Paychex Inc. (PAYX) reported first-quarter fiscal 2011 earnings of 36 cents per share, beating the Zacks Consensus Estimate by two cents. The quarter’s results are indicative of an improving client retention rate and the company’s constant effort to improve selling operations.
Paychex reported first-quarter 2011 revenues of $518.3 million, up 3.6% from $500.2 million in the year-earlier quarter and was above the Zacks Consensus Estimate of $507.0 million. The revenue upside could be attributed to year-over-year growth in both checks processed per client and the retirement services client base.
Segment-wise, Payroll Service revenues increased 1.8% from the year-ago quarter to $360.7 million, attributable to a 1.2% growth in checks processed per client and an increase in pricing per check.
Management stated that the improvement in checks per client was primarily driven by an increase in corporate hiring and a higher retention rate. However, contributions from new clients were slightly down from the comparable period last year. Gong forward however, changes in selling processes are expected to generate new business for Paychex.
The Human Resource Services segment generated $145.5 million, up 10.1% from the prior-year quarter. Both the number of client employees served and the number of clients grew in the last quarter, contributing to the quarter’s performance. This stems from the positive impact of the recently passed Healthcare Reform Act in the U.S., as well as from increased hiring and retirement expenses per employee.
Operating Results
In the first quarter, the company incurred a total operating expense of $317.5 million, up 2.3% from the year-ago quarter. Total expense increased 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 $200.8 million, up 5.7% from the year-ago period, attributable to higher revenue and better cost management.
Net income of $131.9 million in the reported quarter increased 6.7% from $123.6 million in the prior-year quarter. Net income per diluted share was 36 cents compared to 34 cents in the year-ago quarter.
Balance Sheet & Cash Flow
Paychex exited the first quarter with cash and cash equivalents of $272.9 million, down from $284.3 million at the end of the prior quarter. Corporate investments increased $94.7 million to $177.2 million. Additionally, during the first quarter, interest on funds held for clients decreased 11.7% year over year to $12.1 million as a result of lower average interest rates earned, partially offset by a 1% increase in average investment balances.
Cash from operations saw a climb from $186.6 million in the prior-year quarter to $194.3 million in the reported quarter. Capital expenditures also increased $6.5 million to $16.6 million.
Guidance
For fiscal 2011, Paychex expects Payroll Service revenues to remain flat year over year and Human Resource Services revenues to increase in the range of 10.0% to 13.0%. Interest on funds held for clients is expected to decrease in the range of 12% to 17%, while net investment income is likely to increase in the range of 24% to 27%.
Net operating income is expected to range between 34% and 35% of total service revenue. The effective tax rate is expected to be roughly 35%. Moreover, net income is projected to improve marginally from fiscal 2010 levels.
Recommendation
Paychex witnessed a modest improvement in the quarter’s results based on increasing headcount and price per employee. However, Paychex maintained its fiscal 2011 guidance, reflecting uncertainty regarding economic conditions and low interest rates. Some analysts believe that there are downside risks to forward earnings estimates, given the lower contribution from new business that has been impacted by the declines in small business employment and lower interest rates earned.
Since small businesses make a major contribution to the company’s total revenue, we remain unsure about when Paychex could return to its normal double-digit revenue growth. However, we look forward to positive contribution from Paychex’s Human Resource Services segment, as there has been a steady increase in clients over the past few quarters.
On the other hand, we are somewhat concerned about escalating competition in the outsourcing space from big players such as Automated Data Processing Inc. (ADP) and Administaff Inc. (ASF), as well as limited margin expansion in the near term due to continuous investment in diverse field.
We currently have a short-term Sell recommendation (Zacks #4 Rank) on Paychex Inc.
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