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Paychex, Inc. Fundamental Analysis

Disclaimer: This article by The Globetrotting Investor is general in nature. We aim to bring you long-term focused analysis driven by fundamental data, hence, providing you commentary based on historical data and analyst forecasts only using an unbiased methodology. This is not a buy/ sell recommendation, and it is solely for educational purposes. Please do your research before investing. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Please read the full disclaimer here.

Paychex, Inc.

Last Updated: 16 Oct 2023

NASDAQ: PAYX

GICS Sector: Industrials

Sub-Industry: Staffing & Employment Services 

https://www.paychex.com

Paychex, Inc. Fundamental Analysis | Paychex, Inc. Logo | Fundamental Analysis by The Globetrotting Investor

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Table of Contents

You can download a summary of Paychex, Inc's fundamental analysis in PDF here.

Management

Paychex, Inc. Management

CEO: John Gibson

Tenure: 1.8 years

Paychex, Inc.'s management team has an average tenure of 6.8 years. It is considered experienced.

Source of Revenue

Paychex, Inc. Source of Revenue

Paychex, Inc. provides integrated human capital management (HRM) solutions for human resources (HR), payroll, benefits, and insurance services for small to medium-sized businesses in the United States and Europe.

 

The company specializes in providing effective HCM solutions to organizations facing the challenges of diverse regulations and changing workplace dynamics. Paychex focuses on assisting businesses lacking the necessary resources and expertise to navigate this evolving landscape.

 

The company offers a wide range of solutions – including HR outsourcing, HCM technology, payroll processing, retirement and insurance solutions – allowing Paychex to customize their offering to their client’s business, whether it is small or large, simple or complex. Its portfolio of solutions comprises:

 

Management Solutions:

  • Payroll processing solutions

  • Payroll tax administration solution

  • Employee payment solutions

  • Regulatory compliance solutions: Paychex provides new-hire reporting and garnishment processing solutions to help clients meet legal requirements, reduce penalties, and enforce child support orders, while also offering Affordable Care Act compliance solutions.

  • HR solutions

  • Retirement solutions administration: This includes various options, such as 401(k) plans, SIMPLE IRAs, and more. These solutions cover plan setup, regulatory compliance, online access, and administrative services. Auto enrollment and customizable investment options are available.

  • HR administration solutions: These services include:

    • Paychex HR Online: Provides tools for personnel management, performance tracking, HR compliance, and reporting. Includes Learning Management for employee training and a workflow and approval engine for performance-related processes.

    • Digital Communication Solutions: Paychex Flex HR Connect and HR Conversations strengthen connections between employees and HR. HR Connect allows for easy submission of inquiries and requests, while HR Conversations facilitates communication between managers and employees with digital 360-degree feedback.

    • Benefits Administration: Manages employee-benefit enrollment for both open enrollment and life events.

    • Time and Attendance Solutions: Includes integrated Paychex Flex Time software for timekeeping, scheduling, and workforce analytics. The InVision IRIS Time Clock offers fast and accurate time capture, and Paychex Flex Time is compatible with wearable technology.

    • Applicant Tracking Suite: Streamlines applicant workflow and onboarding processes for companies of all sizes.

  • Other HR solutions and support: Paychex provides Section 125 plan administration for tax-advantaged health benefits and state unemployment insurance solutions, handling all aspects including implementation, compliance, and claims processing.

 

Professional Employer Organization (PEO) and Insurance Solutions:

  • PEO solutions: Paychex licensed PEO subsidiaries provide businesses with a comprehensive package, acting as co-employers and offering a PEO Protection Plus Package to protect against unforeseen costs like cyberattacks and employee lawsuits.

  • Insurance solutions: Paychex Insurance Agency, Inc., offers insurance from various carriers, providing employers with affordable property, casualty, and health coverage. This simplifies finding suitable plans for small businesses, with the option to integrate insurance with Paychex payroll processing for efficient administration.

 

It markets and sells its services primarily through its direct sales force.

 

Revenue primarily comes from service fees and investment income on client funds. They recognized service fees when control of the services is transferred to clients, typically based on processing volume or employee transactions.

