Paychex Should be Valued At $35

Paychex (NYSE:PAYX) is one of the two major publicly traded payroll processors in the U.S. Its stock price has risen by more than 20% from $36 in July to $44 presently. During this period, the company announced its Q1 FY 2014 earnings, which were largely positive. Paychex posted total revenues of $608 million, an increase of 5% year-on-year. Rising by 6% y-o-y, net income grew faster than revenues to $163 million, as expenses grew at a slower rate (4%) than revenues. ^[1]

Although the company’s quarterly results demonstrate the growing strength in its business, we think that its stock is overvalued at the current market price. We have a price estimate of $35 for Paychex, and believe that this assigns a fair value to the stock due to the reasons we have taken under consideration.

The U.S. Department Of Labor recently released employment data for the month of October 2013, which suggests that the size of the work force in the U.S. is declining due to weakness in the job market. This could lower the growth rate in number of clients for payroll processors, including Paychex, which added less than 1% new clients in fiscal year 2013. Further, the prevailing low interest rate environment, which has been adversely impacting interest revenue earned by Paychex in the past several quarters, is expected to continue in the near term.

See our complete analysis of Paychex Here

Contraction In Work Force Could Slow New Client Additions

According to the U.S. Department Of Labor, unemployment rate in the U.S. economy stood at 7.3% this October, substantially lower than 10% in October 2009. ^[2] However, these numbers alone do not describe the state of unemployment in the world’s largest economy. This is because labor force participation rate in the U.S. has been on a downward trend, and declined to 63% from 65% contemporaneously – its lowest in 35 years. ((Labor Force Participation Rate, United States Department Of Labor, November 21, 2013)) The labor force includes people available for and willing to work. It excludes people who are unwilling to work, such people are not accounted for as unemployed.

There were 11.3 million unemployed workers this October, lower than 12.2 million a year ago. On the other hand, the number of employed workers stood at 143.6 million, nearly unchanged from a year ago. ^[3] Conjointly analyzing these figures with the labor force participation rate, clearly indicates that the decline in unemployment rate was driven by a rise in the number of workers not willing to work, and not of an actual increase in the number of workers employed.

Some economists blame a weaker job market since the recession for forcing discouraged people to leave the work force. ^[4] Even if the job market along with the economy improves over the years to come, it is unlikely that the labor force participation rate will rise above its current level. This stems from the fact that an increasing number of baby boomers have been retiring since 2000. The Federal Reserve Bank of Chicago believes that the labor force participation rate will be lower in 2020 than it is today. ^[5]

Payroll processing is the primary source of revenue for Paychex. The business is directly related to the employment scenario of the economy and makes up approximately 60% of our value estimate for the company. A decrease in size of the workforce impacts Paychex by hampering the average number of employees per payroll client.

If coupled with sluggishness in economy, a squeezing workforce also adversely affects new client additions. The following chart describes our forecast for number of Paychex’s payroll clients.

Falling Client Interest Revenue Still A Matter Of Concern

Interest earned on client funds is also an important determinant of Paychex’s stock value according to our model. Paychex receives interest income by investing client funds that have been collected, but not yet remitted to tax or regulatory authorities, or to client employees. In this way, interest rates in the U.S. economy and client fund balances affect the company’s earnings.

The interest earned by Paychex on client funds has been falling year-over-year due to the low interest rate environment prevailing in the U.S. The company earned $113 million as interest on client funds in FY 2008. This declined to $41 million in FY 2013, even as average client fund balances increased from $3.5 billion to $3.7 billion during the same period. As a result, the contribution of interest on client funds to Paychex’s total revenues also fell from over 5% in FY 2008 to less than 2% in FY 2013.

Due to a downbeat U.S. economy, interest rates are not expected to reach their pre-recession levels until 2017, which would restrict Paychex’s ability to generate interest income from client funds. ^[6]

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1. Paychex Q1 FY 2014 10-Q, www.sec.gov, October 2013 [↩]
2. Unemployment Rate, United States Department Of Labor, November 21, 2013 [↩]
3. Employment Situation Summary, United States Department Of Labor, November 9, 2013 [↩]
4. Oct jobless report paints dim picture of US job market, China Daily USA, November 9, 2013 [↩]
5. The U.S. labor force is still shrinking. Here’s why., The Washington Post, November 8, 2013 [↩]
6. Fed rates to stay low until Miley Cyrus is 30, CNBC, November 5, 2013 [↩]