Paychex Inc. ( PAYX ) reported second-quarter fiscal 2012 earnings of 39 cents per share, beating the Zacks Consensus Estimate by a penny. The quarter's results indicate slow recovery in the small and medium business ( SMB ) sector. Paychex is highly dependent on the performance of the SMB sector. The sector is being hit hard by lackluster demand due to high unemployment and inflation rates. Shares decreased 1.62% in after-market trade.

Revenues

Paychex reported second-quarter 2012 revenues of $545.7 million, up 6.6% from $512.0 million reported in the year-ago quarter. The upside can be attributed to year-over-year growth in both checks processed per client and the HR services client base.

Payroll Service segment revenue increased 4.8% from the year-ago quarter to $371.7 million, attributable to the contribution from SurePayroll Inc., acquired in February. Excluding the SurePayroll contribution, Payroll revenue would have grown only 3.0%.

Continued increase in checks processed per client as well as revenue per checks also aided the growth. But the growth was not at par with the historical trend. Moreover, the increase in new unit sales was sluggish, due to the limited number of new companies commencing business during the quarter.

The Human Resource Services segment generated $163.3 million in revenues, up 12.5% from the prior-year quarter. The improvement was partly based on the contribution from ePlan Services, which was acquired in May. Excluding ePlan, Human Resource Services' revenue growth would have been 10.0%.

The number of client employees served and the number of clients grew during the quarter, contributing to the improvement. Moreover, demand for a new product, HR Essentials, also added to the segment's revenue growth.

Operating Results

In the second quarter, Paychex incurred total operating expense of $327.8 million, up 6.4% from the year-ago quarter. The rise was mainly due to acquisition-related costs as well as the company's continued efforts to train sales personnel, provide better customer service and enhance technological infrastructure.

Operating income was $217.9 million, up 6.9% from the year-ago period, attributable to modest revenue growth and better cost management. Operating margin grew 640 basis points year over year to 41.7%.

Net income of $140.4 million in the reported quarter reflected a 4.9% increase from $133.9 million in the prior-year quarter. Net income per diluted share was 39 cents compared with 37 cents in the year-ago quarter. There was no one-time item during the quarter.

Balance Sheet & Cash Flow

Paychex exited the second quarter with cash and cash equivalents of $96.1 million, down from $113.1 million at the end of the prior quarter. Corporate investments decreased $57.0 million sequentially to $315.0 million.

Additionally, interest on funds held for clients decreased 10.8% year over year to $10.7 million as a result of lower average interest rates earned, partially offset by an increase in average investment balances. Paychex has no long-term debt.

Cash from operations was $110.0 million compared to $187.2 million in the prior quarter. Capital expenditures were $23.9 million compared to $20.2 million in the prior quarter.

Guidance

Keeping in view the current market and economic conditions, Paychex believes that checks per client will moderate through fiscal 2012, impacting quarterly comparisons for both Payroll Service and Human Resource Services revenues.

Moreover, the favorability in expenses realized in the second quarter may not be realized throughout fiscal 2012 due to the planned investments in its business. Hence, Paychex reaffirmed its full-year guidance.

For fiscal 2012, Paychex expects a 5-7% increase in Payroll Service revenues compared to the year-ago quarter. Human Resource Services revenues are expected to increase in the range of 12.0% to 15.0%.

Total service revenue is likely to grow in the range of 7% to 9%. The company expects a 12-14% decline in interest on funds held for clients and a roughly 2% increase in net investment income.

Interest on funds held for clients and investment income for fiscal 2012 are expected to be impacted by the low interest rate environment. However, investment of cash generated from operations is expected to continue, increasing investment income.

Net operating income is expected in the range of 35-36% of total service revenue. The effective tax rate is expected to be in line with the second quarter and net margin is projected at between 5% and 7%.

The guidance for fiscal 2012 includes anticipated results from Paychex' recent acquisition of SurePayroll Inc. and its ePlan Services. The acquisitions are expected to have an approximately 2% positive impact on revenue, nonetheless resulting in earnings dilution of around 1 cent per share due to amortization on acquired intangible assets and some one-time acquisition costs.

Our Take

Paychex' second quarter results were modest, with the bottom line exceeding the Zacks Consensus Estimate by mere a penny. We are also positive on management's positive commentary regarding continued investments in product development and synergies from the recent acquisition. We also believe that cost control will remain a catalyst for Paychex, going forward.

Though new business wins in the SMB sector and stiff competition from Automated Data Processing Inc. ( ADP ) and Administaff Inc. will remain a constant worry, we believe that Paychex can benefit from the improvement in the U.S. employment situation and zero European exposure.

Paychex has a Zacks # 2 Rank, implying a short-term Buy recommendation.