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  • Student Investment Fund Stock ReportAnalysts: Carolyn VanderStaay & Juan Hernandez-Martinez

    Page1

    Paychex,Inc.NASDAQ:PAYX

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    PAYX ADP ASF Industry

    GrossMargin

    OperatingMargin

    ProfitMargin

    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- $52MPretax 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 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&P500

    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.

    Ancillary Service Utilization rate FY08 Revenue GrowthPayroll tax administration services 93% 8%Employee payment services 73% 19%

    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.

    Sector Life Cycle 2009 2010 2011 2012 2013Accounting, Tax, Bookkeeping & Payroll Services

    Growth 2.0% 3.4% 3.2% 3.1% 3.1%

    IT Support, CRM & Data Processing Services

    Mature High Growth

    2.9% 10.1% 9.8% 9.2% 11.2%

  • Student Investment Fund Stock Report: PAYX

    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 others 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%

    14employees

    77%

    519employees

    18%

    2049employees

    4%

    50+employees

    1%

    TargetMarket

    14employees

    39%

    519employees

    42%

    2049employees

    13%

    50+employees

    6%

    PaychexClientBase

  • 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