Paychex, Inc. Form 10-Q Summary
Reporting period: Third quarter and nine months ended February 28, 2018, compared with the corresponding periods ended February 28, 2017. Although the request identifies “2017 Q3,” the filing covers fiscal 2018 third quarter. Paychex provides payroll, human resources, retirement, insurance, and other HCM services primarily to U.S. small and medium-sized businesses, with limited European operations.
Key Financial Metrics
| Metric | Three months ended Feb. 28, 2018 | Year-over-year change | Nine months ended Feb. 28, 2018 | Year-over-year change |
|---|---|---|---|---|
| Total revenue | $866.5 million | 9% | $2,509.8 million | 7% |
| Service revenue | $848.4 million | 8% | $2,464.0 million | 6% |
| Interest on funds held for clients | $18.1 million | 37% | $45.8 million | 25% |
| Operating income | $292.5 million | (5)% | $969.7 million | 3% |
| Operating margin | 33.7% | Down from 38.5% | 38.6% | Down from 40.0% |
| Net income | $260.4 million | 29% | $705.2 million | 13% |
| Diluted EPS | $0.72 | 29% | $1.95 | 14% |
| Cash flow from operations | Not separately provided | — | $988.9 million | 29% |
Payroll service revenue was $455.0 million for the quarter, up 2%, while human resource services revenue was $393.4 million, up 17%. The HRS increase reflected growth in comprehensive HR outsourcing, retirement, time and attendance, and insurance services, including contributions from HROI.
Adjusted operating income, a non-GAAP measure excluding the license-termination charge, was $325.1 million, up 6%, with a 37.5% adjusted operating margin. Adjusted net income was $227.5 million and adjusted diluted EPS was $0.63; these measures exclude selected tax benefits and unusual items and should not replace GAAP results.
Financial Position, Debt, and Liquidity
- Cash and cash equivalents were $323.9 million at February 28, 2018, compared with $184.6 million at May 31, 2017.
- Cash and total corporate investments totaled $826.6 million.
- Funds held for clients were $3.945 billion, compared with $4.302 billion at May 31, 2017, with corresponding client fund obligations of $3.972 billion.
- Short-term borrowings were $57.7 million, all under the PNC $150 million credit facility. No borrowings were outstanding under the $1 billion and $500 million JPMorgan facilities at quarter-end.
- Committed unsecured credit facilities totaled $1.65 billion. The company was in compliance with all related covenants.
- Standby letters of credit totaled $56.8 million, primarily securing insurance commitments.
- Cash flow from operations for the nine months was $988.9 million. Cash used in financing activities was $874.0 million, including $538.7 million of dividends and $94.1 million of share repurchases.
- Available-for-sale securities had a fair value of $3.756 billion and a net unrealized loss of $34.9 million at February 28, 2018, versus a net unrealized gain of $32.0 million at May 31, 2017.
Material Changes Versus the Prior Comparable Period
- Revenue growth accelerated through HRS and higher interest income, while payroll revenue growth remained modest.
- Operating income declined in the quarter because expenses increased 17%, exceeding 9% revenue growth. Expenses included a $32.6 million charge to terminate certain license agreements in connection with a contractual dispute.
- Compensation-related expenses increased 8% in the quarter, including the impact of a one-time bonus for non-management employees. PEO insurance costs rose 54%, and other expenses rose 31%.
- Net income and EPS benefited materially from the Tax Cuts and Jobs Act. The company recorded $56.9 million of estimated tax benefits, including a $20.8 million deferred-tax-liability revaluation benefit and a $36.1 million benefit from the fiscal-year effective tax-rate change.
- The effective tax rate fell to 11.7% for the quarter and 27.7% for the nine months, compared with 34.2% and 34.1%, respectively, in the prior-year periods.
- The company acquired HROI on August 18, 2017, expanding its PEO operations, for $75.4 million in cash and stock. It acquired Lessor Group on February 28, 2018, expanding its European HCM operations, for $160.6 million net of cash acquired.
- Goodwill increased by $170.3 million from May 31, 2017, primarily due to the HROI and Lessor acquisitions.
- Property and equipment purchases increased to $122.0 million for the nine months, including the purchase and renovation of a new Rochester, New York campus.
- The company terminated four uncommitted secured lines of credit totaling $900 million in August 2017; no amounts were outstanding under those lines.
Guidance, Outlook, Risks, and Unusual Items
Management updated fiscal 2018 guidance to reflect the Tax Act and Lessor acquisition. Payroll service revenue is expected to grow approximately 2%; HRS revenue 13% to 14%; interest on funds held for clients 20% to 25%; and total revenue approximately 7%. Operating margin is expected to be approximately 38%, investment income approximately $8.0 million, and the effective tax rate 28.5% to 29.0%. Net income is expected to increase approximately 13%, diluted EPS 13% to 14%, adjusted net income approximately 15%, and adjusted diluted EPS 15% to 16%.
Management expects available cash, corporate investments, operating cash flow, and financing capacity to fund normal operations, capital expenditures, dividends, share repurchases, and potential acquisitions for the foreseeable future. The quarterly dividend was increased 9% to $0.50 per share in July 2017.
- Interest-rate changes affect investment income and the fair value of available-for-sale securities. Management estimates that a 25-basis-point change in short-term rates could 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 the available-for-sale portfolio by approximately $25 million, with the change generally recorded in equity unless impairment is recognized.
- PEO workers’ compensation and health insurance reserves depend on claims experience, actuarial estimates, legal developments, and damage awards.
- Material risks include cybersecurity incidents, system or facility failures, third-party service-provider failures, regulatory changes, competition, employment and benefits-law exposure, interest-rate and investment risk, litigation, acquisition integration, and changes in employment and wage levels.
- The company recorded $32.6 million of liabilities and $24.7 million of after-tax expense related to terminating certain license agreements. In March 2018, it acquired related client-list rights for approximately $30.0 million. Management states the termination event is not expected to recur.
- The company expects to adopt the new revenue-recognition standard in fiscal 2019, potentially under the full retrospective method. It expects additional contract-related costs to be deferred and amortized, but does not expect a material impact on the timing or amount of revenue.
- The company reports that outstanding legal matters are not expected to have a material adverse effect, while acknowledging that legal outcomes remain uncertain.
Most Important Facts to Verify
- Separate recurring operating performance from the $56.9 million of Tax Act-related benefits and the $24.7 million after-tax license-termination item.
- Assess whether HRS growth and HROI-related expansion can offset modest payroll-service growth and elevated PEO insurance costs.
- Monitor the integration, valuation, and future contribution of Lessor and HROI, including the provisional $119.2 million of Lessor goodwill.
- Review interest-rate sensitivity, the $34.9 million unrealized investment loss, portfolio duration, and credit quality.
- Confirm the sustainability of the 38% fiscal 2018 operating-margin outlook after one-time items and acquisition-related costs.
- Track liquidity after dividends, share repurchases, acquisitions, and Rochester campus spending, including the $57.7 million of outstanding short-term borrowings.
- Evaluate the effect of the forthcoming revenue-recognition and lease-accounting standards on reported assets, liabilities, expenses, and disclosures.