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Paychex Rolls Out a $400 Million Share Repurchase – Buyback Wednesdays

  • February 7, 2024

Paychex, Inc. (PAYX): $122.19

Market Cap: $43.14B

EV: $42.61B

DocuSign (DOCU) decided to lay off 6% of its workforce this week. Last month, Microsoft (MSFT), which closed its acquisition of Activision Blizzard last year, decided to lay off 1,900 of its videogaming staff. Last year, Meta Platforms (META), in the spirit of Mark Zuckerberg’s “year of efficiency” laid off a whopping 22% of its staff.

January started with 16,000 tech company layoffs and the damage was not just limited to the tech sector. UPS decided to cut 12,000 positions. Staff cuts from the unfolding regional banking issues have yet to hit the wire. While all of this sounds ominous, it is hardly a drop in the bucket.

The tech sector had indulged in excessive hiring during a period of cheap money in 2020-2021 because of a perceived war for talent and has been right sizing for well over a year. Some of those cuts at UPS are seasonal, coming off the Christmas shopping season and the rest is Amazon creating headwinds for both FedEx and UPS by transitioning logistics in-house. One can only hope that the regional banking issues remain a blip like they did last year when Silicon Valley Bank failed instead of becoming a full-blown crisis.

This does not feel like the aftermath of the dot com bubble in 2001-2003 when jobs in the tech sector were rarer than a black swan. It certainly does not feel like the Great Recession of 2008-2009 when almost every sector was impacted and the unemployment rate spiked to 10%. The unemployment rate has been dropping for years and barring the COVID distortion, has been consistently at or below 4% since May 2018.

Companies that provide payroll services or human resource management software like Automatic Data Processing (ADP) and Paychex (PAYX) have been beneficiaries of this trend. It is not surprising to see that Paychex is returning capital to shareholders by announcing a large share buyback. The big question is whether the good times can continue to justify the company’s current valuation.

Key Insights

  • Paychex primarily focuses on serving small and medium-sized businesses (SMBs), providing them with scalable and customizable solutions to meet their payroll and HR needs.
  • Over the past decade, Paychex has grown its top line at a CAGR of approximately 8%.
  • Paychex’s retention rate in HR outsourcing solutions remains at record levels as of 2Q FY24 earnings (fiscal year ends in May).
  • The company raised guidance twice in this fiscal year.
  • Paychex has a clean balance sheet with no net debt and has strong earnings growth.
  • The company is richly valued despite its strong margins, growth and capital allocation.

As the future of work continues to evolve, Paychex leads the way by making complex HR, payroll, and benefits relatively simple. Its combination of digital HR technology and advisory solutions meets the changing needs of employers and their employees.

Founded in 1971 by B. Thomas Golisano, Paychex provides Human Capital Management (HCM) and benefit-related services to mainly SMBs. The company has ~740,000 business clients in the U.S. and Europe. It is also a top HR outsourcer, serving 2.2 million worksite employees through its HR outsourcing solutions. This is a 10% increase from fiscal 2022. Paychex has two key segments: management solutions (75% of revenue), professional employer organizations (PEOs) and insurance services.

The challenging labor market and rising healthcare expenses are prompting numerous businesses to reassess their HR and benefit approaches. Paychex emerges as a dependable ally during these challenges. Amid the pandemic, Paychex played a crucial role in assisting numerous businesses in claiming tax credits through its Employee Retention Tax Credit (ERTC) Service. While this was a temporary scenario, prolonged economic downturns and persistently high unemployment levels could potentially disrupt the company’s operations.

Jobless claims skyrocketed under covid-19

Source:www.pbs.org

 

Job Index Trends & GDP

The Paychex Small Business Employment Watch is released each month by Paychex and focuses exclusively on businesses with less than 50 workers. The monthly report offers an analysis of national employment and wage trends, as well as examines regional, state, metro, and industry sector activity. This industry benchmark delivers real-time insights into the small business trends driving the U.S. economy.

