PAYCHEX INC PAYX S
July 15, 2014 - 2:56pm EST by
crestone
2014 2015
Price: 42.24 EPS $1.85 $2.00
Shares Out. (in M): 365 P/E 23.0x 21.0x
Market Cap (in $M): 15,434 P/FCF 0.0x 0.0x
Net Debt (in $M): -551 EBIT 0 0
TEV ($): 14,883 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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  • HR Service
  • Outsourcing
  • Payroll
  • Competitive Threats

Description

Paychex is overvalued assuming everything goes perfectly, yet it faces significant competitive threats that make the perfect outcome unlikely. I model ~25% downside to fair value, before any potential impact from competition, and recommend shorting the company.

Paychex provides outsourced payroll and human resources and benefits services to approximately 580,000 small- to medium-sized businesses in the United States. For years PAYX has split the overall outsourced payroll market with ADP, which focuses on larger enterprises. Anecdotally, it appears that both companies have grown comfortable and mistake-prone in their dominate positions, and in recent years a swarm of new entrants have jumped into the space, offering easier-to-use, cheaper solutions, and have seen dramatic growth.

Limited growth (or surprise) potential:
 
The primary economic driver for PAYX is the number of employed persons at SMBs—hence growth is roughly tied to GDP. PAYX seeks to drive incremental growth by increasing market share, selling more services per client, and increasing prices. Because the core driver of the business is associated with GDP growth, and because the company is at a fairly mature level of penetration in the overall market, dramatic upside surprises are unlikely, and topline growth has a natural ceiling. The range-bound nature of the business can be seen by looking at segment results from last quarter. In the quarter, the company grew total payroll clients by 2% and checks per client increased 1.1%. With slight increases in pricing, total payroll service revenues grew 3%. The smaller human resources segment saw 10% revenue growth due to a 13% increase in clients. The human resources segment is thus able to lift total growth somewhat above the low-single-digit growth of the mature payroll services business, but total growth is still bounded. The natural bounds to growth are also seen in the company's historical results--the 10 year sales CAGR is 7.8%, and EPS 7.2%. The 3 year and 1 year EPS growth rates are slower still, at 5.7% and 3.3%.
 
Valuation disconnect:

Based on the economic drivers to the business, maturity and penetration levels, and slowing historical results, earnings growth in excess of market averages seems highly unlikely. Yet, PAYX trades at a significant premium to the market. Currently, PAYX trades at 23x NTM earnings, while guiding to 6-8% net income growth. In contrast, the S&P 500 trades at 16x NTM earnings, which are projected to grow at 8%. With growth characteristics that should at best only match that of the market, the seven turns of multiple premium are not warranted. On this simplistic basis, the company would have 30% downside to fair valuation.

Competitive threat:
 
Yet, Paychex may have significant difficulty maintaining, for the long-term, the near-market-level growth it is guiding to for this year. PAYX faces numerous competitive threats from SaaS providers of payroll and HR services including Intuit, Ultimate Software, Paylocity, Paycom, Workday, Zenefits, and Zen Payroll—all of which have been growing extremely rapidly in the SMB space. (They have been somewhat less successful with the very large enterprises that ADP serves).

In recent years, both the traditional players and the new SaaS entrants have been taking share from smaller providers, but the SaaS companies have been winning much more, and in certain segments have been winning at the expense of PAYX and ADP. According to Goldman Sachs (Jan 2014):
 
[The] 7 percentage points of share gain for outsourced payroll providers [from 2002-2012] is split roughly 80/20 between the largest SaaS (INTU and ULTI) and traditional (ADP, PAYX and Ceridian) providers… In the SMB segment, SaaS provider INTU has significantly outperformed the market, gaining 13 percentage points of share, measured by employees, from 2002 to 2012. Over the same period traditional providers have lost 3.3pp of share. SaaS share gains in the SMB segment pose the largest challenge for PAYX who has roughly 70% exposure to small business clients.

