Student Investment Fund Stock Report Analysts: Carolyn VanderStaay & Juan Hernandez-Martinez Page 1 Paychex, Inc. NASDAQ:PAYX 0 20 40 60 80 PAYX ADP ASF Industry Gross Margin Operating Margin Profit Margin Metrics Paychex, Inc ADP, Inc. 5-year ROIC 115% 65% WACC 9% 9% 5-year Revenue Growth 11.8% 4.8% Gross Margin 65.8% 55.4% Operating Margin 42.8% 20.6% Profit Margin 29.8% 13.2% Long Term Debt -0- $52M Pretax ROE 59.2% 38.0% 5-year average ROE 30.2% 19.1% Pretax ROA 15.9% 7.5% Return on Capital (ROC) 39.4% 23.1% Reinvestment Rate 9.3% 11.8% ROE Relative to S&P 500 2.22 1.40 Key Statistics Recommendation: Buy Market Cap: $9.27 Bil Recent Price: $28.26 (11/28/08) Target Price: $49.60 Primary Sector: Payroll Services Secondary Sector: Data Processing Services Highlights • Low capital requirements consistently drive the ROIC in the range of 105%- 120%; FY08 ROIC is 115% • Inherent scalability of operations delivers higher margins relative to the industry • FY08 is the 18 th consecutive year of record total revenue, net income, and diluted EPS • Two-thirds of new clients come from referral sources such as CPAs, banks and current clients • Client retention was 80% in FY08 Business Summary Paychex, Inc. is a leading provider of comprehensive payroll and integrated human resource and employee benefits outsourcing solutions for small- to medium-sized businesses in the U.S. Their services include payroll processing, payroll tax administration services, employee payment services, and other payroll-related services, including regulatory compliance. Paychex's Human Resource Services includes its Professional Employer Organization, retirement services administration, workers' compensation insurance services, health and benefits services, time and attendance solutions and other products and services. As of May 31, 2008, they serviced approximately 572,000 clients and had approximately 12,200 employees. Paychex maintains their corporate headquarters in Rochester, New York, and has more than 100 offices nationwide. They also serviced approximately 1,200 clients in Germany through four offices. Profitability vs. the Industry PAYX Industry S&P 500 Price Performance
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Paychex, Inc.services administration, workers' compensation insurance services, health and benefits services, time and attendance solutions and other products and services. Paychex
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Student Investment Fund Stock Report Analysts: Carolyn VanderStaay & Juan Hernandez-Martinez
Primary Sector: Payroll Services Secondary Sector: Data Processing Services
Highlights • Low capital requirements consistently
drive the ROIC in the range of 105%-120%; FY08 ROIC is 115%
• Inherent scalability of operations delivers higher margins relative to the industry
• FY08 is the 18th consecutive year of record total revenue, net income, and diluted EPS
• Two-thirds of new clients come from referral sources such as CPAs, banks and current clients
• Client retention was 80% in FY08
Business Summary Paychex, Inc. is a leading provider of comprehensive payroll and integrated human resource and employee benefits outsourcing solutions for small- to medium-sized businesses in the U.S. Their services include payroll processing, payroll tax administration services, employee payment services, and other payroll-related services, including regulatory compliance. Paychex's Human Resource Services includes its Professional Employer Organization, retirement services administration, workers' compensation insurance services, health and benefits services, time and attendance solutions and other products and services. As of May 31, 2008, they serviced approximately 572,000 clients and had approximately 12,200 employees. Paychex maintains their corporate headquarters in Rochester, New York, and has more than 100 offices nationwide. They also serviced approximately 1,200 clients in Germany through four offices.
Profitability vs. the Industry
PAYX
Industry
S&P 500
Price Performance
Student Investment Fund Stock Report: PAYX
Carolyn VanderStaay & Juan Hernandez-Martinez Page 2
Company Overview Paychex has built around it a protective barrier to economic downturns that is driven by
• High customer switching costs allows Paychex to build a relatively sticky client base • Low capital requirements drive a high return on capital and • Inherent scalability allows Paychex to add new customers without incurring direct marginal costs • 66% of new clients come from referrals such as CPAs, banks and current clients • FY08 was the 18th consecutive year of record Revenue, Net Income and EPS
Products and Services Payroll processing is the foundation of the Paychex service portfolio and drives 75% of its revenue. Payroll processing ancillary services include payroll tax administration services, employee payment services, and other payroll-related services, including regulatory compliance. Paychex's Human Resource Services includes its Professional Employer Organization (PEO), retirement services administration, workers' compensation insurance services, health and benefits services, time and attendance solutions and other products and services. Paychex also earns interest on funds held for clients between the time of collection from our clients and remittance to the applicable tax or regulatory agency. Interest Income historically accounts for 6% of total revenue.
