Paychex (PAYX)

Q3 2011 Earnings Call

March 24, 2011 10:30 am ET

Executives

John Morphy - Chief Financial Officer, Principal Accounting Officer, Senior Vice President, Secretary and Member of Executive Committee

Martin Mucci - Chief Executive Officer, President, Director and Member of Executive Committee

Analysts

Adam Frisch - Morgan Stanley

Joseph Foresi - Janney Montgomery Scott LLC

Julio Quinteros - Goldman Sachs Group Inc.

David Parker - Lazard Capital Markets LLC

Tien-Tsin Huang - JP Morgan Chase & Co

Giridhar Krishnan - Crédit Suisse AG

Rod Bourgeois - Sanford C. Bernstein & Co., Inc.

Vishnu Lekraj

Grant Keeney

Ashwin Shirvaikar - Citigroup Inc

James Macdonald - First Analysis Securities Corporation

Mark Marcon - Robert W. Baird & Co. Incorporated

Gary Bisbee - Barclays Capital

James Kissane - BofA Merrill Lynch

David Grossman - Stifel, Nicolaus & Co., Inc.

Glenn Greene - Oppenheimer & Co. Inc.

Presentation

Operator

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Welcome, and thank you for standing by. [Operator Instructions] Now I will turn the meeting over to Mr. John Morphy, Senior Vice President and Chief Financial Officer.

John Morphy

Thank you for joining us today for our third quarter earnings release. Also with us is Marty Mucci, our President and CEO. During the call, we will review our third quarter 2011 financial results and guidance for full year fiscal 2011. Marty will then provide an overview, and we will conclude with a Q&A session.

Yesterday afternoon after the market closed, we released our financial results for the third quarter ended February 28, 2011. We have also filed our Form 10-Q with the SEC, which provides additional discussion and analysis of results for the quarter. These are available by accessing our Investor Relations page at www.paychex.com. In addition, this teleconference is being broadcast over the Internet and will be archived and available on our website for approximately one month.

The favorable results we experienced in the first half of this fiscal year have continued in the third quarter. Some of the key indicators are as follows:

Checks per client, the number of checks issued during the period divided by our average client base, represents our most meaningful barometer of how the economy is doing. Our checks per client reflected increase of 2.8% for the third quarter and 2.1% for the nine months compared to the same periods last year. This compares to declines of 2.2% and 3.6% for the same period in the prior year. If you recall over the fourth quarter of last year when we experienced our first increase, 1.1% since February of 2007.

On the bonus season, it was a good year-end, as double-digit growth was seen in both bonus, checks and dollars. That compares to a year ago when checks were basically flat.

As of February 28, 2011, excluding SurePayroll, our client base declined 1.6% compared to February 28, 2010. This compares to a decrease of 3.6% for the comparable period a year ago. This is our first meaningful quarter-over-quarter improvement since the start of the recession, and we anticipate continued improvement in the fourth quarter.

The improvement relates primarily to better retention as weak new business starts continue to negatively affect selling new clients. Sales of new units for the third quarter were close to the prior year.

On February 8, 2011, we completed the acquisition of SurePayroll, Inc., a leading provider of software-as a-service payroll processing for small businesses. The purchase price was approximately $115 million in cash. SurePayroll serves approximately 30,000 small businesses, and revenue for SurePayroll for the 2010 calendar year was approximately $23 million. Our financial results for the quarter include SurePayroll from the date of acquisition. We do not anticipate that SurePayroll will have a material impact on our financial results for the fiscal year.

In summary, our third quarter was a good quarter, consistent with the first half of the year and consistent with our expectations for achieving fiscal 2011 results. Looking forward to the remaining quarter of fiscal 2011, we expected to trend lower, which is consistent with what we have experienced in recent years. Some comments on the fourth quarter, which were considered when we developed our financial guidance last spring, are as follows:

Human Resource Services revenue growth is expected to be lower in the fourth quarter than what we have experienced in the first nine months. PEO [professional employer organization] net service revenue is not as predictive as other revenue streams and tends to vary quarter-to-quarter, with the fluctuations in adding and retaining client employees served and in workers' compensation revenue. We expect fiscal 2011 PEO revenues will be stronger for the first nine months compared to the last three months due to timing of some of these fluctuations. We'll review our guidance for the full year in a few moments.

Operating income, net of certain items, is expected to grow at a lower rate in the fourth quarter, bringing the full-year growth rate down slightly from what we have experienced for the first nine months. It is normal for our operating margins to be lower in the second half of the year due to the timing of price increases, timing of additions to our sales force, year-end payroll revenue and expense in our third fiscal quarter and higher levels of selling expense in the second half of the fiscal year. Sequential earnings per share is not as applicable to our business as it may be for others. While we do not experience significant seasonality, our quarters tend to match up better with the prior quarter versus the sequential quarter.

We now move on to talking about the third quarter and the nine months ended February 28, 2011. Payroll service revenue increased 2% for both the third quarter and the nine months to $366 million and $1.1 billion. The primary reason for the payroll service revenue growth is the aforementioned increase in checks per client. Offsetting some of these positive factors was our lower client base compared to a year ago, with the decrease primarily occurring in the last quarter of fiscal 2010. As I mentioned earlier, the client base is down 1.6% from a year ago, compared to an overall decline of 3.6% last year at this time. The payroll client base as of February 28, 2011, excludes SurePayroll clients.

Human Resource Services revenue increased 13% for the third quarter and 11% for the nine months to $153 million and $444 million. HRS revenue growth reflects modest improvements in economic conditions, client growth and our annual price increase. Some additional highlights of contributions to HRS revenue growth were:

Paychex HR Solutions client employees served increased 14% to 536,000 employees as of February 28, 2011. We have seen positive results from increases in both clients and client employees. Contributing to this growth, in the clients and client employees, is our new product offering, Paychex HR Essentials. HR Essentials is an ASO [administrative services organization] product that provides support to our clients over the phone or online, to help manage employee related topics. HRS revenue was also positively impacted by growth in certain products that primarily support MMS clients.

Health and benefit services revenue increased 27% to $10 million for the third quarter and 32% to $30 million for the nine months of fiscal 2011, driven primarily by a 26% increase in the number of applicants as of February 28, 2011, compared to a year ago. Fluctuations in PEO workers' compensation positively impacted PEO net service revenue in the quarter, as we mentioned, our workers' compensation costs frequently fluctuate from quarter-to-quarter.

Combined interest on funds held for clients and investment income decreased 13% for the third quarter and 10% year-to-date. Yields available on high-quality securities continue to remain low. Expenses decreased 2% for the quarter and were flat for the nine months. However, during the prior year of third quarter, we recognized an expense charge of approximately $19 million to increase our litigation reserve. Excluding this expense charge, expenses would have increased 4% for the quarter and 2% for the nine months, due to costs related to continued investment in our sales force, customer service and technological infrastructure. Improvements in operation productivity with related lower headcount have somewhat offset these increases.

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