Paychex, Inc. — Fiscal 2011 First-Quarter Form 10-Q Summary
Business Context and Reporting Period
Paychex provides payroll, human resource, employee benefits, retirement, insurance, and related outsourcing services primarily to small and medium-sized businesses in the United States. The company reports one segment, with Germany contributing less than 1% of revenue. This filing covers the three months ended August 31, 2010, compared with the three months ended August 31, 2009.
Financial Results and Key Metrics
| Metric | Q1 FY2011 | Q1 FY2010 | Change |
|---|---|---|---|
| Payroll service revenue | $360.7 million | $354.4 million | 2% |
| Human Resource Services revenue | $145.5 million | $132.1 million | 10% |
| Total service revenue | $506.2 million | $486.5 million | 4% |
| Interest on funds held for clients | $12.1 million | $13.7 million | (12%) |
| Total revenue | $518.3 million | $500.2 million | 4% |
| Total operating and SG&A expenses | $317.5 million | $310.3 million | 2% |
| Operating income | $200.8 million | $189.9 million | 6% |
| Net income | $131.9 million | $123.6 million | 7% |
| Diluted EPS | $0.36 | $0.34 | 6% |
| Cash flow from operations | $194.3 million | $186.6 million | 4% |
- Operating margin was approximately 38.7% of total revenue, compared with approximately 38.0% in the prior-year quarter. Net income margin was approximately 25.4% in both periods.
- Operating income excluding interest on funds held for clients, a non-GAAP measure, was $188.7 million, or 37.3% of service revenue, compared with $176.2 million, or 36.2%, in the prior-year quarter.
- The effective income tax rate was 34.8%, compared with 35.2%.
- Cash dividends were $0.31 per common share; $112.0 million was paid during the quarter.
- At August 31, 2010, cash and cash equivalents were $272.9 million. Cash plus corporate investments totaled $716.4 million, and the company reported no debt.
- Funds held for clients were $3.290 billion, with corresponding client fund obligations of $3.214 billion. These balances primarily reflect client payroll and tax-related funds and obligations.
- Total stockholders’ equity was $1.437 billion, compared with $1.402 billion at May 31, 2010.
Material Changes Versus the Prior Comparable Period
- Payroll revenue growth reflected a 1.2% increase in checks per client, annual price increases, and a 12% reduction in client losses. New client sales were slightly lower.
- Human Resource Services revenue growth was driven by higher client and employee counts, expansion of the PEO business, insurance and retirement services growth, and increased retirement-plan asset values. Excluding the October 2009 sale of Stromberg time-and-attendance operations, this revenue would have increased 13%.
- Interest income declined because average portfolio yields fell to 1.5% from 1.7%, despite a 1% increase in average funds held for clients.
- Expenses increased primarily because of continued investments in sales, customer service, and technology infrastructure. Productivity improvements and lower operating headcount partly offset these costs.
- Investment income increased 57% to $1.4 million, primarily from higher average corporate investment balances and slightly higher yields.
- Investing cash flow decreased to $172.5 million from $247.5 million, while financing cash use improved to $378.2 million from $591.6 million, principally because the decline in client fund obligations was smaller than in the prior-year quarter.
- Available-for-sale securities increased to $2.570 billion at fair value from $2.152 billion at May 31, 2010. The portfolio had a net unrealized gain of $85.1 million and no securities in an unrealized loss position at quarter-end.
Guidance, Outlook, Risks, and Unusual Items
- Fiscal 2011 guidance assumed current economic and interest-rate conditions would continue. Payroll service revenue was expected to be flat; Human Resource Services revenue was expected to increase 10% to 13%; interest on funds held for clients was expected to decline 12% to 17%; and investment income was expected to increase 24% to 27%.
- Management expected operating income excluding interest on funds held for clients to be 34% to 35% of service revenue, an effective tax rate of approximately 35%, and slightly higher fiscal-year net income.
- The expected average return on combined client funds and corporate investments was 1.4%. Planned fiscal 2011 capital expenditures were $90 million to $95 million, depreciation was projected at $65 million to $70 million, and intangible amortization at approximately $20 million.
- Management described the outlook as cautiously optimistic and stated that first-quarter results were slightly better than anticipated, but it had not revised the June 2010 guidance.
- Low interest rates remain a significant earnings risk. Management estimated that a 25-basis-point change in short-term rates could affect after-tax earnings by approximately $3.5 million over twelve months. More than 20% of the long-term portfolio was expected to mature within twelve months and be reinvested at an anticipated average rate of approximately 1.0%.
- Investment risks include credit deterioration, interest-rate volatility, and potential impairment of municipal and other fixed-income securities. The company reported that more than 95% of the portfolio was rated AA or better, with no high-risk or illiquid investments and no derivatives.
- Workers’ compensation reserves, legal proceedings, regulatory changes, economic conditions, competition, technology and systems failures, third-party service-provider failures, and internal-control risks could affect results. Management did not expect current legal matters to have a material adverse effect, while acknowledging that outcomes are uncertain.
- The company entered into a separation agreement with former CEO Jonathan J. Judge during the quarter. Related one-time costs were included in compensation and stock-based compensation expenses, but the filing does not provide a separately identified total amount.
- The company had $900 million of unused capacity under four secured, uncommitted short-term credit lines, no borrowings outstanding, $47.5 million of standby letters of credit, and $9.6 million of capital-asset purchase commitments.
Important Facts for Investors to Verify
- Whether sustained low interest rates reduce interest income and portfolio reinvestment yields in line with, or beyond, management’s assumptions.
- Whether payroll client retention, checks per client, new sales, and PEO expansion support the stated revenue outlook.
- The amount and ongoing effects of the former CEO’s separation-related costs.
- Changes in the fair value, credit quality, duration, and unrealized gains or losses of the investment portfolio.
- Actual fiscal 2011 capital spending, operating margin, tax rate, and cash flow relative to guidance.
- Developments in workers’ compensation claims, legal matters, regulatory requirements, and other contingencies.
- The company’s continued ability to fund operations, capital investments, and dividends without debt financing.