Paychex, Inc. — Fiscal 2019 First-Quarter 10-Q Summary
Business context and reporting period
Paychex provides payroll, human capital management, HR, benefits, professional employer organization (PEO), and insurance services primarily to small and medium-sized businesses in the United States, with limited European operations. The filing covers the three months ended August 31, 2018, the first quarter of fiscal 2019, compared with the three months ended August 31, 2017.
Paychex adopted ASC Topic 606 on June 1, 2018 using the full retrospective method. Prior-period amounts were recast, and adoption increased stockholders’ equity by $262.9 million as of June 1, 2016. The adoption materially affected quarterly revenue timing and balance-sheet presentation, particularly deferred contract costs, but management stated it did not materially affect annual revenue recognition.
Key financial metrics
| Metric | Q1 FY2019 | Q1 FY2018, adjusted | Change |
|---|---|---|---|
| Total revenue | $862.8 million | $792.9 million | Up 9% |
| Management Solutions revenue | $687.7 million | $665.9 million | Up 3% |
| PEO and Insurance Services revenue | $158.0 million | $113.3 million | Up 39% |
| Interest on funds held for clients | $17.1 million | $13.7 million | Up 25% |
| Operating income | $320.3 million | $317.3 million | Up 1% |
| Operating margin | 37.1% | 40.0% | Down 290 basis points |
| Net income | $243.6 million | $210.4 million | Up 16% |
| Diluted EPS | $0.67 | $0.58 | Up 16% |
| Effective tax rate | 24.5% | 34.1% | Down 960 basis points |
| Cash flow from operations | $273.7 million | $343.6 million | Down 20% |
Adjusted net income was $242.0 million, up 18%, and adjusted diluted EPS was $0.67, also up 18%. These are non-GAAP measures and exclude specified tax-related items.
Financial position, liquidity, and capital allocation
- Cash and cash equivalents were $440.1 million at August 31, 2018. Cash plus corporate investments totaled $787.6 million.
- Funds held for clients were $3.764 billion, matched by client fund obligations of $3.792 billion. These balances are principally timing-related and do not represent unrestricted corporate liquidity.
- Short-term borrowings were $56.7 million under the PNC facility. Paychex had three committed unsecured credit facilities totaling $1.65 billion of maximum capacity and was in compliance with all covenants.
- Standby letters of credit totaled $61.8 million, primarily supporting insurance commitments; no amounts were drawn.
- Capital expenditures were $24.4 million. The company had approximately $10.5 million of outstanding capital-asset purchase commitments.
- Paychex paid $201.4 million in dividends and repurchased 456,430 shares for $32.8 million during the quarter. Approximately $67.7 million remained available under the repurchase authorization.
- Management stated that available cash, corporate investments, projected operating cash flow, and short-term financing should support operations, capital purchases, dividends, and share repurchases for the foreseeable future.
Material changes versus the prior comparable period
- Revenue growth was led by PEO and Insurance Services, which benefited from increased client worksite employees, insurance applicants, higher workers’ compensation premiums, and the HROI acquisition.
- HROI, acquired in August 2017, contributed approximately 20% of PEO and Insurance Services revenue growth and approximately 4% of total revenue growth. Lessor Group, acquired in February 2018, contributed less than 1% of Management Solutions revenue growth.
- Total expenses increased 14% to $542.5 million. Compensation-related expenses rose 11% due to increased sales, technology, and operating headcount; PEO insurance costs increased 70% due largely to PEO growth and HROI.
- Operating margin contracted despite revenue growth because expenses grew faster than revenue.
- Net income and EPS benefited substantially from the lower effective tax rate following the Tax Cuts and Jobs Act, partly offset by deferred-tax revaluation items.
- Operating cash flow declined because of changes in operating assets and liabilities and lower deferred-tax provisions. Cash-flow comparisons were also affected by the timing of client-fund collections and remittances.
- Interest income benefited from higher rates: the combined average portfolio yield increased to 1.8% from 1.4%, despite a 3% decline in average funds held for clients and corporate investments.
Guidance, outlook, risks, and unusual items
- Fiscal 2019 guidance was unchanged. Management Solutions revenue is expected to increase approximately 4%, and PEO and Insurance Services revenue is expected to increase 18% to 20%.
- Management expects the total investment portfolio to average approximately $5.0 billion in fiscal 2019, with approximately 40% in short-term investments and variable-rate demand notes and 60% in available-for-sale securities.
- Available-for-sale securities had $35.9 million of net unrealized losses at August 31, 2018. Management attributed the losses primarily to interest-rate changes and concluded they were not other-than-temporary impairments. The filing states that the loss increased to approximately $50.7 million as of September 28, 2018.
- A hypothetical 25-basis-point increase in longer-term rates could reduce the fair value of available-for-sale securities by approximately $20 million to $25 million, primarily through equity rather than immediate earnings.
- A 25-basis-point change in short-term rates is estimated to affect after-tax earnings by approximately $3 million to $4 million over twelve months.
- Key risks include changes in employment and wage levels, interest rates, investment values and credit quality, competition, regulation of payroll taxes and benefits, PEO insurance claims, cybersecurity incidents, system or facility failures, third-party service-provider failures, litigation, acquisition integration, and tax-law changes.
- Workers’ compensation and health-insurance reserves involve actuarial estimates and could change materially based on claims trends, legal developments, and settlement outcomes.
- Paychex is renovating a new Rochester, New York campus; renovations were expected to be substantially completed later in fiscal 2019.
- The company expects adoption of the lease standard in fiscal 2020 to add assets and liabilities to the balance sheet. The potential effects of recently issued cloud-computing and fair-value disclosure standards were still being evaluated.
Important facts for investors to verify
- Confirm the impact of ASC Topic 606 on recast quarterly revenue, deferred contract costs, retained earnings, and comparability with future periods.
- Assess whether PEO growth, including the HROI contribution, can continue without disproportionate increases in insurance costs and claims reserves.
- Monitor operating-margin pressure from compensation, technology investment, acquisitions, and PEO insurance expenses.
- Track interest-rate movements, portfolio duration, unrealized investment losses, and the effect of rates on interest income and equity.
- Verify the sustainability of cash generation after dividends, share repurchases, capital expenditures, acquisitions, and client-fund timing effects.
- Review the status of the $56.7 million short-term borrowing, available credit capacity, letters of credit, and compliance with financing covenants.
- Evaluate the assumptions supporting fiscal 2019 revenue guidance and the company’s stated ability to fund dividends and repurchases.
- Review subsequent filings for changes in litigation, PEO insurance reserves, cybersecurity matters, Tax Act accounting, and acquisition integration.