Paychex, Inc. — Fiscal 2017 First-Quarter Form 10-Q Summary
Reporting period: Three months ended August 31, 2016, compared with the three months ended August 31, 2015. Paychex provides payroll, human resource, retirement, insurance, and related human capital management services, primarily to U.S. small and midsized businesses. The company also has immaterial operations in Germany and equity-method investments in Brazil and Canada.
Financial Performance and Position
| Metric | Q1 FY2017 | Q1 FY2016 | Change |
|---|---|---|---|
| Total revenue | $785.5 million | $723.0 million | 9% |
| Service revenue | $773.5 million | $712.2 million | 9% |
| Payroll service revenue | $450.9 million | $432.5 million | 4% |
| Human Resource Services revenue | $322.6 million | $279.7 million | 15% |
| Interest on funds held for clients | $12.0 million | $10.8 million | 11% |
| Operating income | $323.0 million | $296.1 million | 9% |
| Operating margin | 41.1% | 41.0% | Up 0.1 percentage point |
| Net income | $217.4 million | $209.1 million | 4% |
| Diluted EPS | $0.60 | $0.58 | 3% |
| Effective tax rate | 33.0% | 29.7% | Up 3.3 percentage points |
| Cash dividends per share | $0.46 | $0.42 | 10% |
Operating expenses increased 8% to $462.5 million. Compensation-related expenses rose 6%, depreciation and amortization increased 10%, PEO insurance costs increased 16%, and other expenses increased 11%. The company had approximately 13,700 employees at August 31, 2016, compared with approximately 12,900 a year earlier.
The combined funds held for clients and corporate investment portfolios earned an average return of 1.2%, compared with 1.1% in the prior-year quarter. Average investment balances declined 2% to $4.76 billion, while average funds held for clients declined 1% and average corporate investments declined 5%.
Cash Flow, Liquidity, and Debt
- Net cash provided by operating activities was $294.7 million, compared with $278.3 million in the prior-year quarter.
- Net cash provided by investing activities was $380.3 million, versus $759.9 million, primarily reflecting changes in investment purchases, sales, maturities, and client funds.
- Net cash used in financing activities was $676.5 million, compared with $752.3 million. The current period included $166.3 million of dividends and $51.3 million of short-term borrowings; no shares were repurchased.
- Cash and cash equivalents were $130.0 million at August 31, 2016. Cash and total corporate investments totaled $944.0 million.
- Funds held for clients were $3.44 billion, and client fund obligations were $3.39 billion.
- Short-term borrowings were $51.3 million, related to payroll funding arrangements through Paychex Advance. No borrowings were outstanding under the company’s $1.0 billion syndicated credit facility at quarter-end.
- Four secured short-term lines of credit provided aggregate unused capacity of $900 million. The company also had a $150 million Paychex Advance facility, of which $51.3 million was outstanding.
- Capital expenditures were $20.3 million. Outstanding commitments to purchase capital assets totaled approximately $7.6 million.
Material Changes Versus the Prior Comparable Period
- Revenue growth was led by 15% growth in HRS revenue, including strong demand for HR outsourcing, retirement, time and attendance, and HR administration services. Worksite employees served in the PEO business grew at a double-digit rate.
- Advance Partners, acquired in December 2015, contributed approximately 1% to payroll revenue growth, 2% to HRS revenue growth, and 1% to expense growth.
- Operating margin remained broadly stable despite investments in personnel, technology, and business growth.
- Net income and diluted EPS grew more slowly than operating income because the effective tax rate increased to 33.0%. Fiscal 2017 benefited by approximately $13.2 million, or about $0.035 per diluted share, from recognition of excess share-based compensation tax benefits, partly offset by a state tax provision. The prior-year quarter included a tax benefit that increased diluted EPS by approximately $0.06.
- The quarterly dividend increased 10% to $0.46 per share. No common shares were repurchased during the quarter, compared with $62.9 million of repurchases in the prior-year quarter.
- The company early adopted ASU 2016-09 for share-based payment accounting. Excess tax benefits are now recognized in income taxes and operating cash flow; prior periods were not adjusted.
Guidance, Outlook, Risks, and Unusual Items
For fiscal 2017, management updated its outlook to include payroll service revenue growth of approximately 3% to 4%, reported net income growth of approximately 7%, and an effective tax rate of approximately 35.0%. Other guidance remained unchanged: HRS revenue growth of 12% to 14%, total service revenue growth of 7% to 8%, and mid-single-digit growth in interest on funds held for clients.
Management expects cash, corporate investments, and operating cash flow to support normal operations, capital expenditures, dividends, share repurchases, and potential acquisitions for the foreseeable future. The outlook assumes current market, economic, and interest-rate conditions continue without significant changes.
- Interest-rate risk: A 25-basis-point change in short-term interest rates is estimated to affect after-tax earnings by approximately $3.5 million to $4.0 million over 12 months. A hypothetical 25-basis-point increase in longer-term rates would reduce the fair value of available-for-sale securities by approximately $25.0 million, with the change generally recorded in equity unless impairment occurs.
- Investment risk: Available-for-sale securities had a net unrealized gain of $63.0 million at August 31, 2016. Securities with unrealized losses had aggregate losses of $0.5 million; management did not consider them other-than-temporarily impaired.
- PEO insurance risk: Workers’ compensation and health insurance reserves depend on actuarial estimates and may change materially based on claims trends, legal developments, and settlement outcomes.
- Business and operating risks: Key risks include economic and employment conditions, competition, regulation of payroll and employee benefits, technology changes, cybersecurity incidents, system or facility failures, third-party service-provider failures, internal-control failures, and legal claims.
- Legal contingencies: The company is subject to ordinary-course claims and legal matters. Management does not currently expect a material adverse effect, but acknowledges that ultimate outcomes are uncertain.
- Liquidity and credit risk: Paychex Advance purchases receivables related to temporary staffing payroll funding arrangements, creating exposure to client credit risk, although no single client was material.
Investor Verification Checklist
- Verify the fiscal 2017 guidance assumptions, particularly the 3%–4% payroll growth, 12%–14% HRS growth, 7%–8% total service revenue growth, and approximately 35% effective tax rate.
- Assess the sustainability of HRS and PEO growth, including worksite employee growth and insurance reserve trends.
- Monitor short- and long-term interest rates because investment yields materially affect client-fund interest income and portfolio fair values.
- Review the impact of the Advance Partners acquisition on revenue growth, receivables, borrowings, expenses, and credit risk.
- Distinguish recurring operating performance from discrete tax benefits and provisions when evaluating net income and EPS growth.
- Track available liquidity, the $51.3 million Paychex Advance borrowing, credit-facility availability, and client fund obligations.
- Evaluate cybersecurity, system-continuity, regulatory, PEO insurance, and legal contingencies disclosed in the filing.