Paychex, Inc. Form 10-Q Summary
Business Context and Reporting Period
Paychex provides payroll, human resource, retirement, insurance, and other human capital management services primarily to U.S. small and mid-sized businesses, with insignificant German and Brazilian operations. The filing covers the three and six months ended November 30, 2016, Paychex’s fiscal 2017 second quarter and year-to-date period. The financial statements are unaudited and prepared under U.S. GAAP.
Financial Performance and Position
| Metric | Three months ended November 30, 2016 | Change vs. 2015 | Six months ended November 30, 2016 | Change vs. 2015 |
|---|---|---|---|---|
| Total revenue | $771.4 million | Up 7% | $1,556.9 million | Up 8% |
| Service revenue | $760.0 million | Up 7% | $1,533.5 million | Up 8% |
| Payroll service revenue | $440.9 million | Up 3% | $891.8 million | Up 4% |
| Human Resource Services revenue | $319.1 million | Up 12% | $641.7 million | Up 14% |
| Operating income | $311.1 million | Up 6% | $634.1 million | Up 7% |
| Net income | $202.1 million | Up 7% | $419.5 million | Up 5% |
| Diluted earnings per share | $0.56 | Up 8% | $1.16 | Up 5% |
- Operating margin was 40.3% for the quarter and 40.7% for the six-month period, compared with 40.7% and 40.8%, respectively, in the prior-year periods.
- Interest on funds held for clients was $11.4 million for the quarter and $23.4 million year to date, up 2% and 6%, respectively. The combined investment portfolio earned 1.2% in both the quarter and six-month period, compared with 1.1% in the prior-year periods.
- Operating expenses increased 8% to $460.3 million for the quarter and $922.8 million year to date. PEO insurance costs increased 19% for the quarter and 18% year to date; compensation-related costs increased 5% and 6%, respectively.
- Net cash provided by operating activities was $413.4 million for the six months, compared with $419.9 million in the prior year. The decline primarily reflected unfavorable changes in operating assets and liabilities, including accounts receivable.
- Capital expenditures were $46.8 million year to date. Dividends paid were $331.5 million, and share repurchases were $166.2 million for 2.9 million shares.
- At November 30, 2016, cash and cash equivalents were $165.0 million, total corporate investments were $560.1 million, and funds held for clients were $3.242 billion.
- Total short-term borrowings were $103.1 million, consisting of $50.0 million under the syndicated facility and $53.1 million under the Paychex Advance facility. The $50.0 million syndicated borrowing was repaid in December 2016.
- Available unused capacity under four secured short-term lines of credit totaled $900 million. Paychex also maintained a $1 billion syndicated credit facility expiring in August 2020 and a $150 million Paychex Advance facility expiring in March 2019.
Material Changes Versus the Prior Comparable Period
- HRS revenue remained the principal growth driver, supported by client growth across HR outsourcing, retirement, time and attendance, and HR administration services. Paychex reported more than one million HR Services worksite employees served.
- Payroll revenue growth reflected increases in the client base and revenue per check, including pricing increases net of discounts. Advance Partners contributed approximately 1% of payroll revenue growth and 2% of HRS revenue growth.
- Investment income declined 40% for the quarter and 19% year to date because average corporate investment balances decreased, partly due to dividends, share repurchases, and the Advance Partners acquisition. Higher average yields partially offset the decline.
- The net unrealized position on available-for-sale securities changed from a $47.6 million gain at May 31, 2016 to a $24.8 million loss at November 30, 2016, primarily due to interest-rate movements. The related after-tax other comprehensive loss was $56.0 million for the quarter and $46.0 million year to date.
- Shares outstanding declined through repurchases, while dividends per share increased 10% to $0.46 from $0.42. The May 2014 repurchase authorization was fully used; $243.5 million remained available under the programs at November 30, 2016.
- The effective tax rate was 35.2% for the quarter and 34.1% year to date, compared with 36.0% and 32.9% in the prior-year periods. Early adoption of share-based compensation guidance produced a $14.1 million year-to-date tax benefit, or approximately $0.04 per diluted share.
Guidance, Outlook, Risks, and Unusual Items
- Fiscal 2017 guidance calls for payroll service revenue growth of 3% to 4%, HRS revenue growth of 12% to 14%, total service revenue growth of 7% to 8%, and upper-single-digit growth in interest on funds held for clients.
- Management expects fiscal 2017 GAAP net income to increase approximately 7%, adjusted net income to increase approximately 8%, and the effective tax rate to be approximately 35%.
- Management expects cash, corporate investments, operating cash flow, and available financing to support normal operations, capital expenditures, dividends, repurchases, and potential acquisitions for the foreseeable future.
- Management highlighted continued investment in Paychex Flex, including HR analytics, mobile-first design, employer workforce analysis, risk monitoring, and year-end reporting.
- Interest-rate risk is significant because the company invests client and corporate funds in fixed-income securities. Management estimated that a 25-basis-point change in short-term rates could affect after-tax earnings by approximately $3.5 million to $4.0 million over twelve months. A 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.
- Management believes securities with $31.5 million of unrealized losses were not other-than-temporarily impaired and expects principal and interest to be collected. This assessment could change with credit conditions, interest rates, or investment strategy.
- Key operating risks include employment and wage trends, competition, regulatory changes affecting payroll and benefits, workers’ compensation and health claims, cybersecurity incidents, technology or system failures, third-party service-provider failures, internal-control issues, and litigation.
- A federal court’s November 2016 preliminary injunction temporarily blocked the Department of Labor’s Final Overtime Rule. Management expects continued demand for regulatory-compliance assistance.
- Legal matters arise in the ordinary course of business. Management does not currently expect a material adverse outcome, but acknowledges that ultimate results are uncertain.
- Adjusted net income and adjusted diluted EPS are non-GAAP measures. The filing excludes volatile share-based compensation tax benefits and an unusual prior-year tax benefit from these measures.
Important Facts for Investors to Verify
- Whether HRS growth and worksite-employee expansion remain sufficient to offset slower payroll growth.
- The effect of changing short- and long-term interest rates on client-fund interest revenue, investment income, and accumulated other comprehensive income.
- The composition, duration, credit quality, and unrealized losses of the $3.5 billion available-for-sale securities portfolio.
- Whether increased PEO insurance costs and claims reserves develop favorably or require material adjustments.
- The sustainability of dividends and share repurchases relative to operating cash flow and short-term borrowing.
- Progress toward implementation of the new revenue, lease, income-tax, and cash-flow accounting standards.
- Cybersecurity, operational-continuity, regulatory, legal, and client-credit exposures, including purchased receivables related to temporary staffing clients.