Paychex (NASDAQ:PAYX) is set to announce the results of its fourth quarter fiscal year 2014 (fiscal year ends on May 31) on July 1, after market closes. In the third quarter, its revenue grew 7.3% to reach $636.5 million driven by strong performance across its Payroll and HR Outsourcing segments, which offset a decline in interest earned on funds held for clients.  Paychex’s net income increased 10.7% to reach $160.1 million.
During the three months form Paychex’s fourth quarter, March, April and May, the unemployment rate for the U.S. has remained well below 7.3%, the average for 2013. In March, the unemployment rate was 6.7% and in April and May it was 6.3%.  Additionally, 191,000, 220,000 and 179,000 jobs were added in March, April and May respectively.  Some of the decline in the unemployment rate came from workers dropping out of the labor force. We believe that Paychex will have benefited from the addition of jobs and improvement in the employment situation in the U.S. and this will reflect in its fourth quarter revenues. However, sequential decline in margins may impact its bottom line.
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Payroll Processing division to benefit from growth in checks per client
Check per client indicates the average number of employees Paychex’s Payroll service caters to for a client. A decrease in unemployment rate indicates that clients are hiring more employees. This in turn increases Paychex’s checks per client. With increase in checks per client, the segment’s revenue also increases.
In the third quarter, Paychex’s Payroll Processing division posted revenue growth of 5% driven by 1% increase in checks per client.  Improving employment conditions in the U.S. have helped increase Paychex’s check per client for 16 consecutive quarters. We believe that this trend will continue in the fourth quarter as well. Combined with price increases, this should lead to mid single digit growth in the segment’s fourth quarter revenue.
Operating Margins May Decline Sequentially
Operating margin is a ratio which measures the proportion of revenues left after accounting for operating expenses. It is an indicator of the company’s operating efficiency and a higher ratio indicates higher efficiency. Paychex’s annual operating margins have historically remained close to 38%.
As per Paychex’s management, the company’s quarterly operating margin trends downwards through the year.  This is also evident from the operating margin for each quarter. In the first quarter of fiscal 2014, the operating margin was 41%. This declined to 39.7% in the second quarter and then 39.4% in the third quarter. We expect the trend to continue into the fourth quarter driven by various technology investments to expand their Software-as-a-Service portfolio and seasonal sales related expenses.
HR Outsourcing division will bolster Paychex’s revenue
The HR Outsourcing division has historically shown strong growth as a value-added service to the company’s existing payroll processing clients. In the third quarter, HR service revenue grew 12.4% to $212.1 million due to an increase in its client base for online HR administration products, retirement services and HR solutions. Growth in average asset value of participant’s funds, insurance premiums and number of health and benefits applicants also contributed to the segment’s revenue. In the fourth quarter, we expect to see low teens growth in the segment driven by the declining unemployment rates.Notes: