Sarajevo 360

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2019-10-22 07:08:18

The payroll and human resources outsourcing business is one that I've had my eye on for a long time. The reason being that the business model is quite sticky for customers because employees want to know that their paychecks are correct and on time.

Paychex (PAYX) is a well-established business in this space with experience dating back to its founding in 1971. Paychex focuses on small and mid-sized companies with solutions for payroll, human resources and benefits outsourcing. As companies look for ways to curtail costs in a bid to become more efficient with their own cash, Paychex is well-positioned to continue to serve that market.

There's still plenty of growth opportunities in this fragmented market as management estimates the total addressable businesses that Paychex could serve at 10 million. At the end of Q1 2020, Paychex had 670,000 clients.

Dividend History

The investment strategy that I primarily employ is dividend growth investing. As a dividend growth investor that means I want to focus on what I perceive to be high-quality companies that have a history of sending excess profits to me: the owner. By focusing on the dividend and the company's ability to continue paying and growing it in the future; it forces you to focus on the fundamentals of the business while allowing you to ignore the volatile share price.

Image by author; data source Paychex Investor Relations

*An interactive version of this chart can be found here.

**The February and May 2013 payouts were accelerated to December 2012 due to the potential increase in dividend taxation.

Paychex is a Dividend Challenger with 9 consecutive years of dividend growth. Their streak took a brief pause during the Great Financial crisis which I'm not too concerned about considering the risk to the business at the time and the massive amounts of layoffs that were occurring. Prior to the pause Paychex had raised dividends every year since 1996.

The 1-, 3-, 5- and 10-year rolling dividend growth rates since 1994 are shown in the following table.

YearAnnual Dividend1 Year DGR3 Year DGR5 Year DGR10 Year DGR1994$0.041995$0.040.00%1996$0.0525.00%1997$0.0980.00%31.04%1998$0.1344.44%48.12%1999$0.1838.46%53.26%35.10%2000$0.2750.00%44.22%46.51%2001$0.3840.74%42.98%50.02%2002$0.4415.79%34.71%37.35%2003$0.452.27%18.56%28.19%2004$0.498.89%8.84%22.18%28.47%2005$0.5512.24%7.72%15.29%29.97%2006$0.6925.45%15.31%12.67%30.01%2007$1.0247.83%27.68%18.31%27.48%2008$1.2219.61%30.42%22.08%25.10%2009$1.241.64%21.58%20.41%21.29%2010$1.240.00%6.73%17.66%16.47%2011$1.250.81%0.81%12.62%12.65%2012$1.293.20%1.33%4.81%11.36%2013$1.365.43%3.13%2.20%11.69%2014$1.467.35%5.31%3.32%11.54%2015$1.609.59%7.44%5.23%11.27%2016$1.7610.00%8.97%7.08%9.82%2017$1.929.09%9.56%8.28%6.53%2018$2.1813.54%10.86%9.90%5.98%2019$2.4211.01%11.20%10.63%6.92%

Table and calculations by author; data source Paychex Investor Relations

*Dividends and growth rates are based off calendar year payments.

**An interactive version of this information can be found here.

Despite the pause and low dividend growth coming out of the Great Recession, Paychex has still managed strong, but fluctuating dividend growth. Of the 25 1-year periods starting in 1995, annual dividend growth has ranged from 0.0% to 80.0% with an average of 19.3% and a median of 11.0%.

Since dividend growth has seen pauses and periods of slower growth, I want to look at the rolling 10-year periods to see how Paychex has historically performed. Of the 16 rolling 10-year periods, annualized dividend growth has ranged from 6.0% to 30.0% with an average of 16.7% and a median of 12.2%.

Image by author; data source Paychex SEC filings

Paychex's payout ratio is higher than I'd like; however, given the steady nature of the business as well as its consistent growth I can tolerate a higher payout ratio. Over the last decade the payout ratio based off net income has averaged 83.2% and over the last 5 years it's 80.4%. The payout ratio based on free cash flow has seen a similar decline with averages of 72.8% and 70.0%, respectively.

Quantitative Quality

In order to have long-term investment success, the simplest method is to find high-quality companies that have a history of generating high returns on capital. To identify high-quality companies I like to examine a variety of quantitative factors to determine the strength of the business.

