Paychex (PAYX)

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Paychex, Inc. (NYSE: PAYX) processes payroll, handles employee benefits, and offers related human resources services for its over 554,000 clients.^[1] Most of its clients are either small or medium-sized businesses with fewer than 100 employees; such firms make up 98% of its customer base.^[2] Rochester, NY-based Paychex does nearly all of its business in the U.S., although it also serves 900 clients in Germany through offices in Hamburg, Berlin, Munich and Dusseldorf.^[3]

Paychex's market exists because developing and administering a payroll processing system is too expensive or time-consuming for many small and medium-sized businesses to do themselves, but Paychex's scale advantage and specialized expertise let it carry out these functions much more efficiently. While the firm's Core Payroll segment accounts for most of its payroll processing business, it also has a Major Market Services (MMS) segment for its larger clients. MMS offers payroll processing in the format of software-as-a-service - i.e., clients pay a fee to use Paychex's software on their own servers and administer the system through an in-house human resources department.^[4]

Paychex also offers related payroll and human resources (HR) services, including payroll tax administration, retirement benefits administration, and workers' compensation insurance services. These business segments are profitable for Paychex because they build on the basic payroll processing system that Paychex already uses for its customers. For example, when Paychex already processes payroll data for a client, it doesn't require much more effort or cost to use this data for payroll tax compliance and to create accounting records.^[5] In addition to the cross-selling opportunities, this strategy also helps keep clients with Paychex; the more business functions a company outsources to Paychex, the more dependent that firm is on Paychex.

Company Overview

Paychex, Inc. is a leading provider of payroll, human resource, and benefits outsourcing solutions for small- to medium-sized businesses. The company offers comprehensive payroll services, including payroll processing, payroll tax administration, and employee pay services, including direct deposit, and check signing. Human resource services include 401(k) plan recordkeeping, health insurance, workers’ compensation administration, section 125 plans, a professional employer organization, time and attendance solutions, and other administrative services for business. The majority of Paychex's revenue comes from payroll processing services.

Paychex Client Base, by Business Size^[1]

Business and Financial Metrics

Third Quarter Fiscal 2010 Results^[6]

Total service revenue during the quarter decreased 4% to $493.8 million. Operating income decreased 15% to $168.2 million. Operating income reflected an $18.7 million expense charge to increase the litigation reserve related to the recent Rapid Payroll decision. Net income and diluted earnings per share decreased 14% to $112.0 million and $0.31 per share, respectively.

The Paychex client base has declined 2.1% since May 31, 2009. The selling season was a difficult one as the company's new sales units for the nine months were down 6% from last year, primarily due to declines in new business formation and fewer companies moving to outsourcing. Client retention, while less favorable than normal, began to show some improvement as clients lost during the first nine months were 5% below the same period a year ago, with a slight improvement in these losses as a percentage of the beginning of the fiscal year client base. Checks per client remained stable with a 2.2% reduction over the same period last year, compared to 3.7% and 5.0% for the second and first quarters of fiscal 2010.

Business Services

Payroll Processing

Payroll processing is the foundation of the Paychex service portfolio. The company's payroll service includes the calculation, preparation, and delivery of employee payroll checks; production of internal accounting records and management reports; preparation of federal, state, and local payroll tax returns; and collection and remittance of clients’ payroll obligations. Payroll processing clients are charged a base fee each period that payroll is processed, plus a fee per employee check processed. Payroll services are made available to clients via traditional or Internet-based methods.

Paychex Online is a secure Internet site which offers core payroll clients a suite of self-service, interactive services and products. These include Paychex Online Payroll, Internet Time Sheet, Paychex Online Reports, and General Ledger Reporting Service.

Major Market Services

MMS primarily targets companies that have more complex payroll and benefits needs or have outgrown the Paychex core payroll service. Approximately one-third of new MMS clients are conversions from the Paychex core payroll service.

Paychex's proprietary MMS software, Preview, provides a powerful payroll solution and allows smooth integration with other Paychex service offerings.

