Summary
- Paychex has a stable growth history in its top line and operating cash flow.
- However, its cash flow from investment activities has an outsize impact on its net cash flow due to a large investment portfolio directly earning a return in the financial markets.
- Its net cash flow as a result has high volatility and less of a linear upward trending compared with its free cash flow.
- It could also face a weaker employment outlook and economic condition ahead that weakens its operating cash flow.
Investment Thesis
Company Overview
Paychex (PAYX), incorporated in 1979 with its headquarter in Rochester, New York, is a human capital management software and services company. The company offers a comprehensive portfolio of technology solutions and services, including fully outsourced HR, HCM software, payroll processing, retirement and insurance solutions. It covers the full employee life cycle but also has à la carte services options. Its business is reported as one segment. The company's fiscal year ends in May each calendar year.
Strength
Paychex provides HR solution from DIY to comprehensive outsourcing targeting small to medium size businesses. The company has about 72,000 clients with 84% retention rate as of fiscal year 2022. As the company stated, most of its clients generally do not specify service agreement and arrangement period. So the client retention is key to its top line and growth. According to the survey, the company ranks high in client retention and repurchase inclination, although its competitors are not trailing too far behind.
With its offering of à la carte services, its clients can either utilize their service team or use the Paychex Flex platform to DIY. And the company is seeing HR outsourcing services moving down-market as a trend. Its sales channel is mostly through direct sales with its sales force, including representatives with defined geographical territories and specialization. In addition, it relies on relationships with existing clients, CPA's (such as AICPA, American Institute of Certified Public Accountants), and banks for new client referrals. It reported 50% of their new clients came from referrals. Also their own website as a digital marketing platform. For a tech firm, the sale channels it utilizes seem quite old-school. But from the financial highlights from its latest report, we can see that they worked.
Paychex offers wide range of services, from management solutions such as payroll processing, tax admin, employer payment, compliance, retirement solution, HR admin, to PEO (Professional Employer Organization) and insurance solution. Its revenue from management solutions and PEO & Insurance Solutions are the key drivers of the revenue growth. By offering services that cover a full employee cycle, Paychex is able to provide both comprehensive and customized à la carte services options. For small and medium size businesses, these options are important to fit to their sometimes volatile growth.
Technological adaptation to client service is one of the advantages of Paychex. On one hand, it helps its clients to improve efficiency, but on the other hand, it also simplifies its own workflow and reduces the cost and operating expenses over time.
Perhaps that is one of the reasons why its cost of revenue measured as a percentage of revenue has been coming down in the past ten years, and operating expenses as a percentage of revenue have been flattened. The company has been able to maintain and control costs and expenses with a steady hand.
The business of human resource department is usually not a direct contributors to the bottom line of business as the company's bread-and-butter clients, small and medium size companies, always try to save on the administrative cost. But Paychex managed to maintain a 70% margin over time and stable margin in all other categories. It shows the company's services is value-added with strong staying power with its clients.
For its long term growth, we are curious to see if Paychex will migrate to more digital efforts in its sales and marketing strategy. For smaller businesses, with their high-birth-and-high-crash rate, they could be more connected with digital and social media than word-of-mouth, if we could speculate.
Weakness/Risks
After a sharp rebound from the early 2020, Paychex's net cash flow has come back down to negative $81.3 million in the most recent quarter.
It's been the company's cash flow from investing activities and financing that were dragging down the net cash flow. Its fiscal year 2022 had a negative net cash flow of $894.7 million. The breakdown of it and the past four years can be seen in the chart below. Although for the first two quarters of fiscal year 2023, which are Q3 and Q4 2022, it had a positive net cash flow of $696.4, its cash and cash equivalent as of Nov, 2022 was $1.096 billion, just about enough to cover one year of similar negative net cash flow like in FY 2022.
PayX Net Cash Flow Breakdown (Bloomberg)
Specifically, its net cash flow from fiscal year 2018 to 2022 are as below. We can see the ups and downs could have a largest difference of over $3 billion.
