During our fourth quarter portfolio update, we profiled portfolio holding, Paychex (PAYX). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.

Paychex

We’ve been long time shareholders of Paychex, a company that serves small and midsize businesses (SMB) with payroll, HR, and PEO services and technology. These are the types of services that are critical to the functioning of all businesses but not necessarily the core focus of their mission or value creation. And to do them properly in house with the right level of staff, without errors and in compliance with regulations, requires a level of scale we believe is in the hundreds to thousands of employees. It’s this market comprised of businesses with a handful to a couple of hundred employees where Paychex focuses its efforts to serve businesses with these mission critical needs.

Paychex was founded in 1971, went public in 1983 and has generated a 20% compounded annual total return since. It started with a payroll service offering and over time has expanded to HR services, employee benefits administration, employee management software, and then fully outsourced employee management services that now includes the 2nd largest Professional Employer Organization (PEO).

In its last fiscal year, it reported more than 730,000 clients and paid 1 in 12 private sector employees in the US generating over $4 billion in revenue, 40% operating margins, an adjusted return on invested capital of over 100%, and threw off nearly $1.4 billion in cash. This is a very lucrative business; one that is supported by a ton of value it creates for its clients doing the meticulous and important behind the scenes work that allows businesses to function every day. It’s the kind of business we’ve previously termed a “cash machine”.

 

Given how mission critical it is to pay employees consistently and correctly, withhold and submit taxes, gather, maintain, and update employee records, stay in compliance with regulations and provide great service to employees, it’s not hard to understand why clients would be very sticky after selecting a service provider – there are huge switching costs involved in the form of time and information burdens and the possibility of mistakes that impact employee paychecks and benefits in switching providers. Collectively the time across an entire employee pool spent to set these systems up and the risk of errors make it they type of service that you’d rather “set it and forget it” for generally risk adverse managers who are more keen to be working on delivering value for their own clients and generating revenue.

Switching from Paychex to another vendor only happens if there is a significant reason to do so – such as poor service quality, unacceptable numbers of errors, or much better capabilities. These are all factors that are within the company’s control with the exception of being able to “be all things to all people”, ie at some point some clients will grow large enough that their needs will get complex enough to move on to a more customizable platform or take the HR/Payroll services inhouse.

Paychex’ client retention looks optically low at 84%, but this has its underlying roots in a significant number of clients who go out of business in the small business market – about 20% of small businesses shut their doors in their first year, while only half remain in business after 5 years. We all know being a small entrepreneur is a risky venture, yet enough start new businesses to keep feeding the Paychex funnel of new clients to replace those lost. On the other hand, those businesses that continue to thrive fuel growth for Paychex’s business which prices many of its services on a per employee per month basis. So as retained customers grow the number of their employees and benefits, Paychex’ revenue also grows.

Paychex has seen revenue grow in the range of 5-7% in the decade prior to the COVID era. Results during the “COVID” period were surprisingly resilient aided by US stimulus packages for businesses, and then accelerated with the pent-up demand in the reopening afterwards. During this period, just like many other businesses who adapted to remote or hybrid work and offered new products as customers’ needs quickly changed, Paychex also managed to both accelerate changes within its sales and service organizations that made it more efficient and quickly brought to market new services to help customers efficiently utilize government stimulus programs such as the Paycheck Protection Plan (PPP), Loan Forgiveness, and Employee Retention Tax Credit (ERTC) programs.

Paychex’ ability to quickly build and deploy critical services that leveraged the customer employee data it already had during a tumultuous time helped a significant number of its clients survive thru the period and increase their loyalty, raising its retention rate from 82% in its May-ending Fiscal Year 2019 to 85% in FY21. In total, Paychex helped over 500,000 businesses apply for and receive $65 billion in PPP loans (9% of the total program payouts and an even larger proportion of loans disbursed to small and medium sized businesses), apply for loan forgiveness afterwards, and helped more than 40,000 clients qualify for and obtain $8 billion in employee retention credits.

In addition, the labor challenges of the past year or so have driven greater adoption of its HR services and software technologies in order to improve employee services in the form of mobile self-service options and employee benefits management for its clients. When it comes to benefits, small and medium businesses are structurally disadvantaged when competing in the marketplace to offer the best compensation packages vs large businesses. For example, many insurance offerings get cheaper per employee with scale and Paychex’s PEO service allows it to bring down the collective cost by pooling all its participating small businesses into one huge employee pool. Bringing automation technologies to its small business clients has also enabled them to work more efficiently during an inflationary period where productivity gains have been the key to preserving and growing their revenue and margins under tight labor constraints. The self-service capabilities and automation has helped also Paychex increase the productivity of its own customer service reps and salesforce, resulting in record core service margins.

The pandemic period has brought to light the importance of adaptability and resilience in business’ ability to thrive over time. The common adage, “the only constant is change”, was very much emphasized during that period. However, more broadly we’ve seen technology really start to penetrate all types of businesses especially over the past decade with the proliferation of the internet everywhere and smartphones in everyone’s pockets. Prior to the pandemic there was some worry that Paychex was too slow to adapt to the consumerization of business services and the self-service buying and control that an increasing proportion of a “digital native” business owners and employees have come to expect. However, despite the company’s origins in the 1970s mainframe era and its coming of age in the 1980s and 1990s PC period, Paychex has shown an ability to adapt at a pace that keeps up (if not necessarily lead) with customers’ needs and being able to leverage its expertise as a trusted partner to provide needed services at both steady and rapidly changing periods of their business lives.

Finally, while the services Paychex provides are not the most exciting topics to talk about, they are essential business to business mission critical services, and they can be very lucrative longer term investments as Paychex’s stock performance demonstrates. We own similar businesses such as Fastenal and Broadridge that also display those types of characteristics. And in markets such as the one we experienced in 2022, in which doubts about the future growth of more discretionary services come into doubt, these kinds of “must have” services made for relative safe havens.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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