Clients In FY08, client retention was approximately 80% of their beginning of the year client base, as switching costs are high for small-to-medium sized businesses. The most significant factors affecting client retention are companies going out of business or no longer having any employees. Paychex's client base is not industry specific and it clients operate in a broad range of industries. No single client has a material impact on total service revenue.
Company Strategy Paychex capitalizes on growth opportunities within their current client base and from new clients by increasing utilization of their ancillary services and products including payroll tax administration services and employee payment services. The portfolio of ancillary services provides Paychex with additional recurring revenue streams and increased service efficiencies as Paychex has integrated these services and products with the core payroll processing services and can leverage the information gathered in the base payroll processing system.
Paychex leverages its highly developed technological and operating infrastructure and proprietary software. Paychex is also able to supplement growth through strategic acquisitions or expansion of service offerings.
Industry Outlook Although Paychex, Inc. classifies itself as both a firm in the Accounting, Tax, Bookkeeping & Payroll Services sector, and as a firm in the Data Processing Services segment in the US, therefore we need to consider the outlook of both sectors to understand Paychex's potential outlook. Both of these sectors are dependent on overall trends in Outsourcing in the U.S. Analysts expect the outsourcing of data processing needs to accelerate over the 5-year outlook horizon. Analysts also report that HR functions are among the most common business functions outsourced.
Carolyn VanderStaay & Juan Hernandez-Martinez Page 3
Market Opportunities There are approximately 9.4 million employers in the geographic markets that Paychex currently serves within the U.S and of those employers, over 99% have fewer than 100 employees and are the primary customers and target market. Based on publicly available industry data, analysts estimate that all payroll processors combined serve approximately 15% of the potential businesses in the target market. The un-penetrated market is composed of businesses with 10 or fewer employees. Paychex, Inc. market segmentation shows that 80% of their business comes from companies with 20 and fewer employees.
Approximately two-thirds of new clients (excluding acquisitions) come from referrals from strong relationships with existing clients, CPAs and banks. Paychex formed a partnership with American Institute of Certified Public Accountants and is now the preferred payroll provider for its AICPA Business Solutions Partner Program.
Competitive Analysis Paychex, Inc.’s closest national competitor is ADP (Automatic Data Processing, Inc.), the largest third-party provider of payroll processing and human resource services in terms of revenue. Paychex and ADP combined serve 40% of this market. Paychex has left the servicing of larger firms to ADP and, at least for the current time, these firms have stayed out of each other’s markets, avoiding the intense competitive behavior that saps margins and profits. Paychex has a greater ability than ADP to drive dollars out of its operations, as both its Operating Margin and its Profit Margin is more than twice that of ADP.
Metric PAYX ADP Gross Margin 65.8% 55.4% Operating Margin 42.8% 20.6% Profit Margin 29.8% 13.2% Long Term Debt -0- $52M
Excellence and discipline in operations drives returns for Paychex that are higher than its industry competitors are.
Profitability Metrics Paychex, Inc ADP, Inc. Administaff, Inc.Pretax ROE 59.2% 38.0% 36.6%5-year average ROE 30.2% 19.1% 18.4%Pretax ROA 15.9% 7.5% 13.5%Return on Capital (ROC) 39.4% 23.1% 23.5%Reinvestment Rate 9.3% 11.8% 17.8%ROE Relative to S&P 500 2.22 1.40 1.62
For Paychex, the ROIC, WACC and Revenue Growth metrics, all components required for creation of value, are also significantly higher than its competitor's metrics.