Image by author; data source: Paychex SEC filings

Some businesses have struggled to grow their revenues over the last decade; however, Paychex is not one of those and has shown growth every year over the last 9 years with the lowest year-over-year growth rate of 4.3%. Over that time, revenue has grown from $1.95 B to $3.77 B which represents total growth of 93.9% or 7.6% annualized.

Operating income has seen a similar improvement growing from $670 M to $1,371 M. That's 104.6% total growth in operating income or 8.3% annualized. Meanwhile, operating cash flow grew from $611 M to $1,272 M which is 108.1% total growth or 8.5% annualized.

Free cash flow bested the growth of revenue, operating income and operating cash flow. Free cash flow grew from $538 M to $1,148 M, which represents 113.4% total growth or 8.8% annualized.

Image by author; data source: Paychex SEC filings

Paychex's margins have been strong and generally trending higher. Operating cash flow margins improved from 31.4% in FY 2010 to 33.7% in FY 2019. The average over the last decade is 33.1%.

Similarly, Paychex's free cash flow margin has improved as well. The free cash flow margin grew from 27.6% to 30.4% over the same period with an average of 29.3%.

My preference is to find companies that have free cash flow margins >10%. Paychex has handily beat that level.

My profitability metric of choice is the free cash flow return on invested capital, FCF ROIC. The FCF ROIC represents the annual cash return that a business generates based on the capital invested in the business. Investing in businesses that have the ability to earn high returns on capital and re-invest capital at similarly high rates reward investors over the long term. I also look at the FCF ROIC Net which nets out the cash held on the balance sheet from both equity and debt. At a minimum, I want to see the FCF ROIC >10%.

Image by author; data source: Paychex SEC filings

Paychex really shines here with a FCF ROIC well above 10% and routinely around 40%. That speaks to the strength of the business model and its stickiness with its customers. Paychex has averaged a 42.1% FCF ROIC over the last decade with a 45.2% average over the last 5 years.

I want the businesses that I invest in to allocate capital in a way that makes sense to me. That means if there's cash generated by the business, first and foremost is re-investing back into the business to maintain and grow its reach. Next would be to return any excess cash to the owners of the business via a dividend. Lastly, if there's still remaining cash left over, I would use the cash for strategic acquisitions, expand into adjacent business lines, strengthen the balance sheet or repurchase shares.

To understand how Paychex uses its free cash flow, I calculate 3 variations of the metric, defined below:

Free Cash Flow, FCF: Operating cash flow less capital expendituresFree Cash Flow after Dividend, FCFaD: FCF less total cash dividend paymentsFree Cash Flow after Dividend and Buybacks, FCFaDB: FCFaD less total cash spent on share repuchases

Quality businesses will generate positive FCFaDB more often than not. I'm not concerned about the levels for any given year because the business environment changes and opportunities have deadlines; rather I prefer to look at the longer term trend to get a glimpse at how management likes to allocate capital. If a business has negative FCFaDB, that shortfall must be made up by cash on the balance sheet, asset sales or taking on debt.

Image by author; data source: Paychex SEC filings

As we said earlier, Paychex has managed positive FCF every year over the last decade which has allowed the company to both pay and grow its dividend payment. Cumulatively, Paychex generated $7.99 B in FCF.

Paychex has also managed a positive FCFaD every year. Paychex has paid out $5.73 B in dividends in total which puts the FCFaD at $2.26 B in total.

With a positive FCFaD, Paychex has been able to repurchase $0.91 B of shares over the last decade with cash generated by the business. That puts the FCFaDB for the entire period at $1.35 B with no negative years of FCFaDB.

Image by author; data source: Paychex SEC filings

Paychex's share count declined from 361.5 M to 359.3 M from FY 2010 to FY 2019. It's pretty clear that Paychex hasn't been a serial share repurchaser, with shares outstanding declining just 0.6% over the last decade. Most of the cash spent on share repurchases has gone towards reducing the dilution due to shares issued for acquisitions.

As I mentioned above, my preference is to see a management team that first reinvests in the business, then pays and grows the dividend and only if there's remaining cash move to share repurchases.

