HR Technology Equity Research Timothy Mchugh, CFA

Global Services | HR Technology Equity Research Timothy McHugh, CFA

+1 312 364 8229 HRDecember Technology 19, 2018 [email protected] Romeo, CFA +1 312 801 7854 [email protected] Automatic Data Processing, Inc. Assessing the M&A Opportunity for PEOs; Detailed Look at Privately Held PEO Competitors Market Perform ADP (NYSE) $130.00 Stock Rating: Cost Synergies, Economies of Scale, and Market Expansion Make PEO Acquisitions TriNet Group, Inc. Attractive. Market Perform TNET (NYSE) $41.58 Acquisitions in the PEO sector often create cost synergies through the elimination Stock Rating: of redundant corporate overhead and the consolidation of technology systems. Part of the Paychex, Inc. value proposition of PEOs is the ability to take advantage of scale investments in HR and insurance solutions, so we also believe that there are scale advantages that accrue to larger Market Perform PEOs. For example, large PEOs can make investments in employment law experts, call center PAYX (NASDAQ) $64.32 Stock Rating: service capabilities, workers’ compensation claims management specialists, and claims management analytics that smaller PEOs cannot cost-effectively match. Larger PEOs also can create vertical market solutions that are hard for a small competitor to replicate, and can negotiate better terms and flexibility in their insurance solutions. Lastly, we believe that acquisitions often provide an efficient way to enter markets and customer segments, as well as expand insurance company relationships. There are certainly risks associated with M&A activity in this sector (particularly with regard to the insurance part of the solution), but the factorsPaychex mentioned and TriNet above Will often Be Active make Withacquisitions M&A attractive in this sector.

. The PEO business model is increasingly important to Paychex (20%-22% of revenue after Oasis deal and fastest-growing part of company), and management has said that it will remain active with M&A. We note, too, that TriNet has a history of doing acquisitions, the company’s consolidated technology platform provides an easier way to integrate acquisitions, and the company’s balance sheet is fully deleveraged (based on net debt). We thus believe that M&A activity will be a key part of the growth at these companies. We also expect that some privately held companies will remain aggressiveLots of PEOs, with but trying Many to Areconsolidate Small. the industry.

Given the factors mentioned above, we compiled a list of all of the PEOs that are certified by the IRS (a new designation available to PEOs during the last few years). We also added any PEO companies that we could identify through other lists of sizable or fast growing PEO companies. We identified about 60 privately held PEOs. We identified enough information to estimate the number of worksite employees (WSE) for 25 of the companies, and then we used the number of employees on LinkedIn as a way to estimate the size of the other companies (see tables later in this report). CoAdvantage is the largest privately held competitor (90,000 WSE) and there are 9-10 additional companies with 20,000-50,000 WSE. Justworks is the fastest-growing company (organically), while CoAdvantage and G&A Partners are the most aggressive with growth through acquisitions. Each of the companies with more than 20,000 WSE would be decent-sized acquisitions for the publicly traded PEO companies, but none are near the size of Oasis, and the mix of services (some of these companies provide staffing, TPA, and/or insurance solutions) makes it unlikely some of those would be acquisition targets. Therefore, while there are still some opportunities for large M&A and we suspect that private-equity-backed companies will try to create other large platforms in this sector, many of the acquisition opportunities are smaller. Please refer to important disclosures on pages 10 – 12. Analyst certification is on page 10. William Blair or an affiliate does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. This report is not intended to provide personal investment advice. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments, or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. William Blair

Cost Synergies and Economies of Scale Make Economics of Acquisitions Attractive While there is risk associated with acquisitions in the PEO sector, we believe that cost synergies and scale-based competitive advantages make acquisitions attractive in many cases. We highlight three reasons why we believe acquisitions make sense in the PEO sector.

