Paychex: Navigating Workforce Trends with Scale
In today's report, we're delving into Paychex, a company that has captured our attention because of its robust business model, top-class margins, returns on capital, and its shareholder-friendly approach. Software solution companies often benefit from the stickiness of their solutions, marked by high switching costs. Through our analysis, we seek to provide a comprehensive overview of the company and its competitive landscape while we conclude our assessment with a discounted cash flow (DCF) calculation.
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1. Key Facts
Description: Paychex, Inc. (“Paychex”, “Company”), with ticker symbol $PAYX, is a leading human capital solutions company. The Company offers human capital management (“HCM”) software solutions for human resources (“HR”), payroll, benefits, and insurance for small- to medium-sized businesses (“SMBs”) and their employees across the U.S. and parts of Europe.
Key Financials: Over the period FY13 to trailing twelve months (“TTM”) Q2 FY24, the Company depicted a revenue Compound Annual Growth Rate (“CAGR”) of 7.9% and operating income CAGR of 8.4%, reaching a TTM revenue of c. $5.15 billion and operating income of $2.11 billion (margin of 40.9%). Paychex has cash and short term investments of $1.4 billion compared to total debt and lease liabilities of $866 million.
Price & Market Cap (as of 19th January 2024): Its market cap is $43.9 billion with a 52-week low of $104 and a 52-week high of $130, whereas it currently trades at $122.
Valuation: Paychex trades at a TTM EV/EBITDA of 18.8x (5 Year average of 18.8x) and a TTM EV/Sales of 8.4x (5 Year average of 8.1x).
2. Business Overview
In 1971, armed with $3,000 and a credit card, Thomas Golisano embarked on a journey that would shape the landscape of payroll and human resource solutions. Recognizing the struggles of small-sized businesses lacking resources to navigate workforce complexities, Golisano positioned Paychex to cater to their needs. Fast forward to today, and Paychex boasts a client base of 740,000 SMBs, serving a staggering 12 million employees—essentially serving 1 in every 12 American private-sector workers.
Paychex's success story lies in its strategic focus on the Small and Medium-sized Business (SMB) sector. From accurate payroll processing to ensuring regulatory compliance and delivering attractive employee benefits, Paychex empowers SMBs to manage their workforce seamlessly.
Paychex goes beyond providing payroll software; it offers HR outsourcing solutions through its Administrative Services Organization (ASO) and Professional Employer Organization (PEO). This unique approach has earned Paychex a significant standing in the HR outsourcing industry, with 2.2 million worksite employees under its ASO and PEO, positioning it as the second-largest HR outsourcer, just behind ADP, which caters to 3 million worksite employees.
Source: Investor Presentation October 2023
At the heart of Paychex's suite is its payroll solution (Payroll & HCM software), delivered through a Software-as-a-Service (SaaS) model on its core Paychex Flex platform. It provides workforce management throughout the employee life cycle; from recruiting and hiring to retirement through an integrated suite of solutions including recruiting, onboarding, HR, time and attendance and employee benefit administration.
While payroll processing remains the bedrock of Paychex's offerings, the Company has strategically evolved. Currently, 57% of its revenues extend beyond payroll processing, a significant increase from the 40% recorded in FY15. Clients initially drawn to Paychex for its payroll expertise find an expanded array of solutions, presenting an opportunity for the Company to upsell its HR services. As small businesses increasingly outsource more HR functions to Paychex, the Company becomes an integral part of their organizational processes. This, in turn, elevates switching costs, strengthening Paychex's pricing power. The evolving trend toward a broader spectrum of services positions Paychex as not just a payroll processor but as a trusted partner.
b. HR Outsourcing
Paychex HR Outsourcing solutions consist of its Administrative Services Organization (ASO) and Professional Employer Organization (PEO). The ASO offers a comprehensive outsourced solution for clients' HR functions, encompassing payroll, employer compliance, HR and employee benefits administration, risk management outsourcing, and the availability of professionally trained HR representatives both virtually and on-site.
How the PEO differs from ASO? A PEO offers similar services to the ASO, however, it goes beyond the ASO by entering into a co-employer agreement with clients' employees, assuming risks and rewards related to certain workers’ compensation insurance and health insurance offerings. Small businesses opting for PEOs benefit from access to high-quality employee benefits due to the scale of PEO operations, which manage hundreds of employees. Paychex leverages its substantial base of 2.2 million worksite employees to offer top-tier health insurance at lower premiums, a significant advantage compared to businesses managing insurance independently.
While the fees for PEO services are typically higher than those for ASO, HR outsourcing, as a whole, represents a higher-value solution than payroll processing.
“One thing that we're really good at is getting a larger share of wallet out of our client base with our -- particularly with our higher value solutions, ASO, PEO, retirement. We still think there's a lot of opportunity inside the base. When you look at a lot of those key solutions, the penetration rates are fairly low. And so we believe we have a lot of opportunity to continue to drive growth there.” Robert Scrader, CFO [own emphasis]
Moreover, PEO clients tend to have a higher lifetime value compared to ASO or payroll clients due to the deeper integration into the client's business. The co-employment arrangement, particularly when health insurance is involved, creates a significant level of stickiness, making it more challenging for clients to transition away from the PEO model.
The demand for Paychex’s HR outsourcing solutions has been growing faster than payroll, driven by the mounting complexity of workforce management and the rise of regulations such as the Affordable Care Act. A major milestone of Paychex’s PEO has been the acquisition of Oasis in FY19, the largest privately owned PEO at the time. This strategic move added 8,400 clients (compared to Paychex’s 6,000 clients as of the end of FY18) and significantly expanded its PEO business, culminating in the largest acquisition in Paychex's history, with an expenditure of $990 million net of cash acquired.
c. Retirement administration services
In addition to its core offerings, Paychex’s suite extends to retirement solutions administration. This service includes plan implementation, continuous compliance with government regulations, reporting for both employees and employers, online access for participants and employers, electronic funds transfer, and a range of other administrative services.
Despite being a smaller segment of Paychex's business (4%-8% of total revenue), retirement solutions have experienced double-digit growth in recent years. Currently, the Company stands as the largest 401(k) recordkeeper for small businesses in the U.S., overseeing an impressive 113,000 plans and catering to over 1 million participants.
Anticipating sustained growth, Paychex's management is eyeing the SECURE Act 2.0 as a potential catalyst. This legislation is expected to further fuel double-digit growth rates, solidifying Paychex's position as a key player in the space.
d. Revenue breakdown
Paychex categorizes its revenue into two main segments: Management Solutions and PEO & Insurance Solutions, collectively constituting