Intuit, which Goldman estimates to have over 20x the number of clients as PAYX does for its SaaS offering, is growing its online payroll base at roughly 20% yoy, and seeing very high attach rates with its Quicken customers. They are not the only SaaS provider that is growing rapidly. This spring, both Paylocity and Paycom went public, and both are growing revenues at 40% yoy. The revenues of Paylocity and Paycom combined are around 10% that of PAYX, so they're large enough to matter. In addition, Workday has entered the payroll services space, and in their February earnings call said payroll "continues to be a very strong add-on in the markets where we offer [it] like the U.S. and Canada." In the May call they again said that attach rates for payroll continued to be very strong. Paychex not only faces competition from multiple public companies, it also faces several, rapidly growing, venture-backed startups. ZenPayroll, backed by Kleiner Perkins and Google Ventures, announced in January that it had increased the annual payroll it was processing from $100 mm to $400 mm just since the prior summer, and that the vast majority of its new customers were gained through word of mouth, noting that nearly 90% of their customers had referred another business to them. Another private competitor is Zenefits, which has been growing over 30% month-on-month. Andreessen Horowitz led a new investment round valuing the company at over $500 mm in June, just four months after leading its Series A. The board member from Andreessen Horowitz explained why they led a new round so quickly, commenting that "the company had significantly outperformed all the business metrics that they presented. We’ve never seen growth like this before.” The rapid growth of these public and private players points to the delta in their value proposition versus that of traditional options. When it takes less than 10 minutes to onboard a new employee (a ZenPayroll stat), pricing is transparent, and customer support is instantly available over multiple channels, it is not surprising that these companies have been able to outshine incumbents like PAYX or ADP, and win over customers that have previously been processing payrolls manually.
 
Valuation:
 
In my valuation model I seek to give the company credit for an optimistic scenario, and do not incorporate any impact from the broad-based competitive threat PAYX faces. Using an internal, standardized methodology to derive a fair value target price, I use consensus or higher growth earnings growth projections for the next three years—I use 8%, 8%, and 11%; Bloomberg consensus is 7.9%, 8.1%, and 7.4%—and then grow earnings at a long term rate of 10% into the future. The methodology applies a discounted market multiple (~9x) on the 5 year forward earnings projected by this model, adjusts for dividends and net cash, and results in a $33 fair value estimate, or 23% downside from present values.

Hence if the competitive threat never impacts PAYX, the stock still appears to be a reasonable short, and if the threat does materialize, there is additional downside potential.

Risks:

Complacency: From speaking with various customers of PAYX and ADP, I found universal dissatisfaction with these traditional providers. Every customer I spoke with had a story of some major mistake, such as certain automatic taxes not being paid that took months to correct. However, many customers were also tolerant of this level of annoyance with the provider, and were afraid of trading the known annoyance for the unknown with a new player.

Price sensitivity: Additionally, I found that not all customers are so price sensitive that potential savings* from a new SaaS player would be sufficient to make them want to risk sensitive operations with an unknown or young company. Indeed, I found that the startups don't focus extensively on price in their direct sales pitches (though I found they will negotiate aggressively), but rather focus on service and ease of use, and don't claim to have prices that are dramatically lower. The hassle of changing systems is a big impediment to competitive takeaways as well. Hence it's not surprising that retention at PAYX remains high (around 80%).

Sustained growth in the HR segment: Currently, the smaller human resources segment is driving growth at the company, helped along by an increasingly complex regulatory environment. While it comprises about one third of total revenues now, if this growth continues it will come provide a bigger share and could sustain higher growth rates for the company. Outsourced HR is clearly a very competitive market as well.
 
Interest rate increases: If interest rates rise, then float income at PAYX will rebound from their low current levels, provide earnings upside, and could offset a small decline in core operating earnings. The duration and size of PAYX's float portfolio means it is less benefited by a rate increase than ADP will be, but it will still be a benefit. The company comments that a 25 bp change in interest rates would increase their earnings by ~$4.5 mm--small in comparison to annual earnings of over $600 mm.


*On price savings, it was difficult to get enough data to make an accurate comparison between companies. Some are very transparent—you can see pricing directly available on Intuit and ZenPayroll's websites--however others, such as Paycom, only gave me a customized quote after speaking with a representative, who adjusted his quote significantly after I referred to the public numbers at Intuit. The IR contact at Paylocity told a colleague that while they were cheaper than PAYX, the savings weren't the primary reason customers switched to them, and the overall cost to a company was usually immaterial. And in the case of PAYX, while their sales agents were EXTREMELY aggressive and persistent in following up on my quote request (I've received at least 8 calls over the last couple months from the regional agent I spoke with, and then his boss), they declined to give me any numbers until I agreed to let them come in and present to my CFO. Hence I was unable to develop a comprehensive price comparison matrix.



