Paychex, Inc. (NYSE: PAYX) processes payroll, handles employee benefits, and offers related human resources services for its over 554,000 clients. 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. 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.
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.
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. 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.
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
|Business size (number of employees)||Paychex Client Base|
Third Quarter Fiscal 2010 Results
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.
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.
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.
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.
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. 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.
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.
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. 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.
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. 
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. 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.