PAYCHEX INC annual report, FY2016

Paychex, Inc. Form 10-K Summary

Reporting period: Fiscal year ended May 31, 2016. The request metadata references “2015 Q4,” but the supplied filing is Paychex’s fiscal 2016 annual report, filed July 22, 2016.

Business Context

Paychex provides integrated human capital management services, including payroll processing, payroll tax administration, human resources, retirement, insurance, professional employer organization services, and related accounting and payment solutions. The company reports as one business segment and primarily serves small- to medium-sized U.S. businesses.

Approximately 605,000 payroll clients at May 31, 2016, up approximately 2% year over year.
Approximately 13,500 employees.
Client retention exceeded 82%, consistent with the prior year’s record level.
Paychex HR Services served approximately 35,000 clients and 944,000 client worksite employees.

Financial Performance and Key Metrics

Metric	Fiscal 2016	Fiscal 2015	Change
Total revenue	$2,951.9 million	$2,739.6 million	8%
Service revenue	$2,905.8 million	$2,697.5 million	8%
Payroll service revenue	$1,729.9 million	$1,656.8 million	4%
HRS revenue	$1,175.9 million	$1,040.7 million	13%
Interest on funds held for clients	$46.1 million	$42.1 million	9%
Operating income	$1,146.6 million	$1,053.6 million	9%
Net income	$756.8 million	$674.9 million	12%
Diluted EPS	$2.09	$1.85	13%
Operating cash flow	$1,018.2 million	$895.2 million	14%

Operating margin was approximately 38.8% of total revenue; operating income, excluding interest on funds held for clients, was approximately 38% of service revenue.
Net margin was approximately 25.6% of total revenue.
The effective tax rate was 34.3%, compared with 36.3% in fiscal 2015. Excluding a discrete tax benefit, the fiscal 2016 effective rate would have been approximately 35.8%.
Cash dividends paid were $606.5 million, or 80% of net income. Dividends declared per share increased to $1.68 from $1.52.
Capital expenditures were $97.7 million, compared with $102.8 million in fiscal 2015.

Financial Position, Liquidity, and Debt

Cash and total corporate investments were $793.2 million at May 31, 2016, compared with $936.4 million at May 31, 2015.
The company reported no debt outstanding and total stockholders’ equity of $1,911.7 million.
Operating cash flow exceeded $1.0 billion for the first time.
Available committed and uncommitted credit capacity totaled up to $1.85 billion, excluding other facilities, with no amounts outstanding at May 31, 2016.
After year-end, Paychex Advance borrowed approximately $56 million under its $150 million credit facility; that borrowing remained outstanding as of the report date.
Standby letters of credit totaled $43.0 million, primarily securing insurance obligations.
Operating leases and purchase obligations totaled approximately $216.4 million, including $109.3 million due within one year.

Material Changes Versus the Prior Comparable Period

HRS revenue growth of 13% outpaced payroll service revenue growth of 4%, increasing the contribution from ancillary HCM services.
Operating expenses increased 7%, slower than revenue growth, supporting higher operating income.
Net income growth included an approximately $0.05-per-share benefit from a tax deduction relating to qualifying customer-facing software produced in prior years. Excluding this item, net income increased approximately 9% and diluted EPS approximately 10%.
Paychex acquired substantially all net assets of Advance Partners in December 2015 for approximately $296.1 million, net of cash acquired. The acquisition added $95.6 million of goodwill and expanded payroll funding and outsourcing services for temporary staffing firms.
Cash used in investing activities declined to $63.1 million from $285.0 million, despite the Advance Partners acquisition, primarily because of changes in funds held for clients and corporate investments.
Cash used in financing activities increased to $993.6 million, primarily due to higher dividend payments and a year-end timing-related decrease in client fund obligations.
The average return on combined client funds and corporate investments increased to 1.1% from 1.0%, while the low interest-rate environment continued to constrain investment income.

Guidance, Outlook, Risks, and Unusual Items

For fiscal 2017, management expected payroll service revenue growth of approximately 4%, HRS revenue growth of 12% to 14%, and total service revenue growth of 7% to 8%.
Interest on funds held for clients was expected to grow at a mid-single-digit rate, and net income was expected to increase approximately 8%, excluding the fiscal 2016 tax benefit.
Operating income, excluding certain items, was expected to approximate 38% of service revenue; the projected effective tax rate was 35.5% to 36%.
Fiscal 2017 capital expenditures were projected at $110 million to $120 million, depreciation at $100 million to $110 million, and intangible amortization at $15 million to $20 million.
Management expected cash, investments, and operating cash flows to fund normal operations, capital expenditures, acquisitions, share repurchases, and dividends for the foreseeable future.
Key risks include regulatory changes affecting payroll, benefits, insurance, and healthcare services; cybersecurity and data privacy incidents; technology execution; system outages; third-party service-provider failures; PEO co-employment liabilities; workers’ compensation and health insurance claims trends; interest-rate changes; economic weakness; competition; and difficulty attracting qualified personnel.
Legal proceedings arise in the ordinary course of business. Management did not expect outstanding matters to have a material adverse effect, but acknowledged that outcomes remain uncertain.
The company’s investment portfolio had $4.1 billion of available-for-sale securities at fair value and a 3.1-year average duration. A hypothetical 25-basis-point increase in longer-term rates could reduce fair value by approximately $20 million to $25 million, with the effect generally recorded in equity unless impairment occurs.
Management and the independent auditor concluded that internal control over financial reporting and disclosure controls were effective as of May 31, 2016.

Investor Verification Checklist

Verify the fiscal-period mismatch between the requested “2015 Q4” label and the supplied fiscal 2016 Form 10-K.
Separate recurring operating growth from the approximately $0.05-per-share discrete tax benefit.
Assess the performance, credit exposure, and integration results of Advance Partners, including acquired receivables and goodwill.
Monitor interest-rate sensitivity because client funds and investment portfolios averaged approximately $5.0 billion.
Review PEO insurance reserves, claims development, and workers’ compensation and health plan exposure.
Evaluate the sustainability of the 80% dividend payout ratio alongside share repurchases and acquisition spending.
Review the $54.2 million reserve for uncertain tax positions and ongoing IRS examinations of fiscal years 2012 through 2014.
Confirm subsequent financing activity, including the approximately $56 million Advance Partners borrowing and the July 2016 dividend and repurchase authorizations.