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Shares of Paychex Inc. (PAYX - Snapshot Report) increased 3.39% in after-hours trade after the company reported third-quarter 2014 earnings of 44 cents per share beating the Zacks Consensus Estimate by a couple of cents. On a year-over-year basis, reported earnings per share increased 10.4%.

Quarter Details

Paychex reported total revenue (including Interest on funds held for clients) of $636.5 million for the quarter which not only increased 7.3% from the year-ago period but also came ahead of the Zacks Consensus Estimate of $627.0 million.

Excluding Interest on funds held for clients, which was down 3.7% on a year-over-year basis, total services revenues (Payroll service and Human Resource Services) increased 7.5% from the year-ago quarter to $626.0 million. Interest on funds held for clients was down due to lower average interest rates earned and lower net realized gains, which more than offset the increase in average investment balances.

Payroll Service segment revenues increased 5.1% from the year-ago period to $413.9 million primarily driven by higher checks per payroll and revenue per check. Checks per payroll increased 1.0% from the year-ago quarter. The company witnessed modest growth in revenue per check on the back of price increases and higher adoption of Paychex’s products.

Buoyed by growth in client base in the retirement services, HR Solutions and eServices products, Paychex’s Human Resource Services segment generated revenues of $212.1 million, which increased 12.4% from the year-ago quarter.

Paychex’s total expenses increased 4.8% from the year-ago quarter to $385.8 million, primarily due to compensation-related expenses. Moreover, higher expenses related to investment in product development and supporting technology and higher sales-related costs were responsible for the rise in expenses. Nonetheless, total expenses as a percentage of total revenue decreased 147 basis points (bps) on a year-over-year basis due to higher revenue base.

Paychex reported operating income of $250.7 million, up 11.4% from the year-ago period, attributable to modest revenue growth supported by better cost management and capacity utilization. Operating margin was 39.4% versus 37.9% in the year-ago quarter.

Excluding Interest on funds held for clients, Paychex’s operating income came in at $240.2 million or 38.4% of total services revenue which increased from $214.1 million or 36.8% of total services revenue.  

Net income for Paychex increased 10.8% from the year-ago quarter to $160.1 million or 44 cents per share while net margins expanded 77 bps on a year-over-year basis.

Balance Sheet & Cash Flow

Paychex exited the quarter with cash and cash equivalents of $271.3 million versus $213.0 million at the end of the previous quarter. Corporate investments were $314.4 million compared with $250.4 million in the previous quarter. Paychex has no long-term debt.

During the third quarter, Paychex repurchased 1.1 million shares for approximately $43.9 million. Year-to-date, the company generated operating cash flow of $705.8 million.

Guidance

Paychex reiterated its outlook for fiscal 2014. Management expects 3–4% increase in Payroll Service revenues from the year-ago period. Human Resource Services revenues are expected to increase in the range of 10.0% to 11.0%.

Total service revenue is expected to increase in the range of 5–6%. Interest on funds held for clients and investment income for fiscal 2014 are expected to be affected by low interest rate. However, investment of cash generated from operations is expected to persist, thus increasing investment income.

Net operating income as a percentage of service revenues is expected to be 38.0% for fiscal 2014. The effective income tax rate for fiscal 2014 is expected in the range of 36–37%. Management expects net income to increase in the range of 9% to 10% (previous guidance was 8% to 9%).

Our Take

Paychex reported better-than-expected third-quarter results primarily boosted by modest revenue growth and margin expansion. Moreover, Paychex’s reiteration of its fiscal 2014 outlook signifies that it is relatively well-paced amid the current macroeconomic sluggishness.

Moreover, we remain encouraged by management’s positive commentary regarding continued investments in product development and focus on building its sales force to support revenue growth. We also believe the company’s expansionary initiatives through joint ventures and acquisitions should bode well for its long-term growth strategy.

Product launches are also expected to provide additional support. Moreover, Paychex’s focus on small and mid-sized businesses looking for HR solutions could provide the company with opportunities.

However, unfavorable interest rates and competition from Automatic Data Processing (ADP - Analyst Report) and Insperity (NSP - Snapshot Report) remain the possible headwinds for the company.

Currently, Paychex has a Zacks Rank #2 (Buy). Investors can also consider Lexmark International (LXK - Analyst Report), which carries a Zacks Rank #1 (Strong Buy).

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