The share price of Paychex Inc. (PAYX, Financial) has risen approximately 196% over the past decade, yielding a decent compounded annual return of 11.60% for its long-term investors. The company has also continuously distributed dividends every year without any interruptions. Based on my analysis, it appears that the business services company is currently fairly valued.
Growing revenue with high and sustainable operating margins
Paychex helps more than 740,000 small and medium-sized businesses globally with their payroll, benefits and insurance as the part of the overall human capital management solutions. Its software-as-a-service (SaaS) product, Paychex Flex platform, provides total workforce management solutions, from recruiting and hiring to retirement for its customers.
The company has experienced significant growth in revenue over the past decade, soaring from $2.33 billion in 2013 to $5 billion in 2023. Concurrently, the operational income has mirrored this upward trend, climbing from $905 million to $2 billion.
Paychex's business model is quite profitable, characterized by a high operating margin ranging between 36% and 40.60%. The consistently high operating margin indicates the company has efficiently managed its operational costs under various economic conditions, resulting in strong and sustainable profitability.
Compared to peers like Automatic Data Processing (ADP, Financial) and ManpowerGroup (MAN, Financial), Paychex's operating margin has been much better. In 2023, its operating margin stayed at 40.60%, nearly double the operating margin of Automatic Data Processing at 21.50%. On the other hand, ManpowerGroup's operating margin was quite minimal at only 1.64%.
Improving return on invested capital
Another impressive factor is the consistent improvement in the company's return on invested capital. Its ROIC has nearly doubled from 9.65% in 2013 to 18% in 2023. The consistent increase in ROIC over the past decade demonstrates the company could grow its customer base, revenue and profitability without having to proportionally increase investments in its infrastructure, system and operations.
Consistently positive cash flow generation
Paychex has quite strong cash flow generating capabilities. In the past decade, its operating cash flow increased from $675.30 million to $1.70 billion. Simultaneously, the free cash flow soared from $576.60 million in 2013 to $1.56 billion in 2023. The free cash flow margin has remained quite healthy over time, staying between 24.79% and 32.52% .
The consistent high level of cash flow creation and sustainable free cash flow margin indicate the effectiveness of Paychex's business model, throwing off a lot of cash available to pay off debt, invest for growth and return cash to shareholders via dividend payments and share buybacks.
High net cash level and low leverage ratio
Paychex possesses a robust balance sheet with a conservative capital structure. By February, shareholders' equity stood at $3.75 billion, alongside cash and cash equivalents totaling close to $1.70 billion. Outstanding interest-bearing debt amounted to a mere $818 million, leaving Paychex a net cash position of $882 million. The company's debt-to-equity ratio remained quite low at 0.22.
Investors might observe the biggest asset item on Paychex's balance sheet is funds reserved for clients, amounting to approximately $6.08 billion. These "client-held funds" represent money collected from clients but not yet disbursed for payroll tax payments or employee wages. Given its designated purpose for specific client obligations, this money is deemed "restricted," barring Paychex from using it for internal expenditures or investments. It must be maintained separately and solely utilized for the intended client-related functions.
Consistent dividend payment
Paychex has been paying dividends to shareholders quite consistently. Since 2003, its dividend per share has risen from 44 cents to $3.26 in 2023. Over the past 20 years, there was only one year when its dividend declined, from $1.27 in 2012 to 65 cents in 2013. After that, it bounced back higher to $1.40 in 2014. At the current trading price, Paychex's dividend yield is quite decent at 2.70%, twice the S&P 500's 1.37% yield.
To assess the company's dividend payment sustainability, investors should look at the payout ratio, which measures the percentage of the company's income distributed to shareholders in the form of dividends. In the past 20 years, Paychex's dividend payout ratio has stayed between 0.42 and 0.95, indicating its strong commitment to paying dividend to shareholders.
However, when the dividend payout ratio reached the upper end of this range at 0.95, it means the company paid most of their profits they made within the year in dividends, leaving little for future growth. This could signal caution. A lower ratio would be more sustainable as it balances shareholder returns with the company's long-term financial health. In 2023, Paychex's dividend payout ratio settled at a more sustainable level of 0.76. Because of the growing operating performance, consistent cash flow generation and reasonable dividend payout ratio, I think there is minimal chance that Paychex would stop the dividend payment.
Fairly valued
Since 2003, Paychex's enterprise value-to-Ebit ratio has fluctuated in the range of 10.77 to 35.17. At the current trading price, the company is valued at 18.21 times its earnings, slightly lower than its average 20-year multiple of 18.76. Thus, Paychex is considered fairly valued when being compared to its historical earnings valuation.
Paychex is expected to generate $5.55 billion in revenue in 2025. Assuming the operating margin stays at 40%, its operating profit would amount to $2.22 billion. An earnings multiple of 20 would value the company's enterprise value at $44.40 billion. Adjusting with the current net cash of $882 million, Paychex's equity value should be worth $45.30 billion. With 362 million shares outstanding, the intrinsic value per share would be $125. Thus, Paychex is fairly valued in the market now.
Potential risk
As Paychex's main business is servicing human resources operations, its business is strongly tied to the growth of its clients, the overall job creation and economic growth. Thus, if the Federal Reserve raises interest rates further, global economic activity will slow down, leading to job cuts that negatively affect its business.
Furthermore, as Paychex's operating leverage advantage comes from its technology and its Flex platform, the company should keep reinvesting into the business for technology innovation and enhancement. If the company cannot adapt with the fast-changing technology environment, customers might switch to its competitors' products. That is the reason why I prefer the company to have a reasonable dividend payout ratio of less than 0.70, so that Paychex has 30% or more of the profits to reinvest for future growth and keep the business sustainable.
Conclusion
Paychex has demonstrated a commendable financial performance over the past decade, with strong operating performance including growing revenue, operating income and cash flow generation. The company maintains an impressive operating margin, significantly outperforming peers, which is indicative of its efficient expense management and profitability. The balance sheet remains robust, with a solid net cash position and a conservative debt-to-equity ratio. Moreover, the company has kept returning cash to shareholders via increasing dividend payments. Based on my analysis, Paychex is fairly valued in the current market. If the company can maintain a reasonable dividend payout ratio, it can be considered a decent investment opportunity for long-term income investors.
