Payroll processors ADP (NASDAQ:ADP) and Paychex (NASDAQ:PAYX) ought to be concerned about the slowdown in the U.S. economy, which contracted during the fourth quarter of 2012.  GDP fell by 0.1% during the quarter, the first time this has happened in approximately three years. This can be troubling news for payroll providers because this contraction could dent business confidence and hurt U.S. employment, which will have a negative impact on both, ADP’s and Paychex’s revenues during the year.
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2013 GDP Forecasts Could Be Cut
Despite the fall in GDP during Q4 2012, U.S. economists predict that the economy will grow at 2% during 2013. However, we think that a revision of these estimates is possible due to a worldwide growth slowdown and the pending U.S. sequester.
For example, the Euro crisis has yet to see an end, and the outcome of the situation continues to remain uncertain. European GDP contracted 0.6% during Q4 2012, the third straight quarter of decline and the largest since Q1 2009.  This situation, combined with the slowdown in China and India can have a negative effect on CEO confidence, which was 46 in Q4 2012 for the Conference Board Measure of CEO Confidence.  While this is up slightly from Q3 2012, a reading below 50 indicates more negative responses than positive ones. This means that more CEOs are negative than positive about U.S. economic prospects, and if this number deteriorates due to recent figures, it could impact hiring and investment in the United States.
Low Small Business Confidence Can Hurt Paychex
Paychex’s payroll processing clients are primarily small and medium businesses. Around 80% of the company’s clients are formed by small businesses with less than 19 employees. What’s troubling for Paychex in this segment is that small business CEO confidence seems to be at a lower level than overall CEO confidence. According to National Federation of Independent Business (NFIB), small business CEO expectations came in at negative 30%, which was the fourth lowest reading in the survey history.  Additionally, the NFIB stated that small business hiring plans are not likely to keep up with population growth in the United States, a factor which will directly hurt Paychex’s payroll processing division.
Currently, we estimate that the company’s payroll processing division makes up approximately 60% of Paychex’s total value. One of Paychex’s primary drivers is the average number of employees per payroll client, whose growth is highly correlated to the state of the small business hiring environment. We currently forecast that the average number of employees per payroll client will increase to 19 by the end of our forecast period, but if low small business CEO confidence causes this figure to remain flat over our forecast period, it would cause 5% downside to our price estimate.
5% Downside to ADP If National Clients Cut Jobs
Similar to Paychex, ADP’s primary source of revenue is its payroll processing business, which currently makes up approximately 80% of the company value. The primary diver of this segment is the average number of employees per national payroll account. We currently forecast that this driver will increase to 2,100 thousand by the end of our forecast period. However, if the job market remains stagnant and the average number of employees per national account remains flat or declines to 2010 levels, we could see up to 5% downside to our price estimate. You can measure the impact that a stagnating job market will have on ADP here.Notes: