Growth In Client Base Could Offset Impact Of Weak U.S. Job Market On Paychex’s Earnings

Paychex (NASDAQ:PAYX), a leading payroll and human resource management company in the U.S., is set to release its first quarter fiscal year 2015 (fiscal year ends May 31) earnings result on Wednesday, September 24, 2014 before the market opens. We believe that the weak U.S. job market during the quarter ended August 31 may have tempered Paychex’s revenue growth in the first quarter. However, it should be able to post growth driven by an increase in its client base.

Revisiting the previous quarter

In the fourth quarter fiscal year 2014, Paychex’s revenue grew 9% year-on-year, to reach $639 million. ^[1] This included the impact of change in Professional Employer Organization (PEO) direct cost adjustment. Excluding the impact of change in accounting for PEO direct costs, the total revenue in the fourth quarter increased 5% year-on-year. Growth in client base at Paychex’s Payroll and Human Resource Service divisions contributed to the revenue growth. Paychex’s operating income, the difference between its revenue and operating expense, grew 8% in the fourth quarter. Net income and earnings per share grew 18% due to the impact of an increase in provision for tax in the fourth quarter fiscal year 2013.

During its fourth quarter earnings conference, Paychex provided a guidance of 8-10% growth in total service revenues for the fiscal year 2015. This guidance includes the impact of classification of PEO direct costs as operating expenses.

See our complete analysis of Paychex here.

U.S. job environment has been weak despite decline in unemployment ratio

Over the three months ended August 31, 2014, the U.S. Bureau of Labor Statistics (BLS) reported unemployment ratios of 6.1%, 6.2% and 6.1%, suggesting a reduction in the number of people without a job. ^[2] However, a deeper look at other numbers, such as job additions, employed-population ratio and participation rates, tell a different story altogether.

The number of job additions during the quarter has been subject to many revisions. The June 2014 job additions were reported as 288,000 in the employment summary issued by the BLS in July. However, this was revised to 298,000 in August and then to 267,000 in September. Inconsistent revisions indicate either a weak market or unreliable reporting, both of which are unfavorable for companies like Paychex. The July 2014 job additions were revised marginally upwards from 209,000 to 212,000. The biggest hit came with the job additions for the month of August, which stood at 142,000, compared to the expectations of 225,000 additions. The disappointing August job additions had a negative impact on Paychex’s stock price, which declined 0.85% during the week ending September 12, when the report was released.

The employed population, which indicates the percentage of the total working age population that is employed, was static at 59% through the quarter ended August 31. This essentially shows that despite job additions, the overall employment in the country has not improved. The important question now is what has been driving the decline in the unemployment ratio? The answer is the increasing number of working age population that is leaving the labor force.

The metric “Not in labor force” reported by the BLS in its employment summary indicates the number of people who are of working age but have chosen to drop out of the labor force, maybe because of the weak job environment. By the end of August 2014, the number of people who dropped out of the labor force increased 2% year-on year. This part of the population, though effectively unemployed, is not taken into account while calculating the unemployed rate since they are not actively seeking work. The unemployment rate only takes into account the unemployed population that is actively seeking work. Therefore an increase in the “Not in labor force” population, reduces the numerator against which the unemployment rate is calculated, resulting in a smaller value which falsely indicates an improving job environment.

The weak job additions and increasing number of people dropping out of the labor force is not a good sign for Paychex’s checks per client metric, which indicates the average number of employees Paychex caters to for a client. Paychex generates incremental revenues with the addition of employees at its clients. Considering the sluggish U.S. job environment, we do not expect to see growth in Paychex’s checks per client, which may lead to flat revenue growth for its payroll services. However, growth in client base, as seen in the previous fiscal, could bolster revenues.

Increase in client base should drive Payroll and HR services revenues

An increase in the number of clients could drive Paychex’s revenues from its Payroll and HR services segments. In the fiscal year 2014, Paychex’s Payroll revenue grew 4% driven by 2% increase in its number of payroll clients. Additionally, its HR services revenue increased 12% due to a 13% increase in the number of clients. The global HR outsourcing market is expected to grow at an average rate of 12.34% per year through 2018 due to increase in the number of companies outsourcing their payroll and HR functions in order to reduce costs and maximize efficiency. ^[3] This should help increase Paychex’s client base.

Additionally, with the deadline of adherence to provisions of the Affordable Care Act approaching, adoption of Paychex’s products catering to the Affordable Care Act should help increase its clients. Separate surveys conducted by Automatic Data Processing (NASDAQ: ADP) and Paychex revealed that only around half of the small, mid and large sized businesses in the U.S. are aware of the impact of the Affordable Care Act and are prepared for them. ^{[4] [5]} This leaves a huge market of potential clients who are looking for solutions that will help maintain compliance with the provisions.

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1. Paychex Q4 2014, www.paychex.com [↩]
2. Employment Situation Summary, www.bls.gov [↩]
3. Global Human Resource Outsourcing Market 2014-2018, May 23, 2014, www.technavio.com [↩]
4. Health Care Reform Is The Big HR Compliance Challenge, www.adp.com [↩]
5. Roughly Half of Small Business Owners Understand, are Prepared for Changes Under the Affordable Care Act, April 24 2014, www.paychex.com [↩]