It's Pay Day for Paychex

08/02/2010 11:27 am EST


Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, and analyst Vishnu Lekraj say the payroll processor is a great dividend payer as well.

Switching from one payroll processing vendor to another is very difficult, and customers’ unwillingness to do so has allowed Paychex (Nasdaq: PAYX) to build a relatively sticky client base since its founding in 1979.

This inelasticity has enabled the firm to raise prices annually and expand profits. Strong scalability has also allowed the firm to be price-competitive without feeling margin pressure.

These factors add up to 30%-plus operating margins, returns on capital averaging 70% of late, and a wide economic moat to preserve this performance, in our view. Based on revenue, Paychex is second only to Automatic Data Processing (NYSE: ADP) in the payroll outsourcing market, and it can leverage its 550,000 small and medium-sized clients to spread costs of its servicing infrastructure.

This focus gives more fluidity to the firm’s client base compared with ADP, but we believe it also gives Paychex more pricing power and a greater ability to expand operating margins. A strong brand plays a role as well; clients are hesitant to entrust critical human resources functions and payroll cash to an unproven rival.

Providing other HR-related services to customers is currently a main strategic focus. Paychex is one of the leading providers of 401(k) record-keeping services, in addition to services in workers’ compensation insurance and total HR outsourcing markets. Revenue for these noncore services has grown to be about a fourth of the company’s total. With small incremental costs, most of this additional revenue flows to the bottom line.

A fiscal 2010 payout ratio of 92% would be sky-high for most businesses, but we think Paychex’s dividend is well supported. The company has zero debt and maintains a large balance of cash and investments—enough to fund six quarters’ worth of dividends.

Free cash flow exceeded dividend payments by $100 million (for an 82% payout ratio based on free cash flow) in fiscal 2010. And, thanks to minimal capital-spending requirements, the company can afford to pay out virtually all of its earnings while continuing to pursue internal growth.

We expect Paychex to raise its dividend in line with earnings growth in the long run, which we forecast at an average annualized rate of 8%. But while Paychex has paid an increased dividend each year since 1988, we do not expect dividend growth to resume until national employment trends improve.

With a 4.7% yield at its recent price of [around $26], we believe Paychex can deliver a total return of 12%–13% per year on average over the long term.

The imminent departure of chief executive officer Jonathan Judge adds a bit of uncertainty to what is otherwise an attractive holding. But with its generous dividend backed by founder and 10.5% owner Tom Golisano, [we] don’t expect a major change in its financial strategy.

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