Last week, the company announced that its board of directors approved a $0.06 increase in the company’s regular quarterly dividend, an increase of 12 percent. The dividend will go from $.50 per share to $0.56 per share.
“This dividend increase demonstrates our commitment to providing a benefit to our shareholders as a result of the Tax Cuts and Jobs Act (TCJA) and continues the company’s history of providing outstanding shareholder value and a leading dividend yield,” said Martin Mucci, Paychex president and CEO. “Paychex is uniquely positioned in our industry to benefit from the TCJA due to our strong margins. As we realize these tax benefits, we continue to invest in strategic growth opportunities. These investments, combined with our financial strength, enable us to expand the returns we deliver to our shareholders.”
Over the past decade, this dividend growth stock has compounded shareholder wealth at an annual rate of 9.40%/year.
The company has managed to grow earnings per share at an annual rate of 5.20%/year. The consensus for 2018 and 2019 earnings per share for Paychex is $2.55 and $2.77. In comparison, Paychex earned $2.25/share in 2017.
The company serves the business needs of over 600,000 small to mid-sized clients in the US. The majority of these clients have less than 100 employees. The number of businesses is cyclical, as it rises and falls with the expansion or contraction of the economy. Low unemployment rates and high labor participation rates are good for payroll processors like Paychex. Bankruptcies and mergers typically reduce the number of customers. New business formations help companies like Paychex. Establishing and maintaining solid long-term relationships with the clients is important for business process outsourcing companies like Paychex.
Paychex offers HR, employee benefits, payroll processing, tax returns filling and submission, as well as accounting records to small and mid sized companies that have less than 100 employees. The company has a solid competitive advantage due to scale of operations and the fact that it targets a the small to mid-size employer niche. There are significant barriers to entry in terms of the need for large fixed investments. It makes sense for those small businesses to use the expertise of someone like Paychex, rather than do it on their own. Once a client is signed up, they are unlikely to abandon their provider since most businesses try to avoid switching costs associated with that action.
Due to the high switching costs, the company is able to raise prices to its customers over time. In addition, it is able to further increase its competitive position by introducing and delivering new and additional services to its offering mix. This ensures stickiness in the relationships and helps in retention of customers. The company can offer additional services at a low marginal cost due to its sheer scale of operations.
Increasing reporting requirements for businesses is a long-term tailwind for companies lie Paychex. The introduction of the ACA has been beneficial for Paychex over the past five years, since employers tried to outsource a lot of Human Resource functions.
The combined interest on funds held for clients and corporate investment portfolios benefit from higher interest rates and slightly higher investment balances over time. Basically, Paychex generates money from client funds that are waiting to be distributed. If interest rates increase, Paychex will generate additional profits from this activity.
Additional profits can be generated through strategic acquisitions. On March 1, 2018, Paychex announced the purchase of Lessor Group, a market-leading provider of payroll and HCM software solutions headquartered in Demark and serving clients in Northern Europe. This should help it expand its footprint in the region.
The lower corporate tax rates will result in higher earnings per share. The excess earnings from the reduced corporate tax rates will likely be reinvested in growing the business. Paychex has a three legged footprint for its cash deployment. Paychex allocates cash to strategic growth initiatives, makes strategic acquisitions and distributes the rest out to shareholders in the form of dividends and some share buybacks.
Over the past decade, Paychex has managed to boost its dividends at an annual rate of 8.80%/year. This was accomplished by the expansion in the dividend payout ratio.
Over the past decade, the dividend payout ratio grew from 58.50% in 2007 to 81.80% in 2017. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings. The company rewards shareholders with dividends, rather than a mix of dividends and share buybacks. I actually like that arrangement, because Paychex shares have been richly valued for the better part of the past decade.
Right now Paychex is selling at 24.50 times forward earnings and yields 3.60%. I view the stock as overvalued, and the dividend payout ratio to be a little too high for my taste. The high dividend payout ratio was the reason I didn’t initiate a position in Paychex when I last analyzed the stock in 2009, prompting me to invest in ADP instead. I would likely consider Paychex on dips below $51/share, which is equivalent to 20 times forward earnings.
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