Paychex, Inc. is a payroll processor for 605,000 businesses in the United States and Germany that have between 10 and 200 employees. It is on the short list of stocks with excellent investment characteristics that I have yet to cover on the site. Since 1990, PAYX stock has created enormous wealth for its shareholders by compounding at a rate of 21.2% annualized—on par with the compounding rates of Warren Buffett at his best. If you invested $10,000 into PAYX back then, you would have $1.6 million today.

The investment thesis for Paychex relies on two factors:

1. Paychex has a remarkably stable customer base.
2. Paychex has extreme profit margins that have stood the generational test of time.

Low PAYX Customer Turnover, Steady Profit Base

The nature of payroll processing is such that Paychex only has a customer turnover rate of 0.8% each year. This makes intuitive sense. If you are running a small business, and you set up an accounting system and enter all the data for employees to receive their salaries, you are not going to switch payroll processors haphazardly. If you see an ad on TV offering a 10% lower rate, that probably won’t be enough to make you switch because you won’t want to create a risk that there will be some type of error during the switch and you also don’t want to put in the time to secure marginal savings.

This means that there are only two (arguably three) scenarios in which PAYX shareholders stand to lose wealth. First, if a competitor comes along to offer drastically lower rates, making the transition cost worth it. This is unlikely, as Paychex has the institutional resources to match the lower rate and the industry does not have a history of aggressive attempts to steal market share. Secondly, it could lose market share if it commits some kind of blunder or processing error that creates a tension with its business clients which trigger them to move.

These risks have not materialized throughout Paychex’s publicly trading history, and the 0.8% turnover rate is a testament to the stickiness of its business.

The arguably third manner in which PAYX shareholders stand to lose wealth is through bankruptcies and insolvencies that lead to businesses to liquidate. When a recession strikes and businesses go under, Paychex is going to lose some clients. Meanwhile, very few new businesses are born during such times, and the departing clients eclipse the rate at which Paychex picks up new clients.

I don’t think this poses a meaningful risk to the intrinsic value of PAYX shares. The proof is in the modestly negative results during the last recession. During the past twenty-seven years, there has only been one two-year period in which Paychex earnings failed to grow over 24 months. And yes, it was during the financial crisis of 2008-2009.

But the damage was limited. In 2008, Paychex earned $1.56 per share in profits. The next year? 1.48 per share. And the year after that? $1.32 per share. And then earnings rebounded and have been on a climb ever since to the current rate of $2.09 per share. From peak to trough, PAYX profits only declined from $576 million to $477 million. That’s the greatest earnings hardship that has ever been imposed on shareholders.

PAYX Profit Margins

Every year since 1990, Paychex’s annual net profit margins have remained between 21% and 28%. It basically makes as much money per unit as Coca-Cola. This is not terribly surprising, as Paychex is one of those businesses that benefits from high operational leverage. When I say operational leverage, I do not mean that in the sense of debt. Instead, I am referring to the high fixed cost basis of the model in which there is a high threshold that must be crossed, and then everything after that flows to shareholders as profit.

In contrast, an example of a business with nearly no operational leverage is a hot dog stand. If you sell hot dogs for $5 that cost you $2.50 in ingredients, you are going to make $2.50 per hot dog and there is a quasi-linear nature to the relationship. If you sell 100 hot dogs, you make $250. If you sell 500 hot dogs, you make $1,250. There is a clear relationship between sales growth and commensurate profit growth. I called it quasi-linear because, even in my simplistic example, you would still have threshold costs for a permit and perhaps heating of the hot dog stand that would act as an initial hurdle to overcome before earning those linear profits.

Other businesses benefit from high operational leverage in which the profits from that 500^th customer are far higher than that 100^th customer. An example would be a business like Facebook. It has to pay data center equipment, staff, and operating costs so facebook.com can run for you throughout the world. Well, it costs about $500 million for the first 100 million customers, and then only costs an additional $260 million for the next 1.1 billion accounts. Facebook spends $5 on its first 100 million customers, but the next 1.1 billion customers only cost $0.23 each to service. The profit margins on providing advertisement to those first 100 million customers are nearly non-existent, but the remaining 1.1 billion have a sizable gap where the real money gets made.

Paychex’s business model is more analogous to Facebook than the hot dog stand. Once it pays its technicians to provide security and inputs for the paychecks of its small business clients, the profits are largely a bolt on. If a company grows its business from 50 employees to 200 employees, it doesn’t cost Paychex four times as much money to provide service on the account.

When businesses that follow this business model mature, they tend to become cash cows with very high profit margins because the fixed costs don’t increase that much, there are few customer defections, and new clients tend to represent something close to pure profit.

This would be a dream business to own outright because its mouth-watering ratio of profits-to-net sales. Of the $2.9 billion that gets charged to customers for its payroll processing, $756 million of that goes to PAYX shareholders as net profit. That is a net profit margin rate of 25.6%. Of the 15,000 publicly traded business in the world, you’d be lucky to find more than five hundred of them that generate profit margins that high. And of those five hundred, most are in the tech or pharmaceutical industry and are subject to blistering competition, technological obsolescence, and the loss of patent exclusivity. Once you subtract those, I would say that Paychex has 100-250 peers in the entire world that can generate such high profits from its sales.

The PAYX Balance Sheet

Since 1990, Paychex has refused to carry any long-term debt. As of the time of writing, Paychex’s debt burden is $0 and it only has $35 million in annual rental expenses. It has $130 million in cash sitting in the bank.

It has pretty low reinvestment needs, and so it usually dedicates about 90% of its annual cash flows towards the dividend and a modest share repurchase program. The dividend payout ratio is usually in the 70% to 80% range, and Paychex currently pays out $1.92 of its $2.09 in earnings as dividends for a payout ratio of 92%.

Sometimes, investors get conditioned to think “high dividend payout ratio is automatically bad” because it signals a low amount of retained earnings that can fund growth and also theoretically suggests trouble funding the dividend in the event of a recession.

Personally, I’m not bothered by the high payout. Paychex has 605,000 businesses as customers. It has no debt and $130 million in cash. It has little reinvest needs. It generates torrents of cash each year compared to the outlays. It makes economic sense to pass those profits onto shareholders rather than just build up cash for liquidity’s sake or engage in acquisitions that don’t neatly attach to the core business model.

The dividends have grown by a rate of 13% annually for the past ten years, so it is not like the high dividend payout ratio has impaired the growth rate of the dividend. The caveat is that ten years ago, the dividend payout ratio was only in the 60% range. But still, even if Paychex had a dividend payout ratio of 90% a decade ago, it still could have grown its dividend by 8-9% annually. And that is what I expect from Paychex going forward—high single digit dividend growth.

Conclusion

Despite Paychex being a wonderful business, I am not crazy about the current 30x valuation rate. When you are growing earnings by 8-12% annually, the current valuation of the stock might knock total returns down to the 6% to 10% range. At some point in 2016, you were able to purchase shares of the stock for $45 or a 21x earnings range. In each of the last three years, the stock was available near the 20x earnings range. But it doesn’t stay there long. Paychex is a remarkable business with a remarkable history, but you gotta get the price close to right. I would get really interested when the price of the stock falls below $50.

Originally posted 2017-01-02 05:18:54.

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