Metric PAYX ADP 5-year Average ROIC 103% 65% WACC 9% 9% 5-year Average Revenue Growth 11.8% 4.8%
1‐4 employees
77%
5‐19 employees
18%
20‐49 employees
4%
50+ employees
1%
Target Market
1‐4 employees
39%
5‐19 employees
42%
20‐49 employees
13%
50+ employees
6%
Paychex Client Base
Student Investment Fund Stock Report: PAYX
Carolyn VanderStaay & Juan Hernandez-Martinez Page 4
Valuation Discounted Cash Flow Valuation Model and Forecast Using a customized DCF model, our estimated per share intrinsic value of Paychex is $49.60, compared with the recent closing stock price of $28.26. Paychex has a stable and consistent operational footprint; therefore, the DCF model assumptions listed below were straightforward to extract from 5-year historical averages.
DCF Model Parameter Historical Value
Cost of Sales 35% SG&A 30% Tax Rate 32% Cash 10% Receivables 13% Good Will 25% ST Investments 236%
The team modified the following model assumptions to reflect current and future business conditions. DCF Model Parameter
Historical Value
Model Value Justification
Revenue Growth 12% FY09 5% Horizon 7%-5%
To reflect a conservative approach to valuation
Dividends payout as % of NI
55% 77% Paychex dramatically increased their payout ratio in FY08 continued the trend in Q1 FY09
Interest Income 6% 2% To reflect volatile interest rates
Net PPE 14.5% 16% To reflect investments in infrastructure over time
Long Term Investment
18% 4% To reflect the current trend in allocation of assets
Results of Model Forecast Because Paychex has high ROIC, wide ROIC over the WACC spread, and expected revenue growth from market opportunities, the model forecasted that Paychex will continue current trends of EVA, MVA, NOPAT, FCF, EPS, DPS as the graphs below demonstrate.
Estimated Per Share Intrinsic Value
Market Close
$49.60 $28.26
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Carolyn VanderStaay & Juan Hernandez-Martinez Page 5
Market Risks Paychex faces the following risks to its strategic plans:
• The current recession, which has the potential to be long and severe, could hurt Paychex's ability to meet target growth rates • Interest income from temporary funds are unreliable given the current interest rate environment • The firm’s Professional Employer Organization service line is exposed to a greater amount of regulatory risk.
Recommendation-Buy Paychex has built around it a protective barrier to economic downturns that is driven by:
• High customer switching costs allows Paychex to build a relatively sticky client base • Low capital requirements drive a high return on capital and • Inherent scalability allows Paychex to add new customers without incurring direct marginal costs
Additionally: • Paychex has no debt • FY08 was the 18th consecutive year of record Revenue, Net Income and EPS • Paychex is a dividend-paying stock with expected yields starting at above 4.5% • Paychex has demonstrated, through its financial results, consistent long-term discipline and excellence in execution
PAYX.xlsm Valuation and Analysis Model, Page 1 of 8
Net income before extraordinary items 303 369 464 515 576Extraordinary items, total 0 0 0 0 0 Extrordinary items
Net income 303 369 464 515 576 Net Income 26.6% 29.5% 29.4% 29.8% 17.4%Total adjustments to net income 0 0 0 0 0 Adjustments to NIBasic weighted average shares 377 378 379 381 368 Share growth 0.3% 0.3% 0.4% -3.3% -0.6% 0.0%Basic EPS excluding extraordinary items 0.80 0.97 1.22 1.35 1.56 18.1%Basic EPS including extraordinary items 0.80 0.97 1.22 1.35 1.56 18.1%Diluted weighted average shares 380 380 381 383 370 Diluted share growth 0.1% 0.4% 0.4% -3.5% -0.7% 0.0%Diluted EPS excluding extraordinary items 0.80 0.97 1.22 1.35 1.56 18.2%Diluted EPS including extraordinary items 0.80 0.97 1.22 1.35 1.56 18.2%Dividends per share -- common stock 0.47 0.51 0.61 0.79 1.20 26.4%Gross dividends -- common stock 177 193 232 301 442 Dividend % of Net Income 58.6% 52.3% 49.9% 58.5% 76.7% 59.2% 77.0%Retained earnings 126 176 233 214 134
values in millions
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Forecasting PercentagesHistorical Income Statements
Forecasted income statement items are based on 5 years of historical average ratios unless a value is entered in the manual cell, in which case the manual entry overrides the historical average. The idea is to consider whether the historical average is truly representative of what the firm can achieve in the future.
