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Morningstar | Paychex: Payroll and Human Resource Services Continue to Diverge

Wide-moat Paychex’s first-quarter fiscal 2019 went as expected, continuing on trends of slower growth in payroll and exceptional growth in its professional employer organization, or PEO, business. For now, we retain our $58 per share fair value estimate and our 2018 forecast. Payroll services revenue growth remains weak, generating year-over-year growth of only 1%, while HR services remains a standout performer, posting organic growth of 12%. In total, GAAP revenue was $845.7 million, representing growth of 8.5% from the previous year. This quarter’s revenue does benefit from the acquisition of HROI, which occurred at the end of Paychex’s first quarter of 2017. Operating margins declined 290 basis points to 37.1%. Much of this was attributable to acquisition-related expenses, and we anticipate meaningfully higher margins later this year. That said, we only expect a modest improvement in operating margins in 2018. For now, we will retain our forecast and believe shares in Paychex offer little to no margin of safety.

As we have said in previous quarters, given the recent strength in employment, we would expect Paychex’s payroll revenue to be growing at a faster rate. In comparison, Paychex’s closest peer, ADP, increased employer service revenue by 4%. Paychex blames some of this on having fewer processing days in the quarter, which would have some impact, but we would still expect growth to be higher. The longer this occurs, the more we worry that Paychex is seeing competition intensifying for its smaller customers. These concerns aren’t abated by the company’s inability to increase its investment balances held for payroll clients. During the quarter, funds held for clients declined 2% from the previous year. This certainly could be related to timing, but balances are still more than 2.5% lower than two years ago. Should this continue, we’ll have to alter our expectations for growth in client balances, which we anticipate will grow by 3% in fiscal 2019.

Finally, Paychex’s PEO business remains a bright spot and offsets much of the competitive concerns we have regarding payroll. As mentioned, HR services, or HRS, revenue grew organically by 12%, but what was especially notable is that growth in HRS was primarily driven by increasing volume and not pricing. Based on how management previously reported segment numbers, HRS revenue is expected to grow 10%-11%. If Paychex hasn’t used pricing to generate growth, we believe the company will easily meet its segment guidance. Overall, we think Paychex is well on track to generate revenue of $3.6 billion while hitting management’s target for adjusted earnings growth of 11%.