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Margin of Safety
Margin of Safety
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Paychex (PAYX): Wide Moat Dug from High Switching Costs

December 15, 2011 | About:

PAYCHEX Overview: Paychex Inc. (NASDAQ:PAYX) was formed in 1979 and is headquartered in New York. The company provides outsourcing solutions to small and medium-sized businesses in the areas of human resource, payroll, and benefits for employees. Paychex operates through a network of over 100 offices across the U.S. and four offices in Germany.

Its services include payroll processing, payroll tax administration services, employee payment services, insurance services, retirement services administration, regulatory compliance services (new-hire reporting and garnishment processing), Paychex HR Solutions, eServices, and miscellaneous other human resource services & products.

The company reports its consolidated results in one segment. However, the majority of its revenues come from its payroll services. Paychex expanded in the domain of self-service payroll services for small businesses through the $115 million acquisition of SurePayroll Inc., a provider of Software-as-a-Service (SaaS) platform, in FY 2011. Geographically, the operations of Paychex are concentrated in the U.S. Less than 1% of its revenues come from its German operations.

Service revenues have largely remained flat over the last three years, growing at a CAGR of 0.5% to ~$2.0 billion in FY 2011. EPS decreased by 1.4% during the same period.


Paychex is a market leader in payroll, tax, benefits, retirement and HR services market for small and medium enterprises. The company derives its competitive advantage from its established customer base, clientele across industries, high switching cost for the consumers, core competency in payroll services, and service diversification. Paychex has a strong base of over 564,000 clients in the U.S. (up 5.2% year over year, including SurePayroll) and 1,900 clients in Germany.

The company is often viewed as a one-stop solution by its clients and it has been successfully cross-selling the bulk of its services. Almost 95% of its clients use the payroll tax administrative services, while 79% use the employee payment services. As a result, over 79% of the clients that existed in the beginning of fiscal year 2011 were retained by the company at the year’s close, which is an impressive rate by industry standards. Paychex benefits from high switching costs for its customers. For small and medium business customers, the alternative to outsourcing payroll, tax, retirement, and HR services is to have an in-house finance and accounting department.

Internally maintained departments entail large capital outlays for equipment & infrastructure and ongoing costs in the form of employee compensation, training, and in-house MIS & other systems. Consumer preference also plays a vital role in ensuring customer retention in this market. Small and medium-sized businesses usually prefer to continue their relationship with the existing service provider because of the sensitivity of data involved and potential risks of switching. However, a number of service providers compete with the company at different levels and those that come up with considerably superior or diversified offerings may become potential alternatives for existing Paychex customers. Therefore, the company is securing its base by effectively diversifying into new areas, primarily through inorganic growth. The acquisitions of smaller players in niche services bring with them a number of benefits, including ready customer bases, operational resources, and required skill sets. Paychex is performing well in such newer domains, such as 401(k) plans, which may become important new revenue streams in the medium to long term.

Payroll and associated services make the biggest contribution (approximately 68.8% of the total service revenue) to the top line. The nature of these services make them vulnerable to the macroeconomic environment. Tough economic conditions are putting a damper on new business initiatives and in turn, putting pressure on client growth of Paychex. In addition, steadily high unemployment rates are expected to hurt Paychex in the short-to-medium term. After declining to 8.9% in February 2011, U.S. unemployment has risen to 9.1% in August 2011 and is expected reach 2010 levels (approximately 9.8%) next year. In addition, checks per client (payroll checks for the clients’ employees that are prepared and delivered by Paychex under its payroll services) plunged during the recession before registering the first year-over-year growth of 2.6% in fiscal year 2011.

Going forward, Paychex expects a stable trend in checks per client growth. Client loss also improved by 9% in the last fiscal year. To consolidate its position in the segment, Paychex is now targeting the Software-as-a-Service (SaaS) model, which offers a self-servicing platform designed for clients who prefer looking after their payroll function themselves. The acquisition of SurePayroll Inc. in February 2011 brings in a ready client base of more than 30,000 and opens up the online market of small and medium-sized business to the company. By bringing an alternative to its own services within its ambit, Paychex is set to gain in the long term. An estimated 5 million enterprises still manage their payroll manually and are slated to move over to web-based services in the next couple of years. SurePayroll is also a provider of payroll-related applications for handheld devices and will help Paychex tap in to the rapidly growing mobile services market.

To propel organic growth, the company is taking a number of initiatives, including the adoption of new technology and revamping its current technological platform. It is increasing its focus on the higher margin Major Market Services (MMS), which are targeted towards larger clients with greater payroll and benefits support requirements. This service package also includes regulatory compliance services and offers the option of Software-as-a-Service (SaaS) model. To attract new customers, it has brought into effect some pricing and packaging enhancements during fiscal year 2010. Paychex is also moving forward to bolster its internal sales function by investing heavily in training programs and streamlining its hiring policies.