According to the Paychex Small Business Employment Watch, January marks the 34th consecutive month of job growth for U.S. small businesses. Wage growth for workers continues to stabilize in the new year with hourly earnings growth remaining essentially unchanged since November at 3.47%.

In light of these developments, Paychex president and CEO, John Gibson commented,

“As we begin 2024, job growth in small businesses is continuing at a steady pace. Nationally, wage growth remains stable despite 65 minimum wage changes taking effect in various states and localities on January 1. Small and medium-sized businesses remain resilient in the face of many challenges, including a tight labor market for qualified workers, the cost of and access to capital, rising employer regulations, and cost of providing benefits to attract and retain employees.”

The U.S. economy has started rebounding faster than expected in 2023, especially in the last quarter of the year. According to the U.S. Commerce Department’s Bureau of Economic Analysis (BEA), the fourth quarter real gross domestic product (GDP) increased at an annual rate of 3.3% in the last quarter of 2023 exceeding expectations. In addition, the economy added 2.7 million jobs in 2023.

As the economy expands, the likelihood of new businesses emerging grows. This drives a heightened demand for payroll processing services, a niche well-served by companies like Paychex.

Room for Growth

The appealing aspect of being a HCM solution provider lies in the long-term stickiness of the solution. Once organizations partner with Paychex, they develop a dependence on it for various HR services. This is reflected in the consistently high retention rates observed in 2Q FY24 earnings. The enduring nature of the product enables Paychex to implement gradual price increases, showcasing their pricing power aligned with the value proposition they offer.

Moreover, the estimated forward revenue growth of around 7% though not very attractive, is in line with the 5-year average growth of the company. This shows the stability of the company in terms of its revenue growth.

Valuation

With a forward P/E of 25.61x and a forward EV/EBITDA is 17.85, valuation appears to be expensive. We ran a DCF model with a conservative EPS growth estimate of 8% in year 1, declining 1% a year thereafter until it reaches a 2% terminal growth rate. We used a discount rate of 10%. The DCF model popped up with an intrinsic value of $63.79.

Adjusting the model to assume 8% earnings growth for the next 10 years, bumped up the valuation to $88.49, implying the stock is trading at a 27% premium to its intrinsic value. We had to bump up the terminal growth rate to 4% and increase EPS growth to 10% per year for 10 years to get the current stock price.

Strong Balance Sheet

Paychex maintains a robust financial position with high-quality cash flows and earnings. The business has a strong balance sheet with a net cash position of ~$580 million as of 2Q FY24 (fiscal 2024 year ends in May 2024). It is worth mentioning that Paychex has been able to maintain a net cash position over the last decade, except for Fiscal 2020, which may have been due to the pandemic. Additionally, the company’s free cash flow has been increasing, justifying the management’s decision to announce a $400 million buyback.

Paychex-Financial statements

Source: InsideArbitrage

Dividends vs. Share Buybacks

Despite Paychex’s rapid earnings growth, its historical inclination towards buybacks has been limited. The company has not consistently executed repurchase announcements, and while shares outstanding decreased in the last decade, recent years have seen relatively flat numbers. Share repurchases have primarily been used to offset the impact of Stock-Based Compensation (SBC). There were no common share repurchases during fiscal 2023. However, in H1 of FY24, the company repurchased 1.5 million shares at an average price of $115.37 per share.

Paychex has been a dividend growth leader, outpacing peers in the sector. Over the past decade, dividends per share (DPS) nearly tripled from $1.27 in FY12 to $3.46 in the last 12 months, showcasing a CAGR of approximately 10%.

In fiscal 2023, Paychex returned $1.2 billion in dividends, representing 75% of net income. The company currently has a forward dividend yield of 2.94% and a payout ratio of 77.23% which is high. With such a high payout ratio, there is a lower probability of the dividend increasing. However, in such a scenario, even if the company’s earnings decrease, shareholders can still expect a significant portion of earnings as dividends.

