EUR 850.00 For Business Accounts Only

Morningstar | Paychex Investors Should View Benign Workers' Comp Environment as the Exception, Not the Rule

This quarter, wide-moat Paychex began absorbing its acquisition of Oasis Outsourcing with no noticeable indigestion. The company earned $0.90 per share in GAAP earnings while producing revenue just shy of $1.1 billion. Though the quarter was noisy, the results are mostly in line with our expectations. Management solutions revenue, which includes payroll, decelerated to 4% year-over-year growth while the lion’s share of growth came from the inclusion of Oasis. Most importantly, Paychex included initial 2020 guidance and expects Oasis to contribute $355 million to $375 million in revenue, which is a little higher than we were expecting. Despite Oasis’ contribution, the company anticipates the added expense of the acquisition will mostly offset the additional sales. Also, the company’s EBITDA margin guidance is modestly higher than we had anticipated. We’ll be making modest adjustments to our model and are increasing our fair value estimate to $60 per share from $58. Our fair value estimate translates into a 2020 price/earnings multiple of 19.8.

We believe shares in Paychex are pricing in a permanently rosy economy that sees limited disruption in labor markets. One margin tailwind that we believe has been overlooked is Paychex has seen minimal workers’ compensation claims, which historically has made PEO margins quite volatile. We believe this placid environment is more the exception than the rule, and that’s why it’s hard for us to see Paychex’s operating margins continue to expand over the next five years. Furthermore, Paychex pointed out state regulators have been lowering insurance premiums, which has had a knock-on effect for the company’s insurance business.

Throughout the call, management promoted its use of artificial intelligence and machine learning, specifically mentioning its chatbot 11 times. We do think it’s interesting the company is so focused on using technology to enable self-service options for customers, which we like. However, we do believe the company is playing catch up here and will need to do more than just match a competitor's product features. Customer service is important, but we feel increasingly the next generation of payroll users will want to have be able to handle issues without having to dial an 800 number.

Perhaps more interesting than the use of chatbots, we are finding Paychex has been more serious than we realized about adopting agile application development techniques that can speed up the development process. We believe agile development is to IT departments what lean manufacturing was to manufacturing companies in the 1980s. Per one industry publication, Paychex began its agile journey in 2014 and now has least 80 agile development teams. We doubt this transition has been easy and we suspect the company took some short-term hit to margins to implement these techniques. Nevertheless, we think it has put the company on better footing to launch products faster. We'll be investigating this further to see what sustainable benefit, if any, Paychex has achieved from adopting this approach.