Automatic Data Processing (NYSE: ADP) and Paychex (NASDAQ:PAYX) are the two biggest players in the HR and payroll outsourcing space. With the job market improving in the end of 2011 only to slow down in the beginning of 2012, we examine the trends that will impact these businesses in coming months. We estimate that the Payroll Processing division of Paychex constitutes 71 percent of our current Trefis price estimate while it constitutes 86 percent of ADP’s current Trefis price estimate. With both the companies highly dependent on the job market, any changes in job growth will impact these companies significantly.
SME Employment Growth
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Employment growth has been averaging almost 250,000 jobs a month since December 2011, and this is likely to slow in the coming months. 
We expect the number of jobs added by small and medium businesses to drive growth in 2012. ADP released its December 2011 employment report indicating that private-sector employment grew by 325,000 jobs from November to December across the nation. The service industry was the largest contributor creating 273,000 new jobs. 
Payrolls in the goods-producing industries increased by 52,000 employees, including 22,000 in the manufacturing sector. As a result of the increase in hiring, the unemployment rate in US dropped to 8.5% in December 2011, the lowest since March 2009. 
The highest growth in employment however was seen in small businesses with less than 50 employees. It created the most jobs in December with employment on small payrolls rising 148,000. Mid-size businesses (those with 50-499 workers) also contributed significantly to employment growth with employment on medium payrolls up 140,000 during the month. This growth will benefit Paychex more than ADP as Paychex’s core payroll services are targeted at small and medium-sized (less than 50 employees) businesses. ADP’s target market has been larger organizations with greater than 500 employees. We expect short term results of Paychex to be better than that of ADP based on this fact.
Cloud And SaaS Key for 2012
ADP is increasing its focus on small businesses. Last year, ADP has expanded its service offerings to the segment. With small businesses going increasingly mobile, ADP launched its popular payroll management platform for small business on the iPhone as well as Android smartphones.
As ADP continues to expand and refine its services to better cater to small businesses, we expect this segment to grow despite stiff competition from Paychex in the SME segment.
Paychex, however is late to enter the SaaS market. SurePayroll and ePlan are smaller offerings on the cloud and contribute to about 2 percent of revenue for Paychex. Its focus on SaaS is evident from the launch of its iPad app Paychex Online Mobile.
Currently it faces competition from ADP and Intuit Inc. whose SaaS-based mobile solutions have already gained the majority share in the market. Revenue from its cloud offering is relatively small and we expect this to grow as smaller businesses tend to be quicker on the uptake and will not have legacy systems already in place to migrate, making turn around time for implementation faster. This is another advantage for Paychex as we expect SME’s to be the biggest growth segment in 2012.
Potential Upside / Downside Scenario
We estimate the number of major payroll clients using ADP’s services to be 66,000 currently and increase to 73,000 by the end of our forecast period. We estimate that Paychex currently has 640,000 clients and will increase to 850,000 by the end of our forecast period. If employment picks up and this estimate increases by 10 percent for both by the end of our forecast period, we can expect a 5 percent upside for ADP while Paychex will experience a jump of nearly 12 percent according to our models.
The downside scenario follows the same pattern with a 5 percent downside for ADP and a 11 percent downside for Paychex on a 10 percent fall in clients. This suggests that Paychex is significantly more dependent on the employment growth than ADP according to our analysis. This makes sense as ADP focuses on larger institutional clients where revenues tend to be much more stable. This is also due to the fact that some of this resilience of ADP has already been factored into its Trefis price estimate which is currently 10 percent higher than the market price.Notes: