Will Paychex continue to deliver the readies?

• Pandemic-related revenue linescould soften
• Management expects EPS toremain in double-digit territory

Long-term holders of Paychex (US:PAYX) have done pretty well for themselves. Since the software company floated on the stock market 50 years ago, its shares have earned investors a total return of 120,000 per cent. Or, to put it another way, if you’d put $1,000 into its 1983 initial public offering, it would be worth around $1.2mn now.

The most striking gains were made in the 1990s, but even over the course of its past five financial years its shares have outperformed both the S&P 500 and a company-benchmarked group of peers that includes the likes of direct competitor Automatic Data Processing (US:ADP), as well as Equifax (US:EFX), Global Payments (US:GPN) and Western Union (US:WU).

There are good reasons for this. Paychex now describes itself as a ‘human capital management’ (HCM) technology company, as opposed to one that just provides payroll and HR software. For instance, it offers professional employer organisation (PEO) services, where Paychex acts as the administrative employer handling functions such as payroll, benefits, training and taxes. This is typically aimed at smaller and medium-sized enterprises.

The pandemic created the opportunity to sell a broader range of services. For instance, when the US government passed the Cares Act – the $2.2tn economic stimulus package aimed at mitigating the economic damage caused by Covid-19 – it contained a measure offering small businesses whose revenues were affected by lockdowns a credit of up to $7,000 per employee, per quarter. Paychex developed the employee retention tax credit (ERTC) service, which allowed companies to check through payments already made to staff and file amended returns that claim back tax. Paychex says more than $8bn has been reclaimed by clients so far.

With more employees working remotely, it also developed tools for employers to keep tabs on them. These included a product that used predictive analysis to identify staff who are thinking of leaving, and a ‘talent dashboard’ that incorporates this data alongside performance insights and time-off balances, allowing business owners to assess which workers were being paid “appropriately and equitably”.

The post-lockdown growth in employment numbers has also been a boon. In the year to 31 May, the company reported payroll and PEO client numbers had increased by 20,000 to 730,000, with higher revenue per client levels also contributing to a 14 per cent increase in revenue, to $4.6bn. Adjusted net income and earnings per share grew at an even faster rate of 24 per cent.

Some of these gains are more durable than others. Although the ERTC service continued to contribute to revenue growth in the quarter to 31 August this year, “its benefit will decline as the year progresses”, chief financial officer Efrain Rivera said on the company’s first-quarter earnings call in September.

Both revenue and earnings per share growth softened in the quarter – to 11 per cent and 16 per cent, respectively. This slowdown has been reflected in its share price, which is around a fifth off the all-time high of nearly $142 a share reached in April.

A lot might hinge on the macroeconomic environment in the US, where Paychex generates 99 per cent of its revenue. Although employment numbers remain strong, the threat of layoffs, particularly among smaller firms, is the “primary risk to the company’s go-forward revenue outlook”, says Andrew Nicholas, a research analyst at broker William Blair.

“Payroll and HCM companies have benefited meaningfully from the aggressive growth/hiring plans of their clients alongside the pandemic recovery, and it’s fair to assume a slowdown in this dynamic over the course of the next 12 months,” Nicholas says.

Guidance from Paychex management suggests adjusted earnings per share can remain in double-digit territory for the remainder of its financial year, off anticipated revenue growth of 7-9 per cent.

Even after their recent sell-off, Paychex shares trade at 27 times FactSet consensus forecast earnings – only a touch below their five-year average. In terms of our screen, they do fail the ‘genuine value’ ratio test, which looks at the company’s price/earnings growth ratio, adjusted for cash and dividend yield. But passing that test is not a pre-requisite: we dropped that demand from our quality shares screens prior to the pandemic, in recognition that it was no longer possible to find good quality businesses trading on cheap valuations. Still, given that, and given the outlook, the danger is that Paychex may not earn investors as much as it did in the past.