Paychex reported their FY1Q16 earnings on September 30. Results showed continued momentum in both sales and new product enhancements, as well as client satisfaction and retention. Total service revenue grew 8.5% (Payroll 4.8%, HRS 14.7%), and client work site employees served grew double digits. Gartner ranked Paychex first in overall satisfaction across payroll functions, technology, provider customer relationship and payroll BPO service outcomes.
Paychex offers services to help small to medium-sized businesses with payroll, HR, retirement, and insurance. Paychex offers an integrated Software-as-a-Service (SaaS) solution suite of human capital management (HCM) products. Paychex Flex is a cloud-based integrated HCM platform. Paychex Flex delivers a streamlined and integrated workforce management solution to a broad range of clients. The Paychex Flex hiring module gives employers access to paperless recruiting, screening and onboarding. Paychex plans to round out the HCM suite with the integration of employee benefits and time and attendance functionality. Paychex also offers Paychex's Employer Shared Responsibility Service to assist in compliance with the Affordable Care Act and the health insurance regulations. Finally, Paychex offers retirement account administration.
Total service revenue grew 8.5% in FY1Q to $712 million. The trailing twelve month service revenue was $2.753 billion up 8.7%. Expenses increased 6.9% in FY1Q primarily from higher compensation. Operating income of $285 million was up 10.9%. Operating margin was up 87 bps to 40.1%. Payroll service revenue increased 4.8% to $433 million, or 60.7% of total service revenue. The increase in payroll service revenue was driven by higher revenue per check and increased client base. The revenue per check increased due to price increases of 2-4%. One additional processing day increased revenue by 1% or 25 bps on an annual basis. HRS revenue increased 14.7% to $280 million. The increase in HRS revenue was driven by growth in both clients and work site employees.
Paychex increased the dividend 11% in July to 42 cents. Paychex is also repurchasing stock. During FY1Q Paychex repurchased 1.3 million shares or 0.4% of the diluted share count.
Acquisitions are a critical way management deploys capital. Paychex has accumulated almost $1 billion in cash reserves, and it is likely they will continue to make accretive acquisitions. Since Martin Mucci became CEO, Paychex has made 6 acquisitions.
1. SurePayroll ($115 million 2010) provides SaaS payroll processing.
2. ePlan Services (2011) provides solutions for the design, provision and management of employer-sponsored retirement plans.
3. Icon Time Systems (2012) provides time and attendance solutions.
4. ExpenseWire (2012) provides expense management software. Paychex partnered with ExpenseWire in 2008 to power Paychex Expense Management, a web-based solution that provides clients with tools to readily manage and control the expense reporting process, including approval, reimbursement, and reporting.
5. myStaffingPro (2013) provides hiring software for human resources.
6. nettime (2014) provides cloud-based time and attendance solutions.
All were private before being acquired by Paychex, and all continue to operate as wholly owned subsidiaries of Paychex. How have past acquisitions performed? It's difficult to say for certain with no financial data for each subsidiary. One measure of capital management which I prefer is return-on-invested-capital (ROIC). Paychex has performed very well as measured by ROIC. During the most recent trailing twelve months, Paychex achieved an excellent ROIC of 71.6% by my calculations. Paychex made $681 million of net operating profit after tax on $951 million of invested capital. By this measure, management is deploying capital extremely productively.
For valuation purposes I compared Paychex with ADP. Paychex has a market capitalization of $18B and ADP is $40B. Both Paychex and ADP have a net cash position resulting in an enterprise value below their market capitalization, $17B & $38B. Paychex and ADP have FY2016 EBITDA forecasts of $1.2B and $2.1B. Now this EBITDA forecast uses management guidance. Paychex guides to 38% operating margin and their mrq came in at 40.1%. ADP on the other hand had a pretty disappointing quarter. ADP is guiding to 18.4% operating margins for 2016 which is a 50 bps improvement over 2015. If AFP can deliver this type of margin, it would be a great improvement over their mrq which had some margin pressure. Based on recent performance, I would say Paychex guidance is conservative and ADP's guidance is an the aggressive side. The resulting EV/EBITDA multiples are 13.9x and 17.8x. Multiples to FCF are 20.3x and 23.6x. PEG ratios to FCF are 2.0x and 2.4x, assuming both have a 10% growth rate. I would say Paychex is performing better and delivering better results and Paychex is trading at a less expensive valuation.
Paychex business is performing well with steady growth in revenue, margins and earnings. Paychex is benefiting from new HR offerings which are boosting growth. Management is returning capital to shareholders and has a disciplined acquisition strategy that appears to be working well based on ROIC. Although it is difficult to foresee what type of acquisition Paychex will make in the future, I trust Mucci, a proven steward of shareholder capital.
Michael Grove, CFA