Ancillary Services and Products

• Payroll tax administration services: As of May 31, 2009, 93% of Paychex clients utilized the payroll tax administration services (including Taxpay), which provide accurate preparation and timely filing of quarterly and year-end tax returns, as well as the electronic transfer of funds to the applicable tax or regulatory agencies (federal, state, and local). Clients utilizing the payroll tax administration services are charged a base fee and a fee per transaction for each period that payroll is processed. In addition to fees paid by clients, Paychex earns interest on client funds that are collected before due dates and invested until remittance to the applicable tax or regulatory agencies.
• Employee payment services: As of May 31, 2009, 75% of Paychex clients utilized employee payment services, which provide the employer the option of paying their employees by direct deposit, Chase Pay Card Plus, a check drawn on a Paychex, Inc. account (Readychex), or a check drawn on the employer’s account and electronically signed by Paychex. More than 80% of new clients select some form of employee payment services.
• Regulatory compliance services: Paychex offers new-hire reporting services, which enable clients to comply with federal and state requirements to report information on newly hired employees. This information aids the government in enforcing child support orders and minimizes fraudulent unemployment and workers’ compensation insurance claims.
• Human resource outsourcing services: Paychex Premier provides businesses a full-service approach to the outsourcing of employer and employee administrative needs. Paychex Premier offers businesses a combined package of services that includes payroll, employer compliance, human resource and employee benefits administration, risk management outsourcing, and the on-site availability of a professionally trained human resource representative.
• Retirement services administration: Paychex's retirement services product line offers a variety of options to clients, including 401(k) plans, 401(k) SIMPLE, SIMPLE IRA, 401(k) plans with safe harbor provisions, profit sharing, and money purchase plans. These services provide plan implementation, ongoing compliance with government regulations, employee and employer reporting, participant and employer access online, electronic funds transfer, and other administrative services.
• Health and benefits services: Paychex offer health and benefits services through its licensed insurance agency, acting as general agent to provide insurance through a variety of carriers who are underwriters.
• Workers’ compensation insurance services: Most employers are required to carry workers’ compensation insurance, which provides payments to employees who are unable to work because of job-related injuries. Paychex provides workers’ compensation insurance services through its licensed insurance agency, acting as general agent to provide insurance through a variety of insurance carriers who are underwriters.
• Time and attendance solutions: Paychex offers Time In A Box, Paychex Time and Labor Online, and other time and attendance solutions, which help employers minimize the time spent compiling time sheet information. These computer-based systems allow the employer flexibility to handle multiple payroll scenarios and result in improved productivity, accuracy, and reliability in the payroll process. Certain clients are charged a monthly fee for use of hardware, software, and support. Clients also have the option to purchase the hardware and software with annual maintenance contracts.
• Other human resource services and products: Paychex offers the outsourcing of plan administration under section 125 of the Internal Revenue Code, allowing employees to use pre-tax dollars to pay for certain health insurance benefits and health and dependent care expenses not covered by insurance. Other Human Resource Services products also include employee handbooks, management manuals, and personnel and required regulatory forms. These products are designed to simplify clients’ office processes and enhance their employee benefits programs.

Trends/Forces

Only 15%-20% of PAYX's target market uses a payroll processing service

Industry data indicate there are approximately 11.5 million employers in the geographic markets that Paychex currently serves within the U.S. Paychex estimates that all payroll processors combined serve approximately 10% to 15% of the potential businesses in the target market, with much of the unpenetrated market being composed of businesses with ten or fewer employees.^[7]

While Paychex trails Automatic Data Processing (ADP) in terms of revenue in the overall payroll processing market, small and medium-sized businesses are Paychex's specialty (making up 98% of clients), whereas Automatic Data Processing (ADP) does more of its business with the 1% of U.S. companies with 100 or more employees.^[8] Therefore, Paychex is in a better position to take advantage of the large number of small/medium companies that don't yet outsource their payroll processing services.

U.S. unemployment rate

Paychex's revenue depends on the fees that businesses pay to have Paychex operate their payroll. When an economic downturn or recession occurs and unemployment rises, firms don't need as many paychecks, which translates to lower demand for Paychex's payroll processing services. The decrease in demand for payroll outsourcing is seen in the decrease in the number of checks processed per client. Checks per client decreased 2.2% in the third quarter of 2010, compared to 3.7% and 5.0% for the second and first quarters of fiscal 2010.