PAYX.xlsm Valuation and Analysis Model, Page 2 of 8
Revenues grow at the same rate each year unless a growth value is manually entered in the cell above the forecast year, in which case the year-by-year value overrides the historical or manual average. It makes sense to start tapering the growth forecasts 5 or 6 years into the forecast period.
PAYX.xlsm Valuation and Analysis Model, Page 3 of 8
values in millionsHistorical Balance Sheets Forecasting Percentages
Forecasted balance sheet items are based on 5 years of historical average ratios unless a value is entered in the manual cell, in which case the manual entry overrides the historical average. The idea is to consider whether the historical average is truly representative of what the firm can achieve in the future.
The model uses the more conservative diluted common shares number for total shares outstanding.
PAYX.xlsm Valuation and Analysis Model, Page 4 of 8
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018Long-term Horizon Value Growth Rate (user-supplied) 5.00%PV of Forecasted FCF, discounted at 9.00% $14,128 $14,925 $15,702 $16,510 $17,347 $18,221 $19,132 $20,088 $21,093 $22,147 $24,068Value of Non-Operating Assets $4,201 $4,398 $4,850 $5,347 $5,859 $6,423 $7,006 $7,650 $8,365 $9,162 $10,055Total Intrinsic Value of the Firm $18,329 $19,324 $20,553 $21,857 $23,206 $24,644 $26,138 $27,739 $29,458 $31,310 $34,123Intrinsic Market Value of the Equity $18,329 $19,324 $20,553 $21,857 $23,206 $24,644 $26,138 $27,739 $29,458 $31,310 $34,123Per Share Intrinsic Value of the Firm $49.60 $52.29 $55.62 $59.15 $62.80 $66.69 $70.73 $75.06 $79.72 $84.73 $92.34MVA (market value added) $17,132 $17,910 $18,896 $19,927 $20,970 $22,061 $23,164 $24,322 $25,538 $26,815 $28,968
Item Value Percent Cost Weighted Cost Risk Free Rate 4.50%ST Debt (from most recent balance sheet) 0 0.00% 6.70% 0.00% Beta 0.90LT Debt (from most recent balance sheet) 0 0.00% 8.50% 0.00% Market Risk Prem. 5.00%MV Equity (look up stock's mkt. cap and enter in cell BB53 9,710 100.00% 9.00% 9.00% Cost of Equity 9.00%Weighted Average Cost of Capital 9.00%
values in millionsHistorical Ratios and Valuation Model
Valuation (in millions where appropriate) -- through year 2018
Weighted Average Cost of Capital Calculations Capital Asset Pricing Model
Forecasted Ratios and Valuation Model -- 10 Years
Valuation Metrics Trend Analysis (NOPAT, EVA, MVA, FCF and Capital in millions) Forecasted Valuation Metrics -- 10 Years
PAYX.xlsm Valuation and Analysis Model, Page 6 of 8
Historical Ratios and Valuation Forecasted Ratios and Valuation
Forecasted Stock Prices Based on Historical Multiples -- 10 Years
In this section we are going to examine historical and forecasted ratios (or "multiples") typically used to value stocks ‐‐ P/CF, Enterprise Value/EBITDA, etc. We first want to compare the historical trends in these ratios to the trends in their forecasted values. If our forecasted multiples are systematically increasing or decreasing our forecasts may be too optimistic or pessimistic, and our forecast assumptions may have to be adjusted. Second, we want to compare our discounted cash flow valuation estimates with those derived from the various multiples. Once again, if there is a large discrepancy between our DCF valuation estimate of the company's stock and the range of values obtained from the various multiples, we may want to adjust our forecast assumptions. 1. You will need to look up the company's year‐end stock prices and enter them in the first 5 (historical) years of the "per share value" category.2. Use the estimated DCF price per share in the forecasted period (link to your forecasted prices in cells BG47‐BP47.3. Market capitalization will be calculated as basic weighted shares x historical year‐end prices and then forecasted basic weighted shares x DCF forecasted prices.4. As with previous calculations, historical multiples use actual historical values and forecasted multiples use forecasted values.
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