Paychex, Inc. 10-Q Summary
Business Context and Reporting Period
Paychex provides payroll, human capital management, HR, benefits, insurance, and professional employer organization services primarily to small and midsized U.S. businesses, with limited European operations. The filing covers the quarter and six months ended November 30, 2019, Paychex’s fiscal 2020 second quarter. The company reports one operating segment.
Results include Oasis Outsourcing Group Holdings, acquired on December 20, 2018. Oasis materially increased PEO and Insurance Services revenue and related expenses.
Key Financial Metrics
| Metric | Three months ended Nov. 30, 2019 | Year-over-year change | Six months ended Nov. 30, 2019 | Year-over-year change |
|---|---|---|---|---|
| Total revenue | $990.7 million | 15% | $1,982.7 million | 15% |
| Management Solutions revenue | $726.7 million | 6% | $1,451.2 million | 6% |
| PEO and Insurance Services revenue | $244.1 million | 57% | $491.1 million | 57% |
| Interest on funds held for clients | $19.9 million | 9% | $40.4 million | 14% |
| Operating income | $341.7 million | 11% | $690.8 million | 10% |
| Operating margin | 34.5% | Down from 35.8% | 34.8% | Down from 36.4% |
| Net income | $258.7 million | 10% | $522.9 million | 9% |
| Diluted EPS | $0.72 | 11% | $1.45 | 9% |
| EBITDA | $398.8 million | 16% | $801.8 million | 14% |
| EBITDA margin | 40% | Flat | 40% | Flat |
Adjusted net income was $253.8 million for the quarter and $511.4 million for the six months. Adjusted diluted EPS was $0.70 and $1.42, respectively. These are non-GAAP measures and primarily exclude excess tax benefits related to employee stock-based compensation.
Cash Flow, Liquidity, Debt, and Investments
- Operating cash flow was $564.6 million for the six months, up 14% from $497.2 million in the prior-year period.
- Investing activities provided $565.2 million, primarily reflecting net proceeds from purchases, sales, and maturities of available-for-sale securities.
- Financing activities used $645.0 million, including $444.3 million of dividends and $171.9 million for repurchases of 2.0 million shares.
- Cash, cash equivalents, and restricted cash totaled $1.420 billion at November 30, 2019. Cash, restricted cash, and corporate investments totaled $707.8 million, excluding funds held for clients.
- Funds held for clients were $3.735 billion and client fund obligations were $3.696 billion.
- Total borrowings were $847.9 million, consisting of $51.3 million of short-term borrowings and $796.6 million of long-term borrowings, net of debt issuance costs.
- Long-term debt consists of unsecured fixed-rate Senior Notes of $400 million due in 2026 at 4.07% and $400 million due in 2029 at 4.25%.
- Paychex had no borrowings outstanding under its $1.0 billion and $500 million JPMorgan revolving facilities at quarter-end. A $51.3 million borrowing remained outstanding under the $150 million PNC facility.
- The company had $147.4 million of standby letters of credit, primarily supporting insurance commitments, with no amounts drawn.
- Management stated that available cash, investments, projected operating cash flow, and financing capacity should support normal operations, capital expenditures, share repurchases, and dividends for the foreseeable future.
Material Changes Versus the Prior Comparable Period
- Oasis was the principal structural change, contributing approximately 9% of second-quarter total revenue growth and approximately 47% of PEO and Insurance Services revenue growth.
- PEO and Insurance Services revenue increased 57%, while Management Solutions revenue increased 6%, driven by client growth, higher revenue per client, price realization, and greater penetration of time and attendance, retirement, and HR outsourcing services.
- Total expenses grew 18%, faster than revenue, reflecting Oasis-related costs, higher headcount, technology investment, PEO insurance costs, and increased depreciation and amortization. Headcount was approximately 15,700, compared with approximately 14,600 a year earlier.
- Operating margin declined because expenses grew faster than revenue, although EBITDA margin remained approximately 40%.
- Other expense, net, changed to $4.7 million from other income of $2.1 million, primarily because of interest expense on acquisition-related debt and lower corporate investment balances.
- Dividend payments increased to $444.3 million from $402.7 million, and share repurchases increased to $171.9 million from $32.8 million.
- The company adopted the new lease standard on June 1, 2019, recording operating lease right-of-use assets of $119.2 million and operating lease liabilities of $138.2 million at November 30, 2019. The adoption did not affect debt covenants.
Outlook, Commentary, Risks, and Unusual Items
Management emphasized continued investment in the Paychex Flex cloud platform, technology enhancements, personalized service, and cross-selling of HCM solutions. The filing does not provide a specific companywide revenue or EPS guidance range.
Management expects the total investment portfolio to average approximately $4.9 billion in fiscal 2020, with approximately 40% in short-term investments and variable-rate demand notes and 60% in available-for-sale securities. A 25-basis-point change in short-term interest rates is estimated to affect annual after-tax earnings by approximately $3 million to $4 million. A hypothetical 25-basis-point increase in longer-term rates could reduce the fair value of the available-for-sale portfolio by approximately $20 million to $25 million, generally through equity unless impairment is recognized.
- Key operational risks include regulatory and tax changes, data privacy and cybersecurity incidents, technology or facility disruptions, third-party service failures, and inability to keep pace with product and technology changes.
- PEO-related risks include co-employment obligations, workers’ compensation and health insurance claims, changing insurance rates, and actuarial reserve uncertainty. The maximum individual workers’ compensation claims liability under applicable policies was $1.0 million for the fiscal year ending May 31, 2020.
- Acquisition integration, goodwill and intangible asset valuation, and increased amortization remain important considerations following the Oasis acquisition. No goodwill or intangible impairment was recognized during the six months.
- The company is exposed to credit risk on investments and purchased receivables. Management concluded that investments with $1.9 million of gross unrealized losses were not other-than-temporarily impaired.
- Pending legal matters arise in the ordinary course of business. Management does not currently expect a material adverse effect, but acknowledges that ultimate outcomes could differ.
- Future accounting standards, including the current expected credit loss model, are scheduled to apply beginning June 1, 2020. The company was evaluating their potential effects.
Important Facts for Investors to Verify
- Assess whether the Oasis-driven 57% PEO revenue growth is sustainable and how effectively integration costs and insurance risks are being managed.
- Monitor the decline in operating margin as expenses grow faster than revenue.
- Review the effect of interest rates on funds-held-for-clients income, investment fair values, and future earnings.
- Verify debt maturity, fixed interest costs, covenant compliance, and reliance on short-term borrowings for operating liquidity.
- Evaluate cash conversion after dividends, share repurchases, capital expenditures, and client-fund timing effects.
- Review workers’ compensation and health insurance reserves, claims trends, and PEO-related contingencies.
- Track implementation of the current expected credit loss standard and any resulting cumulative adjustment to retained earnings.