Paychex Prepares For Hiring Mode

Payroll and human resource service specialist Paychex (Nasdaq: PAYX) continues to struggle as the U.S. economy remains focused on handing out pink slips. At some point, conditions will improve sufficiently and return to job creation, but in the meantime the company remains handsomely profitable. A combination of a lower stock price, higher interest rates and improved sales and earnings prospects would be nice for shareholders moving forward.

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Recent Results
Second quarter revenues fell 5% to $162.6 million on a 7% drop in flagship payroll service revenue (70.6% of total revenue) and a respectable 3% increase in human resource (HR) service revenues (26.6% of total). The rest of the decline stemmed from a precipitous 31% drop in interest earned from holding client payroll funds before they are disbursed to employees. This category represented a miniscule 2.7% of total revenue but is highly lucrative for Paychex, especially when short-term interest rates are high, which is not the case right now. Larger Rival Reports Similar Trends
Rival ADP (NYSE: ADP) reported similar trends during its most recent Q1 as total revenues fell 4% to $2.1 billion. ADP was also able to boost its bottom line by 4% on cost controls and share buybacks. ADP doesn't break out its employer services revenue but focuses on payroll services and also provides HR services to compete with Paychex and even IBM (NYSE: IBM) and Marsh & McLennan (NYSE: MMC) in this space, along with purer-play rival Hewitt Associates (NYSE: HEW).

Operating expenses fell in sympathy with total revenue, declining 5% to represent 32.6% of the total quarterly top line. However, SG&A expenses only fell 1%, which meant total expenses fell only 3% and pushed operating income down 9% to $193.1 million, or 38.9% of revenues. A higher share count and lower investment income served to send diluted earnings down 10% to 35 cents per share, which was still ahead of analyst expectations.

Outlook
Paychex's Q2 results indicate where it currently projects the full year to end up. It expects a mid-single-digit decline in payroll service revenues, mid-single-digit growth in HR services and a mid-single-digit decline in total revenues, as interest rates should remain low and continue to cut into interest income. As a result, net income will decline 10% to 12%. Analysts expect full-year earnings of $1.32 per share, which would represent a 10.8% decline from last year's $1.48 per share.

Bottom Line
Despite the difficult near-term trends due to extremely low interest rates and dreary employment levels, Paychex remains fantastically profitable, as evidenced by its net income margin of 25.3% during the quarter. It also ended the quarter with no long-term debt and $287.3 million in cash on the balance sheet. Finally, year-to-date free cash flow fell 11.4% but was still substantial at $256 million as management ramped down capex. The only true knock against the company is its stock valuation, which is currently too high at a forward P/E ratio of 23, implying that operations will have to improve substantially to support the current share price. (Calculate your company's share price to its per share earnings; read P/E Ratio: What Is It?)

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