Paychex, Inc. Form 10-Q Summary
Reporting period: Three and nine months ended February 29, 2016, representing fiscal 2016 third-quarter results. The filing compares results with the periods ended February 28, 2015. Paychex provides integrated payroll, human resource, retirement, insurance, payment, and related services primarily to small and midsized U.S. businesses, with less than 1% of revenue from Germany.
Financial Results and Key Metrics
| Metric | Three months ended Feb. 29, 2016 | Year-over-year change | Nine months ended Feb. 29, 2016 | Year-over-year change |
|---|---|---|---|---|
| Total revenue | $752.6 million | 7% | $2,198.0 million | 7% |
| Service revenue | $740.7 million | 7% | $2,164.2 million | 7% |
| Payroll service revenue | $439.6 million | 4% | $1,299.5 million | 4% |
| Human Resource Services revenue | $301.1 million | 12% | $864.7 million | 13% |
| Interest on funds held for clients | $11.9 million | 11% | $33.8 million | 8% |
| Operating income | $280.0 million | 6% | $870.3 million | 9% |
| Net income | $180.4 million | 7% | $578.7 million | 13% |
| Diluted earnings per share | $0.50 | 9% | $1.60 | 13% |
| Operating cash flow | Not separately provided | — | $791.2 million | 14% |
Margins: Third-quarter operating margin was approximately 37.2% of total revenue and net margin was approximately 24.0%. Operating income, net of certain items, was $268.1 million, or 36% of service revenue, compared with $253.6 million, or 37%, in the prior-year quarter. For the nine months, this non-GAAP measure was $836.5 million, or 39% of service revenue, compared with 38% in the prior-year period.
Tax rate: The effective tax rate was 36.0% for the quarter and 33.9% for the nine months, compared with 36.3% for both prior-year periods. The nine-month rate benefited from a discrete tax benefit related to prior tax years; excluding that benefit, management indicated the rate would have been approximately 36.0%.
Financial Position, Cash Flow, Debt, and Liquidity
- Cash and cash equivalents were $253.1 million at February 29, 2016, compared with $170.0 million at May 31, 2015.
- Cash and total corporate investments were $755.8 million. Paychex reported no debt outstanding at period end.
- Funds held for clients were $4.717 billion, with corresponding client fund obligations of $4.664 billion. These balances primarily relate to client payroll and tax obligations and should not be viewed as unrestricted corporate liquidity.
- Total assets were $7.068 billion and stockholders’ equity was $1.874 billion at February 29, 2016.
- Operating cash flow for the nine months was $791.2 million, compared with $692.8 million in the prior-year period.
- Investing cash flow used $563.6 million, including $296.1 million for acquisitions and $70.0 million for property and equipment.
- Financing cash flow used $144.5 million, including $455.0 million of dividends and $107.9 million of share repurchases.
- Four uncommitted secured short-term lines of credit provided aggregate unused capacity of $900 million. A committed unsecured syndicated credit facility provides borrowing capacity of up to $1.0 billion through August 2020; no amounts were outstanding at quarter end.
- Standby letters of credit totaled $43.0 million, with no amounts drawn. Capital-asset purchase commitments were approximately $5.8 million.
Material Changes Versus the Prior Comparable Period
- Human Resource Services was the principal growth driver, increasing 12% in the quarter and 13% for the nine months, supported by client and worksite-employee growth in ASO and PEO services, insurance, and Affordable Care Act offerings.
- Payroll service revenue increased 4% in both periods, driven by client growth and higher revenue per check, including pricing increases net of discounts.
- Expenses increased 7% in both periods. Compensation-related expenses increased 5% in the quarter and 6% for the nine months; depreciation and amortization increased 14% and 8%, respectively, primarily due to internally developed software placed in service.
- Average combined funds held for clients and corporate investments declined 4% in the quarter and was approximately flat for the nine months. Higher average yields supported interest income despite the low-rate environment.
- The company acquired substantially all assets of Advance Partners on December 22, 2015, for base consideration of $190.5 million plus debt settlement of $118.4 million, net of $12.8 million of cash acquired. The acquisition added $94.7 million of tax-deductible goodwill and was considered immaterial to consolidated results; management said it contributed approximately 1% to third-quarter service-revenue growth and expense growth.
- Quarterly dividends increased to $0.42 per share from $0.38. During the nine months, Paychex repurchased 2.2 million shares for $107.9 million.
Guidance, Outlook, Risks, and Unusual Items
- Fiscal 2016 guidance calls for payroll service revenue growth of 4% to 5%, HRS revenue growth of 10% to 13%, total service revenue growth of 7% to 8%, and net income growth of 8% to 9%, excluding the prior-year tax benefit recorded in the first quarter.
- Management expects interest on funds held for clients to grow at a high-single-digit rate for fiscal 2016 and expects an effective tax rate of approximately 36.0%, excluding the discrete tax benefit.
- Fiscal 2016 capital expenditures are expected to be $110 million to $120 million, depreciation expense $95 million to $105 million, and intangible-asset amortization $15 million to $20 million.
- Management cited continued investment in Paychex Flex, product development, and supporting technology, while reporting strong client retention and double-digit growth in worksite employees served through human-resource outsourcing.
- Interest-rate changes remain a key earnings and valuation risk. Management estimated that a 25-basis-point change in short-term rates could affect after-tax earnings by approximately $3.5 million to $4.0 million over the following 12 months. A 25-basis-point increase in longer-term rates could reduce the fair value of available-for-sale securities by approximately $20 million to $25 million, with the effect generally recorded in equity unless impairment occurs.
- Other risks include economic and employment conditions, competition, regulatory changes affecting payroll and benefits, insurance claims trends, cybersecurity and system failures, third-party service-provider failures, internal-control failures, and legal matters.
- Workers’ compensation and health-insurance reserves involve actuarial estimates and could change materially as claims trends, laws, or settlement outcomes change. Management does not expect current legal matters to have a material adverse effect, but acknowledges that outcomes are uncertain.
- Recently issued accounting standards on revenue recognition, leases, financial instruments, and deferred-tax classification were under evaluation; management did not expect a material impact from the deferred-tax classification standard.
Important Facts for Investors to Verify
- Confirm that fiscal 2016 guidance remains applicable after the February 29, 2016 quarter and assess the effect of interest-rate changes on client-fund investment income.
- Separate the nine-month reported net-income growth from the effect of the discrete prior-year tax benefit; management indicated adjusted net-income growth was approximately 9% rather than 13%.
- Evaluate Advance Partners’ subsequent contribution, integration costs, acquired receivables, and the preliminary purchase-price allocation.
- Monitor PEO workers’ compensation and health-insurance reserves, including claims development and potential adverse adjustments.
- Review the composition, duration, credit quality, and unrealized gains or losses of the approximately $5.2 billion combined funds-held-for-clients and corporate investment portfolio.
- Assess the sustainability of dividends and share repurchases relative to operating cash flow, acquisition spending, capital expenditures, and client-fund obligations.
- Consider the distinction between client funds and unrestricted corporate cash when evaluating liquidity.
- Verify the status of pending legal matters, standby letters of credit, credit-facility covenants, and the company’s effective disclosure controls.