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Head to Head Battle of HR Outsourcing Providers - Paychex (PAYX) vs. Automatic Data Processing (ADP)

January 23, 2012 | About:
Paychex is a market leader in payroll, tax, benefits, retirement, and HR services market for small and medium enterprises. Almost 82% of its clients are micro entities with less than 20 employees. Its services include payroll processing, payroll tax administration services, employee payment services, insurance services, retirement services administration, regulatory compliance services (new-hire reporting and garnishment processing), Paychex HR Solutions, eServices, and miscellaneous other human resource services and products. The company reports its operations in one segment, of which payroll services have the highest share.

The Company was formed in 1979 in and is currently headed by Martin Mucci as the president and CEO. Paychex follows a tight executive compensation policy, which ranges below the industry average. Its main competition comes from Automatic Data Processing Inc. (ADP) and a host of smaller players at national, regional, and local levels. The online marketplace offers its own set of rivals.

Growth and Performance

The long term revenue trend is characterized by an overall growth of 9.1% with a sharp decline during the recession. Paychex entered in the negative zone in fiscal year 2010 with a rebound in fiscal year 2011 that almost set off the previous year decline. Payroll being the dominant segment, the key performance metrics for the Company is checks per client (number of payroll checks processed for each client), which was affected by the contraction in customer base during recession when several small and medium entities went out of business and new initiatives were minimal. In terms of revenue per employee and net income per employee, Paychex stacks up well against the competition. Zero debt combined with above average returns further highlights its financial strength as indicated by the table below.





PAYX


Industry


S&P 500


5-yr Average ROA


9.6%


9.7%


6.7%


5-yr Average ROI


33.4%


15.7%


8.9%


5-yr Average ROE


35.1%


18.7%


21.3%


Paychex is a regular payer of dividends with a high payout ratio, averaging 88.3% in last three years. This rate may become unsustainable considering the challenging marketing conditions and the company’s own requirements to fuel future growth. Though the quarterly dividends increased by $0.01 to $0.32 per share in second quarter fiscal year 2012, the payout ratio came down to 78.8%. The EPS trend chart below clearly indicates the impact of the recent recession on the Company’s earnings and the rebound in fiscal year 2011. As per the consensus estimates, revenues for fiscal year 2012 are expected to be around $2,223.6-$2,251.2 million, while fiscal year 2013 revenues are expected between $2,330.9 and $2,476.6 million. EPS is likely to be $1.49-$1.53 for fiscal year 2012 and $1.58-$1.69 for fiscal year 2013. Five-year growth forecast for the Company is 9.5%.

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Long-term Strategy and Vision

Paychex operates in a highly competitive environment, where its rivals range from small online players to large and established organizations. The company has targeted the small and micro-level customers that remain largely out of the ambit of big players. Paychex beats the competition from smaller players by leveraging its infrastructure to provide a comprehensive set of services under one roof, which may not be feasible for a number of small competitors. Almost 95% of its clients use the payroll tax administrative services, while approximately 79% use the employee payment services, clearly indicating an overlap of services for a large section of clients. The company also benefits from its existing customer based across various industries, averaging out the impact of downturns associated with business cycles of different industries. High switching costs for the customers and its core competency in payroll processing provides durable competitive advantage to Paychex.

The company is taking proactive steps to safeguard its future market position in the form of service diversification and inorganic growth. The acquisition of SurePayroll in early 2011 implies access to an existing client base of more than 30,000 small & medium businesses for Paychex and a service platform which offers an alternative to its own services. This will further help Paychex make inroads in a new segment of clients, who prefer self-servicing and like to go mobile.

The recession taught Paychex some important lessons in customer diversification. A client base of predominantly micro-level organizations leaves the company vulnerable to low economic cycles when these entities are among the first ones to go out of business, contract, or resort to extreme cost-cutting measures. Revenues dropped from double digit growth in pre-recession period to 0.8% in fiscal year 2009 and -3.9% in fiscal year 2010. In fiscal year 2010, Paychex brought in some important pricing, packaging, and internal sales service enhancements in the high margin Major Market Services (MMS) group that caters to large clients. Another key initiative taken by the company recently is the acquisition of ePlan Services in mid-2011 to expand its existence in plan 401(k) services. ePlan adds administrative services portfolio for more than 4,000 Defined Contribution 401(k) plans to the company’s existing services to almost one-tenth of the 401(k) plans.

Automatic Data Processing

Introduction

Automatic Data Processing is one of the world’s largest outsourcing companies in the world. With a client list of approximately 570,000 businesses of different sizes, the Company is comparable to 564,000-strong customer base of Paychex. Automatic Data Processing offers similar services as Paychex, structured around three primary segments. Of which, Employer Services remains the dominant segment with roughly 70% contribution to the revenue, while Professional Employer Organization and Dealer Services contribute approximately 15% each.United States is the biggest playing field for the company with approximately 80% share.

