Paychex, Inc. Fiscal 2010 Form 10-K Summary
Business context and reporting period
Paychex provides payroll, human-resource, benefits, retirement, insurance, and related outsourcing services primarily to small and medium-sized U.S. businesses. The filing covers the fiscal year ended May 31, 2010, not a calendar 2009 fourth quarter. The company reported as one business segment, served approximately 536,000 clients, and employed approximately 12,200 people at year-end.
Financial performance and liquidity
| Metric | Fiscal 2010 | Change versus fiscal 2009 |
|---|---|---|
| Service revenue | $1.946 billion | Down 3% |
| Interest on funds held for clients | $55.0 million | Down 27% |
| Total revenue | $2.001 billion | Down 4% |
| Operating income | $724.8 million | Down 10% |
| Operating margin | 36% | Down from 39% |
| Net income | $477.0 million | Down 11% |
| Diluted EPS | $1.32 | Down 11% |
| Cash flow from operations | $610.9 million | Down 11% |
| Dividends paid | $448.6 million | 94% of net income |
- Payroll service revenue declined 5% to $1.405 billion, while Human Resource Services revenue increased 3% to $540.9 million.
- Operating income included an $18.7 million charge to increase the Rapid Payroll litigation reserve, reducing diluted EPS by approximately $0.03. Operating income excluding interest on client funds and this unusual charge was $688.5 million, down 6%.
- Cash and total corporate investments were $656.9 million at May 31, 2010; total debt was zero. The company also had $900 million of unused secured short-term credit capacity.
- Funds held for clients and corporate investments totaled $3.914 billion at fair value, including $2.152 billion of available-for-sale securities. Management reported no other-than-temporary impairment and no exposure to high-risk or illiquid investments.
- Capital expenditures were $61.3 million. Total assets were $5.226 billion and stockholders’ equity was $1.402 billion.
Material changes versus the prior comparable period
- The recession reduced client formation, client retention, payroll transaction volumes, and average client-fund balances. The client base decreased 3.2% to approximately 536,000, while checks per client decreased 2.6%.
- Interest income declined because average investment balances fell 5% and portfolio yields decreased. The combined average return on client funds and corporate investments fell to 1.5% from 2.1%.
- Human Resource Services growth was supported by increased Paychex HR Solutions, insurance, retirement, and health-and-benefits activity. HR Solutions employees served increased 11% to approximately 502,000, and retirement plan assets increased 33% to $11.3 billion.
- Cost controls included a salary-increase freeze and suspension of the 401(k) match, each producing approximately $15 million of fiscal 2010 savings. Salary increases resumed March 1, 2010; the 401(k) match had not been reinstated by year-end.
- Paychex completed implementation of an enhanced core payroll processing platform after investing more than $60 million and sold the immaterial Stromberg time-and-attendance business for $13.1 million.
- Client retention was approximately 77% of the beginning client base, broadly consistent with the prior year, while clients lost decreased 6%.
Guidance, outlook, risks, and unusual items
For fiscal 2011, management projected flat payroll service revenue, Human Resource Services revenue growth of 10% to 13%, a 12% to 17% decline in interest on funds held for clients, and a 24% to 27% increase in net investment income. Operating income excluding certain items was expected to be 34% to 35% of service revenue, the effective tax rate approximately 35%, and net income slightly above fiscal 2010. Excluding the fiscal 2010 litigation charge, management expected fiscal 2011 net income to be approximately flat.
- Management expected the combined portfolio yield to decline to approximately 1.3% in fiscal 2011. A 25-basis-point change in short-term rates was estimated to affect annual after-tax earnings by approximately $3.5 million.
- Fiscal 2011 capital expenditures were projected at $80 million to $85 million, with depreciation of $65 million to $70 million and intangible amortization of approximately $20 million.
- The California Rapid Payroll litigation was resolved after the company satisfied a judgment including $15 million of compensatory and $11 million of punitive damages, and the company recorded an additional $18.7 million reserve charge.
- The company faced a New York State income-tax audit for fiscal years 2004 through 2007. Proposed adjustments exceeded the recorded $27.5 million uncertain-tax-position reserve, but the ultimate impact could not be reasonably estimated.
- Key risks include weak employment and wage levels, lower interest rates, regulatory changes affecting payroll and benefits, competition, technology implementation, cybersecurity and confidentiality breaches, business continuity failures, third-party service-provider disruptions, PEO co-employment liabilities, workers’ compensation claims, and legal contingencies.
- Future contractual obligations included $220.9 million of operating leases and purchase obligations, including $73.0 million of purchase commitments. Standby letters of credit totaled $50.3 million.
- Chief Executive Officer Jonathan Judge announced his resignation effective July 31, 2010. His separation agreement provided a $1.9 million severance payment, accelerated vesting of specified equity awards, and continued benefits.
Most important facts for investors to verify
- Whether client counts, retention, payroll transaction volumes, and payroll service revenue recover from recession-related declines.
- The sensitivity of earnings to persistently low interest rates and reinvestment of maturing securities at lower yields.
- The sustainability of the high dividend payout relative to operating cash flow and projected earnings.
- The outcome and potential financial effect of the New York State tax audit and any remaining legal matters.
- Execution and economic returns from the enhanced payroll platform, technology spending, and continued expansion of Human Resource Services.
- The effect of the CEO transition and accelerated equity vesting on fiscal 2011 expenses and governance.
- Workers’ compensation reserve adequacy, PEO liabilities, cybersecurity controls, and the company’s ability to protect client funds and confidential data.