Paychex, Inc. Form 10-Q Summary
Business Context and Reporting Period
Paychex provides payroll, human resource, insurance, benefits, retirement, and related outsourcing solutions primarily to small and medium-sized businesses in the United States, with immaterial German operations. This filing covers the three and nine months ended February 28, 2014, Paychex’s fiscal 2014 third quarter and year-to-date period. The financial statements are unaudited.
Financial Performance and Position
| Metric | Three Months Ended February 28, 2014 | Year-over-Year Change | Nine Months Ended February 28, 2014 | Year-over-Year Change |
|---|---|---|---|---|
| Payroll service revenue | $413.9 million | 5% | $1,204.8 million | 4% |
| Human Resource Services revenue | $212.1 million | 12% | $619.6 million | 12% |
| Total service revenue | $626.0 million | 7% | $1,824.4 million | 7% |
| Total revenue | $636.5 million | 7% | $1,854.9 million | 7% |
| Operating income | $250.7 million | 11% | $754.4 million | 9% |
| Net income | $160.1 million | 11% | $481.6 million | 8% |
| Diluted EPS | $0.44 | 10% | $1.31 | 7% |
| Operating cash flow | Not provided for the quarter | — | $705.8 million | 16% |
Third-quarter operating margin was approximately 39.4% of total revenue, compared with approximately 37.9% in the prior-year quarter. Net margin was approximately 25.2%, compared with approximately 24.4% previously. Operating income, net of certain items, excluding interest on funds held for clients, was $240.2 million, or 38.4% of service revenue, versus $214.1 million, or 36.8%, in the prior-year quarter.
At February 28, 2014, cash and cash equivalents were $271.3 million, corporate investments were $314.4 million, and long-term corporate investments were $377.8 million. Management reported cash and total corporate investments of $963.5 million and no debt. Funds held for clients were $4.9 billion, offset by client fund obligations of $4.9 billion. Stockholders’ equity was $1.8 billion.
For the nine months, investing activities used $894.2 million, including $62.8 million for property and equipment and $9.3 million for acquisitions. Financing activities provided $352.4 million, including $841.0 million from the net change in client fund obligations, offset by $383.4 million of dividends and $203.0 million of share repurchases. Cash and cash equivalents increased by $164.0 million to $271.3 million.
Material Changes Versus the Prior Comparable Period
- Service revenue growth was led by HRS revenue, which increased 12%, compared with 5% growth in payroll service revenue.
- Payroll revenue benefited from higher checks per payroll, increased revenue per check, pricing and product penetration, and one additional processing day in the quarter.
- HRS growth reflected continued expansion in ASO, PEO, retirement services, eServices, and related products. Higher direct PEO costs modestly tempered growth.
- Interest on funds held for clients declined 3% in the quarter and 1% year to date because of lower average yields and lower realized gains, partially offset by higher investment balances.
- Expenses increased 5% in both periods, principally because of higher compensation, wages, performance-based compensation, sales commissions, product development, technology, and sales-force investments.
- Share repurchases were $203.0 million for the nine months, compared with none in the prior-year period. The company repurchased 5.0 million shares year to date and 1.1 million shares in the quarter.
- Dividends paid declined year over year because the prior-year period included accelerated dividend payments. The quarterly dividend was increased to $0.35 per share in July 2013.
Guidance, Outlook, Risks, and Unusual Items
Fiscal 2014 guidance assumes current market, economic, and interest-rate conditions continue without significant change. Management expects payroll service revenue growth of 3% to 4%, HRS revenue growth of 10% to 11%, total service revenue growth of 5% to 6%, and net income growth of 9% to 10%. Operating income, net of certain items, is expected to be approximately 38% of service revenue, with an effective tax rate of 36% to 37%.
Management expects the fourth quarter to be affected by one fewer processing day than the prior-year quarter. Fiscal 2014 investment portfolio returns are expected to average approximately 1.0%; reinvestment of maturing securities may occur at yields of approximately 1.0% to 1.5%. Capital expenditures are projected at $100 million to $110 million, depreciation at $85 million to $90 million, and intangible amortization at approximately $15 million.
Low interest rates remain a significant earnings headwind. The company’s combined funds-held-for-clients and corporate investment portfolios earned 0.9% in the quarter and 1.0% year to date. A 25-basis-point change in short-term interest rates is estimated to affect after-tax earnings by approximately $4.5 million over the following 12 months. The investment portfolio primarily consists of investment-grade municipal and short-term securities; management reported no high-risk or illiquid investments and no other-than-temporary impairment.
Available-for-sale securities had a net unrealized gain of $39.2 million at February 28, 2014, while securities with fair values below amortized cost had unrealized losses of $3.9 million. The company has $500 million of committed unsecured credit capacity through June 2018, four uncommitted secured lines totaling $900 million, and $43.0 million of standby letters of credit; no amounts were outstanding under these facilities at period end.
Key risks include employment and wage trends, interest-rate and investment-market changes, demand and competition, regulatory changes affecting payroll and benefits, workers’ compensation claims, cybersecurity or systems failures, third-party service-provider failures, internal-control issues, and litigation. The company maintains reserves for PEO workers’ compensation claims, which are subject to actuarial and legal uncertainties. Management believes outstanding legal matters will not have a material adverse effect, but acknowledges that outcomes remain uncertain.
The company launched or expanded payment-processing, cloud-based SaaS, mobile, and health-care-reform compliance offerings during the quarter. Fiscal 2013’s fourth-quarter state income-tax settlement reduced prior-year diluted EPS by approximately $0.04 and creates a favorable comparison for fiscal 2014 net-income growth.
Investor Verification Points
- Verify that HRS growth, particularly in PEO, retirement, and SaaS-related services, remains sufficient to offset slower payroll growth and related direct costs.
- Assess the effect of continued low interest rates and reinvestment yields on interest income and total earnings.
- Review the investment portfolio’s credit quality, duration, unrealized gains and losses, and impairment conclusions.
- Reconcile guidance with the reported nine-month results, including the one-fewer-processing-day impact expected in the fourth quarter.
- Monitor PEO workers’ compensation reserves, claims development, and potential regulatory or litigation exposure.
- Track capital expenditures, technology investment, share repurchases, dividend policy, and remaining repurchase authorization.
- Confirm liquidity availability and the absence of borrowings under credit facilities and standby letters of credit.