First, there are typically cost synergies that can be realized through acquisitions. Like many acquisitions, much of the corporate overhead at the acquired company can by eliminated. In addition, acquired PEOs can often be moved off their legacy technology systems and onto the platforms at the acquired firm. Many PEOs use third-party technology, such as PrismHR, to power their solutions, which sometimes makes it easier to migrate clients onto the acquiring company’s technology. We note that when discussing its strategy for acquisitions, TriNet’s management recently commented that it “would be looking to rotate all of those people [from an acquisition] on to our payroll engine, within at least the one-year anniversary of their entire installed base.” The magnitude of the cost savings varies depending on the acquired firm, but we believe that cost synergies are usually attractive following these transactions.

Second, part of the value proposition of PEOs is the ability to take advantage of scale investments in HR and insurance solutions. Therefore, it is natural that there are some scale advantages that accrue to larger PEOs relative to smaller PEOs. It does not cost much in capital to establish a PEO, and many parts of this business are dependent on local sales relationships and client service, so there will probably always be a fairly large number of small competitors in this sector. We believe, however, that there are economies to scale in terms of the technology, risk management and analytics, service capabilities, and insurance relationships that larger PEOs can invest in. For example, large PEOs can make investments in employment law experts, call center service capabilities, workers’ compensation claims management specialists, and claims management analytics that smaller PEOs cannot cost-effectively match. Larger PEOs such as TriNet also can create vertical market solutions that are hard for a small competitor to replicate. Lastly, larger PEOs can negotiate better terms and flexibility in their insurance solutions, which can create better terms for their clients and/or higher profits. This creates a competitive advantage for larger PEOs, which is obviously enhanced through acquisitions.

Third, acquisitions provide an efficient way to enter markets and customer segments. While there are economies to scale, this is still a relationship-driven business and some of the economies to scale are local in nature. It therefore might be more efficient to enter a new region through an acquisition. Acquisitions also can sometimes bring relationships and a track record with smaller health plans that might serve a specific geographic market.

PEO Is a Bigger Focus for Paychex The PEO market is becoming increasingly important for Paychex. Paychex historically has had a very large client base for its administrative service offering (ASO), which is a bundled solution that includes many aspects of a PEO solution but lacks the insurance component of the offering. The number of employees served through this channel has consistently grown at a low- double-digit pace for Paychex (see exhibit below).

Paychex Number of Comprehensive Outsourcing Employees Served (in millions) 1.4 1.2 1.2 1.0 1.0 0.9 0.9 0.8 0.8 0.7 0.6 0.6 0.6 0.5

0.4

0.2

0.0 2010 2011 2012 2013 2014 2015 2016 2017 2018

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Paychex historically had only a limited presence in the PEO sector, because of the volatility and risk associated with the insurance component of the solution. Paychex started to compete a little more aggressively in this sector in 2014 when it introduced a minimum premium insurance offering in Florida. We believe that organic growth in Paychex’s PEO business has been strong during the last few years, but acquisitions have had the biggest impact on the size of this business. The company then acquired HROI for $75 million in 2017, and announced the acquisition of Oasis in November 2018. HROI was majority owned by Clarion Partners and was led by the same management team that had previously led SOI (which TriNet acquired in 2012).

Paychex Key Events in Growth of PEO Business

Date Event Jan-14 Adds insurance component to solution offering in Florida Aug-17 Acquisition of HROI Sep-18 Provides new segments w ith Insurance and PEO as a separate segment Nov-18 Oasis acquisition announced

As noted in the table above, Paychex changed its segment reporting this fiscal year. The change was prompted by a new accounting standard, but we believe the growing importance of the PEO business likely influenced how the business is being shown to investors. The PEO and insurance services segment accounted for 14% of fiscal 2017 revenue but 26% of Paychex’s incremental organic growth in fiscal 2018. Excluding the PEO and insurance segment, Paychex’s revenue growth has been fairly muted. The new HR Management Solutions (HRS) segment grew organically at 2.4%, 2.7%, 3.3%, and 2.5% over the last four quarters, with midsingle-digit growth in the other parts of the HRS segment and 1%-2% growth in payroll.

