Paychex, Inc. — Form 10-Q Summary
Reporting period: Three and nine months ended February 29, 2012, compared with the corresponding periods ended February 28, 2011. The filing represents fiscal 2012 third quarter; the request metadata identifies “2011 Q3.” Paychex provides payroll, human-resource, benefits, retirement, insurance, and related outsourcing services primarily to U.S. small and medium-sized businesses. Germany generated less than 1% of revenue.
Financial Performance and Position
| Metric | Three months ended Feb. 29, 2012 | Year-over-year change | Nine months ended Feb. 29, 2012 | Year-over-year change |
|---|---|---|---|---|
| Total service revenue | $558.5 million | 8% | $1,645.5 million | 8% |
| Total revenue | $569.5 million | 7% | $1,678.3 million | 7% |
| Operating income | $210.4 million | 6% | $658.0 million | 9% |
| Net income | $135.4 million | 4% | $424.7 million | 7% |
| Diluted EPS | $0.37 | 3% | $1.17 | 7% |
| Operating cash flow | Not separately provided | — | $562.6 million | 2% |
| Cash dividends per share | $0.32 | 3% | $0.95 | 2% |
- Revenue mix: Third-quarter payroll service revenue increased 5% to $386.5 million; Human Resource Services revenue increased 12% to $172.0 million. For nine months, the respective increases were 5% and 14%.
- Profitability: Approximate third-quarter operating margin was 36.9% of total revenue and net margin was 23.8%. Nine-month operating margin was approximately 39.2% and net margin approximately 25.3%. Non-GAAP operating income, excluding interest on funds held for clients, was $199.4 million, or 35.7% of service revenue, versus 36.0% in the prior-year quarter.
- Expenses and taxes: Operating and SG&A expenses increased 8% in the quarter and 7% year to date. The effective tax rate increased to 36.1% in the quarter and 35.9% year to date from 34.8% in each prior-year period.
- Liquidity and debt: Cash and corporate investments totaled $798.7 million, and the company reported no debt. Cash and cash equivalents were $146.5 million at February 29, 2012, compared with $119.0 million at May 31, 2011.
- Client funds: Funds held for clients were $4.167 billion, offset by client fund obligations of $4.109 billion. Total funds held for clients and corporate investments were $4.819 billion, compared with $4.119 billion at May 31, 2011.
- Cash flow and capital allocation: Operating cash flow was $562.6 million; investing activities used $791.2 million, primarily reflecting investment portfolio activity; financing activities provided $256.1 million, including a $595.5 million increase in client fund obligations and $344.3 million of dividends paid.
- Investments: Available-for-sale securities had a fair value of $3.619 billion and a net unrealized gain of $68.1 million. Management stated that the portfolio was high quality, liquid, and not other-than-temporarily impaired.
Material Changes Versus the Prior Comparable Period
- Total service revenue grew 8%, supported by higher checks per payroll, modest pricing increases, client growth, and ancillary-service growth.
- Checks per payroll increased 1.8% in the quarter, while client losses improved 5% from the prior-year quarter. Management expects checks-per-payroll growth to moderate during the remainder of fiscal 2012.
- SurePayroll and ePlan contributed approximately 2% of third-quarter total revenue growth. Excluding those acquisitions, total service revenue growth was 6% for both the quarter and nine months.
- Interest on funds held for clients declined 7% in the quarter and 8% year to date because lower yields more than offset higher average investment balances. The combined portfolio earned 1.1% in the quarter versus 1.2% in the prior-year quarter.
- Expense growth reflected acquisitions and continued investment in product development and technology. The company had approximately 12,400 employees, compared with approximately 12,300 a year earlier.
- Paychex acquired Icon Time Systems, an employee time-and-attendance solutions provider, during the quarter. The related business acquisition was described as immaterial.
- The quarterly dividend increased 3% to $0.32 per share from $0.31 per share.
Guidance, Outlook, Risks, and Unusual Items
- Fiscal 2012 guidance: Payroll service revenue growth of 5%–7%; Human Resource Services revenue growth of 12%–15%; total service revenue growth of 7%–9%; interest on funds held for clients down 12%–14%; investment income growth of 0%–2%; and net income growth of 5%–7%.
- Non-GAAP operating income as a percentage of service revenue is expected to be 36%–37%. The effective tax rate is expected to approximate the first-nine-month rate.
- Management expects a $0.01 EPS dilution from SurePayroll and ePlan, primarily from acquired-intangible amortization. Capital expenditures are projected at $90 million–$95 million, depreciation at $75 million–$80 million, and intangible amortization at $20 million–$25 million for fiscal 2012.
- Management expects the combined investment portfolio to earn approximately 1.1% for fiscal 2012. A 25-basis-point change in short-term interest rates could affect after-tax earnings by approximately $3.5 million–$4.0 million over 12 months.
- Key risks include low interest rates, changes in employment and wage levels, competition and demand, regulatory changes affecting payroll and benefits, workers’ compensation claims, technology and cybersecurity failures, system or service-provider disruptions, internal-control failures, and unfavorable legal outcomes.
- PEO workers’ compensation reserves involve actuarial estimates and could change materially as claims trends, legal standards, and economic conditions develop. The company’s maximum individual claims liability was $1.0 million under its fiscal 2012 policy.
- The company had $900 million of unused capacity under four uncommitted secured lines of credit, with no borrowings outstanding. Standby letters of credit totaled $46.8 million, with no amounts outstanding.
- Management stated that pending legal matters were not expected to have a material adverse effect, while acknowledging that litigation outcomes remain uncertain.
Investor Verification Points
- Verify the period designation: the filing is for fiscal 2012 third quarter, despite the request metadata stating 2011 Q3.
- Assess the sustainability of revenue growth as checks-per-payroll growth moderates and the contribution from SurePayroll and ePlan lapses from comparisons.
- Monitor interest-rate sensitivity, reinvestment yields, portfolio duration, and the effect of low rates on client-fund interest revenue.
- Review the quality, liquidity, and unrealized gains or losses in the municipal-bond and variable-rate-demand-note portfolios.
- Evaluate PEO workers’ compensation reserves, claims development, and related insurance exposures.
- Reconcile reported GAAP operating income with the company’s non-GAAP operating income excluding interest on funds held for clients.
- Confirm progress toward the company’s fiscal 2012 revenue, margin, capital-expenditure, tax-rate, and EPS-dilution guidance.