 

Insurance Solutions revenues come from earned commissions on premiums. Fees for funding client payrolls are a percentage of funding amounts and recognized over an average collection period. Revenue from delivery services is part of service revenue, and delivery costs are in the cost of service revenue.

 

Over 50% of its revenues are gained from its services beyond payroll processing.

 

Paychex reports as one segment. Substantially all of the company’s revenue is generated within the U.S. Approximately one percent of the company’s total revenue was generated within Europe for each of the fiscal years ended 2023, 2022, and 2021.

Paychex, Inc. Reportable segments include Management Solutions, PEO and Insurance Solutions, and Interest on funds held for clients.

Paychex, Inc. Reportable Segment Revenue FY2023

Paychex, Inc. Economic Moat

Paychex, Inc. Economic Moat
Paychex, Inc. has a wide economic moat. This is based on its intangible asset, cost advantage, efficient scale, network effect and switching cost.

Paychex, Inc. Economic Moat 

 

Economic Moat: Wide

There are many ways to identify Paychex, Inc.’s economic moat, but I focus on the above 5 types. The rating is purely subjective and based on my in-depth understanding and analysis of Paychex, Inc.. Please check my summary to understand more about the economic moat. 

Paychex, Inc. Performance Checklist

Performance Checklist

Is Paychex, Inc.’s revenue growing YoY for the past 5 years consistently? Yes.

Is the net income growing YoY for the past 5 years consistently? Yes.

Is the cash flow from operating activities growing YoY for the past 5 years consistently? Yes.

Is the free cash flow positive for the past 5 years? Yes.

Is the gross margin % consistent/ growing for the past 5 years? Yes.

Is the EPS growing for the past 5 years? Yes.

Paychex, Inc. financial performance which includes its revenue, net income, operating cash flow, and FCF over the recent 5 years.

Paychex, Inc. Revenue, Net Income, Operating Cash Flow, and FCF (USD Million)

Is the free cash flow per share growing for the past 5 years? Yes.

Paychex, Inc. free cash flow per share is growing for the past 5 years.

Paychex, Inc. FCF per Share

Paychex, Inc. Management Effectiveness

Management Effectiveness

Is Paychex, Inc.’s ROE consistently at 12%-15% YoY for the past 5 years? Yes.

Paychex, Inc. ROE is above its industry average ROE.

Paychex, Inc. Return on Equity

 

Is the ROIC consistently at 12%-15% YoY for the past 5 years? Yes.

Paychex, Inc. ROIC is more than its WACC.

Paychex, Inc. Return on Invested Capital vs Weighted Average Cost of Capital

 

The trendline for the number of shares outstanding is increasing, which is something that an investor would not be pleased to see. 

The number of Paychex, Inc. shares outstanding has been increasing over the past 5 years.

Paychex, Inc. Shares Outstanding (Million Shares)

Paychex, Inc. Financial Health

Paychex, Inc. Financial Health

Paychex, Inc. balance sheet which includes total equity, total debt, and cash & short-term investments.

Paychex, Inc. Financial Health (USD Million)

Current Ratio: 1.2 (pass my requirement of >1.0)

Debt-to-EBITDA: 0.4 (pass my requirement of <3.0)

Interest Coverage: 56.1 (pass my requirement of >3.0)

Debt Servicing Ratio: 2.2% (pass my requirement of <30.0%)

Paychex, Inc. Dividend

Dividend

Current Dividend yield: 3.0%

Have the dividend payments been stable for the past 5 years? Yes.

Have the dividend payments been growing for the past 5 years? Yes.

 

Paychex, Inc.’s dividend payments are reasonably covered by its earnings and cash flows. 

Paychex, Inc. Stock Performance

The following graph shows a five-year comparison of the total cumulative returns of investing $100 on 31 May 2018, in Paychex common stock, the S&P 500 Index, and a Peer Group Index. All comparisons of stock price performance shown assume reinvestment of dividends.

Paychex, Inc. Stock Performance
Paychex, Inc. stock performance against its respective benchmarks.

Paychex, Inc. Stock Performance 

Paychex, Inc. Intrinsic Valuation

Paychex, Inc. Intrinsic Valuation

Estimated intrinsic value: $77.61

 

Value is calculated using the discounted cash flow method (taking into account their cash and debt) and scenario planning.

