Paychex, Inc.
What's Driving Growth?

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By JustMee01
August 14, 2009

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I find myself liking Paychex. Gross margins and profit margins are very good and the return on equity is impressive. They seem to have a solid stranglehold on their small business market and they've returned decent top line growth over the last five years (until the recession), while still maintaining (or even improving) those margins. They aren't just dropping prices to stimulate sales and giving it away to get that top line growth. All of that with no debt, plenty of cash, and credit facilities available to weather any storm. They appear bullet-proof from a recession standpoint. Whether or not their out of favor stock is bullet-proof is another matter...

They're also expanding their product portfolio over the last five or so years, offering more expansive HR outsourcing options, worker's comp insurance brokering (or is it underwriting?), retirement program coordination, and an interesting co-op model for providing health insurance for small business clients (where they are co-employers of another company's employees opening up small businesses to insurance savings available only to larger corporations like Paychex). This last one is pretty innovative. Anyone know of other companies that provide a similar service? Overall, these ancillary services seem like a key growth driver going forward. It also seems like Paychex believes that the 1-10 employee market segment is very under-served and could provide a good source of growth if they could reach those potential clients. A recently launched web-hosted version of their software seems like it's probably targeted at that market, as I imagine that an easily implemented cookie-cutter solution hosted in a secure environment could easily become a low cost option for Ma and Pa operations.

Anyway, everything looks quite inviting. But, I'm bothered by one little thing. Paychex is a growth stock that's lost its mojo. Yes, the economy has blown everybody up, but PAYX started its haircut in 2000-2001. That got me wondering why. Why did a company that's still growing get that haircut?

Every annual report I've run across has a useful little table breaking down the market segments into tiers and laying out the distribution of companies within the total market and the distribution of their clients within those same segments. (1-4 employees, 5-19, 20-49, 50-99 and 100+ employees) Since they provide total client numbers and total market numbers, you can extract the raw numbers and get the total number or clients in each segment, as well as the percentages of each market tier that they've captured.

Those numbers look nice on the surface. From 2005 to 2008 they grew in every category. In the mid-size tiers (20-49 and 50-99 employees), Paychex owned 20 and 30% of the segments, respectively. That's pretty impressive, given that their space is crowded and no one provider owns more than 15% of the overall payroll market. They've clearly targeted that mid-tier market and captured it effectively. But, the growth rates overall were systematically weakening. For that matter, the market segments themselves were actually growing faster that Paychex's client base. They were actually losing market share over that time, not gaining it. There were just more businesses in the US economy. It was the total market growth that was driving their growth, not improved sales performance. That disturbs me a little bit. I was thinking of Paychex as just a company that got caught in the recession. But, when you dig in the numbers, their top line growth has come from the economy, not an improvement in their sales performance per se. The raw numbers had led me to the opposite conclusion; that they were probably gaining market share. So, I'm caught on the fence. I like the company, but the multiple requires growth to make sense, even at these reduced levels. Can they deliver enough growth to reward shareholders for patience? I thought the answer was a strong "yes", IMO. But, I'm not so sure now. The better question is, can the economy provide sufficient growth? They're looking like more of a cyclical turnaround play than I originally thought. I will add though, that their ancillary services are growing quite robustly, and their improvement even in 2009 is encouraging. But, those services are such a small segment of revenue that they can't provide much oomph yet.

Can anyone convince me that Paychex can get the lead out, and get back to taking market share like it once did? Can they deliver growth even if the economy is limited to low single digits growth for 3-5 years?