Paychex has normally carried no debt on its balance sheet. However, in FY 2019 the company issued debt to help finance the Oasis Outsourcing acquisition. Even with the debt, the balance sheet is still pristine with a debt to capitalization ratio of 23%.

Image by author; data source: Paychex SEC filings

The entire debt load could be retired with just 0.1 year of FY 2019's free cash flow plus the cash on the balance sheet. It could also be retired with just 0.4 year of FY 2019's FCFaD plus the cash on the balance sheet.

Valuation

The minimum acceptable rate of return, MARR, analysis is a method you can use to estimate the value of the business. The idea is that you estimate the future growth of earnings and dividends, assign a multiple to those earnings and of course have a margin of safety factored in. If the expected return is less than your hurdle rate, then you wait for the price-to-value relationship to change or look for other opportunities.

Analysts expect Paychex to have FY 2020 EPS of $3.10 and FY 2021 EPS of $3.34. They also expect Paychex to obtain 8.4% annual earnings growth over the next 5 years. I assumed that EPS growth would slow to 6.0% per year for the following 5 years. Dividends are assumed to target a 80% payout ratio as per Paychex's history.

Historically, Paychex has traded between ~16x and 30x TTM P/E ratio. Currently, Paychex's TTM P/E ratio is 28.9x. According to Morningstar, Paychex's 5-year average P/E ratio is 26.6x. For the MARR analysis, I ll examine P/E ratios ranging from 15x to 30x.

Data by YCharts

The following table shows the potential internal rates of return that an investment in Paychex could provide, given that the assumptions listed above are in the ballpark of future results. Returns include dividends taken in cash and are calculated assuming a purchase price near $84.25, Friday's closing price. Returns are run through the end of calendar 2024, 5 Year and calendar year 2029, 10 Year.

Alternatively, I calculate what level I would need to purchase shares to generate the returns that I desire from my investments. Once again, the calculations are based off the assumptions above being close to what comes to pass. The target returns that I will use are 10%, my typical minimum investment threshold, and 13%. The 13% is derived from the ~7.3% estimated annualized earnings growth over the next 10 years, plus the 2.94% current dividend yield, plus 2.3% for 25% undervaluation normalizing over 10 years.

Another valuation method that I use is dividend yield theory. Dividend yield theory is based on reversion to the mean and assumes that a good proxy for the fair value of established companies is the 5-year average dividend yield.

Image by author; data source Yahoo Finance and Paychex Investor Relations.

*An interactive version of this chart can be found here.

Paychex's shares currently offer investors a 2.94% dividend yield with a 5-year average yield of 3.17%. Dividend yield theory suggests a fair price for Paychex's shares of $78.23.

Conclusion

I believe that Paychex firmly fits the bill of being a high-quality business. Consistent growth in revenues has fueled the continued growth in free cash flow and of course the dividend.

Paychex's free cash flow profitability is top-notch with margins regularly around 30% and returns on invested capital around 40%.

The sector is fragmented which should lead to further consolidation with Paychex likely to win out in the long run as a leader in the technology and infrastructure necessary to be a one-stop outsourcing provider of payroll and HR services to small-to-medium sized businesses.

Paychex's payout ratio is higher than I'd like with management targeting to pay out 80% of net income to owners. The elevated payout is great during good times; however, it's likely going to lead to a repeat of the pause in dividend growth whenever the next recession comes which it inevitably will.

Dividend yield theory suggests a fair value range between $71 and $87, implying that shares are currently on the upper end of fair value. My fair value range based on the MARR analysis is $69-83.

Paychex is a business that I want to eventually add to my portfolio and it's a justifiable nibble at current prices near $84 per share. Of course, that comes with the caveat that multiple contraction is likely to be a hindrance on returns going forward.

The price in the market is on the upper end of fair value at this time so I wouldn't want to commit a big chunk of capital to the business. However, I'm very tempted to add a starter position to my portfolio with plans to add on any dips into the mid-to-low $70s.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PAYX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not a financial professional. Please consult an investment advisor and do your own due diligence prior to investing. Investing involves risks. All thoughts/ideas presented in this article are the opinions of the author and should not be taken as investment advice.


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