Earnings Preview: Paychex Inc.

Paychex Inc. (PAYX) is scheduled to announce its third quarter fiscal 2011 results on March 24, and we do not see any major variation in analyst estimates at this point.

Second Quarter Overview

Paychex delivered modest second quarter 2011 results, with earnings of 37 cents per share beating the Zacks Consensus Estimate by two cents. The quarter’s results indicated an improving client retention rate and selling operations.

Paychex’s second quarter revenues increased 3.1% year over year to $512.0 million and surpassed the Zacks Consensus Estimate of $511.0 million. The improvement was attributed to year-over-year growth in both checks processed per client and the retirement services client base.

Payroll Service revenues were down 1.1% from the year-ago quarter, due to a 2.5% growth in checks processed per client and an increase in pricing per check.Revenues from the Human Resources Services segment grew 9.8% from the year-ago quarter driven by the positive impact of the Healthcare Reform Act passed in the U.S. and increased hiring.

Paychex generated operating income of $203.9 million, up 5.6% from the year-ago quarter and net income of $133.9 million, up 6.4% year over year. The company exited the quarter with cash and cash equivalents of $233.2 million.

Paychex witnessed a modest improvement in the quarter’s results on increasing headcount and price per employee. Despite economic uncertainties and low interest rates, Paychex provided an encouraging guidance. Considering improving business trends, the company raised its guidance for Payroll Services revenue, Investment Income and net operating margin.

Guidance

For fiscal 2011, Paychex expects Payroll Service revenues to increase in the range of 1–2% from the year-ago quarter (previously flat year over year). Human Resource Services revenues are expected to increase in the range of 10.0% to 13.0%. Total service revenue is likely to grow in the range of 3% to 5%. 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 29% to 32% (previously 24% to 27%).

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% (previously 34–35%) of total service revenue. The effective tax rate is estimated at roughly 35% and the net margin between 4% and 6%.

The guidance for fiscal 2011 does not include any anticipated results from Paychex’s recent acquisition of SurePayroll Inc. However, earnings dilution is expected to be approximately 1 cent per share due to amortization on acquired intangible assets and one-time acquisition costs.

Agreement of Analysts

Out of the nineteen analysts providing estimates for the third quarter, only one moved upward in the last thirty days. There was no downward revision for the quarter. Further, there were no upward or downward estimate revisions for fiscal year 2011 or 2012.

The limited number of changes to estimates also point to the fact that there was no major catalyst during the quarter that could drive results. Consequently, the analysts are sticking to the estimates projected post second quarter earnings. But the analysts are positive about Paychex’ key business indicators such as, checks per client, revenue per check and client retention.

Magnitude of Estimate Revisions

There were no changes to analyst estimates for the third quarter or fiscal year 2011 over the past 30 days. However, the Zacks Consensus Estimate for the third quarter inched up by a penny over the past ninety days. Moreover, the Estimate for fiscal 2011 went up to $1.41 from $1.38 in the past ninety days. We also note that the Zacks Consensus Estimate for fiscal 2012 has gone up by two cents to $1.51 since the second quarter.

The upside in estimates, though minor, indicates positive investor sentiment, which might have been backed by an upbeat guidance and positive fundamentals.

Recommendation

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 concern 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.

We also look forward to a positive contribution by 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 slightly concerned about growing 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 due to continuous investments in diverse fields. But we expect the SurePayroll acquisition to provide Paychex with additional small business market share and revenue growth.

Paychex has a Zacks Rank # 2, implying a short-term Buy recommendation.

PAYCHEX INC (PAYX): Free Stock Analysis Report

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