Paychex, Inc. — Fiscal 2018 Second-Quarter 10-Q Summary
Business Context and Reporting Period
Paychex provides payroll, human-resource, retirement, insurance, and professional employer organization services primarily to small and medium-sized U.S. businesses, with Germany contributing less than 1% of revenue. The filing covers the three and six months ended November 30, 2017, compared with the corresponding 2016 periods.
Key Financial Metrics
| Metric | Three months ended Nov. 30, 2017 | Year-over-year change | Six months ended Nov. 30, 2017 | Year-over-year change |
|---|---|---|---|---|
| Total revenue | $826.5 million | 7% | $1,643.3 million | 6% |
| Service revenue | $812.5 million | 7% | $1,615.6 million | 5% |
| Payroll service revenue | $444.8 million | 1% | $902.6 million | 1% |
| HRS revenue | $367.7 million | 15% | $713.0 million | 11% |
| Interest on funds held for clients | $14.0 million | 23% | $27.7 million | 19% |
| Operating income | $332.2 million | 7% | $677.2 million | 7% |
| Operating margin | 40.2% | Down from 40.3% | 41.2% | Up from 40.7% |
| Net income | $217.0 million | 7% | $444.8 million | 6% |
| Diluted EPS | $0.60 | 7% | $1.23 | 6% |
Adjusted net income, a non-GAAP measure excluding discrete excess tax benefits from employee stock-based compensation, was $214.4 million for the quarter and $437.2 million for the six months. Adjusted diluted EPS was $0.59 and $1.21, respectively.
Cash flow from operations was $519.4 million for the six months, up from $413.4 million in the prior-year period. Capital expenditures were $95.5 million, business acquisitions used $17.9 million, dividends paid were $358.9 million, and share repurchases were $94.1 million.
As of November 30, 2017, cash and cash equivalents were $257.2 million, while cash and total corporate investments were $819.5 million. Funds held for clients totaled $4.888 billion and client fund obligations were $4.898 billion. Short-term borrowings were $133.4 million, consisting of $75.0 million under a JPMorgan $500 million facility and $58.4 million under a PNC $150 million facility. The JPMorgan $500 million borrowing was repaid in December 2017; the PNC balance remained outstanding as of the filing date.
Total available committed credit capacity was $1.65 billion across three unsecured facilities. The company was in compliance with all related covenants. Standby letters of credit totaled $52.8 million at quarter-end, with an additional $4.1 million opened after quarter-end in connection with HROI insurance commitments.
Cash dividends increased to $0.50 per share from $0.46 per share. The company repurchased 1.6 million shares for $94.1 million during the six months and had approximately $149.4 million remaining under its repurchase authorization.
Material Changes Versus the Prior Comparable Period
- HRS revenue growth substantially exceeded payroll revenue growth, driven by broader client adoption across HR outsourcing, retirement, time and attendance, and insurance services.
- The acquisition of HR Outsourcing Holdings, Inc. in August 2017 contributed approximately 3% to second-quarter service revenue growth and expanded Paychex’s PEO presence. Consideration was $75.4 million, including $42.2 million of cash and $33.2 million of Paychex stock; $41.0 million of provisional, non-tax-deductible goodwill was recorded.
- Interest revenue increased as average yields rose, while average investment balances were broadly flat. Combined portfolio yield increased to 1.5% in the quarter from 1.2%.
- PEO insurance costs increased 57% in the quarter and 33% for the six months, primarily due to HROI and growth in the minimum-premium insurance offering.
- Operating margin was slightly lower in the quarter but higher for the six-month period. Depreciation and amortization increased due primarily to internally developed software placed in service.
- Operating cash flow improved, but investing cash flow changed to a use of $751.1 million from a prior-year source of $697.9 million, reflecting investment portfolio activity, higher capital expenditures, and the HROI acquisition.
- The investment portfolio moved from a $32.0 million net unrealized gain at May 31, 2017 to a $14.2 million net unrealized loss at November 30, 2017, primarily due to interest-rate movements. Management did not consider the securities other-than-temporarily impaired.
- Paychex purchased five Rochester buildings and placed approximately $16.0 million in escrow for renovations. Total estimated campus cost is approximately $60 million.
Guidance, Outlook, Risks, and Unusual Items
Fiscal 2018 guidance was unchanged. Payroll service revenue is expected to grow 1% to 2%, HRS revenue 12% to 14%, interest on funds held for clients in the mid- to upper-teens, and total revenue approximately 6%. Operating margin is expected at 39% to 40%; investment income is expected to be $9 million to $11 million; the effective tax rate is expected at 35.0% to 35.5%; net income growth is expected at approximately 5%; and diluted EPS growth is expected at 5% to 6%. Adjusted net income and adjusted diluted EPS growth are expected at approximately 7% and 7% to 8%, respectively.
Guidance did not include tax reform. Management anticipated that tax reform could reduce the annualized effective tax rate by 10% to 12%, subject to interpretation of the final law, with part of the benefit expected to be reinvested in the business.
Key risks include sensitivity to employment and wage levels, interest rates and investment valuations, competition, regulation of payroll, PEO and employee-benefit services, workers’ compensation and health-insurance claims, cybersecurity and system failures, third-party service providers, acquisition integration, legal and tax matters, and potential liability arising from PEO co-employment relationships.
The company identified no material adverse effect expected from pending legal matters, although it cautioned that legal outcomes are inherently uncertain. PEO insurance reserves are based on actuarial estimates and could change materially. The company also expects adoption of the new revenue-recognition standard in fiscal 2019, primarily affecting the deferral and amortization of certain contract acquisition and fulfillment costs, with no expected material impact on revenue timing or amount. Lease accounting adoption is expected to affect the balance sheet.
Most Important Facts for Investors to Verify
- Whether HROI integration sustains the reported acceleration in HRS and PEO growth without disproportionate insurance or operating costs.
- Whether payroll service growth remains within the 1% to 2% fiscal 2018 guidance range and whether HRS growth reaches the 12% to 14% target.
- The realized benefit and reinvestment impact of tax reform, compared with the company’s preliminary 10% to 12% effective-rate benefit estimate.
- Exposure to rising interest rates, including the effect on funds-held-for-client income and the $14.2 million unrealized investment loss.
- Capital spending and total cost of the Rochester campus project relative to the approximately $60 million estimate.
- Changes in PEO insurance reserves, workers’ compensation and health claims, and related contingencies.
- Future short-term borrowing needs, credit-facility usage, dividend funding, and remaining share-repurchase capacity.
- The final accounting and disclosure effects of revenue-recognition and lease-accounting standards.