Paychex Organic Growth by Business Area 30% 25% 25% 20% 20% 17% 16% 16% 15% 14% 11% 12% 12% 11% 10% 10% 10% 7% 7% 6% 5% 4% 2% 1% 2% 2% 0% PEO and Insurance HRS ex Insurance and PEO Legacy payroll Client funds balance

2016 2017 2018 2019E 2020E

While growth in insurance services has contributed to the growth of this revenue line, we believe that the PEO business has been the biggest contributor. We estimate that PEO will account for almost one-third of revenue next year, versus 6% in fiscal 2014. This business has grown as a result of the company’s decision to provide a minimum premium insurance plan in fiscal 2015, the acquisition of HROI last year and Oasis Outsourcing recently, and strong organic growth (15% last quarter). Paychex’s organic growth in this business lagged competitors in fiscal 2017, but it has been stronger than most competitors during the last year.

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Paychex Percentage of Revenue from PEO (includes pass through items) 35% 30% 30%

25%

20%

15% 13% 11% 10% 8% 8% 8% 6% 5%

0% 2014 2015 2016 2017 2018 2019E 2020E

Despite its significant growth, Paychex is still small in PEO versus the other leading providers. Similar to other PEOs, Paychex’s reported PEO revenue includes pass-through items related to the insurance part of this product. If we adjust for some of those pass-through items, competitors ADP and TriNet report underlying revenue that is about 25% of the gross revenue reported for this business. Excluding insurance pass-throughs, our best guess is that Paychex will have about $400 million of revenue from PEO, compared with $975 million at ADP, $880 million at TriNet, and $600 million at Insperity. Revenue excluding pass- throughs will represent 10%-11% of Paychex’s revenue. Paychex’s market presence would be much bigger if we included administrative service offerings, but as it relates to traditional PEO services, Paychex is still relatively underpenetrated in this market. We believe Paychex will remain focused on scaling this business.

TriNet Likely Will Return to Doing Acquisitions We believe that TriNet will become more active with acquisitions during the next few years for three reasons (besides the economic benefits of acquisitions in this sector that we described earlier). First, TriNet has fully deleveraged its balance sheet (on a net debt basis) and the company continues to produce strong free cash flow. This provides TriNet with significant capital that could be deployed into acquisitions and share repurchases.

TriNet Net Debt to Trailing Adjusted EBITDA

6.0

5.0 5.0

4.0

3.0 2.5 2.2 2.0 1.7 1.5

1.0 0.3 - - 2012 2013 2014 2015 2016 2017 2018E

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TriNet Free Cash Flow as a % of Adjusted Net Income

200% 179% 180% 157% 160% 152% 145% 140% 121% 120% 109% 97% 100% 76% 80%

60%

40%

20%

0% 2011 2012 2013 2014 2015 2016 2017 2018E

Second, TriNet is now complete with the painful process of consolidating the technology and service platforms that came from some of its old acquisitions. The company is past the distraction that came from migrating clients off old platforms, and it now has one main platform that it is focusing its resources on. We believe that this approach makes it simpler for TriNet to integrate acquisitions. TriNet’s management commented recently at a conference that “the migration is over, so you will see us start to do M&A activity in the coming year. We’re looking to start that more on a smaller scale. We would like to have that go into new geographies for us. The best of all would be a geography where there is a regional carrier that is locked into a PEO.”

Third, prior to the last few years, acquisitions were a core part of TriNet’s growth strategy. The acquisition of SOI was challenging for the company, but management believes that it has learned a lot from its historical acquisitions. We thus expect TriNet to become more active with acquisitions.

