Paychex Inc. (PAYX) reported third-quarter fiscal 2011 earnings of 36 cents per share, beating the Zacks Consensus Estimate by a penny. The quarter’s results are indicative of an improving client retention rate and higher checks per client.
Paychex reported third-quarter 2011 revenues of $531.3 million, surpassing the Zacks Consensus Estimate of $528.0 million and improving 4.6% from $507.8 million reported in the year-ago quarter. The revenue upside can be attributed to year-over-year growth in both checks processed per client and the HR services client base.
Payroll Service segment revenues increased 2.3% from the year-ago quarter to $366.4 million, attributable to continued growth in checks processed per client. However, sale of new units remained flat sequentially, reflecting low volume of new businesses due to slower economic recovery.
The Human Resource Services segment generated $153.2 million in revenues, up 13.1% from the prior-year quarter. The number of client employees served and the number of clients grew during the quarter, contributing to the increase. Moreover, demand for a new product, HR Essentials, also added to the segment’s revenue growth.
Operating Results
In the third quarter, Paychex incurred total operating expense of $332.4 million, down 2.1% from the year-ago quarter. The decrease was mainly due to an $18.7 million litigation expense included in operating expenses of the year-ago quarter. Excluding the litigation expense charge, total operating expenses would have increased 4% year over year due to the company’s continued effort to train sales personnel, provide better customer service and enhance technological infrastructure. However, the increase was partially offset by a higher utilization rate and lower headcount.
Operating income was $198.9 million, up 18.3% from the year-ago period, attributable to modest revenue growth and better cost management. Operating margin increased 430 basis points year over year to 37.4%.
Net income of $130.6 million in the reported quarter reflected a 16.6% increase from $112.0 million in the prior-year quarter. Net income per diluted share was 36 cents compared with 31 cents in the year-ago quarter. There was no one-time item during the quarter.
Balance Sheet & Cash Flow
Paychex exited the third quarter with cash and cash equivalents of $236.0 million, up from $233.2 million at the end of the prior quarter. Corporate investments increased $3.4 million sequentially to $233.7 million. Additionally, interest on funds held for clients decreased 16.4% year over year to $11.7 million as a result of lower average interest rates earned, partially offset by a 3% increase in average investment balances. Paychex has no long-term debt.
Cash from operations grew from $124.9 million in the prior-year quarter to $335.5 million in the reported quarter. Capital expenditures also increased from $27.5 million in the prior quarter to $34.9 million.
Guidance
The fourth quarter has been lackluster in the recent past, relative to the other three quarters. Paychex expects the trend to continue in the next quarter, given lower contribution from HR Service revenue, which happens to be less predictive and depends much on employee retention or addition and unmatched workers’ compensation.
For fiscal 2011, Paychex continues to expect a 1–2% increase in Payroll Service revenues compared to the year-ago quarter. Human Resource Services revenues are expected to increase in the range of 10.0% to 11.0% (previously 10.0% to 13.0%). Total service revenue is likely to grow in the range of 3% to 5% (reiterated). The company also reiterated projections of a 12-17% decline in interest on funds held for clients and a 29-32% increase in net investment income.
Interest on funds held for clients and investment income for fiscal 2011 are expected to be impacted by the low interest rate environment. However, investment income is expected to benefit from the ongoing investment of cash generated from operations.
Net operating income is expected to be 36% of total service revenue. The effective tax rate is expected to be roughly 35% and net margin is projected at between 4% and 6%.
The guidance for fiscal 2011 includes anticipated results from Paychex’s recent acquisition of SurePayroll Inc. Revenue is expected to have an impact of less than 1% and earnings dilution is likely to be less than 1 cent per share due to amortization on acquired intangible assets and one-time acquisition costs.
Our Take
We remain encouraged with decent numbers posted by Paychex as well as better-than-expected top and bottom lines. Despite the weak guidance for the fourth quarter, Paychex reiterated its overall outlook for fiscal 2011, while tweaking the HR Service revenue expectation a bit. Moreover, we believe that cost control measures will remain a catalyst for Paychex this year.
A recent survey conducted by Paychex indicates that roughly 50% of small business owners expect to see growth momentum in their businesses in fiscal 2011, although some of them expressed concerns regarding government regulations. Since small businesses make a major contribution to the company’s total revenue, we can expect healthy inputs in the coming quarters.
However, we remain concerned about growing competition in the outsourcing space from big players such as Automated Data Processing Inc. (ADP) and Administaff Inc. (ASF). But we expect the SurePayroll acquisition to provide Paychex with additional small business market share and revenue growth.
Currently, Paychex has a short-term Buy recommendation, as is indicated by the Zacks #2 Rank.
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