 
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Because of the impediments to competitive takeaways noted above, the likelihood of a huge miss in any given quarter seems low, and we are not shorting it based on this expectation. Instead the competitive threat is more likely to gradually pressure growth rates or pricing, as new customers predominantly choose a more nimble, friendlier startup over a big traditional player. As growth or pricing gets pressured, eventually the premium multiple on the stock should re-rate.  

 
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    Description

    Paychex is overvalued assuming everything goes perfectly, yet it faces significant competitive threats that make the perfect outcome unlikely. I model ~25% downside to fair value, before any potential impact from competition, and recommend shorting the company.

    Paychex provides outsourced payroll and human resources and benefits services to approximately 580,000 small- to medium-sized businesses in the United States. For years PAYX has split the overall outsourced payroll market with ADP, which focuses on larger enterprises. Anecdotally, it appears that both companies have grown comfortable and mistake-prone in their dominate positions, and in recent years a swarm of new entrants have jumped into the space, offering easier-to-use, cheaper solutions, and have seen dramatic growth.

    Limited growth (or surprise) potential:
     
    The primary economic driver for PAYX is the number of employed persons at SMBs—hence growth is roughly tied to GDP. PAYX seeks to drive incremental growth by increasing market share, selling more services per client, and increasing prices. Because the core driver of the business is associated with GDP growth, and because the company is at a fairly mature level of penetration in the overall market, dramatic upside surprises are unlikely, and topline growth has a natural ceiling. The range-bound nature of the business can be seen by looking at segment results from last quarter. In the quarter, the company grew total payroll clients by 2% and checks per client increased 1.1%. With slight increases in pricing, total payroll service revenues grew 3%. The smaller human resources segment saw 10% revenue growth due to a 13% increase in clients. The human resources segment is thus able to lift total growth somewhat above the low-single-digit growth of the mature payroll services business, but total growth is still bounded. The natural bounds to growth are also seen in the company's historical results--the 10 year sales CAGR is 7.8%, and EPS 7.2%. The 3 year and 1 year EPS growth rates are slower still, at 5.7% and 3.3%.
     
    Valuation disconnect:

    Based on the economic drivers to the business, maturity and penetration levels, and slowing historical results, earnings growth in excess of market averages seems highly unlikely. Yet, PAYX trades at a significant premium to the market. Currently, PAYX trades at 23x NTM earnings, while guiding to 6-8% net income growth. In contrast, the S&P 500 trades at 16x NTM earnings, which are projected to grow at 8%. With growth characteristics that should at best only match that of the market, the seven turns of multiple premium are not warranted. On this simplistic basis, the company would have 30% downside to fair valuation.

    Competitive threat:
     
    Yet, Paychex may have significant difficulty maintaining, for the long-term, the near-market-level growth it is guiding to for this year. PAYX faces numerous competitive threats from SaaS providers of payroll and HR services including Intuit, Ultimate Software, Paylocity, Paycom, Workday, Zenefits, and Zen Payroll—all of which have been growing extremely rapidly in the SMB space. (They have been somewhat less successful with the very large enterprises that ADP serves).

    In recent years, both the traditional players and the new SaaS entrants have been taking share from smaller providers, but the SaaS companies have been winning much more, and in certain segments have been winning at the expense of PAYX and ADP. According to Goldman Sachs (Jan 2014):
     
    [The] 7 percentage points of share gain for outsourced payroll providers [from 2002-2012] is split roughly 80/20 between the largest SaaS (INTU and ULTI) and traditional (ADP, PAYX and Ceridian) providers… In the SMB segment, SaaS provider INTU has significantly outperformed the market, gaining 13 percentage points of share, measured by employees, from 2002 to 2012. Over the same period traditional providers have lost 3.3pp of share. SaaS share gains in the SMB segment pose the largest challenge for PAYX who has roughly 70% exposure to small business clients.