TriNet Acquisition History

Acquisition Year Brief Description HR Logic 2002 Boston-based company with East Coast presence E3 Group 2003 Texas-based PEO ALTRES 2003 Hawaii-based PEO Outsource Group 2006 Focused on professional services clients John Parry & Alexander 2007 Focused on community banks LMC Resources 2008 Higher-end Colorado PEO Gevity 2009 Struggling public company based in Florida SOI 2012 Focused on blue collar employers Accord 2012 Focused on blue collar employers Ambrose 2013 High-end PEO on East Coast

Acquisitions Have Been a Core Strategy for Growth at Some PEOs Insperity and ADP have not acquired many PEOs during the last 10-15 years and yet continue to deliver strong growth, so acquisitions certainly are not a necessity for growing a PEO business. Still, in addition to TriNet a few years ago and Paychex lately, there is a fairly active history of M&A activity in this sector. Many of the privately held companies in this sector have growth through acquisitions. The table below shows the acquisition history for CoAdvantage (which is now the largest privately held PEO), Oasis Outsourcing (which Paychex is acquiring), and G&A Partners (which is one of the largest remaining privately held PEO companies and has been aggressive with M&A activity).

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PEO Industry Acquisition History for Selected Group of Privately-Held PEOs

Acquiring Company Acquired Company Year Background CoAdvantage Remedy Employer Services 2018 Florida-based PEO CoAdvantage Total HR Management 2018 Added presence in California CoAdvantage Progressive Employer Management 2017 Significant presence in Florida CoAdvantage Discovery Outsourcing 2014 Denver-based company CoAdvantage Compensation Solutions 2014 New Jersey-based PEO

Acquiring Company Acquired Company Year Background Oasis Outsourcing Aureon HR 2018 Added presence in Iowa Oasis Outsourcing Staff One 2017 Increased presence in Texas Oasis Outsourcing DHR 2017 expanded presence in Western region Oasis Outsourcing Fortune Industries 2016 Struggling public company with 14,000 WSE Oasis Outsourcing Doherty Employer Services 2015 Minneapolis-based PEO Oasis Outsourcing A1HR 2015 Florida-based PEO with 20,000 WSE

Acquiring Company Acquired Company Year Background G&A Partners Zogg Benefits 2018 Dallas-based PEO G&A Partners Ascend HR 2017 Salt Lake City-based PEO G&A Partners Employer Essentials 2017 Denver-based PEO G&A Partners Platinum Colorado 2017 Denver-based PEO

List of Competitors Given the potential for continued M&A activity in this sector, we thought it would be helpful to provide a detailed look at some of the privately held PEOs so that investors can assess how big these companies are and monitor their developments. With that in mind, we compiled a list of PEOs based on 1) PEOs that are certified by the IRS; 2) PEOs that were included in Inc. Magazine’s list of the fastest-growing small companies; 3) PEOs that showed up in Staffing Industry Analysts’ research/lists; 4) a list of the largest PEOs in Florida published in Florida Trend; and 5) a list of the “Best PEOs” that we found on Business News Daily. We eliminated a few companies that looked very small, but we still ended up with a list of almost 60 companies. We found enough information to reasonably guess or directly identify the WSE/client count for 23 companies, as shown below. Our estimates are based on disclosures about WSE for each company that were spread across 2017 and 2018, so the exact size of each company today might be a little different. Still, we believe that this list provides a reasonable look at the privately held companies in this industry.

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Estimated Size for Various Privately-held PEOs

Name of Company Number of WSE Number of clients Number of employees on LinkedIn 1 CoAdvantage 90,000 4,500 381 2 Justworks 50,000 404 3 Frank Crum 50,000 201 4 G&A Partners 45,000 1,300 356 5 Modern Business Associates (MBA) 40,000 1,000 108 6 Avitus Group 30,000 339 7 Engage 30,000 132 8 Group Management Services Inc 25,000 1,350 268 9 Resourcing Edge/Sequent 18,000 200 10 Questco 17,000 117 11 Extensis Group 15,000 171 12 Prestige PEO 14,000 117 13 Lyons HR 13,000 700 173 14 Landrum HR 13,000 111 15 RMI Solutions 10,000 500 NA 16 Surge HR/Matrix One 10,000 900 NA 17 Tandem HR 9,000 200 87 18 XcelHR 8,000 600 82 19 MatrixOneSource 7,000 700 34 20 AccessPoint 6,000 600 62 21 Alcott HR 4,400 96 22 Unique HR 3,400 78 23 Empower HR 220 65