The economic downturn has severely impacted the company’s client base, the medium and small businesses, across the country. On the other hand, continued softness in the interest rates has adversely affected the secondary revenue stream for Paychex. The share of interest earned on funds (IEF) held for the clients in total revenue has declined from more than 7% in the pre-recession period to approximately 2.3% currently. Realizing the changing market dynamics, Paychex has been taking measures to reduce its reliance on the secondary sources of income and expand its reach in new market segments.

The company is paying more attention to other revenue streams such as plan 401(k) related services. During fiscal year 2011, the client base increased organically by approximately 5% year over year and it currently caters to almost one-tenth of all the 401(k) plans in the U.S. Towards this end, it also acquired Denver-based ePlan Service Inc. in May 2011. This move will provide the company direct access to the retirement services market in all the 50 states.

ePlan is a provider of record keeping and administrative services to over 4,000 Defined Contribution 401(k) plans. The 401(k) market has been the fastest growing retirement plan segment in the pre-recession period with CAGR of approximately 4%. The segment is expected to grow a rate of more than 4% over the next three years, representing significant opportunity for Paychex. This acquisition will also allow it to make inroads in the financial advisory services, which is likely to be the fastest growing service line in this market. ePlan’s established market and core competence will help Paychex take on competitors, like Automatic Data Processing (NASDAQ:ADP), successfully. ADP, one of the world’s largest providers of payroll, employee benefits, tax, and HR services, benefits from its established brand name and economies of scale. ADP competes with Paychex across all the segments, including retirement plans and benefits administration.

HR services constitute approximately 29.3% of the total service revenues. The company’s services cater to almost 567,000 employees (up approximately 13% year over year) for its 21,000 clients. Paychex offers two packages of services in this segment, Administrative Services Organization (ASO) and Professional Employer Organization (PEO). Both of these packages combine services such as payroll, employer compliance, human resource, employee benefits administration and risk management and offer on-site availability of a human resource representative. The difference between PEO and ASO is that under PEO, the company assumes the risk and rewards of employee compensation insurance as a co-employer and also provides health insurance to the employees. It introduced a phone-based ASO product, HR Essentials in fiscal year 2011, which has contributed significantly in the revenue growth in this segment. Currently, the company serves 100,000 insurance clients (up approximately 8% year over year) and approximately $1 billion in premiums.

A strong financial profile is another factor that provides a definite competitive advantage to Paychex over its competitors. Above average profit margins and returns that exceed two times the industry averages, zero debt in a highly levered industry, and cash reserves allow Paychex to respond quickly to the upcoming opportunities and take pro-active initiatives to maintain its competitive position.

Operational Performance

Over a period of 10 years from fiscal year 2002 to fiscal year 2011, Paychex’s year-over-year revenue growth followed an uptrend with a sharp decline during the recession and with improvement in the last one year. The trend is clearly indicated in the five and three-year averages. However, the average net margin has stayed in the high 20s. Long-term EPS growth has mirrored revenue trends. The year-over-year growth rate lags behind the pre-recession rates by more than 100%. Average ROIC and ROE have largely remained in the range of low to mid-30s over the last decade, while ROA has been in the high single digits, indicative of above-average returns on invested capital. Tables 1 and 2 indicate that the free cash flows (FCF) have shown a fairly stable trend during the trailing 10 years, though the growth rates have fluctuated in line with the revenue. Free cash flows increased consistently with a sudden plunge during the recession. The year-over-year FCF growth has picked up in the last one and is nearing pre-recession levels.



10 year earnings and equity per share are shown on the above chart and table. Since we look to predictability of the business as a key factor in our investment decisions, we dusted off an old Journal of Portfolio Management article by Hunter and Coggins and use their stability formula:

Stability EPS=σEPS √1-R2/Arithmetic Mean EPS

This formula is best used with large companies with relatively stable earnings that have economic moats. The formula provides a measurement of stability of EPS (or revenue, BVPS, FCF) from a linear regression.

We apply this measurement to revenues, free cash flow and book value per share over a 10-year period. This statistic can theoretically yield a broad range of values, with .00 corresponding to no error about the regression line. The statistic is an “average error about the regression line” divided by the mean EPS (or Revenue, BVPS, FCF). In the vast majority of cases, the output will be a positive decimal between 0-1. By subtracting the statistic value from 1, we obtain a percentage that represents stability in the metric of interest. The statistic gives a picture of the long-term stability of key operational metrics and is useful in comparing different companies. When the formula is applied to Paychex, we see relatively stable revenue, FCF, and EPS over the last 10-years, with slightly less stability in book value/share. All in all, this confirms that, while not the sexiest growth company, Paychex has been a steady performer and FCF-based valuation methods are reasonable.


Financial Health

Paychex has a very strong financial profile. It has zero debt in an industry where the average debt equity ratio is 13.9, making it more attractive as compared to the competitors. The company has positive liquidity, though it lags behind the industry, with a current ratio of 1.1 against 2.1 for the peers. Paychex continues to show strength in cash generation. In fiscal year 2011, the operating cash flow increased by 17.0% year over year to $715 million. Free cash flows increased by 14.3% to $615 million during the same period. Net cash outflow was $165 million against $188 million in the previous year. In fiscal year 2011, the outflow was primarily driven by dividends paid ($449 million), acquisition ($126 million), capital expenditure ($101 million), and net increase in investments ($180 million). During fiscal year 2010, the outflow was mainly on account of dividends paid ($449 million) and net increase in investments ($403 million).