Average free cash flow used: USD$1,400M

Projected growth rate: 8% - 9%

Beta: 1.0

Discount rate: 8%

Margin of safety: 20% (Uncertainty: Low)

Price range after the margin of safety: <$63.00

Date of calculation: 16 Oct 2023 

Paychex, Inc. valuation is based on the discounted cash flow method. A fundamental analysis by The Globetrotting Investor.

Paychex, Inc. Valuation

Free cash flow used is a weighted average that is rounded to the nearest tens. In some instances, I used a more realistic number to represent the free cash flow.

Total debt and cash and short-term investments are last quarter figures that are rounded to the nearest tens. In some instances, I used more realistic numbers to represent them.

Paychex, Inc. fair value and its 52-week range.

Paychex, Inc. Intrinsic Valuation

Paychex, Inc. Relative Valuation

Paychex, Inc. Relative Valuation

Comparison of Paychex, Inc. EV-to-EBITDA against its five closest industry peers.

Paychex, Inc. EV-to-EBITDA vs its peers

Comparison of Paychex, Inc. price-earnings ratio against its five closest industry peers.

Paychex, Inc. Price-Earnings Ratio vs its peers

Paychex, Inc. price-earnings ratio for the past 5 years and its 5-year average.

Paychex, Inc. Historical Price-Earnings Ratio

Additional Resources

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My Top Concern

My Top Concern

The business, financial health, and operational results of the company are vulnerable to macroeconomic and political factors in the U.S. and the global economy, and this impact could be significantly negative.

 

Factors like inflationary pressure, banking instability, and other economic or political events can affect the company and its clients. Banking volatility may lead to losses on uninsured funds and hinder access to equity or debt financing, and obtaining such financing may become more challenging.

 

Paychex’s success relies heavily on its clients' continued use of its solutions and support, and any adverse economic changes may lead to a decline in client operations, which in turn could result in unpaid services and reduced revenue. Clients under financial stress may also decide to discontinue services, leading to decreased revenue. Workforce reductions by clients and pricing pressures in a competitive industry may further impact the company's revenue and ability to onboard new clients. 

 

The company faces potential risks associated with its co-employment relationship in its PEO business.

 

Federal and state laws do not clearly define the responsibilities and obligations in this co-employment relationship, and the legal landscape is constantly changing, making it difficult to predict the impact on the company's operations.

 

There is a chance that Paychex may be held liable for violations of employment or discrimination laws by its clients and their employees, even if Paychex is not directly involved in those violations. While client agreements include indemnification provisions, enforcing and collecting such obligations may be challenging. Additionally, the company may face liabilities related to its employee benefit plans if it's determined that it does not qualify as the "employer" under relevant state or federal laws. These potential liabilities could negatively affect the company's financial results.

Summary for Paychex, Inc.

Summary for Paychex, Inc.

Paychex possesses a wide economic moat, thanks to its high switching costs and valuable intangible assets, which include its well-established brand, extensive referral network, and cost-saving benefits derived from its substantial size.

 

Like other payroll and Human Capital Management (HCM) companies, Paychex benefits significantly from high switching costs. Transitioning to a different provider can be both expensive and disruptive. Businesses invest a substantial amount of time and resources into their payroll and HCM systems, making any changes potentially problematic, leading to challenges such as staff training, software integration, and potential data loss. This issue becomes even more complex for customers who rely on Paychex for HR outsourcing, utilizing administrative services organization (ASO) or professional employer organization (PEO) models, which are deeply intertwined with daily operations.

 

Despite fierce competition, Paychex has improved its client retention rate slightly, maintaining an average of 84% over the five years leading up to 2023, as opposed to 83% over the previous decade. This high retention rate reflects the significant barriers to switching providers, with approximately 8.5% of client losses stemming from business failures.

 

Paychex has established a strong and decades-long reputation for delivering reliable and compliant solutions to small businesses. This reputation enables them to gain market share and charge at premium prices. Payroll is a critical aspect of any business, demanding reliability, accuracy, compliance, and data security. The consequences of payroll errors or noncompliance can be substantial. Paychex’s well-established reputation gives them a competitive edge over newer, less proven competitors, making them attractive to new businesses.

