company that has been very consistent in its growth. At the same time, it’s a nice dividend grower, increasing its distribution for 10 consecutive years. The stock currently yields over 3%.
That said, the stock’s valuation is a bit high compared to historical levels, and the jobs and employment picture are about as good as gets. It has a few minor headwinds it’s been dealing with and should see the benefit from ERTC go way, although none of this is anything particularly concerning.
Overall, I think PAYX is a solid stock, and I rate it a “Hold.” I prefer PAYC, which I wrote about recently , in the space.
For further details see:
Paychex: Hold For The Steady Growth And Increasing Dividend