Paychex, Inc. Form 10-K Summary
Reporting period: Fiscal year ended May 31, 2011. The supplied metadata references 2010 Q4, but the filing is Paychex’s fiscal 2011 annual report and includes quarterly data for fiscal 2011 and fiscal 2010.
Business Context
Paychex provides payroll, human-resource, benefits, retirement, insurance, and related outsourcing services primarily to small and medium-sized U.S. businesses. The company reports one business segment and had approximately 564,000 clients, 12,400 employees, and more than 100 U.S. offices as of May 31, 2011. Germany represented less than 1% of consolidated revenue.
- Payroll service revenue is primarily recurring and driven by client count, checks or transactions per client, pricing, and ancillary-service utilization.
- Fiscal 2011 acquisitions included SurePayroll, acquired February 8, 2011 for $114.9 million, and ePlan Services, acquired May 3, 2011 for $15.2 million, both net of cash acquired.
Key Financial Metrics
| Fiscal year ended May 31 | 2011 | 2010 | Change |
|---|---|---|---|
| Payroll service revenue | $1,438.8 million | $1,404.9 million | 2% |
| Human Resource Services revenue | $597.4 million | $540.9 million | 10% |
| Total service revenue | $2,036.2 million | $1,945.8 million | 5% |
| Interest on funds held for clients | $48.1 million | $55.0 million | (13%) |
| Total revenue | $2,084.3 million | $2,000.8 million | 4% |
| Operating income | $786.4 million | $724.8 million | 8% |
| Operating margin | 38% | 36% | Up 2 percentage points |
| Net income | $515.3 million | $477.0 million | 8% |
| Net margin | 25% | 24% | Up 1 percentage point |
| Diluted EPS | $1.42 | $1.32 | 8% |
| Cash flow from operations | $715.3 million | $610.9 million | 17% |
| Dividends paid | $448.8 million | $448.6 million | Comparable |
| Capital expenditures | $100.5 million | $61.3 million | Higher |
Operating income, net of certain items, a non-GAAP measure excluding interest on client funds and the fiscal 2010 litigation-reserve charge, increased 7% to $738.3 million from $688.5 million. As a percentage of service revenue, this measure improved to 36.3% from 35.4%.
Financial Position and Liquidity
- Cash and total corporate investments were $671.3 million at May 31, 2011, compared with $656.9 million at May 31, 2010.
- The company had no debt and reported total stockholders’ equity of $1,496.2 million.
- Funds held for clients and corporate investments totaled $4.119 billion at fair value, including $2.737 billion of available-for-sale securities.
- Four secured, uncommitted short-term credit facilities provided aggregate unused capacity of $900 million; no amounts were outstanding.
- Standby letters of credit totaled $47.4 million, primarily supporting insurance commitments.
- Cash flow from operations funded normal operations, acquisitions, capital expenditures, and dividends. Management expects available cash, investments, and operating cash flow to support these needs for the foreseeable future.
Material Changes Versus Fiscal 2010
- Service revenue growth returned to 5%, compared with a 3% decline in fiscal 2010. Payroll revenue increased 2% after declining 5% in fiscal 2010.
- Human Resource Services revenue accelerated to 10% growth from 3%, supported by growth in HR Solutions, insurance, health and benefits, and retirement services.
- Checks per client increased 2.1%, reversing a 2.6% decline in fiscal 2010. Excluding 33,000 SurePayroll clients, the overall client base declined 0.9%.
- Client retention improved to approximately 79% of the beginning client base, two percentage points above fiscal 2010, while client losses declined 9%.
- Interest on client funds declined 13% because average investment yields fell to 1.3% from 1.5%, partially offset by higher average investment balances.
- Fiscal 2010 included an $18.7 million litigation-reserve charge related to the Rapid Payroll court decision, reducing fiscal 2010 diluted EPS by $0.03. No comparable charge was recorded in fiscal 2011.
- Operating and selling, general and administrative expenses increased 2% in fiscal 2011, reflecting personnel costs, product development, technology investment, and acquisition-related expenses.
- Goodwill increased to $513.7 million from $421.6 million, primarily from the SurePayroll and ePlan acquisitions. No goodwill impairment was recorded.
Guidance, Outlook, and Management Commentary
For fiscal 2012, management assumed continuation of prevailing economic and interest-rate conditions and did not speculate on future interest-rate changes.
| Fiscal 2012 outlook | Low | High |
|---|---|---|
| Payroll service revenue growth | 5% | 7% |
| Human Resource Services revenue growth | 12% | 15% |
| Total service revenue growth | 7% | 9% |
| Interest on funds held for clients | (14%) | (12%) |
| Investment income, net growth | 0% | 2% |
| Net income growth | 5% | 7% |
- Operating income, net of certain items, as a percentage of service revenue was expected at 35% to 36%.
- The effective tax rate was expected to approximate 35%.
- The combined portfolio yield was expected to average approximately 1.2%.
- Fiscal 2012 capital expenditures were expected to be $90 million to $95 million; depreciation was expected at $75 million to $80 million; and intangible amortization was expected at $20 million to $25 million.
- SurePayroll and ePlan were expected to add approximately 2% to service revenue and dilute EPS by approximately $0.01, primarily from acquired-intangible amortization.
Risks, Contingencies, and Unusual Items
- Persistently low interest rates could reduce income earned on client funds and corporate investments. Management estimated that a 25-basis-point short-term rate change could affect after-tax earnings by approximately $3.5 million to $4.0 million over twelve months.
- Economic weakness, lower employment and wage levels, fewer new-business formations, and client closures could reduce payroll volumes, client additions, and funds available for investment.
- Regulatory changes affecting payroll taxes, employee benefits, retirement plans, insurance, workers’ compensation, or professional employer organizations could increase costs or reduce demand.
- Cybersecurity incidents, confidentiality breaches, system failures, catastrophic events, or third-party service-provider failures could interrupt operations and create liability.
- The PEO business exposes Paychex to co-employment, employment-law, benefits, healthcare, and workers’ compensation risks. Workers’ compensation liabilities totaled $27.9 million at May 31, 2011.
- Paychex was under a New York State income-tax audit for fiscal 2004 through fiscal 2009. The proposed adjustments exceeded the recorded reserve, and the ultimate impact could not be reasonably estimated.
- The reserve for uncertain tax positions was $34.4 million, up from $27.5 million.
- Operating leases and purchase obligations totaled $222.4 million, including $83.6 million due within one year.
- Management believed outstanding legal matters would not materially affect financial condition or results, but acknowledged that outcomes remain uncertain.
- Management and Ernst & Young reported effective internal control over financial reporting and effective disclosure controls as of May 31, 2011.
Investor Verification Priorities
- Verify that fiscal 2011 annual results, rather than a fiscal 2010 fourth-quarter period, are the intended comparison period.
- Assess the sustainability of service-revenue growth excluding the contribution from the 33,000 acquired SurePayroll clients.
- Monitor client retention, new sales, checks per client, employment trends, and ancillary-service adoption.
- Track interest rates, portfolio yields, reinvestment rates, and the effect of maturing securities on interest income.
- Review the New York State tax audit, uncertain-tax-position reserve, and any subsequent settlement or proposed assessment.
- Evaluate workers’ compensation reserves and PEO-related claims experience.
- Consider acquisition integration, goodwill and intangible-asset amortization, and the expected fiscal 2012 EPS dilution.
- Reconcile GAAP operating income with management’s non-GAAP operating income, net of certain items.