Paychex, Inc. Form 10-Q Summary
Business context and reporting period
Paychex provides payroll, human resources, benefits, insurance, and professional employer organization (PEO) services primarily to small and medium-sized businesses in the United States, with limited European operations. The filing covers the three and six months ended November 30, 2018, representing the second quarter and first half of fiscal 2019. The statements are unaudited and presented under U.S. GAAP.
Effective June 1, 2018, Paychex adopted ASC Topic 606 using the full retrospective method. Prior-period amounts were recast, and stockholders’ equity increased by $262.9 million as of June 1, 2016. The adoption materially affected balance-sheet classifications and quarterly revenue timing but did not materially affect annual revenue recognition.
Financial performance and liquidity
| Metric | Three months ended November 30, 2018 | Change | Six months ended November 30, 2018 | Change |
|---|---|---|---|---|
| Total revenue | $858.9 million | 7% | $1,721.7 million | 8% |
| Service revenue | $840.6 million | 7% | $1,686.3 million | 8% |
| Management Solutions revenue | $685.4 million | 5% | $1,373.1 million | 4% |
| PEO and Insurance Services revenue | $155.2 million | 15% | $313.2 million | 26% |
| Interest on funds held for clients | $18.3 million | 31% | $35.4 million | 28% |
| Operating income | $307.2 million | 1% | $627.5 million | 1% |
| Operating margin | 35.8% | Down from 37.7% | 36.4% | Down from 38.9% |
| Net income | $235.8 million | 19% | $479.4 million | 17% |
| Diluted EPS | $0.65 | 18% | $1.33 | 18% |
Revenue growth was driven by client and worksite-employee increases, higher retirement-services asset-fee revenue, and the Lessor acquisition. Expense growth exceeded revenue growth, reflecting increased headcount, technology and product investment, PEO insurance costs, and service-optimization initiatives. Headcount was approximately 14,600 at November 30, 2018, versus approximately 14,000 a year earlier.
The effective tax rate declined to 23.8% for the quarter and 24.1% for the six months, from 34.8% and 34.4%, respectively, primarily because of the Tax Cuts and Jobs Act. This tax-rate reduction was the principal contributor to the stronger net-income and EPS growth relative to operating-income growth.
Cash flow from operations was $497.2 million for the six months, down from $519.4 million in the prior-year comparable period. Capital expenditures were $60.8 million, and cash paid for dividends was $402.7 million. Paychex repurchased 0.5 million shares for $32.8 million, compared with 1.6 million shares for $94.1 million in the prior-year period.
At November 30, 2018, cash and cash equivalents were $510.6 million, while cash and total corporate investments were $769.0 million. Funds held for clients were $3.7 billion and client fund obligations were $3.7 billion. Short-term borrowings were $57.3 million, all under the PNC facility, and the company was in compliance with its credit-facility covenants. Standby letters of credit totaled $67.8 million.
Material changes versus the prior comparable period
- PEO and Insurance Services revenue accelerated 15% in the quarter and 26% year to date, materially outpacing Management Solutions revenue growth.
- Interest income benefited from higher rates: the combined investment portfolio’s average rate increased to 1.9% in the quarter from 1.5% and to 1.8% year to date from 1.4%.
- Operating margin contracted because total expenses rose 10% in the quarter and 12% year to date, faster than revenue.
- Net income benefited from the lower effective tax rate following the Tax Act.
- Funds held for clients and corporate investments declined to $3.9 billion at November 30, 2018 from $5.1 billion at May 31, 2018, largely reflecting timing of client-fund collections, remittances, and investment activity.
- Available-for-sale securities had $45.3 million of net unrealized losses at November 30, 2018. Management attributed the losses primarily to interest-rate changes and did not consider them other-than-temporary.
Guidance, outlook, risks, and unusual items
Excluding Oasis, management revised fiscal 2019 guidance to approximately 4% growth in net income and diluted EPS, 11% to 12% growth in adjusted net income and adjusted diluted EPS, 20% to 25% growth in interest on funds held for clients, and $10 million to $15 million of net investment income. Other guidance remained approximately 4% Management Solutions revenue growth, 18% to 20% PEO and Insurance Services revenue growth, 6% to 7% total revenue growth, a 37% operating margin, and a 24% effective tax rate.
Paychex completed its acquisition of Oasis on December 20, 2018, after the reporting date, for approximately $1.0 billion net of approximately $200 million of cash acquired. The transaction was funded with approximately $400 million of cash and temporary borrowings of approximately $800 million. Management expects Oasis to add $155 million to $175 million of fiscal 2019 revenue, have minimal EPS impact excluding one-time costs, and reduce fiscal 2019 diluted EPS by approximately $0.03 for acquisition-related costs. Permanent financing was still being secured.
Key risks include interest-rate and investment-portfolio volatility, credit losses, PEO workers’ compensation and health-insurance claims, cyberattacks and data-security failures, technology or facility disruptions, regulatory changes affecting payroll and benefits, competition, litigation, acquisition integration, and the ability to retain skilled technology personnel. A 25-basis-point change in short-term rates is estimated to affect after-tax earnings by approximately $3 million to $4 million over twelve months. A hypothetical 25-basis-point increase in longer-term rates would reduce the fair value of available-for-sale securities by approximately $20 million, with the effect generally recorded in equity unless impairment occurs.
The company reported no material legal contingencies, no material self-insured losses, and no material impairment of deferred contract costs. It expects the adoption of lease accounting guidance in fiscal 2020 to add assets and liabilities to the balance sheet but does not expect a material income-statement effect.
Important facts for investors to verify
- Reconcile fiscal 2019 guidance with the incremental Oasis revenue, financing costs, integration costs, and approximately $0.03 per-share one-time charge.
- Monitor post-acquisition borrowings, permanent financing terms, leverage, interest expense, and Oasis purchase-accounting allocations.
- Assess whether expense growth moderates enough to stabilize operating margins, which declined to 35.8% in the quarter and 36.4% year to date.
- Track interest rates, client-fund balances, investment yields, unrealized securities losses, and the sensitivity of earnings to rate changes.
- Verify the impact of ASC 606 recast figures when comparing this filing with earlier Paychex filings.
- Review PEO insurance reserves, workers’ compensation and health-benefit claims trends, cybersecurity disclosures, and acquisition-integration risks.