Paychex primarily depends upon its operating cash flows for its funding needs. The company had cash and cash equivalents and corporate investments, including interest receivable, of $493.4 million and $395.5 million at May 31, 2011 and May 31, 2010, respectively. The company also maintains four uncommitted, secured, short-term lines of credit, aggregating to $950 million. The facilities are meant to be used for short-term funding requirements related to deposit account overdrafts and client fund obligations in ordinary course of business. At May 31, 2011, no amount was drawn against these facilities. The company also had irrevocable, standby letters of credit amounting to $47.4 million May 31, 2011 and $50.3 million at May 31, 2010. No amounts were outstanding against these letters of credit.



A DuPont analysis compared with its larger rival ADP reveals superior profit margins, ROE, and roughly equivalent relative valuation metrics.


President and CEO Martin Mucci joined Paychex in 2002 and has been serving in his current capacity since 2010. An MBA from the University of Rochester, he holds a bachelor’s degree in accounting from St. John Fischer College, Rochester. Mucci had a 20-year long industry experience before joining Paychex, having served Frontier Telephone of Rochester in senior positions. Currently, he is an independent firector in the board of Cbeyond Inc. (CBEY) and the vice chairperson of Rochester Business Alliance. Senior vice president, chief financial officer and treasurer, Efrain Rivera is a doctor of management from Case Western Reserve University, Cleveland and an MBA from the University of Rochester. He has over two decades of industry experience in senior level positions with Bausch & Lomb. Earlier, he also had served the Civil Division of the U.S. Department of Justice as an attorney.

Paychex is returning money to its shareholders in the form of cash dividends, with an average payout ratio of 88.3% in the last three years. The current rate of payment may be unsustainable in the medium to long-term considering the high levels of payouts and challenging market conditions. This is particularly true because Paychex primarily caters to small and medium enterprises that are more vulnerable to changing macro-economic conditions. While the risk is low, dividend investors should take note.

Moreover, Paychex has been giving above average returns, justifying the retention of a higher portion of earnings that may be utilized for growth initiatives. Currently, its return on equity is 35.6 against the industry average of 15.1. The corporate governance at Paychex can be considered as fair. In fiscal year 2011, the net income increased by 7.9%, while the total executive compensation increased by 5.5%. The CEO’s compensation decreased by 28.5% during the same period. The company also performs peer-group benchmarking to ensure that its executive compensation falls below the peer-set median.


A DCF model is reasonable for a company with such steady free cash flow over the past 10 years.


We assumed FCF growth rates of 8%, 4% and 3% over the 5, 6-10 and 10-15 year time periods, with a terminal rate of 3% and a 9.5% discount rate. We believe that approximately $35 is a reasonable valuation for Paychex. While only trading less than 20% discount to intrinsic value, this debt-free, steady cash-flow generator that benefits from high switching costs yields 4.3% and is a good stock for your watch list to buy on dips.

Disclosure: Long PAYX, acquired at $26.15

About the author:

Margin of Safety
Margin of Safety Equity Research is a value-investing focused company providing equity research services, the Securities Analysis System investment software, stock valuation models, and other financial resources for value investors. Members of our subscription services have access to the Margin of Safety value-oriented portfolio and discounted access to our software.

We apply Buffett's and Charlie Munger's four filters in selecting stocks as part of a concentrated portfolio (10-15 equities). Criteria for selecting companies are:

1.They are strong businesses; as defined by high long-term cash generation, above-average return on invested capital, possession of favorable underlying economics and a durable ...More competitive advantage, good financial health, and above-average profit margins

2. We understand the business

3. They are run by competent management

4. They are available at bargain prices.

We require a 25-50% margin of safety, depending on the stability and economic moat for the company.

In addition to equity research services, we are a member of the Gerson Lehman Group Expert Counsel of Advisors and provide research/consulting services to investment banks.

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Rating: 3.7/5 (23 votes)


Johnheiderscheit - 6 years ago    Report SPAM
You had me until the 9.5% discount rate in your DCF. I would use at least 11% for a company with a 1.1x current ratio. I have PAYX right around fair value so I don't see much of a margin of safety. Thanks for the very detailed write up though.

Margin of Safety
Margin of Safety - 6 years ago    Report SPAM
I appreciate the comments John, while we differ on the discount rate. We do not have a screaming discount to IV, which is why we would advise to buy on dips. Regards,
Tnkenyon - 6 years ago    Report SPAM
No mention of the role of float and the effect of low interest rates on the business? Also affects the ROA since funds held for clients shows up on the BS. How about pays per control trends? I like PAYX, and am long, but you missed a few key aspects of the business.

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