Payroll Processing Remains Key To Long-Term Growth For Paychex Despite HR Outsourcing Growth

Paychex (NASDAQ:PAYX) has been a market leading human capital management service provider over the years, with a strong presence in payroll processing and HR outsourcing services. Paychex’s core client base consists of small and medium businesses (SMBs). On the other hand, competing firm ADP (NASDAQ:ADP) has a more significant presence in HR services and payroll processing in the market space for large enterprise clients.

Both Paychex and ADP have witnessed strong growth in HR outsourcing and other services revenues over the years as shown below. Despite higher growth in HR services, the core payroll processing business remains crucial to Paychex and continues to be the largest revenue segment within the company. Moreover, payroll processing is more profitable for the company given that it must sustain a huge employee base for HR outsourcing services.

According to our estimates, Payroll Processing makes up over 45% of the company’s valuation, generating almost 60% of the company’s revenues. Below we take a look at key growth metrics for the Payroll Processing division and why it forms such a large part of the company’s valuation. We have a $55 price estimate for Paychex’s stock, which is roughly in line with the current market price.

See our complete analysis of Paychex Here

Payroll Processing Generates Consistent Revenue Growth

Paychex offers payroll processing services to its customers, which includes processing of pay checks for its client employees, tax administration and filing services for the tax returns of its employees and other obligations. Paychex’s core customer base includes small and medium-sized businesses, primarily in the U.S. Paychex’s payroll processing revenues have grown consistently at 3-4% over the last few years. Growth was driven by a 1% annual increase in the number of clients served by the company, complemented by a steady 2-3% annual price increase as shown below.

With a large customer base under its belt, the company is in a strong position to capture the untapped market in the U.S. According to the company’s estimates, there are around 12 million businesses in the U.S. that are within its addressable market, of which at least half are still untapped. Going forward, we forecast Paychex’s total number of payroll processing clients to continue to increase to over 660,000 clients at a CAGR of over 1% over the next five years.

 

Moreover, if the company continues to increase its fee per client in line with industry standards, its average implied fee per payroll client could increase and help generate meaningful growth in payroll revenues. Paychex’s management expects payroll revenues to grow at around 4% to $1.8 billion in fiscal year 2017. ^[1] We forecast the average fee per client to increase from under $2,900 per client in 2016 to $3,200 per client over the next five years. As a result, net revenues from the payroll division could grow at a CAGR of over 3% through the forecast period.

 

Higher Profit Margins From Payroll Processing

Paychex’s cash operating expenses for Payroll Processing have increased at a slower rate than revenue growth due to economies of scale. The resulting EBITDA margin (adjusted for non-cash expenses) for the Payroll Processing division has improved from 41.8% in 2011 to 43% in fiscal 2016, as shown below. Comparatively, the company-wide EBITDA margin has only increased by around 70 basis points in the same period. This was a result of strong growth in the company’s HR outsourcing business, which is a capital-intensive division. Scaling up that division has led to higher operating expenses due to an increase in the number of worksite employees.

We expect the revenue growth in the payroll division to continue to improve the division’s profitability. We forecast the EBITDA margin of the payroll division to improve further to over 44% in the next five years. Given that the expenses in the client funds interest segment are fixed in nature, top line growth in that division could directly translate to an improvement in company-wide EBITDA. However, strong growth in HR services could offset that increase. As a result, the company-wide EBITDA margin could increase at a slower pace, with much of the growth coming from the company’s core payroll processing business.

 

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