Paychex spent 18.3% of its FCF of H1 FY24 on share repurchases and 69.4% of the same for paying dividends. This 1:4 ratio clearly shows that the company prioritizes dividends over share repurchases as a means of returning cash to shareholders.

Growth

Over the past 10 years, Paychex has grown from a $2.47 billion revenue business to a $5.15 billion business today, with positive growth for every single one of the last 10 years. That is an 8% growth compounded annually. It is worth mentioning that in fiscal 2023, approximately 56% of total service revenue was generated from sources beyond payroll, such as HR solutions, retirement, insurance solutions, and PEO.

Paychex-revenue and DPS growth

Source: Paychex (Annual Report)

In the context of growth, the company’s CFO, commented:

“We have used M&A as a way to drive growth in the business, and that has been part of our growth formula. It’s part of what we’ve delivered over the last five and 10 years, and we expect that we’ll continue to look for opportunities, and that will be part of our growth in the future.”

One notable aspect of the business is the cash balances being held. The company has benefited greatly from the increase in interest rates, with interest on funds held for clients increasing by 83% to $32.7 million in the first quarter. However, if interest rates decline, this segment may not substantially contribute to revenue growth.

FY 2023 Report

Paychex - FY2023 highlights

Source: Paychex (10Q)

Q2 FY2024 Results

Paychex reported decent results in the second quarter, exceeding EPS estimates by $0.01 but missing revenue estimates by $8.58 million. There was particularly strong performance in the PEO, mid-market HCM, and retirement segments.

  • Total revenue for the quarter increased 6% to $1.3 billion.
  • Adjusted diluted earnings per share increased by 10% to $2.23.
  • Operating income increased 7% over the prior-year period to $506 million.
  • Cash flow for operations for H1 was $1 billion, up 40% compared to the same period last year.
  • Paychex raised its guidance following the recent quarter’s strong performance. PEO and Insurance Solutions growth is now expected in the 7% to 9% range, up from the previous 6% to 9%. Similarly, adjusted diluted earnings per share is expected to grow between 10% and 11%, raised from the previous 9% to 11%.

A total of $811 million was returned to shareholders during the first six months which includes $642 million of dividends and $169 million of share repurchases.

Profitability

Paychex has strong profitability with a gross margin of 71.54% and a net income margin of 31.62%. This is significantly above the sector median’s average and also surpasses the company’s historical 5-year average. Gross profit and net income have more than doubled over the last decade. The company has grown its net income at a CAGR of 10.70% over the last ten years.

Paychex is way ahead of its peers including TriNet Group, Inc. (TNET), Automatic Data Processing, Inc. (ADP) and innovative firms like Gusto in terms of profitability.

Paychex - Peers comparison for profitability

Source: Seeking Alpha

Strategy

One of the company’s strategies this year is to revisit the base clients and get them over into the PEO model, because the economics in that model over the long term are very favorable. In short, the company leverages the stickiness of the business to establish a connection with their clients. For example, when the clients with their health insurance with Paychex were to leave the PEO, that would be very disruptive for their employees. They may have to get new insurance cards and that might be very disruptive. They prefer sticking to Paychex instead.

Risks

  • SMBs are most exposed to the macrocycle. In a recession, these businesses are typically the first to go out of business, and when that happens, Paychex will lose customers. Also, there would be fewer new businesses during a recession, which means Paychex’s growth will be impacted too.
  • Fewer job openings will be a headwind for the company.
  • Paychex has to continuously monitor the various regulations passed by the government. For eg. recently, Paychex released the top five regulatory and compliance-related topics employers should be monitoring heading into 2024. The annual list is intended to keep business leaders up to date on the regulatory changes that are most likely to impact them in the coming year.
  • If Paychex starts operating globally, then managing payroll across different regions with diverse regulations, currencies, and tax structures can be complex. Globalization adds layers of complexity to payroll processing.
  • As a result of its investing activities, changes in interest rates may materially impact the earnings potential of future investments and will cause fluctuations in the fair value of its longer-term AFS securities.
  • Paychex operates in a technology-driven industry, and requires the company to stay on top of rapidly evolving technologies to stay competitive.

