AMM Dividend Letter Issue 18: Funding a Longer Retirement with PayChex (PAYX)
This is from the AMM Dividend Letter released April 2, 2015. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
The “standard” retirement age of 65 in the U.S. is becoming more difficult for many to achieve as life spans increase and retirement funds need to be stretched over a longer period of time. A 65 year old woman today can expect, on average, to live 20.5 more years to 85.5 while a 65 year old man can expect to live 17.9 more years to 82.9. As we continue to crack the genetic code and unravel the Gordian Knot that is cancer, life expectancy will continue to grow and retirements will need to be funded even longer.
Funding longer retirements is both a large national and individual problem. 80% of working households have less than one year’s worth of their annual income saved for retirement when some estimates suggest that they’ll need somewhere around 22 times their annual income.
Such a large problem has some very straight forward solutions. One of the most important solutions is to save more.
When Defined Benefit Plans (Pensions) were the standard retirement plan the way to a secure retirement was to make sure the company you retired from knew where to send your checks. In these kinds of plans, a retiree knows exactly (defined benefit) what their retirement income will be. The advent of the defined contribution plan, the overwhelming standard at most companies today, shifted the responsibility for saving and investing to the employee.
In their book Nudge, authors Richard Thaler and Cass Sunstein outline the systems 401K plan administrators should implement to get everyone to save more. Not all 401K plans follow these guidelines so it is important for you to know them and implement them yourself if your plan administrator does not.
1) Enroll. All 401K plans should automatically enroll participants but not all do. If you’re starting a new job or recently switched jobs then make sure you are set-up to start making contributions right away.
2) Automatic savings. As discussed in AMM Dividend Letter Vol. 15 it is important to build systems that don’t rely on your will power to make the correct decisions all the time. Having money automatically deducted from your paycheck and contributed to your retirement plan is the simplest of systems to save more for retirement.
3) Employer matching. Set your contribution levels to at least your employer’s matching level. A majority of companies will match a certain amount of your 401K contributions. For example 50% of your contribution until it reaches a threshold like 6% of your salary. Your employer’s matching contribution is free retirement money so make sure you are contributing enough to get it all.
4) The “Save More Tomorrow” plan. Not everyone can start contributing the maximum amount possible to their 401K plan. In this situation, the goal should be to contribute a little more every year. Each year try to increase the percentage of your salary that is automatically deducted even if it is just another 1%. Another tip is for every pay raise you receive, increase your retirement contribution rate by 3%. On average, pay raises are around 3.5%. You’re already used to living at your old salary level. Take the extra money from the pay raise and put it in your retirement plan instead of getting used to spending it.
A recent study of 401K plans that implemented the “Save More Tomorrow” plan followed the employees who had the lowest savings rate of 3.5% at the start of the program. Under the “Save More Tomorrow” plan in 3.5 years and 4 pay raises later this group was now saving 13.6% of their income.
“An object at rest will stay at rest unless an external force acts upon it.”
This is part of Newton’s First Law of Motion also known as inertia. People are subject to inertia too in what economists call “status quo biases” and they can be harmful, especially in saving for retirement. Without automatic enrollment into 401K plans a lot of people aren’t saving at all. For the people who have enrolled a good majority of them haven’t made any adjustments to their savings rates in years. The steps above may not be ground breaking, but are intended to be the “external force” that moves us towards better retirement savings decisions. Implementing these tips and systems now will reap large benefits in the future.
Your Portfolio Management Team
Dividend Stock in Focus
PayChex (PAYX): $49.25*
*price as of the close April 2, 2015
A small business owner has a lot to do in the day to make sure their business is growing, operating efficiently and ultimately thriving. Talk to any small business owner, however, and you’ll find they are often inundated with mundane tasks that take time away from their core goal of building a profitable and growing business. What if these owners could outsource these daily tasks to someone for a nominal fee? Not only would it free up precious time for the business owner but it would also eliminate the big cost increase associated with adding new staff.
This is PayChex.
It started with payroll processing. Outsourcing payroll processing was nothing new. There were several firms already doing it for large corporations but no one was servicing the businesses with fewer than 100 employees. The small businesses above that need the most help. In 1971, B. Thomas Golisano took advantage of this opportunity, and with $3,000, one employee, and 40 clients, he founded Paymaster which became PayChex, to provide payroll to small-to-medium sized businesses.
PayChex now serves over 580,000 clients, American Money Management is one of them, and expanded its offerings to include 401K administration, human resources, and insurance.
Over the last 9 years PayChex has grown their dividend at a compound annual rate of 9.67%. However, as the chart below shows, the lions share of this dividend growth came in 2008 when the company significantly increased it’s dividend and brought the payout ratio to 76.9%.
Following the financial crisis of 2008, PayChex was unable to increase its dividend again until a nominal increase in 2012. Now that the company has recovered from the recession and earnings have begun to grow again, there is room for payouts to increase at a higher rate (see chart below: Earnings per Share are in green and Dividends per Share are in blue).
Additionally, PayChex’s dividend growth has been hurt by low interest rates. As we’ll discuss further below we see both earnings growth and higher interest rates as a path for renewed dividend growth at PayChex.
