Quite often, in the business world, we have seen companies consisting of both cash cow and cash calf. On the one hand, the cash-cow business takes care of generating reliable, repeatable, and predictable cash streams protected by sustainable competitive advantages. On the other hand, the cash calf plays as the growth engine in charge of increasing the company’s top line. This way, long-term buy-and-hold investors harvest both economic moat on the defensive side and the growth opportunities on the offensive side.

Paychex is a typical case here. The Rochester, NY-based company (PAYX) is the leading provider of integrated human capital management (referred to as “HCM”) solutions for payroll, human resources, retirement, and insurance services for small- and mid-sized businesses. It has more than 100 offices serving approximately 670,000 payroll and PEO clients through the US and Europe.

The company operates two business segments as follow –

  • Management Solutions, which involves payroll, tax, compliance, administration, etc., mainly through Paychex’s cloud-based software-as-a-service platforms;
  • PEO and Insurance Services: PEO services offer combined packages that include payroll, employer compliance, and benefits administration, among other services; insurance offerings include property and casualty coverage and benefits coverage.

As described below, Management Solutions, the “cash cow,” represented roughly 78% of the total sales in FY2019. PEO/Insurance, the “cash calf,” drove the majority of the growth momentum (i.e., 46% YoY in FY2019, 32% YoY in FY2018).

Source: 2019 Annual Report.

Economic Moat

Paychex builds the majority of its economic moat through the installed base of its integrated cloud-based HCM platform. This, along with a strategic focus on the small- to mid-market space as well as the comprehensiveness of HCM services provided, helps the company dominate the category that it operates in.

Paychex’s clients have the option to select the HCM modules that they need with the ability to easily add more as they grow. This flexibility allows clients to define the solution that best meets their needs throughout different stages, thereby increasing customer loyalty. Service agreements are generally terminable by the clients upon relatively short notice. But HR departments should hesitate to risk operational disruption or spend time and capital on integration and training even though a slightly higher-quality or lower-cost product emerges.

The recent client retention rate was around 82%, in line with Paychex’s historic best retention rate. The figure is indicative of the sound economic moat around the company’s economic castle. But it also displays the characteristic of more bankruptcies and acquisitions specific to small businesses and certainly some room for improvement, especially compared with the 91% retention rate at Automatic Data Processing (ADP).

Speaking of competitors, in addition to ADP, the global mass-market player, Paychex also competes with the smaller new entrants in the space, including Paylocity (PCTY), Benefitfocus (BNFT), and Workday (WDAY), while the latter two have yet to break even.

As you can imagine, the financial performance of Paychex should be highly correlated with the situation of the job market. But during the great recession, Paychex still generated superior returns on invested capital between 35% and 45%, beating the performance of ADP (see below). The contributing factor here could be that during the recession, more cost-conscious businesses may consider Paychex’s products and services to improve efficiency.

Source: YCharts; data as of 9/24/2019.

At the same time, the company also delivered more than 10% FCF return on total assets, compared to mostly below 5% at ADP. Today, Paychex can produce more than twice the amount of free cash flow on one dollar of assets that its major peers do on average (see below), indicating an enduring competitive position.

Source: YCharts; data as of 9/24/2019.

Over the past decade, the business maintained its superior FCF margin of above 25% and more annual free cash flow was generated than annual net profit every year (see below), showing quite some resilience in the highly competitive and fragmented in the HCM space.

Source: GuruFocus; data as of 9/24/2019.

Source: GuruFocus; data as of 10/10/2019.

Long-term Prospect

The last decade has seen PEO grow in popularity as a go-to HR outsourcing solution, especially for small and medium-sized enterprises. Smaller employers can become overwhelmed with modern HR tasks and responsibilities, which have grown in complexity in recent years, especially with compliance. But by partnering with a PEO, small business owners can instead outsource HR and focus all their attention on other areas of the business.

The industry almost doubled its size, with a CAGR of roughly 8%. That growth rate is 14 times higher than that of employment in the US economy as a whole.

Although the growth rate is going to moderate, we believe that the growth momentum of Paychex’s “cash-calf” PEO business will continue. Paychex is now the 2nd largest PEO in the US by the number of worksite employees, which increased from 770,000 in 2014 to 1,500,000 in 2019. As for the FY2020, the management set the guidance for a 30% YoY growth in PEO/Insurance compared with 5% in Management Solutions.

According to the management’s analysis, there are over 10 million addressable businesses in the geographic markets that the company currently serves. Compared to the two-thirds of one million clients using Paychex’s products and services, the majority of which, are not even PEO customers, we see the massive runway ahead for growth.

In the meantime, the cash-cow side of Paychex enables the business to invest in R&D, sales & marketing, and M&A deals. As a result, the gap against its competitors can hopefully be widened.

Some recent acquisitions include Oasis Outsourcing (the largest private PEO in the US) and Lessor Group (a provider of payroll and HCM software solutions in Denmark). Those deals have already contributed considerably to the top line and bottom line at Paychex. But we, as the investors, should understand that more than half of acquisitions do not work to our favor in the long run. M&A should not be regarded as a sustainable growth driver, and investors should keep their eyes on the evolvement of the company’s return on tangible assets (see below).

Source: GuruFocus; data as of 10/10/2019.

On the organic side, we think a low-teens CAGR is possible for Paychex to increase its EPS and FCF per share for the next few years.


At the moment, we think that PAYX is a bit overpriced. According to Morningstar below, all prevailing price multiples (e.g., P/E, P/S, P/B, P/CF) are above their respective historical averages.

Source: Morningstar; data as of 10/10/2019.

The chart below also shows the steadily rising valuation of the stock since 2012 in terms of EV/EBIT.

Source: GuruFocus; data as of 10/10/2019.

Paychex current has a free cash flow yield (our favorite valuation indicator) of around 4%. Assuming a 10% CAGR in FCFPS, we would preferably demand a 5% FCF yield that could price in more margins of safety.

Source: GuruFocus; data as of 10/10/2019.


Overall, we believe that Paychex is a great business that consists of both the moaty cash cow and the rapidly-growing cash calf. However, when it comes to valuation, the stock looks a bit expensive at this level. We would bury the name into our watch list and wait patiently for pullbacks and better entry points.

Disclosure: I am/we are long PAYX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Mentioning of any stock in the article does not constitute investment recommendations. Investors should always conduct careful analysis themselves and/or consult with their investment advisors before acting in the stock market.

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