For the PEOs where we could not find any information about WSE, we looked up their number of employees on LinkedIn. The PEOs in the table above average about 130 WSE per employee on LinkedIn, so this is a rough way to estimate the size of these companies. The main idea of this second list is to identify which of the other PEOs are decent sized. South East Employee Leasing, Nextep, Vensure, and CertiPay are likely reasonably good-sized. We saw an estimate that South East Employee Leasing (owned by its leadership team) has almost 80,000 WSE as of March 2017, but we were not able to verify that and it feels somewhat high relative to the employee base; it is most likely the largest company shown in this second list, however. Other than the companies mentioned above, most of the other companies on this second list are fairly small.

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Other PEOs for Which We Couldn't Estimate a Size

Name of Company Number of employees on LinkedIn 1 Nextep 188 2 Southeast Employee Leasing 151 3 Vensure Employer Services 125 4 Certipay 123 5 Employer Advantage 69 6 C2 Essentials 68 7 Axcet HR 55 8 Emplicity 54 9 National PEO 50 10 Propel PEO 45 11 Impact Workforce Solutions 43 12 Regis HRG 42 13 Choice HR 42 14 People HRO 37 15 Syndeo 36 16 Abel HR 33 17 The Synergy Companies Inc 28 18 Sourcepoint 26 19 Midwest HR 25 20 Lever1 24 21 GenesisHR Solutions 24 22 Human Capital Concepts 24 23 Innovative Employer Solutions 19 24 Optimum Employer Solutions 18 25 Siracusa Staffing and leasing LLC 18 26 Enterprise HR 12 27 Pinnacle PEO 12 28 Center Point Business Solutions 11 29 Einstein HR 10 30 Intandem Human Resources 10 31 Erigo Employer Solutions 9 32 Premier Employer Services, Inc 3 33 OneSourceBusiness Solutions LLC 2 34 Avalon HR NA 35 Emergent HR Solutions NA

Overall, while we identified six privately held PEO companies that we believe have more than 25,000 WSE and 13 that have 10,000-25,000 WSE, the rest of the companies likely have less than 10,000 WSE. As a reminder, we believe that Paychex and TriNet have a little over 300,000 WSE, Insperity has 215,000 WSE, and ADP serves 500,000 WSE. The privately held companies with more than 25,000 WSE would represent good-sized acquisitions for most of the publicly traded companies, but not nearly as big as Oasis (260,000 WSE). There are a relatively small number of potential acquisitions within that size range, though. Most of the acquisition opportunities in this sector will therefore be tuck-in deals.

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Privately-Held PEO Companies Number of Companies with WSE in Ranges Shown Below 40 (based only on list of companies that we identified)

35 35

15 13

5 3 3

0 More than 50,000 25,000-50,000 10,000-25,000 Less than 10,000

Closer Look at the Biggest Competitors Lastly, we provide a slightly closer look at the biggest privately held companies that we identified above. Several of these companies are based in Florida, where the PEO industry is the most mature. CoAdvantage and G&A Partners have been the most aggressive with regard to acquisitions, and a few of these companies (Frank Crum, Southeast Employee Leasing, Avitus, and Group Management Services) provide a broader set of services beyond PEO. Lastly, Justworks, which has raised $93 million from its investors since its inception in 2012, is probably the fastest-growing company on this list. Justworks has quickly grown to 50,000 WSE, with all of its growth organic. The company has gained this scale despite serving only a few geographic markets. Justworks has a large presence in New York and has a growing presence in other parts of the East Coast (Washington, D.C.), with the company only recently expanding into a few select markets in other parts of the country.

