As Small Businesses Try to Recover so Too Does Paychex (NASDAQ:PAYX)

We sometimes hear an economy referred to as a Goldilocks economy, not too hot, not too cold. At the individual stock level, Paychex (NASDAQ:PAYX) can be considered a Goldilocks company - not too exciting, but not all that boring either.

The fortunes of the Rochester, New York-based payroll services provider are largely tied to the success of small businesses. It's understandable then that the company's recent performance has been impacted by the misfortunes of small businesses everywhere in the wake of the coronavirus crisis.

Before the market open on July 7^th, Paychex reported lackluster fiscal 2020 fourth-quarter results that reinforced this relationship. For the three months ending May 31^st revenues declined 7% to $915.1 million.

Net income fell 4% to $220.7 million and diluted earnings per share (EPS) of $0.61 topped the Zacks consensus estimate by a penny.

Paychex had over 670,000 payroll clients across the U.S. and Europe at the end of the period. It is the payroll processor for one out of every 12 private-sector employees in the U.S.

Pandemic Reduces Paycheck Volumes

President and CEO Martin Mucci noted that the COVID-19 crisis had a significant impact on the company's operations in the quarter. This was to be expected given that small to medium-sized businesses are the core market for Paychex.

With these many of these businesses forced to suspend operations, this meant there was less of a need for payroll processing and other human capital management services.

Revenue in the Managed Solutions segment decreased 6% due to lower check volumes. With fewer serviceable employees, Insurance Solutions revenue dropped 11% because of a decline in health and benefits applications and lower workers' compensation premiums.

Although the company has seen improvements in the business since the beginning of May, the effects of the pandemic are likely to linger for some time as employees slowly return to work and small businesses review their needs for the types of services offered by Paychex.

Fortunately, investments in technology and the expansion of its SaaS portfolio leading up the pandemic were timely. It allowed Paychex to service existing clients with little disruption.

With many customers scrambling to apply for emergency Small Business Administration loans and loan forgiveness, Paychex also played an integral role in processing more than 400,000 payroll reports to help move along these processes.

Opportunities to win new business, however, were rather limited because small business owners worldwide faced uncertainty around the sustainability of their operations let alone their capacity to invest in payroll, benefits, and insurance SaaS products.

Forecast Calls for Cloudy Skies

Despite the ongoing uncertainty around the economy's pace and magnitude of recovery, management took a stab at providing fiscal 2021 guidance.

It forecasts full-year revenue to be down 2% to 5%. Full-year adjusted EPS are expected to be lower by 6% to 10%.

Paychex also plans to accelerate its long-term strategy of reducing its geographic footprint to reduce costs and improve operational efficiency. It expects to incur one-time costs associated with this consolidation of about $40 million most of which will impact the next quarter's performance.

Prior to the earnings release, the Zacks consensus EPS forecast for the first quarter of fiscal 2021 was $0.60. This represents a 15% decline from the first quarter of 2020. We may start to see analysts lower their first quarter and full-year estimates based on the company's latest outlook and subdued tone.

Rising Costs Leading to a Slowdown in Profit Growth

The underwhelming fourth-quarter performance is both a reflection of the challenging operating environment since March 2020 as well as the company's rising expense headwind.

Although amid the pandemic expenses were naturally down 8% in the fourth quarter, they increased 7% for the full fiscal year to $2.6 billion. This was because of higher compensation-related, professional employer organization (PEO) direct insurance, and intangible asset amortization costs. Integration and other costs associated with the company's recent acquisition of privately-held human resources outsourcing company Oasis Outsourcing also played a role.

The Oasis acquisition has, however, helped solidify Paychex's leading position in the outsourcing market. It expanded its customer base and will likely result in significant synergies.

But as Paychex has moved to take advantage of increased opportunities in the human capital management industry, expenses in marketing, sales, and product development have climbed. This has led to a deceleration of earnings growth from 16% in 2018 to 11% in 2019 and 6% in 2020.

Built to Survive but not Thrive

Paychex exited the fourth quarter with $1 billion in cash compared to $802 million in debt for a net cash position of $198 million. With businesses starting to reopen and access to other credit facilities, it has ample financial strength to run the business, make capital investments, maintain dividend payments, and repurchase stock.

But with a long recovery road ahead for many businesses, Paychex lacks near-term growth catalysts. It remains far from business as usual for small and medium-sized businesses in the U.S. and Europe. Many are coming back with far fewer employees and some will never return to their pre-pandemic workforce levels. This will make it challenging for Paychex to grow.

The recent stock market rally has been largely led by companies that are expected to benefit from the current economic environment. Investors are seeking resilient "survive and thrive" stocks.

It will likely be some time before Paychex returns to normal business conditions. At this point, it is merely a survive stock rather than one that will thrive.