Paychex’s Earnings To Benefit From Improving Employment Scenario However Margins May Decline

Paychex (NASDAQ:PAYX) is set to announce the results of its third quarter fiscal year 2014 (fiscal year ends on May 31) on March 26 2014. Paychex offers payroll processing to businesses of varying sizes around the globe. Payroll processing includes the paper and electronic distribution of employee compensation, along with the processing of tax withholdings and other employee contributions. Businesses save time and resources by outsourcing their payroll processing needs to companies like Paychex. In its second quarter fiscal year 2014, Paychex’s revenue grew 7% year-on-year to reach $600.5 million. ^[1] Paychex’s Payroll Services revenue grew 5% and HR outsourcing revenue grew 12%.

During the three months that form Paychex’s third quarter, December 2013, January and February 2014, the unemployment rate for the U.S. has remained well below 7.3%, the average for 2013. In December 2013 and February 2014, the unemployment rate was 6.7% and in January 2014 it was 6.6%. ^[2] Additionally, the participation rate improved slightly since December 2013, indicating a renewed confidence in the working population towards the job environment in the U.S. We believe that Paychex’s third quarter result is set to benefit from these trends.

We have a price estimate of ~$35 for Paychex, which represents a downside of ~16% to the market price.

See our complete analysis of Paychex Here

Payroll Processing Division To Post Moderate Growth

Payroll processing is Paychex’s most important division contributing around 61.5% to its intrinsic value. This division accounted for almost 65% of total revenues in the first six months of the fiscal year and grew by about 4% year-on-year. ^[1] During the second quarter, the division grew 5% driven by increases in checks per payroll and revenue per check, which grew as a result of the price increase.

For the third quarter, we expect the Payroll services division to benefit from the declining unemployment rates and increasing participation rates. The growing employment rates have a direct impact on Payroll’s check per client and revenue per check metrics. Check per client indicates the average number of employees Paychex’s Payroll service caters to for a client. An increase in employment rate indicates that clients are hiring more employees. This in turn increases Paychex’s checks per client. With increase in checks per client, the revenue per check also increases, thereby boosting the segment’s revenues. Paychex’s check per client has been increasing for the past 15 quarters and we believe that it will increase in the third quarter as well. Combined with price increases, this should lead to high single digit growth in the third quarter.

During the second quarter, Paychex completed an acquisition of a payroll service provider in Germany. ^[3] This may lead to an increase in the number of clients that Paychex serves. However, Paychex believes operations in Germany are immaterial to the overall company results right now.

HR Outsourcing And Other Services To Drive Revenues Significantly

The HR Outsourcing division has historically shown strong growth as a value-added service to the company’s existing payroll processing clients. During the second quarter of fiscal 2014, the HR services division’s revenues grew by 12% to $407.5 million. ^[1] The increase was driven primarily by client base growth, particularly in retirement services, Paychex HR Solutions, and eServices products. Additionally, revenues of the retirement services division also benefited from an increase in the average asset value of participants’ funds. Insurance services revenue reflected higher premiums in workers’ compensation insurance services and an increase in the number of health and benefits applicants.

For the third quarter, we expect the HR Outsourcing division to post low teens growth benefiting from the increasing employment and participation rates.

Operating Margins May Decline Sequentially

Operating margin is a ratio which measures the proportion of revenues left after accounting for operating expenses and is an indicator of the company’s operating efficiency. Paychex’s annual operating margins have historically remained close to 38%.  However, fluctuations do appear from quarter to quarter. Generally, Paychex’s quarterly operating margin trends downwards through the year. In the first quarter of fiscal 2014, the operating margin was 41%. This declined to 39.7% in the second quarter. In continuation with this trend, we expect that operating margins will be slightly lower than 38% during the third quarter.

We will update our $35 price estimate for Paychex once the company reports its fiscal 2013 earnings.

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1. Paychex 2014 Q2 8K [↩] [↩] [↩]
2. US Employment Situation Summary, www.bls.gov [↩]
3. Paychex Management Discusses Q2 2014 Results – Earnings Call Transcript, December 19 2013, www.seekingalpha.com [↩]