PEO Industry Selected Information for Largest Privately-held Companies

Company Headquarters Ownership Geogrpahic focus Other Notable Factors CoAdvantage Tampa Bay Morgan Stanley National coverage Active with M&A in the sector; New CEO named last year Justworks New York Bain, Spark, Redpoint East coast, but expanding elsewhere Growing very quickly Modern Business Associates (MBA) Tampa Bay Privately-owned National coverage Leadership change in 2016 G&A Partners Houston Privately-owned Large presence in Texas, as well as Active with M&A in the sector Colorado and Utah Avitus Group Denver Privately-owned Large presence in Northeast Provides a variety of business services including training, marketing services, and accounting Group Management Services Inc Cleveland Privately-owned Mostly Ohio, Midwest, and Southeast Also operates as a TPA Frank Crum Tampa Bay Privately-owned National coverage Family of companies includes staffing and insurance companies Engage Fort Lauderdale Privately-owned Mostly Southeast $25 million of revenue according to Inc. Magazine rankings; CEO formerly led AlphaStaff until sale of that company in 2008 Southeast Employee Leasing Tampa Bay Privately-owned Focused on Florida, Illiois and Southern Heavy exposure to construction; owned by CEO, who also owns states Lion Insurance, which provides workers compensation insurance

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IMPORTANT DISCLOSURES

William Blair or an affiliate is a market maker in the security of Automatic Data Processing, Inc., TriNet Group, Inc. and Paychex, Inc.

William Blair or an affiliate expects to receive or intends to seek compensation for investment banking services from Automatic Data Processing, Inc., TriNet Group, Inc. and Paychex, Inc. or an affiliate within the next three months.

Officers and employees of William Blair or its affiliates (other than research analysts) may have a financial interest in the securities of Automatic Data Processing, Inc., TriNet Group, Inc. and Paychex, Inc.

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Timothy McHugh attests that 1) all of the views expressed in this research report accurately reflect his/her personal views about any and all of the securities and companies covered by this report, and 2) no part of his/her compensation was, is, or will be related, directly or indirectly, to the specific recommendations or views expressed by him/her in this report. We seek to update our research as appropriate. Other than certain periodical industry reports, the majority of reports are published at irregular intervals as deemed appropriate by the research analyst.

DOW JONES: 23675.60 S&P 500: 2546.16 NASDAQ: 6783.91 Automatic Data Processing, Inc. Rating History as of 12/18/2018 powered by: BlueMatrix Mkt Mkt 07/20/17 07/27/17 160

140

120

100

60 Jan 16 Apr 16 Jul 16 Oct 16 Jan 17 Apr 17 Jul 17 Oct 17 Jan 18 Apr 18 Jul 18 Oct 18

Closing Price

OP:Outperform Mkt:Market Perform UP:Under Perform NR:Not Rated I:Initiation of Coverage D:Dropped Coverage Source: FactSet & Willaim Blair

TriNet Group, Inc. Rating History as of 12/18/2018 powered by: BlueMatrix 70

10 Jan 16 Apr 16 Jul 16 Oct 16 Jan 17 Apr 17 Jul 17 Oct 17 Jan 18 Apr 18 Jul 18 Oct 18

Closing Price

OP:Outperform Mkt:Market Perform UP:Under Perform NR:Not Rated I:Initiation of Coverage D:Dropped Coverage

Source: FactSet & Willaim Blair

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Paychex, Inc. Rating History as of 12/18/2018 powered by: BlueMatrix Mkt Mkt 07/20/17 08/22/17 80 75 70 65 60 55 50 45 Jan 16 Apr 16 Jul 16 Oct 16 Jan 17 Apr 17 Jul 17 Oct 17 Jan 18 Apr 18 Jul 18 Oct 18

Closing Price

OP:Outperform Mkt:Market Perform UP:Under Perform NR:Not Rated I:Initiation of Coverage D:Dropped Coverage Source: FactSet & Willaim Blair

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