Written by Nick Ackerman. This article was originally published to Cash Builder Opportunities on March 29, 2023.
Paychex (NASDAQ:PAYX) delivered another solid quarter. This is something that this company regularly delivers, too. They’ve missed EPS estimates only once out of the last 16 quarters. That was the same for the revenue estimates, with only one miss in the last 16 quarters. The size of the beats wasn’t the most substantial in terms of percentage surprise, but a beat is a beat.
PAYX describes itself as a “leading provider of integrated human capital management solutions for payroll, benefits, human resources, and insurance services.” With that, it would seem fairly clear why a recession would be particularly harmful to a company that requires a strong labor force to maintain its own growth and profitability. So perhaps it’s even better news that guidance and forecasts still remain attractive despite an expected recession sometime in the next year.
Since our last update, the company’s shares have performed essentially flat. That might be discouraging against the broader S&P 500 Index moves, but it doesn’t deter my optimism for holding PAYX over the longer term.
The company posted adjusted diluted EPS of $1.29, up 12% from the $1.15 reported in fiscal Q3 2022. Revenue was similarly positive, with a climb to $1.381 billion for the quarter, 8% over the $1.276 billion from the quarter in the year prior.
The company had really benefited from multiple cylinders that were all working together. They’ve seen increased clients, seen an increase in clients’ employees, and they’ve seen higher revenue per client. Not only are they achieving new customers, but the customers they already have are spending more by adding even more services from Paychex’s offerings.
However, one area that might not seem overly obvious until you drill into the earnings is that they have a bit of a mini-bank business. Not literally, of course, but they earn interest on funds held for clients. As that cash is earning something these days due to higher interest rates – that’s something they can benefit from. They expect the current fiscal year to earn around $100 to $105 million in interest.
To look at this another way, there were an average of 360.5 million common shares outstanding for the three months that ended Feb. 28, 2023. Share count actually declined as they had averaged 360.9 million the prior year. Anyway, that means that at $100 million in interest, that would contribute to $0.277 in EPS. Suffice it to say the company is benefiting from higher interest rates. While that might not be a focus of their business, it certainly doesn’t hurt.
Even without that, the company is looking set to achieve strong growth as they’ve already been achieving strong EPS growth. That includes even seeing growth through 2020 during the pandemic. If the next recession is mild as it’s suggested to be, it doesn’t seem that the recession headwind would be anything that they couldn’t deal with.
While analysts expect 12.79% in growth, their guidance is for expected adjusted EPS to be 13 to 14% for the current fiscal year. That’s slightly narrowed from the 12 to 14% range they mentioned in the previous quarter. As we wind down closer to the end of their fiscal year, it’s encouraging to see they are coming in toward the higher end of their given range.
To achieve this growth, it does require more employees for PAYX themselves. Employees expect higher wages as inflation has been eating purchasing power, which is more than sensible. So on the downside, they’ve also seen expenses increase 8%, driven by those factors. Simply put, you have to spend money to make money.
Worth noting talking about higher interest rates is debt. There are a lot of companies struggling with rising costs to service their debt. PAYX is not one of them, as they have no net debt.
At the end of the last quarter, cash and cash equivalents sat at $1.317 billion, with total long-term debt of $798.1 million. That would bring the net total long-term debt down to -$518.9 million with the latest quarter. This isn’t a new phenomenon for this company either – it’s a fairly regular occurrence. Having net debt would be the anomaly around 2019.
This has meant with the latest quarter, they’ve generated $5.8 million in interest income compared to an interest expense of $8.5 million from the prior year.
In the earnings call, we got some color on the 2024 fiscal year as well, but those details were fairly limited.
However, let me share some of our preliminary thought process around fiscal 2024. On a preliminary basis, we believe that the exit rate in the fourth quarter is a decent approximation for total revenue growth for 2024. This should result somewhere in the range of 6% to 7%. And again, we got more to do there, but just giving you what our thought process is at the moment. And it’s heavily dependent on what we think will happen with interest rates during the year. And at this point, our assumptions are conservative.
Still Worth Buying?
After these latest strong results have shares flying higher by nearly 7% at the time of writing, it’s helped push shares to be about flat on a year-to-date basis.
That being said, that only puts us at about the fair value estimate based on the historical P/E rate this company has been trading at in the last 10 years. The valuation has become much more attractive in the last year or so after trading well above their fair value estimate range.
Wall Street analysts might have PAYX rated as a “Hold,” but their average price target is $121.56. That means they expect there could be a bit of upside even from these levels. This also is dealing with the figures we’ve known already, not with the current earnings posted. That means there could be some changes as this new information is digested.
All this being said, I believe that shares remain worth buying at these levels. This is especially true as the latest earnings just reaffirmed an optimistic outlook.
Investors don’t have to wait around to experience the anticipated price appreciation due to attractive growth only – we have the dividend to also look forward to.
They’ve been growing their dividend after a pause during COVID. That pause in growth didn’t seem necessary given the earnings growth the company still experienced, but it’s always better to provide more liquidity and a stronger balance sheet than to wish you had one. After that, they hiked the dividend quite substantially.
If they raise as they’ve done in the last two years, we should be expecting a dividend announcement next month. Dividend estimates from analysts see the dividend going up to a $3.29 annual rate from the current $3.16. That would represent a 4.11% raise.
I would actually anticipate or hope to see an even larger increase. I don’t necessarily see it being another 20% eye popper, but I could see it being higher single digits. Given their earnings growth expectations, something around an 8% to 10% increase would seem feasible.
In that case, my best estimate would be an annual dividend in the $3.40 to $3.48 range or around $0.85 to $0.87 per quarter. They have what could be considered a higher payout ratio, but they’ve seemed comfortable with this for a while. This would keep the payout ratio around 80%, which they’ve been at for years now, assuming their projections for fiscal 2024 are similar to analysts.
PAYX isn’t necessarily cheap, but it also isn’t necessarily expensive either. It’s around current fair value estimates based on historical information and analyst targets. That being said, for a longer-term investor, this still suggests an opportunity here. While the more recent results have the stock underperforming the market, longer-term PAYX has actually crushed it.
That isn’t to say that’s guaranteed going forward, but if they achieve the growth expected from them, that certainly could send the stock in the right direction. At the same time, we have a growing dividend that helps support returns while waiting.