Catalysts for Dividend Growth and Price Appreciation:
Higher Interest Rates
PayChex’s payroll processing service takes control of its clients’ funds before distributing it out to its clients’ employees. Like insurance companies these funds become float or cash in PayChex’s accounts that it can earn interest on. Unlike insurance companies that can invest their float for long periods of time because their liabilities are many years into the future, PayChex’s float is extremely short-term. PayChex has to balance the ability to earn interest on their float with the short-term liabilities of their Clients’ payroll. PayChex does this by buying short-term paper like 1-3 year U.S. Treasuries, 1-3 year corporate bonds, and commercial paper.
The Federal Reserve’s Zero Interest Policy (ZIRP) has taken the yields on short-term paper down to minuscule levels. In 2007 before the Federal Reserve started cutting interest rates PayChex was able to earn a blended yield on its Funds Held for Clients at 4.0%. That blended yield is currently 0.9%. Even though PayChex’s Funds Held for Client balances have grown over 45% since 2007 its income earned on the balance has dropped 69%.
If PayChex’s blended yield on Funds Held for Clients was anywhere near 2007 levels we estimate that they would have generated around $209 million in interest income in fiscal 2014 versus the $10 million actually earned. The majority of the interest income earned on Funds Held for Clients flows through to PayChex’s free cash flow which can be used for dividend increases and share buybacks.
It will likely take a long time for interest rates to approach anything like the 2007 levels. Also, the blended maturity of PayChex’s portfolio is 3 years. This means any interest rate hikes by the Federal Reserve will take time to flow through to PayChex’s holdings but PayChex will benefit from a rising interest rate environment.
Economic Growth, Unemployment Down, Wage Growth
PayChex’s most profitable segment is its payroll processing services. It is also the segment most heavily dependent on the economic environment. When the economy is growing, unemployment rates are decreasing, and wages are growing then PayChex’s payroll servicing is growing. When the opposite happens PayChex payroll servicing stagnates. When you have the slow economic recovery that the U.S. has had since the 2008 financial crisis then PayChex’s payroll servicing growth is subdued too. However, like we discussed in the last Dividend Letter the U.S. economy has essentially broken even and the foundations are there for continued economic growth. More importantly for PayChex, when the economy grows the labor market tightens and wages grow too. Growing wages increases the dollar amount of payroll that PayChex processes. Lower unemployment means more people working and more payroll checks for PayChex to process.
Human Resource Services Growth
Payroll processing is a mature business for PayChex with revenue growing in the low single digits. PayChex has grown its total revenue between 8-10% the last few years because of the cross selling of ancillary services. These services fall under the category of Human Resource Services and include human resources, retirement benefits, and insurance. Human Resource Service revenue has been growing in double digits the last few years and is becoming a larger part of PayChex’s total revenue.
Increased regulations like the new healthcare law and offering attractive benefit packages for top talent means that small business owners have an even greater demand for cost effective help from an outsourcer like PayChex. Hiring another individual (or multiple individuals) to do all of this is another large financial and operational commitment. PayChex can offer a bundled package for all or some of these services at very attractive prices. The bundled package also saves the small business owner time since they don’t have to shop around for each service. PayChex is also focused on making sure their services are high quality and valuable to the small business owner.
The added benefit of cross selling ancillary services is increased client retention. Providing so many services to a small business makes it costly and time consuming for the small business owner to switch to a competitor. The longer a small business remains a client of Paychex the more profitable and valuable that client is to PayChex.
Pre-Mortem (Potential Risks to our Thesis):
ADP Targets Small Businesses
ADP is the 800lb gorilla in payroll processing and generates 5x as much revenue as PayChex. However, ADP focuses on large businesses while PayChex serves the small business market. This focus on smaller businesses gives PayChex pricing power in their customer relationships. Juxtapose this to ADP, who’s very large customers have significantly more power in negotiating contracts. This is evident in a margin comparison between the two companies. PayChex EBIT Margin (earnings before interest and taxes) is in blue and ADP’s is in red.
For the most part, The two companies have stayed within their respective markets but ADP does go after small businesses too. Increased competition, especially by a company the size of ADP, can hurt Paychex’s pricing power and margins. Lower margins means lower free cash flow and slower dividend growth. So far Paychex has done a great job fending off ADP but it is an ongoing risk that we need to monitor.
Perpetually Low Interest Rates
The bulk of the damage from low interest rates on PayChex’s ability to earn income off its float has been done. The problem going forward is if the U.S. turns Japanese by which we mean ZIRP stays in effect for decades. PayChex should still grow but the boost to free cash flow from income earned off Funds Held for Clients will remain subdued and will not be supportive of significant dividend growth.
PayChex has built a strong moat around servicing small businesses. More than 80% of its clients have fewer than 20 employees. With all the services PayChex provides small businesses it is extremely hard for competitors to come in and win business away from PayChex. It would be too disruptive operationally for the small business to switch and it is why PayChex’s client retention rate exceeds 80% on a regular basis.
Given the potential for further economic growth, higher interest rates, and the cross selling of ancillary services we think PayChex is well positioned for growth in the coming years. Our estimate of fair value for PayChex is $51 per share.
All previous AMM Dividend letters are archived here.
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