To see what's happening, there is an important item in Paychex's financials that readers should know about. Paychex has a substantial part of its current asset as "funds held for clients", and similarly substantial part of current liabilities as "obligations to clients", due to the funds held for clients. This "fund held for clients" is defined as the funds collected from clients before due dates for payroll tax administration services and for employee payment services and invested until remittance to the applicable tax or regulatory agencies or client employees. As of November 2022, among the total investments in the chart below, funds held for clients was $3.132 billion, almost 18x of the $165.6 million corporate investments in it. The company invests both "funds held for client" and corporate investment into high quality, investment-grade marketable available-for-sale ("AFS") securities, money markets, and other cash equivalents. Breakdown of this total financial investment in AFS securities as of Nov, 2022 is as the chart below. The total value of the funds invested in financial market to earn a return is $3.302 billion at the time reported by its 10k . Its corporate investment, which was invested alongside with funds held for clients, declined in value from $853.9 in May, 2022 to November's $165.6 million. The company didn't explain why the decline but it didn't seem like this in-house financial investment exercise was making a positive return, it currently has unrealized losses on the available AFS securities of $217.8 million, reported as of Nov, 2022.
payx (payx)
And that's why we see the outsized impact on net cash flow from the cash flow from investing activities over time. Their influence on cash from investing activities can reach 90% to sometimes more than the total cash from investing activities.
PAYX ((PAYX))
And the net change in client fund obligations, which Paychex pay from its proceed of sales and maturities of the financial assets including funds held for clients, also sometimes had almost 50% influence on the cash from financing activities.
payx (payx)
We can see its cash flow from both investing and financing activities are highly volatile, resulting the volatile net cash flow we showed earlier.
Although the operating cash flow continues to grow, it is shadowed by the influence of cash flow from the financial assets return. This correlation of its net cash flow with the volatility of the financial market should worry investors when trying to project a long-term view of the company's future cash flow.
And this "fund held for client" is also reported under current assets. To put this in context, as of Nov 30, 2022, its current asset before funds held for clients was $3.065 billion and "funds held for clients" were $3.132 billion, and they all added up to be its total current assets. And similarly, current liabilities before client fund obligations were $1.4 billion and its client fund obligations was $3.35 billion. Although assets and liabilities eventually cancel out to produce the net, they are still substantial in each of its categories.
And looking forward, Paychex's operating cash flow could experience more weakness due to the weaker economic environment and perhaps only the beginning of larger layoff waves. So far, most of the employers have been hanging onto their personnel, except for some large layoffs in the tech sector. But weakness can already be seen. The data on the business of the small business with less than 20 employees shows employment has begun to trend down.
Employment: Small Business of less than 20 Employees ((FRED))
Certainly this is the section of business community perhaps most vulnerable and sensitive to economic conditions, but the medium size business cannot be immune to it as cost cutting hits. With less employees, the workload and cost of HR will be cut as well. Without a definitive service agreement, the clients of Paychex could downgrade the services without binding obligations. So it could happen faster than otherwise.
Financial Overview
Valuation
Paychex has outperformed its peer group and the broader market in the past five year.
payx (payx)
We take into account the analysis above and use our proprietary models to assess the fair value of Paychex with a ten-year projection forward. We factored in the volatility from the net cash flow as it could impact the company's long term liquidity position. In our bullish case, although Paychex could experience weakness in '23 and '24, it continues a steady growth pattern; it was valued at $87.03. In our bearish case, competition and integration could bring less upside growth in the longer term, although it is unclear how it will play out, we expect more competition in the sector of HR management; in this case it is valued at 74.85. In our base case, the steady and gradual growth wins the day, it has weakness in '23 and '24 and although less stellar but steady growth later; it is valued at $83.38. The current market price is higher than our top estimate.
payx (payx)
Conclusion
Paychex has been in business for four decades and has strong network and connection that it utilizes as driving force in reaching new clients. This old fashion strategy combined with new technological platform has serve clients well and produce steady growth revenue. What's new for this company is the outsize impact from investing and financing activities on its net cash flow and the volatility it brings. With uncertain economic and financial market conditions ahead, it seems the company might get hit on both fronts on its net cash flow. We see its current price to be overvalued and will recommend a sell.
For further details see:
Paychex: Weaker Outlook Compounded With Volatile Return From Financial Investment Portfolio