Paychex, Inc. Form 10-Q Summary
Reporting period: Third quarter and nine months ended February 28, 2019, corresponding to fiscal 2019 Q3. The filing was signed March 29, 2019. Paychex provides payroll, human capital management, HR, benefits, PEO, and insurance services primarily to U.S. small and medium-sized businesses.
Key Financial Metrics
| Metric | Three months ended Feb. 28, 2019 | Prior comparable period | Change |
|---|---|---|---|
| Total revenue | $1,070.4 million | $936.1 million | 14% |
| Service revenue | $1,047.4 million | $918.0 million | 14% |
| Management Solutions revenue | $801.6 million | $768.8 million | 4% |
| PEO and Insurance Services revenue | $245.8 million | $149.2 million | 65% |
| Interest on funds held for clients | $23.0 million | $18.1 million | 27% |
| Operating income | $429.3 million | $369.0 million | 16% |
| Operating margin | 40.1% | 39.4% | Up 70 basis points |
| Net income | $324.6 million | $367.2 million | Down 12% |
| Diluted EPS | $0.90 | $1.01 | Down 11% |
For the nine months ended February 28, 2019, revenue was $2,792.1 million, up 10%; operating income was $1,056.8 million, up 7%; net income was $804.0 million, up 4%; and diluted EPS was $2.22, up 3%. The nine-month operating margin was 37.8%, compared with 39.1% in the prior-year period.
Reported quarterly net income and EPS were reduced by comparison with the prior year, which included a nonrecurring tax benefit related to the Tax Cuts and Jobs Act. On an adjusted basis, quarterly net income was $322.4 million, up 3%, and adjusted diluted EPS was $0.89, up 3%. Nine-month adjusted net income was $799.7 million, up 12%, and adjusted diluted EPS was $2.21, up 12%.
Cash Flow, Liquidity, and Capital Structure
- Cash flow from operating activities was $988.9 million for the nine months, compared with $1,022.8 million in the prior-year period; management characterized operating cash flow as approximately $1.0 billion and up 3% in its discussion.
- Capital expenditures were $122.0 million for the nine months. Cash paid for acquisitions was $178.5 million, compared with $984.1 million in the current period, primarily reflecting the Oasis acquisition.
- Cash, restricted cash, and corporate investments totaled $886.4 million at February 28, 2019. Funds held for clients were $5,405.5 million, with related client fund obligations of $5,415.4 million.
- Available-for-sale securities had a fair value of $2,557.3 million and net unrealized losses of $9.8 million. Management stated that the investments were not other-than-temporarily impaired.
- Short-term borrowings were $53.6 million on the balance sheet. An additional $800.0 million was outstanding under JPMorgan credit facilities to temporarily finance Oasis, classified as long-term debt because of a subsequent refinancing arrangement.
- On March 13, 2019, the company refinanced the $800.0 million temporary borrowings with $400.0 million of 4.07% Series A Senior Notes due 2026 and $400.0 million of 4.25% Series B Senior Notes due 2029.
- Dividends declared during the nine months were $603.9 million, or $1.68 per share. Share repurchases totaled $32.8 million, and approximately $67.7 million remained available under the repurchase authorization at February 28, 2019.
Material Changes Versus the Prior Comparable Period
- The December 20, 2018 acquisition of Oasis materially expanded PEO and Insurance Services revenue. Oasis contributed $72.7 million of revenue and $3.5 million of operating income during the current three- and nine-month periods, including one-time acquisition and integration effects.
- Excluding Oasis, third-quarter total revenue increased 7% and PEO and Insurance Services revenue increased 17%.
- Management Solutions revenue rose 4%, driven by client growth, higher revenue per check, pricing, and retirement-services asset fees.
- Expenses increased 13% for the quarter and 12% for the nine months. The increases reflected Oasis, higher compensation, technology and sales investments, higher PEO insurance costs, and increased amortization of acquired intangible assets.
- Prior-year results included a $32.6 million charge for terminating certain license agreements. The charge did not recur in 2019 and is excluded from adjusted results.
- Paychex adopted ASC Topic 606 and the restricted-cash cash-flow standard effective June 1, 2018. ASC Topic 606 was applied retrospectively and increased stockholders’ equity by $262.9 million as of June 1, 2016. The company also revised prior interim cash-flow presentations for restricted cash classification.
Guidance, Outlook, and Management Commentary
Excluding Oasis, fiscal 2019 guidance remained unchanged. Management expects Management Solutions revenue growth of approximately 4%; PEO and Insurance Services revenue growth of 18% to 20%; interest on funds held for clients growth of 20% to 25%; and total revenue growth of 6% to 7%. Operating margin is expected to be approximately 37%, net interest income is expected to be $10 million to $15 million, and the effective tax rate is expected to be approximately 24%.
Excluding Oasis, management expects net income and diluted EPS growth of approximately 4%, and adjusted net income and adjusted diluted EPS growth of 11% to 12%. Oasis is expected to add $155 million to $175 million of fiscal 2019 revenue, with minimal EPS impact excluding one-time costs. Acquisition and integration costs are expected to reduce fiscal 2019 diluted EPS by approximately $0.03.
Management expects available liquidity, operating cash flow, and financing capacity to support operations, capital expenditures, share repurchases, and dividends. The company is investing in the Paychex Flex cloud platform and expects to adopt lease accounting under ASC Topic 842 in fiscal 2020, which is expected to materially increase recognized lease assets and liabilities but not materially affect income.
Risks, Contingencies, and Unusual Items
- Key risks include employment and wage trends, interest rates, competition, regulatory changes affecting payroll, PEOs and employee benefits, insurance claim trends, cybersecurity incidents, system failures, third-party provider failures, and acquisition integration risks.
- PEO workers’ compensation and health-benefit reserves depend on actuarial estimates and could change materially because of claims trends, legal developments, economic conditions, and damage awards.
- The investment portfolio is exposed to interest-rate and credit risk. A hypothetical 25-basis-point increase in longer-term rates would reduce the fair value of available-for-sale securities by approximately $20.0 million, with the effect generally recorded in equity unless impairment is recognized.
- A 25-basis-point change in short-term interest rates is estimated to affect after-tax earnings by approximately $3 million to $4 million over 12 months.
- Standby letters of credit totaled $72.7 million at February 28, 2019, primarily securing insurance commitments. Capital-asset purchase commitments were approximately $5.7 million.
- The company was subject to ordinary-course legal claims and contingencies. Management did not expect a material adverse effect, while noting that legal outcomes remain uncertain.
- Disclosure controls and procedures were concluded to be effective at a reasonable assurance level as of February 28, 2019.
Investor Verification Items
- Verify the period designation: the supplied filing is for fiscal 2019 Q3, not calendar 2018 Q3.
- Assess recurring growth and margins excluding Oasis, prior-year Tax Act benefits, and the prior-year license-termination charge.
- Review Oasis integration, preliminary purchase accounting, goodwill of approximately $968.8 million, and the effect of permanent debt financing on future interest expense.
- Reconcile reported debt classifications at February 28, 2019 with the March 13, 2019 refinancing and confirm resulting covenant and liquidity effects.
- Monitor PEO insurance reserves, workers’ compensation trends, client-fund balances, investment yields, and interest-rate sensitivity.
- Evaluate the impact of ASC Topic 606 and the forthcoming lease standard on comparability, balance-sheet presentation, and performance metrics.