I went to executives at Electronic Accounting Systems with my plan. They looked at me and said, 'We don't think it's a good idea.' I sat on the idea for about two more months. Then I walked into the president's office one more time and said, "What do you think?" He said no. I said, "Well, I'm going to leave and start a company." It was November 1970. I was 29. He wished me well, sort of.
- Thomas Golisano, founder of Paychex
Rochester, NY-based Paychex is the recognized leader in the payroll, human resource, and benefits outsourcing industry.
The company was founded in 1971 by American entrepreneur Thomas Golisano with just $3,000 and the ambition of making payroll outsourcing easy and affordable for small businesses. Before Paychex was started, the conventional wisdom was that it was a waste of time selling payroll services to small companies. Nonetheless, Mr. Golisano did the math and proved that smaller firms needed payroll processing services just as much as larger ones, while still offering an excellent return on investment.
From those early days with just one employee, Paychex today has more than 14,000 employees serving approximately 670,000 small- to medium-sized businesses across the US and Europe.
In our opinion, Paychex operates a “cash-cow” and a “cash-calf” business. The legacy Management Solutions segment, which involves payroll, tax, compliance, administration, and so forth, represented around 78% of the 2019 sales, grew at a stable low-to-mid-single-digit compound annual growth rate for the recent few years. The PEO & Insurance Services segment drove the majority of growth momentum. Although contributing only 22% of the total, its sales increased remarkably by 46% year-over-year in 2019 and 32% in 2018.
Paychex’s clients fulfill various tasks (from payroll processing to time and labor management) on an on-demand basis through the company’s proprietary consumer-grade, SaaS-based human capital management (referred to as “HCM”) platforms, such as Paychex Flex, SurePayroll. This is where the business builds the majority of its economic moat.
One company only needs one HCM platform. Once the client chooses to go with Paychex, the staff is trained, and data is integrated, it is not so easy for the client to switch over, which may cause operational disruption or require time and capital on system migration. Paychex's clients also have the option to select the HCM modules that they need with the ability to add more as they grow. This flexibility allows clients to define the solution that best meets their needs throughout different stages, hence increasing customer loyalty.
The high switching cost is also reflected by the client retention rate of around 82%. The figure appears mediocre compared to 91% at the rival, Automatic Data Processing (ADP, Financial). But we should note the characteristic of more bankruptcies and acquisitions specific to small businesses, which Paychex mainly targets.
The SaaS model also enables the company to generate predictable recurring cash flow. As you can see below, Paychex has been converting one dollar of net income to more than one dollar of free cash flow every year since 2003.
In addition to Automatic Data Processing, the global mass-market player in the space, Paychex competes with a few smaller firms, including Paycom (PAYC, Financial), Paylocity (PCTY, Financial), Benefitfocus (BNFT, Financial), and Workday (WDAY, Financial). According to the chart below, Workday and Benefitfocus have yet to break even while Paylocity just started to make a profit in 2017.
As shown below, Paychex consistently delivered higher annual returns on assets than Automatic Data Processing since the start of this century. The gap was even widened over the past decade. As of the recent fiscal year, Paychex was able to produce more than twice the amount of earnings on one dollar of assets than Automatic Data Processing. Although Paycom has improved its ROA significantly for the last couple of years, trying to catch up, we need time to verify the long-term consistency of financial performance.
As you may have expected, the business at Paychex should be highly correlated with the situation of the job market. But keep in mind that during tough times, more cost-conscious businesses may consider Paychex's HCM platform and PEO services to improve efficiency. Per the chart below, we see only slight declines in cash flow from operations and even top-line growths during the last two recessions. Supported by the cash richness of the business, Paychex can take advantage of the economic downturn by investing in R&D, sales & marketing, and acquisitions for the long term.
Per the management, there are over 10 million addressable businesses in the geographic markets where Paychex currently operates. Compared with only the two-thirds of one million clients that the company serves presently, we see the massive runway ahead for long-term growth.
At the same time, we believe that the cash-calf PEO business can continue its growth momentum, benefiting from the industry trend of the increasing popularity of PEO as the go-to HR outsourcing solution, especially for small and medium-sized enterprises. Paychex is now the second-largest PEO in the US by the number of worksite employees.
Disclosure: The mention of any stock in this article does not constitute an investment recommendation; investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market; we own shares of Paychex.
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