Human resources solutions and payroll provider Paychex, Inc. (NASDAQ:PAYX) released fiscal fourth-quarter 2018 earnings on Wednesday before the markets opened. The company's report revealed that it made headway on both revenue and earnings over the last three months; we'll dive into the details after a review of headline numbers directly below.

Paychex: The raw numbers

Metric Q4 2018 Q4 2017 Year-Over-Year Growth
Revenue $871.1 million $798.6 million 9.1%
Net income $228.5 million $195.3 million 17%
Diluted earnings per share $0.63 $0.54 17%

Data source: Paychex, Inc.  

What happened with Paychex this quarter?

  • The company's 9% top-line advance was paced by human resources revenue, which expanded 17% to $401.0 million during the fourth quarter.

  • Payroll service revenue grew at a much more moderate clip, improving 3% to $452.4 million.

  • Interest on funds held for clients of $17.7 million represented a 27% leap over the prior-year quarter. This was due to an average earned interest rate of 1.7% versus 1.3% last year, applied to funds held for clients of $4.2 billion. The interest Paychex earned is the equivalent of nearly 8% of total net income for the quarter.

  • Paychex's total revenue growth was supported by two recent acquisitions. HR Outsourcing Holdings (HROI) is a professional employer organization (PEO) serving small and medium-sized businesses, which Paychex acquired in August 2017. HROI contributed eight percentage points of the 17% growth in Paychex's human resources business during the quarter.

  • Paychex acquired Danish human resource and payroll software provider Lessor Group in March of this year. Management intends to extend its footprint in Europe via Lessor Group over the next 18 to 24 months. During the quarter, revenue from Lessor contributed one percentage point of the 3% growth in payroll services.

  • Paychex achieved operating income of $320.3 million during the last three months, versus $300.5 million in the comparable prior-year quarter. However, operating margin slipped roughly one percentage point, to 36.7%. According to management, the sales growth contribution from acquisitions was partly offset by higher expenses related to the acquired companies, an increase in PEO direct pass-through costs, and higher headcount as the company invested more in its sales and product development teams.

  • In April, Paychex announced a 12% increase in its quarterly dividend to $0.56 per share, which, at the current share price, returns a handsome annualized dividend yield of 3.2%. The company attributed its dividend increase to additional cash flow realized as a result of last year's U.S. corporate tax legislation. Management also noted that Paychex now pays out roughly 80% of net income to shareholders.

  • The company repurchased $143.1 million of its shares during the quarter, primarily to offset dilution from stock compensation expense. 

Hand placing toy wooden blocks with stamped human figures in pyramid.

Image source: Getty Images.

What management had to say

While acquired revenue delivered a meaningful boost to Paychex's top line, the company has also demonstrated a knack for organic growth through product innovation in recent years. During management's earnings conference call, CEO Martin Mucci discussed a new product for small and medium-sized businesses introduced this quarter, which is illustrative of the company's current strategy regarding payroll clients:

[W]e introduced Paychex Promise, which was a first-of-its-kind offering in the payroll and HR industry. Paychex Promise is a subscription-based service that delivers peace of mind to business owners through protection against payroll interruptions, and solutions to address the routine challenges of running a successful business. The primary offering is payroll protection, which extends the collection period of payroll funds from a business' bank account by 7 days without interruption of service. This will allow business owners to pay their employees and remit taxes on time regardless of cash flow timing issues.

This is particularly helpful for small businesses that many times have cash flow timing challenges. The service also provides access to other tools to help businesses build their credit files, stay on top of regulatory changes, and resolve fraudulent events. We are pleased with the positive reaction to this service received so far in the market, with over 1,000 clients joining us so far.

This fee-based service is intriguing as it enables Paychex to further utilize its vast store of client funds and essentially enter the short-term lending business with its legions of smaller business clients. Perhaps more importantly, a service that can assist small business owners with the crucial task of making timely payroll payments, regardless of cash-flow timing issues, should prove a powerful retention tool for Paychex, which currently retains payroll clients at an annual rate of 81%. Each percentage point of improvement in retention equates to significant earnings and revenue potential.

Looking forward

Alongside earnings, Paychex provided its outlook for the new fiscal 2019 year. The organization expects revenue growth of 6% to 7% inclusive of interest earned on held client funds. Operating margin is projected to hover around the current level of 37%, and adjusted diluted earnings per share (EPS) is expected to increase 11%. Given fiscal 2018's adjusted diluted EPS reading of $2.56, Paychex is thus aiming for roughly $2.84 in earnings in the current 12-month period.

Asit Sharma has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.