Paychex, Inc. Form 10-Q Summary
Business Context and Reporting Period
Paychex provides payroll, human-resource, employee-benefits, retirement, workers’ compensation, and related outsourcing services primarily to small and medium-sized U.S. businesses. The filing covers the third quarter and nine months of fiscal 2010 ended February 28, 2010; the filing text does not identify this as fiscal 2009 Q3. Paychex reports one operating segment, with Germany contributing less than 1% of revenue.
Financial Performance and Position
| Metric | Three months ended Feb. 28, 2010 | Year-over-year change | Nine months ended Feb. 28, 2010 | Year-over-year change |
|---|---|---|---|---|
| Total revenue | $507.8 million | (4%) | $1,504.6 million | (5%) |
| Service revenue | $493.8 million | (4%) | $1,463.3 million | (4%) |
| Operating income | $168.2 million | (15%) | $551.2 million | (13%) |
| Operating margin | 33% | Down from 37% | 37% | Down from 40% |
| Net income | $112.0 million | (14%) | $361.5 million | (14%) |
| Diluted EPS | $0.31 | (14%) | $1.00 | (14%) |
| Cash flow from operations | Not provided for the quarter | — | $503.0 million | Down from $563.3 million |
Payroll service revenue declined 6% to $358.3 million in the quarter and $1,063.6 million for the nine-month period. Human Resource Services revenue increased 3% to $135.5 million in the quarter and 2% to $399.7 million for the nine months.
Cash and cash equivalents were $279.3 million at February 28, 2010, compared with $472.8 million at May 31, 2009. Corporate investments totaled $409.9 million, producing cash and corporate investments of $689.1 million. The company reported no debt. Funds held for clients were $4.1 billion, matched by client fund obligations of $4.0 billion.
Paychex paid $336.4 million in dividends during the first nine months, or $0.93 per share. The quarterly dividend remained $0.31 per share. Unused secured short-term credit lines totaled $900 million, with no amounts outstanding. Standby letters of credit totaled $65.3 million and were fully undrawn.
Material Changes Versus the Prior Comparable Period
- Total revenue and service revenue declined because of weak economic conditions, a 2.1% decrease in the client base since May 31, 2009, and lower checks per client.
- Checks per client declined 2.2% in the third quarter and 3.6% for the nine-month period. New business sales remained weak, although client losses improved.
- Interest on funds held for clients fell 14% in the quarter and 32% for the nine months, reflecting lower interest rates and lower average client-fund balances.
- Combined operating and selling, general and administrative expenses increased 3% in the quarter primarily because of an $18.7 million litigation-reserve charge. Excluding that charge, expenses declined 3% in the quarter and 2% for the nine months.
- Operating income, excluding interest on client funds and the litigation charge, declined 4% to $172.9 million in the quarter and 7% to $528.6 million for the nine months. This non-GAAP measure was 35.0% of service revenue in the quarter and 36.1% for the nine months.
- Human Resource Services growth was supported by increases in comprehensive human-resource outsourcing, health and benefits, and retirement-services activity. Health and benefits revenue increased 54% in the quarter to $7.8 million.
- The company completed implementation of an enhanced core payroll platform, representing more than $60 million of investment; more than 470,000 clients had migrated by February 28, 2010.
- Paychex sold its immaterial Stromberg time-and-attendance business and received $13.1 million of proceeds during the nine months.
Guidance, Outlook, Risks, and Unusual Items
Fiscal 2010 guidance was unchanged. Management projected payroll service revenue down 7% to 5%, Human Resource Services revenue up 3% to 6%, total service revenue down 5% to 2%, total revenue down 5% to 2%, and net income down 12% to 10%. Operating income excluding certain items was expected to equal 34% to 35% of service revenue, and the effective tax rate was expected to approximate 35%.
Management expected lower interest income because of low short-term rates and a projected 5% decline in average invested balances. Slightly more than 15% of the long-term investment portfolio was expected to mature during the following 12 months and be reinvested at an estimated average rate of approximately 1.0%. A 25-basis-point change in short-term rates was estimated to affect annual after-tax earnings by approximately $3.5 million.
Fiscal 2010 capital expenditures were projected at $60 million to $65 million, depreciation at approximately $65 million, and intangible amortization at approximately $20 million to $25 million.
- The company increased its litigation reserve by $18.7 million. A California judgment included $15.0 million of compensatory damages and $11.0 million of punitive damages, plus statutory interest; Paychex stated it would satisfy the judgment without further appeal.
- Total litigation reserves were $39.1 million at February 28, 2010. Management believed outstanding legal matters would not materially adversely affect the company, but acknowledged that ultimate outcomes could materially affect a future reporting period.
- Investment portfolios were concentrated in high-credit-quality securities. The company reported a $76.1 million net unrealized gain on available-for-sale securities and stated that investments were not other-than-temporarily impaired.
- Key risks include employment and wage trends, client demand and competition, interest-rate and investment-credit risk, regulatory changes, workers’ compensation claims, technology and business-continuity failures, third-party service-provider performance, internal controls, and litigation.
- Management stated that disclosure controls were effective and that there were no material changes in internal control over financial reporting during the quarter.
Important Facts for Investors to Verify
- Confirm that the intended comparison is fiscal 2010 Q3, ended February 28, 2010, rather than the metadata label “2009 Q3.”
- Assess the sustainability of payroll revenue and client-base trends as the economy and employment conditions recover.
- Evaluate the effect of persistently low interest rates and reinvestment yields on client-fund and corporate-investment income.
- Review the $18.7 million litigation charge, the $39.1 million reserve, and remaining legal contingencies.
- Reconcile GAAP operating income with management’s non-GAAP operating income excluding interest on client funds and litigation costs.
- Monitor liquidity and investment risk, including the $4.5 billion combined funds-held-for-clients and corporate-investment portfolio, credit quality, duration, and unrealized gains or losses.
- Verify whether unchanged fiscal 2010 guidance was subsequently revised and compare actual results with the stated revenue, margin, tax-rate, and capital-expenditure ranges.