    Intuit, which Goldman estimates to have over 20x the number of clients as PAYX does for its SaaS offering, is growing its online payroll base at roughly 20% yoy, and seeing very high attach rates with its Quicken customers. They are not the only SaaS provider that is growing rapidly. This spring, both Paylocity and Paycom went public, and both are growing revenues at 40% yoy. The revenues of Paylocity and Paycom combined are around 10% that of PAYX, so they're large enough to matter. In addition, Workday has entered the payroll services space, and in their February earnings call said payroll "continues to be a very strong add-on in the markets where we offer [it] like the U.S. and Canada." In the May call they again said that attach rates for payroll continued to be very strong. Paychex not only faces competition from multiple public companies, it also faces several, rapidly growing, venture-backed startups. ZenPayroll, backed by Kleiner Perkins and Google Ventures, announced in January that it had increased the annual payroll it was processing from $100 mm to $400 mm just since the prior summer, and that the vast majority of its new customers were gained through word of mouth, noting that nearly 90% of their customers had referred another business to them. Another private competitor is Zenefits, which has been growing over 30% month-on-month. Andreessen Horowitz led a new investment round valuing the company at over $500 mm in June, just four months after leading its Series A. The board member from Andreessen Horowitz explained why they led a new round so quickly, commenting that "the company had significantly outperformed all the business metrics that they presented. We’ve never seen growth like this before.” The rapid growth of these public and private players points to the delta in their value proposition versus that of traditional options. When it takes less than 10 minutes to onboard a new employee (a ZenPayroll stat), pricing is transparent, and customer support is instantly available over multiple channels, it is not surprising that these companies have been able to outshine incumbents like PAYX or ADP, and win over customers that have previously been processing payrolls manually.
     
    Valuation:
     
    In my valuation model I seek to give the company credit for an optimistic scenario, and do not incorporate any impact from the broad-based competitive threat PAYX faces. Using an internal, standardized methodology to derive a fair value target price, I use consensus or higher growth earnings growth projections for the next three years—I use 8%, 8%, and 11%; Bloomberg consensus is 7.9%, 8.1%, and 7.4%—and then grow earnings at a long term rate of 10% into the future. The methodology applies a discounted market multiple (~9x) on the 5 year forward earnings projected by this model, adjusts for dividends and net cash, and results in a $33 fair value estimate, or 23% downside from present values.

    Hence if the competitive threat never impacts PAYX, the stock still appears to be a reasonable short, and if the threat does materialize, there is additional downside potential.

    Risks:

    Complacency: From speaking with various customers of PAYX and ADP, I found universal dissatisfaction with these traditional providers. Every customer I spoke with had a story of some major mistake, such as certain automatic taxes not being paid that took months to correct. However, many customers were also tolerant of this level of annoyance with the provider, and were afraid of trading the known annoyance for the unknown with a new player.

    Price sensitivity: Additionally, I found that not all customers are so price sensitive that potential savings* from a new SaaS player would be sufficient to make them want to risk sensitive operations with an unknown or young company. Indeed, I found that the startups don't focus extensively on price in their direct sales pitches (though I found they will negotiate aggressively), but rather focus on service and ease of use, and don't claim to have prices that are dramatically lower. The hassle of changing systems is a big impediment to competitive takeaways as well. Hence it's not surprising that retention at PAYX remains high (around 80%).

    Sustained growth in the HR segment: Currently, the smaller human resources segment is driving growth at the company, helped along by an increasingly complex regulatory environment. While it comprises about one third of total revenues now, if this growth continues it will come provide a bigger share and could sustain higher growth rates for the company. Outsourced HR is clearly a very competitive market as well.
     
    Interest rate increases: If interest rates rise, then float income at PAYX will rebound from their low current levels, provide earnings upside, and could offset a small decline in core operating earnings. The duration and size of PAYX's float portfolio means it is less benefited by a rate increase than ADP will be, but it will still be a benefit. The company comments that a 25 bp change in interest rates would increase their earnings by ~$4.5 mm--small in comparison to annual earnings of over $600 mm.


    *On price savings, it was difficult to get enough data to make an accurate comparison between companies. Some are very transparent—you can see pricing directly available on Intuit and ZenPayroll's websites--however others, such as Paycom, only gave me a customized quote after speaking with a representative, who adjusted his quote significantly after I referred to the public numbers at Intuit. The IR contact at Paylocity told a colleague that while they were cheaper than PAYX, the savings weren't the primary reason customers switched to them, and the overall cost to a company was usually immaterial. And in the case of PAYX, while their sales agents were EXTREMELY aggressive and persistent in following up on my quote request (I've received at least 8 calls over the last couple months from the regional agent I spoke with, and then his boss), they declined to give me any numbers until I agreed to let them come in and present to my CFO. Hence I was unable to develop a comprehensive price comparison matrix.



     
    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Because of the impediments to competitive takeaways noted above, the likelihood of a huge miss in any given quarter seems low, and we are not shorting it based on this expectation. Instead the competitive threat is more likely to gradually pressure growth rates or pricing, as new customers predominantly choose a more nimble, friendlier startup over a big traditional player. As growth or pricing gets pressured, eventually the premium multiple on the stock should re-rate.  

     
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