 

Furthermore, Paychex has established robust distribution relationships with U.S. accounting organizations, banks, and existing clients, with over half of their new small-business payroll customers coming from referrals.

 

Over the past decade, Paychex has expanded its services to include a broad range of HCM solutions, including HR outsourcing, benefits, insurance, and traditional payroll. They offer bundled and standalone options and can integrate with other small-business software, such as accounting and point-of-sale systems, including platforms like Indeed for job listings. Customers can enhance their Paychex software by adding modules like benefits administration and time tracking, increasing their attachment to the service. Small businesses often prefer all-in-one solutions, making Paychex well-suited to offer additional modules. In the five years leading up to fiscal 2021, there was an increased demand for retirement plans and health insurance, surpassing overall client growth.

 

In the long term, Paychex will continue to invest in software development, customer service, and user experience to maintain customer satisfaction and high retention rates. This strategy ensures a consistent stream of recurring revenue at a low cost.

 

Paychex enjoys a cost advantage through economies of scale, setting it apart from smaller competitors. This scale enables Paychex to distribute its fixed costs, such as software development and marketing, across a larger customer base, resulting in lower marginal costs compared to smaller competitors.

 

For example, a smaller operator like Paylocity, representing only 4% of Paychex’s client base, spent around 45% of its revenue on selling, general, and administrative expenses over the five years leading up to fiscal 2021, while Paychex spent 32%. Adding new customers to Paychex’s platform is cost-effective and provides significant operational leverage.

 

This cost advantage should allow Paychex to withstand competitive pricing pressure and offer additional modules to existing clients at a lower cost, enhancing customer loyalty.

 

Considering the formidable competitive advantages outlined, Paychex stands as a wide moat company. Its high switching costs, strong brand reputation, extensive referral network, and cost-saving efficiencies derived from its scale all contribute to its resilient position in the market. With a commitment to continual improvement and a strategic focus on customer satisfaction, Paychex is well-positioned to maintain its dominant market presence.

 

Paychex has demonstrated remarkable consistency and growth over the past five years. Their revenue has consistently increased year over year, a positive trend indicating a strong and thriving business. The net income has also followed suit. Furthermore, its cash flow from operating activities has exhibited a similar pattern, suggesting a well-managed financial operation.

 

The company's ability to maintain positive free cash flow for the past five years highlights their financial stability. In addition, the gross margin percentage has even shown signs of growth. 

Paychex has demonstrated sound capital allocation strategies over the past five years. Their ROE has consistently remained within the healthy range of 12% to 15% year over year. Notably, Paychex's ROE surpasses the industry average, signifying their ability to generate superior returns for shareholders.

 

Their ROIC has consistently met the 12% to 15% threshold, outpacing their WACC, a positive sign of effective capital utilization. However, it is worth noting that the number of shares outstanding has shown an increasing trend, which might be a concern for investors as it could dilute existing shareholders' value

 

Paychex maintains a strong and healthy financial position. With a current ratio of 1.2, they comfortably exceed the ideal benchmark of 1.0, showcasing their ability to cover short-term liabilities. Their debt-to-EBITDA ratio indicates a manageable debt burden. Notably, Paychex holds more cash on hand than their total debt, reinforcing their financial stability.

 

The interest coverage ratio stands impressively high at 56.1, surpassing the recommended level of 3.0, which means they have ample earnings to meet interest obligations. Furthermore, the debt servicing ratio of 2.2% is comfortably below the 30.0% limit, underscoring their capacity to service their debt without straining their financial health.

 

Investing in Paychex presents both opportunities and considerations. The company boasts a wide economic moat, indicative of its competitive advantage within the industry. Their satisfactory performance and prudent capital allocation strategies have resulted in a sound balance sheet, underpinned by strong financial metrics. However, it's essential to acknowledge that investing in any company carries a level of inherent uncertainty, and Paychex is no exception. To mitigate risks, investors may want to establish a high margin of safety, perhaps as much as 20%. This margin of safety can act as a buffer against unforeseen challenges and market fluctuations.

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