Bottom Line

Paychex is a company with strong financials, excellent margins and a robust balance sheet. Over the past decade, it has consistently exhibited growth. The company has demonstrated prudence in capital allocation, increasing dividends and share repurchases. The only concern is that the company’s current valuation seems to be high.

Insiders of the company are exercising options, but are only selling enough shares to cover tax obligations. Over the last 90 days, ten analysts have revised their earnings estimates upward. With regards to earnings per share (EPS), the company has exceeded estimates in every quarter over the past two years, and revenue estimates in 7 out of the last 8 quarters.

The company is very well managed and we would love to own it in our portfolio at some point in the future. Our recommendation is to exercise caution and wait for a potential stock price correction close to its intrinsic value before considering a position in the company.


Welcome to edition 86 of Buyback Wednesdays, a monthly series that tracks the top stock buyback announcements during the prior month. The companies in the list below are the ones that announced the most significant buybacks as a percentage of their market caps. They are not the largest buybacks in absolute dollar terms. A word of caution. Some of these companies could be low-volume small-cap or micro-cap stocks with a market cap below $2 billion.

The number of buyback announcements decreased significantly for the second month in a row. Sixty-seven companies declared buybacks this month, compared to seventy-seven in the previous month.

Top 5 Stock Buyback Announcements 

1. Solid Power, Inc. (SLDP): $1.665

On January 23, 2023, the Board of Directors of this EV battery developer approved a new $50 million share repurchase authorization, equal to around 24% of its market cap at announcement.

Market Cap: $297.MAvg. Daily Volume (30 days): 5,290,701Revenue (TTM): $19.26M
Net Income Margin (TTM): -243.94%ROE (TTM): -8.78% Net Cash: $183.84M
P/E: N/AForward P/E: N/AEV/EBITDA (TTM): -1.55

2. State Street Corporation (STT): $72.45

On January 19, 2023, the Board of Directors of this financial products and services provider announced that it had approved a new $5 billion stock repurchase agreement. This represents around 21.5% of its market cap at announcement.

Market Cap: $21.88BAvg. Daily Volume (30 days): 2,350,733Revenue (TTM): $11.90B
Net Income Margin (TTM): 16.34%ROE (TTM): 7.94% Net Cash: $74.81B
P/E: 13.01Forward P/E: 9.52Price/Book (TTM): 1.00

3. XOMA Corporation (XOMA): $20.81

On January 2, 2023, the Board of Directors of this biotech royalty aggregator announced that it had approved a new $50 million share repurchase program, equal to around 21% of its market cap at announcement.

Market Cap: $239.06MAvg. Daily Volume (30 days): 28,349Revenue (TTM): $4.41M
Net Income Margin (TTM): N/AROE (TTM): -22.60% Net Cash: $33.69M
P/E: N/AForward P/E: N/AEV/EBITDA (TTM): -9.49

4. SLM Corporation (SLM): $19.22

On January 23, 2023, the Board of Directors of educational loan provider approved an additional $650 million share repurchase program, equal to around 15% of its market cap at announcement.

Market Cap: $4.23BAvg. Daily Volume (30 days): 2,149,721Revenue (TTM): $1.46B
Net Income Margin (TTM): 39.72%ROE (TTM): 32.23% Net Debt: $1.02B
P/E: 8.03Forward P/E: 7.19Price/Book (TTM): 2.6

5. Collegium Pharmaceutical, Inc.  (COLL): $33.24

 On January 3, 2023, the Board of Directors of this specialty pharmaceutical company authorized a new $150 million stock repurchase program, equal to around 14.6% of its market cap at announcement.

Market Cap: $1.08BAvg. Daily Volume (30 days): 465,542Revenue (TTM): $546.64M
Net Income Margin (TTM): 1.65%ROE (TTM): 4.79% Net Debt: $413.82M
P/E: 131.15Forward P/E: 27.23EV/EBITDA (TTM): 6.17

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