Business Context and Reporting Period
Paychex, Inc. provides integrated human capital management, payroll, HR, benefits, PEO, and insurance solutions primarily to small and medium-sized businesses in the United States, with additional European operations. The company reports one operating segment.
This unaudited Form 10-Q covers the three and six months ended November 30, 2020, Paychex’s fiscal 2021 second quarter and first half, compared with the corresponding 2019 periods.
Financial Highlights
| Metric | Three months ended Nov. 30, 2020 | Year-over-year change | Six months ended Nov. 30, 2020 | Year-over-year change |
|---|---|---|---|---|
| Total revenue | $983.7 million | (1%) | $1,915.9 million | (3%) |
| Service revenue | $968.9 million | Flat | $1,886.2 million | (3%) |
| Operating income | $354.3 million | 4% | $638.3 million | (8%) |
| Operating margin | 36.0% | Up from 34.5% | 33.3% | Down from 34.8% |
| Net income | $272.4 million | 5% | $484.0 million | (7%) |
| Diluted EPS | $0.75 | 4% | $1.34 | (8%) |
| Cash flow from operations | Not separately provided | — | $430.7 million | Down from $564.6 million |
Management Solutions revenue increased 1% to $732.8 million in the quarter but declined 2% to $1.42 billion for the six months. PEO and Insurance Solutions revenue decreased 3% to $236.1 million in the quarter and 5% to $466.0 million for the six months.
Interest on funds held for clients declined 25% to $14.8 million in the quarter and 27% to $29.7 million for the six months, reflecting lower average investment balances, lower interest rates, and lower realized gains. The combined average interest rate earned on client funds and corporate investments was 1.3%, compared with 2.0% in the prior-year six-month period.
Adjusted diluted EPS, a non-GAAP measure, was $0.73 for the quarter, up 4%, and $1.36 for the six months, down 4%. Six-month adjusted operating income was $670.5 million, down 3%, and adjusted EBITDA was $773.0 million, down 4%.
Balance Sheet, Debt, Liquidity, and Cash Flow
- Cash and cash equivalents were $693.5 million at November 30, 2020, compared with $905.2 million at May 31, 2020.
- Cash, restricted cash, and total corporate investments totaled $963.4 million. Funds held for clients were $3.393 billion, supported by client fund obligations of $3.285 billion.
- Total short- and long-term borrowings, net of debt issuance costs, were $803.9 million, including $797.0 million of long-term borrowings and $6.9 million of short-term borrowings.
- The company had approximately $1.7 billion available under committed credit facilities and was in compliance with its debt covenants.
- Six-month cash flow from operations was $430.7 million. Investing activities used $490.4 million, primarily reflecting net purchases of available-for-sale securities, while financing activities used $462.4 million.
- The company paid $446.7 million of dividends during the six months and repurchased $28.8 million of common stock. No shares were repurchased during the second quarter; $199.3 million remained available under the repurchase authorization.
- Capital expenditure purchase commitments were approximately $7.7 million. The company also had $147.9 million of standby letters of credit, with no amounts outstanding.
Material Changes Versus the Prior Comparable Period
- Second-quarter performance improved sequentially from the first quarter, with management reporting 6% sequential growth in total revenue and 27% sequential growth in diluted EPS.
- Compared with the prior-year quarter, revenue was broadly stable because Management Solutions growth offset declines in PEO and Insurance Solutions and client-fund interest income.
- Operating income and net income increased in the quarter despite lower revenue, primarily because of lower discretionary spending, reduced facilities costs, cost-saving initiatives, and lower amortization.
- Six-month results remained weaker year over year because of COVID-19-related declines in client activity, worksite employees, check volumes, PEO revenue, and investment yields.
- Accounts receivable and PEO unbilled receivables increased to $519.0 million and $448.0 million, respectively, from $384.1 million and $380.0 million at May 31, 2020.
- The company accelerated initiatives to reduce its geographic footprint and optimize headcount, recording $32.2 million of costs during the six months. These costs were characterized as nonrecurring.
Outlook, Commentary, Risks, and Unusual Items
Management stated that COVID-19 continued to affect results but that client retention remained strong, sales produced year-over-year growth in clients sold, and financial performance improved sequentially. The company continued investing in Paychex Flex technology, remote-work capabilities, compliance tools, and new PEO and HR products.
Management expects cash, restricted cash, corporate investments, projected operating cash flow, and available financing to support operations, capital purchases, share repurchases, and dividends for the foreseeable future. The filing does not provide a clear quantitative fiscal 2021 revenue or EPS guidance range.
- Key risks include the continuing COVID-19 impact on small and medium-sized business clients, changes in government regulation, cybersecurity and data privacy incidents, technology or systems failures, third-party service-provider disruptions, PEO co-employment risks, insurance claims trends, client payment failures, litigation, acquisitions, and debt-covenant compliance.
- Lower interest rates pose a material earnings risk: management estimated that a 25-basis-point change in short-term interest rates would affect annual after-tax earnings by approximately $3.0 million to $3.5 million.
- A hypothetical 25-basis-point increase in longer-term rates would reduce the fair value of the available-for-sale securities portfolio by approximately $25.0 million, with the change recorded in equity unless an impairment were recognized.
- The investment portfolio had $108.9 million of net unrealized gains at November 30, 2020. Securities with fair values below amortized cost had gross unrealized losses of only $0.5 million, and management concluded that no credit-loss allowance was required.
- Workers’ compensation and health insurance reserves depend on actuarial estimates and could change materially with adverse claims, legal, or economic trends. Management believed outstanding legal matters were not expected to have a material adverse effect, while noting the inherent uncertainty of litigation.
- During the quarter, the company ceased using certain leased property and recorded a $24.4 million reduction of operating lease right-of-use assets during the first quarter; related accelerated amortization in the second quarter was immaterial.
Important Facts for Investors to Verify
- Whether COVID-19-related declines in worksite employees, check volumes, PEO revenue, and client-fund yields persist or reverse.
- The sustainability of margin improvement from cost controls and whether cost-saving benefits offset compensation, insurance, and technology investment costs.
- The effect of prolonged low interest rates on interest income from client funds and corporate investments.
- Changes in accounts receivable, PEO receivables, client fund obligations, and related credit-loss reserves.
- Future cash returns, including dividends and share repurchases, relative to operating cash flow and debt levels.
- Developments in workers’ compensation and health insurance claims, cybersecurity, regulatory compliance, litigation, and other contingencies.
- The filing’s non-GAAP adjusted results and reconciliation to GAAP results, particularly the treatment of cost-saving initiative charges and employee stock-based compensation tax benefits.