Paychex, Inc. — Form 10-Q Summary
Business Context and Reporting Period
Paychex provides payroll, human resource, benefits outsourcing, retirement, workers’ compensation, and related services primarily to small and medium-sized U.S. businesses. The company reports one operating segment, with less than 1% of revenue generated in Germany. This filing covers the three months ended August 31, 2009, the first quarter of fiscal 2010, compared with the same period in fiscal 2009.
Financial Results and Key Metrics
| Metric | Q1 FY2010 | Q1 FY2009 | Change |
|---|---|---|---|
| Service revenue | $486.5 million | $509.9 million | Down 5% |
| Interest on funds held for clients | $13.7 million | $24.2 million | Down 43% |
| Total revenue | $500.2 million | $534.1 million | Down 6% |
| Operating income | $189.9 million | $221.6 million | Down 14% |
| Operating margin | 38% | 41% | Down 3 percentage points |
| Net income | $123.6 million | $148.7 million | Down 17% |
| Diluted EPS | $0.34 | $0.41 | Down 17% |
| Cash flow from operations | $186.6 million | $214.6 million | Down 13% |
- Payroll service revenue declined 6% to $354.4 million. Human Resource Services revenue increased 1% to $132.1 million.
- Operating income excluding interest on funds held for clients, a non-GAAP measure, declined 11% to $176.2 million from $197.4 million.
- Net margin was approximately 25%, compared with 28% in the prior-year quarter.
- Combined operating and selling, general and administrative expenses declined 1% to $310.3 million, reflecting cost controls and stable headcount of approximately 12,400 employees.
- The effective tax rate increased to 35.2% from 33.8%, primarily because of lower tax-exempt income and higher state tax rates.
- Cash and cash equivalents totaled $315.3 million at August 31, 2009. Cash plus corporate investments totaled approximately $634.1 million, and the company reported no debt.
- Funds held for clients were $3.02 billion, matched by client fund obligations of $2.95 billion; these balances primarily relate to client payroll and tax remittances and should not be viewed as unrestricted corporate liquidity.
- Stockholders’ equity was $1.36 billion and total assets were $4.71 billion at August 31, 2009.
- Cash dividends remained $0.31 per common share; $112.1 million of dividends were paid during the quarter.
Material Changes Versus the Prior Comparable Period
- Weak economic conditions reduced client growth, checks processed per client, revenue per check, and average client fund balances.
- Checks per client declined 5%, new client sales from new business starts declined 13%, and clients lost because businesses failed or had no remaining employees increased 1% year over year.
- Average funds held for clients declined 10% to $2.91 billion. The company attributed the decline partly to the 2009 economic stimulus package, which reduced tax withholdings for client employees.
- Average combined investment yields fell to 1.7% from 2.9%. Interest on funds held for clients declined because of both lower yields and lower balances.
- Average corporate investments increased, but corporate investment income declined 70% to $0.9 million because of lower interest rates.
- Human Resource Services indicators remained comparatively stronger: comprehensive HR outsourcing clients increased 10% to approximately 18,000, and client employees served increased 4% to approximately 463,000.
- Available-for-sale securities had a net unrealized gain of $68.6 million at August 31, 2009, compared with $66.7 million at May 31, 2009. The company reported no other-than-temporary impairment.
Guidance, Outlook, Risks, and Unusual Items
- Fiscal 2010 guidance assumes weak economic and financial conditions continue. Management projected payroll service revenue down 7% to 5%, Human Resource Services revenue up 3% to 6%, total service revenue down 5% to 2%, total revenue down 5% to 2%, and net income down 12% to 10%.
- Interest on funds held for clients was projected to decline 30% to 25%, while net investment income was projected to decline 35% to 30%. Management does not include speculative future interest-rate changes in its guidance.
- Operating income excluding interest on funds held for clients was expected to equal 34% to 35% of service revenue. The effective tax rate was expected to approximate 35%.
- Fiscal 2010 capital expenditures were projected at $55 million to $60 million, depreciation at approximately $65 million to $70 million, and intangible amortization at approximately $20 million to $25 million.
- The long-term investment portfolio had an average yield to maturity of 3.0% and duration of 2.6 years. Slightly less than 15% was expected to mature over the following twelve months and to be reinvested at an estimated average rate of approximately 1.2%.
- Paychex maintained $900 million of unused capacity under four uncommitted secured short-term lines of credit, with no borrowings outstanding. A separate committed secured revolving facility expired on September 20, 2009 and was not renewed.
- Standby letters of credit totaled $65.8 million and were collateralized by investment securities. Capital purchase commitments were approximately $6.4 million.
- The litigation reserve was $20.4 million. Management did not expect pending legal matters to have a material adverse effect, but acknowledged that litigation outcomes remain uncertain.
- Key risks include continued economic weakness, lower employment and payroll volumes, interest-rate declines, investment credit and valuation risk, workers’ compensation claims, technology or processing failures, third-party service disruptions, regulatory changes, errors and omissions, and adverse legal outcomes.
- The company adopted several accounting standards during the quarter; management stated that they had no material effect. The filing reported effective disclosure controls and no material change in internal control over financial reporting.
Important Facts for Investors to Verify
- Whether payroll volumes, client retention, new client sales, and checks per client stabilized or deteriorated further after August 31, 2009.
- The effect of sustained low interest rates and reinvestment yields on interest income, investment income, and fiscal 2010 guidance.
- The distinction between restricted client funds and unrestricted corporate cash and investments when assessing liquidity.
- The status and terms of replacement financing after the September 20, 2009 revolving credit facility expiration.
- Whether investment portfolio unrealized gains remain intact and whether any securities subsequently become other-than-temporarily impaired.
- Developments in the $20.4 million litigation reserve, workers’ compensation claims, and other contingencies.
- Whether management’s projected fiscal 2010 revenue and earnings ranges remain achievable under prevailing economic conditions.