Paychex (PAYX)

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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.^[3]

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.^[4] 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. Client retention in FY 2007 was a record 80%, and the main reason for the 20% loss was that the firms went out of business entirely.^[5]

[edit] Financial Overview

^[6]

Paychex has been consistently successful since the early 1990's; its revenue and earnings have each grown for 17 consecutive years.^[7] Revenues grew at double-digit rates in each of the last three fiscal years, as did net income.

The majority of Paychex's 2007 revenue came from payroll processing services. Paychex's other sources of revenue are its human resources outsourcing offerings, as well as interest income earned on client funds. Certain payroll and HR processes require that Paychex temporarily hold money for clients, and it lends some of this money out to earn interest.^[9] The chart to the right shows the contribution of each of these income sources to Paychex's overall revenues in FY 2007.

[edit] Trends/Forces

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

Of the 7.9 million businesses in the U.S., 99% have fewer than 100 employees, therefore falling into Paychex's target market. Of these small to medium-sized businesses, only 15%-20% are served by payroll processing firms like Paychex.^[10] This leaves enormous potential for growth in the market.

Moreover, 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.^[11] 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.

[edit] U.S. unemployment rate hit 5.5% in May 2008

In May 2008, the U.S. unemployment rate rose to 5.5% from 5% the previous month, the largest one-month increase in 20 years.^[12] 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.

[edit] Fed slashed interest rates from 5.25% to 2% in 2007-2008

Between September 2007 and April 2008, the U.S. Federal Reserve cut interest rates by 3.25% to just 2%. This impacts Paychex because it makes 7% of its total revenue from the interest earned on clients' money.^[13] 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. The rate cuts of 2007 and 2008 will take a bite out of Paychex's interest income for FY2008.

[edit] Competition/Market Share

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. ^[14] The following table shows revenue and net income for each company from 2005-2007.
Note 1: Ceridian went private in 2007 when it was acquired by Fidelity National Financial (FNF) and Thomas H. Lee Partners ^[15], so net income and revenue for 2007 are not available.
Note 2: Market share percentages are based on a figure of 5,885,784 as the total number of U.S. firms with employees: a number accurate as of 2004, the last year with available data.^[16]

While Paychex is dwarfed by ADP in overall sales, Paychex has an advantage in that 99% of the 7.9 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.^[25] Another fact that supports Paychex's strength is that its 2007 profit margin was 27% while ADP's was just 12% (CEN's 2006 ratio was similarly only 11%).

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.

[edit] References

1. ↑ PAYX 2007 10-K, pages 2-3
2. ↑ PAYX 2007 10-K, pages 2
3. ↑ PAYX 2007 10-K, page 4
4. ↑ PAYX 2007 10-K, page 3
5. ↑ PAYX 2007 10-K, page 2
6. ↑ PAYX 2007 10-K, page 18
7. ↑ Paychex: A Value and Growth Opportunity - Barron's, Seekingalpha.com, October 7, 2007
8. ↑ PAYX 2007 10-K, page 13
9. ↑ PAYX 2007 10-K, page 4
10. ↑ PAYX 2007 10-K, page 2
11. ↑ PAYX 2007 10-K, page 3
12. ↑ Unemployment benefits pass House, but future uncertain - CNN.com, June 12, 2008
13. ↑ PAYX 2007 10-K, page 13
14. ↑ PAYX 2007 10-K, page 7
15. ↑ Ceridian to Be Taken Private in $5.3 Billion Deal, The New York Times, May 31, 2007
16. ↑ Statistics about Business from the Census Bureau
17. ↑ ADP 2007 10-K, page 13
18. ↑ ADP 2007 10-K, page 3
19. ↑ ADP 2007 10-K, page 7
20. ↑ PAYX 2007 10-K, page 13
21. ↑ Paychex F3Q07 (Qtr End 2/28/07) Earnings Call Transcript, Page 2
22. ↑ PAYX 2007 10-K, page 1
23. ↑ CEN 2006 10-K, page 31
24. ↑ Ceridian - About Us
25. ↑ PAYX 2007 10-K, page 2