Paychex, Inc. Form 10-Q Summary
Reporting period: Three and nine months ended February 28, 2017, compared with February 29, 2016. Although the request identifies “2016 Q3,” the filing is Paychex’s fiscal 2017 third-quarter report, filed March 31, 2017.
Business context
Paychex provides payroll, human resources, retirement, insurance, and related human capital management services primarily to small and medium-sized U.S. businesses, with immaterial operations in Germany. The company reports one operating segment. Its offerings include payroll processing, HR outsourcing, professional employer organization services, retirement administration, insurance, and temporary-staffing-industry funding through Paychex Advance.
Financial performance and key metrics
| Metric | Three months ended Feb. 28, 2017 | Year-over-year change | Nine months ended Feb. 28, 2017 | Year-over-year change |
|---|---|---|---|---|
| Total revenue | $795.8 million | 6% | $2,352.7 million | 7% |
| Service revenue | $782.6 million | 6% | $2,316.1 million | 7% |
| Payroll service revenue | $446.6 million | 2% | $1,338.4 million | 3% |
| Human Resource Services revenue | $336.0 million | 12% | $977.7 million | 13% |
| Interest on funds held for clients | $13.2 million | 11% | $36.6 million | 8% |
| Operating income | $306.6 million | 10% | $940.7 million | 8% |
| Operating margin | 38.5% | Up from 37.2% | 40.0% | Up from 39.6% |
| Net income | $202.5 million | 12% | $622.0 million | 7% |
| Diluted earnings per share | $0.56 | 12% | $1.71 | 7% |
| Net cash from operations | Not separately provided | — | $769.3 million | Down from $791.2 million |
Margins and expenses: Total expenses increased 4% in the quarter and 6% year to date, slower than revenue growth. Compensation-related expenses rose 2% in the quarter and 5% year to date; PEO insurance costs increased 15% and 17%, respectively. The effective tax rate was 34.2% for the quarter and 34.1% year to date.
Adjusted results: Adjusted net income, excluding discrete tax items, was $199.3 million for the quarter, up 10%, and $604.7 million year to date, up 8%. Adjusted diluted EPS was $0.55 for the quarter and $1.66 year to date. These are non-GAAP measures.
Liquidity, investments, debt, and capital allocation
- Cash and cash equivalents were $189.9 million at February 28, 2017, compared with $131.5 million at May 31, 2016.
- Cash and total corporate investments totaled $844.1 million. Funds held for clients were $4.785 billion, compared with $3.998 billion at May 31, 2016.
- Short-term borrowings were $55.4 million, versus none at May 31, 2016. The borrowing was under Paychex Advance’s $150 million committed facility, which expires in March 2019.
- The company had no borrowings outstanding under its $1.0 billion syndicated facility at February 28, 2017 and had $900 million of unused capacity under four uncommitted secured lines of credit.
- Operating cash flow was $769.3 million for the first nine months. Investing cash flow used $947.1 million, primarily reflecting investment activity, capital expenditures of $66.8 million, and no business acquisitions. Financing cash flow provided $236.2 million, primarily from the increase in client fund obligations.
- Dividends paid were $496.9 million year to date. The quarterly dividend was increased 10% to $0.46 per share from $0.42.
- The company repurchased 2.9 million shares for $166.2 million year to date. No shares were repurchased during the quarter. Approximately $243.5 million remained available under the July 2016 repurchase authorization at quarter-end.
- Available-for-sale securities had a fair value of $4.460 billion and a net unrealized gain of $8.9 million at February 28, 2017, compared with a $47.6 million net unrealized gain at May 31, 2016.
Material changes versus the prior comparable periods
- HRS revenue continued to outpace payroll revenue, increasing 12% in the quarter and 13% year to date, driven by client growth across HR outsourcing, retirement, time and attendance, and HR administration services.
- Payroll revenue growth was 2% in the quarter and 3% year to date. Quarterly growth was tempered by one fewer processing day; pricing and client-base growth supported revenue per check.
- Interest revenue benefited from modestly higher investment yields as interest rates began to rise. The combined investment portfolio earned 1.2% in the quarter versus 1.0% in the prior-year quarter.
- Operating margin improved to 38.5% from 37.2% in the quarter and to 40.0% from 39.6% year to date.
- Operating cash flow declined despite higher net income, primarily because of unfavorable changes in operating assets and liabilities, including accounts receivable and prepaid assets.
- Investment cash outflows increased substantially because of portfolio management and greater use of variable-rate demand notes; the prior-year period also included $296.1 million for the Advance Partners acquisition, while the current period had no business acquisition spending.
- The company adopted new stock-compensation accounting guidance prospectively. Excess tax benefits of $17.3 million were recognized in income taxes for the first nine months and increased diluted EPS by approximately $0.05.
Guidance, outlook, risks, and unusual items
For fiscal 2017, management expects payroll service revenue growth of 3% to 4%, HRS revenue growth of 12% to 14%, total service revenue growth of 7% to 8%, and upper-single-digit growth in interest on funds held for clients. GAAP net income is expected to increase approximately 7%, adjusted net income approximately 8%, and the effective tax rate is expected to be approximately 35%.
Management expects available cash, corporate investments, operating cash flow, and financing capacity to fund normal operations, capital expenditures, dividends, share repurchases, and potential acquisitions for the foreseeable future.
- Results are sensitive to short- and long-term interest rates, investment fair values, portfolio credit quality, and the timing of client fund collections and remittances. Management estimates that a 25-basis-point change in short-term rates could affect after-tax earnings by approximately $3 million to $4 million over twelve months.
- The company estimates that a 25-basis-point increase in longer-term rates could reduce the fair value of its available-for-sale portfolio by approximately $20 million to $25 million, with the change recorded in equity unless impairment is recognized.
- Material risks include economic and employment conditions, competition, regulatory changes affecting payroll and employee benefits, cyberattacks and data breaches, technology or systems failures, third-party service-provider failures, insurance claims trends, and legal matters.
- PEO workers’ compensation and health-insurance reserves involve actuarial estimates and could require significant future adjustments. Management believes current reserves are adequate.
- Standby letters of credit totaling $46.8 million supported certain insurance commitments. Capital-asset purchase commitments were approximately $6.7 million.
- Management believes outstanding legal matters will not materially affect financial position or results, while acknowledging that litigation outcomes are inherently uncertain.
- The company expects to adopt the new revenue standard in fiscal 2019, currently anticipating that certain contract acquisition and fulfillment costs will be deferred and amortized over the estimated client life.
Most important facts for an investor to verify
- Confirm the applicable period: this is fiscal 2017 third quarter, not fiscal 2016 third quarter.
- Assess whether HRS growth can remain strong while payroll revenue growth remains comparatively modest.
- Evaluate the sustainability of the 38.5% quarterly operating margin amid investments in technology, personnel, and PEO expansion.
- Monitor interest-rate movements, unrealized investment gains and losses, and the duration and credit quality of the client-fund portfolio.
- Reconcile GAAP earnings with adjusted earnings and understand the effect of recurring stock-compensation tax benefits.
- Track cash generation after dividends and share repurchases, including the new $55.4 million borrowing balance.
- Review PEO insurance reserves, purchased temporary-staffing receivables, cyber and operational risks, and pending legal contingencies.
- Verify the company’s fiscal 2017 guidance against subsequent results and any changes in interest-rate, employment, or regulatory conditions.