ASF Administaff, Inc.

Paychex Inc. (PAYX) is scheduled to announce its fourth quarter fiscal 2011 results on June 23, and we do not see any major variation in analyst estimates at this point.

Third Quarter Overview

Paychex delivered modest third quarter 2011 results, with earnings of 36 cents per share beating the Zacks Consensus Estimate by a penny. The quarter’s results indicated an improving client retention rate and higher checks per client.

Paychex’s third quarter revenues increased 4.6% year over year, backed by increases of 9.8% in Human Resources Services revenue and 2.3% in the Payroll Service revenue.

Paychex generated operating income of $198.9 million, up 18.3% from the year-ago quarter and net income of $130.6 million, up 16.6% year over year. The company exited the quarter with cash and cash equivalents of $236.0 million.

Paychex witnessed a modest improvement in the quarter’s results despite an increasing headcount and price per employee. However, following historical trends Paychex guided to a lackluster fourth quarter.

Guidance

Paychex expects a weak fourth quarter, given lower contribution from HR Service revenue, which happens to be less predictive and depends much on employee retention or addition and unmatched workers’ compensation.

For fiscal 2011, Paychex continues to expect a 1–2% increase in Payroll Service revenues from the year-ago quarter. Human Resource Services revenues are expected to increase in the range of 10.0% to 11.0% (previously 10.0% to 13.0%).

Total service revenue is likely to grow in the range of 3% to 5% (reiterated). The company also reiterated projections of a 12–17% decline in interest on funds held for clients and a 29–32% increase in net investment income.

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 cash generated from operations.

Net operating income is expected to be 36% of total service revenue. The effective tax rate is expected to be roughly 35% and net margin is projected at between 4% and 6%.

The guidance for fiscal 2011 includes anticipated results from Paychex’ recent acquisition of SurePayroll Inc. Revenue is expected to have an impact of less than 1% and earnings dilution is likely to be less than 1 cent per share attributable to amortization on acquired intangible assets and one-time acquisition costs.

Agreement of Analysts

Out of the 19 analysts providing estimates for the fourth quarter, none made any revision in their estimates in the last thirty days. However, out of the 22 analysts providing estimates for fiscal year 2011, one reduced the estimate in the same time period.

The nominal change 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 their estimates projected post third quarter earnings.

But some analysts prefer to remain cautious based on management’s commentary of not seeing a significant sign of improvement in new small-business formation. Moreover, a few analysts think that aggressive pricing from Automated Data Processing Inc. (ADP) is taking away more customers from Paychex.

In the short span between the time when Paychex receives payroll from its clients and pays it out to employees, the company earns an interest. Now with the government contemplating to keep interest rates low despite an economic revival, this quick income stream of the company will also be restricted.

Magnitude of Estimate Revisions

There was no change to analyst estimates for the fourth quarter or fiscal 2011 over the past 30 days. However, the Zacks Consensus Estimate for fiscal 2011 went up to $1.42 from $1.41 in the past ninety days.

Recommendation

A recent survey conducted by Paychex indicates that roughly 50% of small business owners expect to see momentum in their businesses in fiscal 2011, although some of them expressed concerns 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 expect the SurePayroll acquisition to provide Paychex with additional small business market share and revenue growth.

However, we would prefer to remain cautious based on management’s expectation for a lackluster fourth quarter.

On the other hand, we are slightly concerned about the growing competition in the outsourcing space from big players such as Automated Data Processing Inc. and Administaff Inc. (ASF), as well as limited margin expansion due to continuous investments in diverse fields.

Paychex has a Zacks # 4 Rank, implying a short-term Sell recommendation.

 
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