Also, high unemployment is indicative of an economic downturn. The 2008 Financial Crisis caused many businesses to cut back on their spending, and payroll processing is one expense that some small businesses have decided not to outsource to Paychex. The Paychex client base has declined 2.1% since May 31, 2009. Paychex's new sales units for the nine months were down 6% from 2009, primarily due to fewer companies moving to outsourcing. However, client retention has begun to show some improvement as clients lost during the first nine months of fiscal 2009 were 5% below the same period a year ago, with a slight improvement in these losses as a percentage of the beginning of the fiscal year client base.

U.S. Unemployment Rate^[9]

Fed slashed interest rates

Since 2007, the U.S. Federal Reserve has consistently cut interest rates. The Federal Funds rate now stands at just 0.25%. This impacts Paychex because it makes 7% of its total revenue from the interest earned on clients' money.^[10] Some payroll services require that clients give Paychex money directly, which Paychex then pays out to the employees or other recipients. To avoid complications, customers often give Paychex the money before it's actually needed. In the time between receiving money from clients and sending it out to recipients, Paychex puts it in an interest-bearing account, earning a return in between major transactions. Unlike banks, however, Paychex doesn't pay out interest to others, so it unambiguously benefits from higher rates.

U.S. Interest Rate (central bank overnight rate)^[11]

Competition/Market Share

Paychex's primary national competitor, Automatic Data Processing (ADP), is the largest U.S. third-party provider of payroll processing and human resource services in terms of revenue. Paychex competes with other national, regional, local, and online service providers, all of which have significantly smaller client bases than Paychex. In addition to traditional payroll processing and human resource service providers, Paychex competes with in-house payroll and human resource systems and departments. Payroll and human resource systems and software are sold by many vendors. Paychex's Human Resource Services also competes with a variety of providers of human resource services, such as retirement services companies, insurance companies, and human resources and benefits consulting firms.

Competition in the payroll processing and human resource services industry is primarily based on service responsiveness, product quality and reputation, breadth of service and product offering, and price.

Paychex is the second-largest payroll processor in the U.S. - Automatic Data Processing (ADP) is the largest, and Ceridian (CEN) comes in third. After these three firms, the market is highly fragmented, which gives Paychex (as well as ADP and Ceridian) scale advantages and opportunities to grow. ^[12]

While Paychex is dwarfed by ADP in overall sales, Paychex has an advantage in that 99% of the 11.5 million businesses in the U.S. have fewer than 100 employees and therefore fall into Paychex's primary target audience. Only 15-20% of this target audience has already outsourced their payroll administration, leaving plenty of room for Paychex to grow.^[13] Another fact that supports Paychex's strength is that its 2009 net margin was 23.8% while ADP's was just 15.2%.

Finally, while the numbers and percentages of clients seem to put Paychex at an equal level with ADP, the respective numbers of W-2s each firm prepared indicate that Paychex operates more efficiently relative to the actual number of employees whose payrolls were processed - ADP prepared almost 5 times as many W-2s as PAYX, but its net income was only 2 times that of PAYX.

References

1. ↑ ^{1.0 1.1} Investor Presentation for the Third Quarter Ending February 28, 2010 - Date Issued: 04/07/10
2. ↑ PAYX 2007 10-K, pages 2-3
3. ↑ PAYX 2007 10-K, pages 2
4. ↑ PAYX 2007 10-K, page 4
5. ↑ PAYX 2007 10-K, page 3
6. ↑ Paychex Reports Third Quarter Results
7. ↑ Paychex 2009 Annual Report
8. ↑ PAYX 2007 10-K, page 3
9. ↑ Google Labs: U.S. Unemployment Rate Data
10. ↑ PAYX 2007 10-K, page 13
11. ↑ Trading Economics: United States Interest Rate
12. ↑ PAYX 2007 10-K, page 7
13. ↑ PAYX 2007 10-K, page 2