Business Context and Reporting Period
Paychex, Inc. provides payroll, human resource, benefits outsourcing, retirement administration, insurance, and related services primarily to small and midsized U.S. businesses. The company reports one segment, with less than 1% of revenue generated in Germany. This Form 10-Q covers the three and six months ended November 30, 2012, representing the second quarter and first six months of fiscal 2013.
Financial Performance and Position
| Metric | Three months ended Nov. 30, 2012 | Year-over-year change | Six months ended Nov. 30, 2012 | Year-over-year change |
|---|---|---|---|---|
| Total service revenue | $559.4 million | 5% | $1,127.5 million | 4% |
| Interest on funds held for clients | $10.0 million | (8%) | $20.1 million | (8%) |
| Total revenue | $569.4 million | 4% | $1,147.6 million | 3% |
| Operating income | $230.0 million | 6% | $468.0 million | 5% |
| Net income | $147.9 million | 5% | $301.0 million | 4% |
| Diluted EPS | $0.41 | 5% | $0.83 | 4% |
- Payroll service revenue was $377.0 million in the quarter, up 1%, and $762.9 million for six months, also up 1%.
- Human Resource Services revenue was $182.4 million in the quarter, up 12%, and $364.6 million for six months, up 10%.
- Operating margin was approximately 40.4% in the quarter and 40.8% for six months, compared with approximately 39.9% and 40.4%, respectively, in the prior-year periods.
- Net margin was approximately 26.0% in the quarter and 26.2% for six months, compared with approximately 25.7% and 26.1%, respectively, in the prior-year periods.
- Operating income excluding interest on funds held for clients, a non-GAAP measure, was $220.0 million for the quarter and $447.9 million for six months. As a percentage of service revenue, it was 39.3% and 39.7%, respectively.
- Cash provided by operating activities was $326.0 million for the six months, compared with $297.2 million in the prior-year period.
- Cash and cash equivalents were $122.6 million at November 30, 2012. Cash and total corporate investments totaled $805.5 million, and the company reported no debt.
- Funds held for clients were $3.72 billion and client fund obligations were $3.66 billion at November 30, 2012.
- Total stockholders’ equity was $1.70 billion, compared with $1.60 billion at May 31, 2012.
- The company held $3.01 billion of available-for-sale securities at fair value, with a $62.9 million net unrealized gain. Management reported no other-than-temporary impairment.
Material Changes Versus the Prior Comparable Period
- HRS revenue growth materially outpaced payroll revenue growth, reflecting continued growth in retirement services, Paychex HR Solutions, and insurance services.
- Payroll service revenue growth was constrained by client disruptions from Hurricane Sandy, estimated at approximately 0.5% of payroll revenue, and by mid-market client mix.
- Checks per payroll increased 1.2% in the quarter and 1.6% for six months, moderating from 2.0% in the first quarter of fiscal 2013. Management expects further moderation during the remainder of the fiscal year.
- Interest on funds held for clients declined despite higher average investment balances because average yields fell and the portfolio contained a greater proportion of lower-yielding tax-exempt securities.
- Total expenses increased 4% in the quarter and 3% for six months, primarily due to investments in product development and supporting technology. Compensation-related expenses increased 3% in both periods.
- Net cash used in financing activities increased to $1.05 billion from $754.9 million, primarily reflecting an $829.8 million net reduction in client fund obligations and $236.4 million of dividends paid.
- Paychex acquired ExpenseWire during the quarter for approximately $12.0 million, net of cash acquired, to enhance its expense-management and Paychex One-Source offerings.
- The quarterly dividend increased 3% to $0.33 per share from $0.32 per share.
Guidance, Outlook, Risks, and Unusual Items
- Revised fiscal 2013 guidance calls for payroll service revenue growth of 2% to 3%, HRS revenue growth of 9% to 11%, total service revenue growth of 5% to 6%, interest on funds held for clients down 8% to 6%, investment income growth of 0% to 5%, and net income growth of 5% to 7%.
- Operating income excluding interest on funds held for clients is expected to be approximately 37% of total service revenue for fiscal 2013. The filing text does not provide a clearer upper or lower range for this percentage.
- The combined investment portfolio is expected to earn approximately 1.1% for fiscal 2013. Approximately 15% of the long-term portfolio is expected to mature over the next twelve months and may be reinvested at an estimated average rate of approximately 1.1%.
- Fiscal 2013 capital expenditures are expected to range from $95 million to $100 million; projected depreciation is $80 million to $85 million, and intangible amortization is expected to be slightly below $20 million.
- Management expects cash, corporate investments, and operating cash flow to fund normal operations, capital expenditures, acquisitions, and dividends for the foreseeable future.
- Four uncommitted secured lines of credit provided total unused capacity of $900 million, with maturities in February 2013. No amounts were outstanding.
- Standby letters of credit totaled $38.8 million, with no amounts drawn. Capital-asset purchase commitments were approximately $5.2 million.
- Key risks include persistent low interest rates, changes in employment and wage levels, competition and demand, regulatory changes, technology failures, cybersecurity or data breaches, operational disruptions, third-party service-provider failures, workers’ compensation claims, and adverse legal outcomes.
- Workers’ compensation reserves for PEO activities totaled $19.9 million at November 30, 2012. Management noted that reserve estimates are subject to potentially significant changes.
- On December 10, 2012, the board declared an accelerated $0.66-per-share dividend, payable December 28, 2012, intended to replace the third- and fourth-quarter fiscal 2013 dividends.
Important Facts for Investors to Verify
- Confirm the sustainability of HRS growth and whether payroll growth and checks per payroll continue to moderate.
- Monitor interest rates, portfolio yields, tax-exempt investment mix, and reinvestment yields because investment income is a meaningful earnings sensitivity.
- Assess whether the 37% fiscal 2013 operating-income-margin outlook remains consistent with quarterly performance and planned technology investments.
- Review the liquidity and operational implications of client fund balances, client fund obligations, and the February 2013 expiration dates of the $900 million credit facilities.
- Evaluate the integration and financial contribution of the ExpenseWire acquisition.
- Track workers’ compensation reserve development, legal contingencies, cybersecurity exposure, and the company’s ability to maintain effective internal controls.