Paychex, Inc. — Fiscal 2014 First-Quarter Summary
Filing and period: Form 10-Q for the three months ended August 31, 2013. Results are unaudited and compared with the three months ended August 31, 2012. Paychex provides payroll, human-resource, insurance, benefits, retirement, and related outsourcing services primarily to U.S. small and medium-sized businesses; Germany contributed less than 1% of revenue.
Financial performance
| Metric | Q1 FY2014 | Q1 FY2013 | Change |
|---|---|---|---|
| Total revenue | $607.9 million | $578.2 million | 5% |
| Service revenue | $597.9 million | $568.1 million | 5% |
| Payroll service revenue | $395.2 million | $385.9 million | 2% |
| Human Resource Services revenue | $202.7 million | $182.2 million | 11% |
| Operating income | $255.1 million | $238.0 million | 7% |
| Operating margin | 42.0% | 41.2% | Expanded |
| Net income | $162.8 million | $153.1 million | 6% |
| Diluted EPS | $0.44 | $0.42 | 5% |
| Operating income, net of certain items | $245.1 million | $227.9 million | 8% |
| Effective tax rate | 36.5% | 36.2% | Up 0.3 percentage points |
Margins and drivers: Operating income, net of certain items, was 41.0% of service revenue versus 40.1% in the prior-year quarter. Expense growth was 4%, with compensation-related costs rising 4% and investments continuing in product development, technology, and sales capacity. Interest on funds held for clients declined 1% to $10.0 million, while net investment income fell 35% to $1.2 million because of lower yields.
Cash flow, liquidity, and capital structure
- Operating cash flow was $266.7 million, compared with $217.7 million in the prior-year quarter.
- Cash and cash equivalents were $111.6 million at August 31, 2013; corporate investments totaled $813.2 million, for cash and corporate investments of $924.8 million.
- The company reported no debt outstanding. It had a new $500 million committed unsecured credit facility expiring June 21, 2018, plus $900 million of unused secured short-term borrowing capacity.
- Funds held for clients were $3.912 billion, offset by client fund obligations of $3.913 billion.
- Capital expenditures were $25.1 million. Fiscal 2014 capital expenditures were expected to be $100 million to $110 million.
- Dividends paid were $127.9 million, and the quarterly dividend was increased to $0.35 per share. The company repurchased 2.1 million shares for $83.9 million, leaving approximately $266.1 million under the repurchase authorization.
Material changes versus the prior comparable period
- HRS revenue growth of 11% materially outpaced payroll service revenue growth of 2%, supported by retirement services, Paychex HR Solutions, eServices, insurance, pricing, and higher retirement-plan asset values.
- Checks per payroll increased 1.6%; revenue per check grew modestly after price increases and discounting.
- Average combined funds held for clients and corporate investments increased 8% to $4.387 billion, but the average return declined to 1.0% from 1.2%.
- Available-for-sale securities moved from a $34.7 million net unrealized gain at May 31, 2013 to an $8.2 million net unrealized loss at August 31, 2013, primarily because of higher market interest rates. The after-tax other comprehensive loss was $26.9 million.
- Net cash used in financing activities decreased to $293.2 million from $949.4 million, primarily because the prior-year period reflected larger timing-related client fund obligation outflows; the current quarter also included $83.9 million of share repurchases.
Guidance, outlook, and management commentary
| Fiscal 2014 outlook | Expected range |
|---|---|
| Payroll service revenue growth | 3%–4% |
| HRS revenue growth | 9%–10% |
| Total service revenue growth | 5%–6% |
| Net income growth | 8%–9% |
| Operating income, net of certain items, as a percentage of service revenue | Approximately 38% |
| Effective tax rate | 36%–37% |
- Management assumed generally unchanged market, economic, and interest-rate conditions.
- The average return on combined investment portfolios was expected to remain approximately 1.0%. Slightly less than 15% of the long-term portfolio was expected to mature over the next 12 months, with proceeds expected to be reinvested at approximately 1.1%.
- Fiscal 2014 depreciation was projected at $85 million to $90 million, and intangible-asset amortization at approximately $15 million.
- Management emphasized investments in SaaS, mobile applications, Paychex Next Generation products, mid-market functionality, and health-care-reform solutions.
Risks, contingencies, and unusual items
- Results remain sensitive to interest rates. Management estimated that a 25-basis-point change in short-term rates could affect after-tax earnings by approximately $4.0 million to $4.5 million over the following 12 months.
- The investment portfolio had $35.0 million of gross unrealized losses, primarily attributed to interest-rate movements. Management believed the securities were not other-than-temporarily impaired and expected principal and interest to be collected.
- PEO workers’ compensation reserves totaled $21.7 million, consisting of $7.1 million current and $14.6 million long term. Final claim costs may differ materially from estimates because of claims trends, legal changes, and damage awards.
- Standby letters of credit totaled $35.5 million and supported certain insurance commitments; none had been drawn.
- Management disclosed risks involving employment and benefits regulation, health-care reform, competition, technology changes, cybersecurity, system or facility failures, third-party providers, internal controls, PEO liabilities, credit risk, and litigation. Management did not expect pending legal matters to have a material adverse effect, but acknowledged that outcomes are uncertain.
- The company adopted new comprehensive-income and indefinite-lived-intangible-asset impairment guidance without a material effect. Newly issued tax-benefit presentation guidance was not expected to have a material effect.
Important facts for investors to verify
- Whether HRS growth and the company’s 9%–10% full-year HRS outlook are sustained, particularly in retirement, eServices, insurance, and PEO operations.
- The effect of persistently low interest rates and portfolio reinvestment yields on interest revenue, investment income, and future earnings.
- Changes in the fair value and credit quality of municipal bonds and the potential for other-than-temporary impairment.
- Progress and spending associated with SaaS, mobile, health-care-reform, and other technology initiatives, including their effect on margins.
- Developments in PEO workers’ compensation claims, insurance reserves, regulatory requirements, cybersecurity, and legal contingencies.
- Future use of the remaining share-repurchase authorization and sustainability of dividend growth relative to operating cash flow.