ADelaware corporation, Automatic Data Processing was incorporated in 1961. It is currently headed by Carlos Rodriguez, who serves as the chairman and CEO. The company’s main competition comes from a number of big and small service providers, such as Paychex, Ceridian, Insperity Inc., Paylocity Corp. and Intuit. The Dealer Services faces competition from The Reynolds and Reynolds Company, DealerTrack Inc., and other similar services organizations.

Growth and Performance

In the long term, Automatic Data Processing has registered a growth of 3.5% with fluctuations year-on-year. The company divested its less profitable Brokerage Services Group business in fiscal year 2007. During recession, the revenues growth was severely affected, plunging to approximately 1%. fiscal year 2011 was a year of recovery when the impact of improving economy and streamlining business activities became apparent. Automatic Data Processing fairs almost equally well as Paychex on the debt front with a debt-equity ratio of 0.01 against the zero debt position of Paychex. The industry debt equity ratio is 0.4. Comparing the table below with Paychex, it is clear that Paychex is a clear winner in terms of returns. ROE for both the companies indicates their inherent strength, while on other metrics Automatic Data Processing is somewhat an underperformer as per the industry standards. The Company leads in terms of revenues generated per employee, while Paychex indicates better cost management as reflected in its higher net income per employee.







ADP


Industry


S&P 500


5-yr Average ROA


4.5%


9.7%


6.7%


5-yr Average ROI


14.2%


15.7%


8.9%


5-yr Average ROE


22.1%


18.7%


21.3%


The EPS trend in the long-term is unstable for both the companies with the impact of recession clearly visible. However, Automatic Data Processing is generating much higher earnings per share in absolute terms. The company is also returning money to its shareholders in the form of repurchases and dividends. In second quarter fiscal year 2011, it increased its quarterly dividends by $0.02 to $0.36 per share. The average payout ratio of Automatic Data Processing in the last three years has been at a comfortable level of approximately 54%, which is a big advantage over Paychex. The retained earnings leave a greater room for strategic investments and growth. The consensus analyst estimate for Automatic Data Processing’s revenues for fiscal year 2012 is in the range $10.6-$10.8 billion, while EPS is expected near $2.71-$2.82. The five-year growth is expected to be 10.3%.

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Long-term Strategy and Vision

Automatic Data Processing derives its long-term advantage from its established brand name (a Fortune 500 Company), market leadership, diversified customer base, multiple service lines, and customer retention. One of the key differentiators for the company is its separate service packages for different types of clients across service lines. For example, under Employer Services, it offers Comprehensive Outsourcing Services (large employers), ADP Workforce Now (mid-sized employers), and ADP Resource (small employers). The services are packed together for each individual suit according to the standard requirements for each type of client, ensuring better customization.

Automatic Data Processing is also riding on the current mobile wave and has taken initiatives to provide its services on-the-go with seamless backend integration across a number of smartphone platforms. Its latest ADP Mobile Solutions application is a step in this direction. Though theU.S. remains the most important geographical area for the Company, it is actively trying to tap in to overseas opportunity through GlobalView, a multinational end-to-end outsourcing solution built on SAP® ERP Human Capital Management and the SAP NetWeaver® platforms. The offering has already reached 41 nations and is slated for further expansion. On the other hand, it caters to its small and mid-sized clients in over 70 countries through ADP Streamline. The company relies heavily on its inorganic growth strategy. In fiscal year 2011, it committed approximately $776 million for various acquisitions, including MasterTax, Cobalt, and AdvancedMD. Cobalt, one of the biggest web-based private companies, will allow better management of online marketing and web design services to the Company’s Dealer Services segment. To bolster its new Strategic Advisory Services Group, it acquired Asparity Decision Solutions in September 2011.

Which Company is better investment for value investors?

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The Net Margin and ROIC charts of the two companies clearly indicate that Paychex has been a stronger performer in the long-term. A well-diversified company, Automatic Data Processing, on the other hand, is larger in terms of market capitalization. The companies come close on EV/EBITDA metrics, though Paychex has a slight edge. PB ratio for Paychex is a bit too high for the tastes of a value investor. Nevertheless, it is in line with its competitor on other parameters as indicated by the tables below. Being in the same industry, both the companies operate in the same environment. Considering their similar performance on the valuation metrics and that both are trading near fair value, better operating performance by Paychex makes it a preferable investment at this point.

About the author:

Margin of Safety
Margin of Safety Equity Research is a value-investing focused company providing equity research services, the Securities Analysis System investment software, stock valuation models, and other financial resources for value investors. Members of our subscription services have access to the Margin of Safety value-oriented portfolio and discounted access to our software.

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