Paychex, Inc. — Q1 Fiscal 2018 Summary
Business context and reporting period
Paychex provides payroll, human capital management, HR, retirement, insurance, and professional employer organization services primarily to U.S. small and medium-sized businesses, with insignificant German operations. The filing covers the three months ended August 31, 2017, compared with the three months ended August 31, 2016. Paychex reports one operating segment.
Financial performance
| Metric | Q1 FY2018 | Q1 FY2017 | Change |
|---|---|---|---|
| Total revenue | $816.8 million | $785.5 million | 4% |
| Service revenue | $803.1 million | $773.5 million | 4% |
| Payroll service revenue | $457.8 million | $450.9 million | 2% |
| HRS revenue | $345.3 million | $322.6 million | 7% |
| Interest on funds held for clients | $13.7 million | $12.0 million | 14% |
| Operating income | $345.0 million | $323.0 million | 7% |
| Operating margin | 42.2% | 41.1% | +110 bps |
| Net income | $227.8 million | $217.4 million | 5% |
| Diluted EPS | $0.63 | $0.60 | 5% |
| Operating cash flow | $343.6 million | $294.7 million | 17% |
Total expenses increased 2% to $471.8 million. Compensation-related expenses were essentially flat, while depreciation and amortization increased 8% and PEO insurance costs increased 9%. The effective tax rate rose to 34.4% from 33.0%.
Management also reported adjusted net income of $222.8 million and adjusted diluted EPS of $0.62, excluding a $5.0 million excess tax benefit related to employee stock-based compensation. These are non-GAAP measures.
Financial position, cash flow, debt, and liquidity
- Cash and cash equivalents were $234.4 million at August 31, 2017, compared with $184.6 million at May 31, 2017.
- Cash and total corporate investments totaled $851.4 million at August 31, 2017.
- Funds held for clients were $4.953 billion, matched by client fund obligations of $4.918 billion. These balances increased substantially from May 31, primarily due to collection and remittance timing.
- Operating cash flow was $343.6 million. Investing activities used $711.0 million, principally reflecting investment activity and changes in client funds, while financing activities provided $417.2 million.
- Short-term borrowings were $57.2 million at August 31, 2017, under the $150 million PNC facility. Paychex had no borrowings outstanding under its $1 billion JPM facility at period-end.
- Committed unsecured credit facilities totaled $1.65 billion, consisting of $1.0 billion, $500 million, and $150 million facilities. The company was in compliance with related covenants.
- Standby letters of credit totaled $52.8 million and were collateralized by investment securities; no amounts were drawn.
- Quarterly dividends increased 9% to $0.50 per share. Paychex repurchased 1.65 million shares for $94.1 million, leaving approximately $149.4 million available under the repurchase authorization.
Material changes and unusual items
- On August 18, 2017, Paychex acquired HR Outsourcing Holdings, Inc., a national PEO, for $75.4 million: $42.2 million in cash and $33.2 million in Paychex stock. The acquisition generated $40.9 million of provisional, non-tax-deductible goodwill and was considered immaterial to consolidated results.
- Paychex announced a Rochester, New York campus project involving five buildings and more than 300,000 square feet of renovations, with an estimated total cost of $60 million. Two buildings had been purchased after quarter-end for $19.5 million in aggregate.
- Average combined investment balances declined 1%, but average yields increased to 1.4% from 1.2%, contributing to higher interest income. Management estimated that a 25-basis-point change in short-term rates could affect after-tax earnings by approximately $3 million to $4 million over twelve months.
- The company terminated four uncommitted secured lines of credit totaling $900 million on August 17, 2017; no amounts were outstanding under those lines.
Guidance, outlook, and risks
For fiscal 2018, management updated guidance to reflect the HROI acquisition and the first-quarter tax benefit:
- HRS revenue growth of 12% to 14%.
- Total revenue growth of approximately 6%.
- Operating margin of 39% to 40%.
- Effective tax rate of 35.0% to 35.5%.
- Capital expenditures of $180 million to $190 million, including the planned Rochester campus.
Management expects cash, corporate investments, operating cash flow, and available short-term financing to support operations, capital expenditures, acquisitions, dividends, and share repurchases for the foreseeable future. Key risks include changes in employment and wage levels, interest rates and investment values, competition and demand, regulation of payroll and PEO services, insurance claims trends, cybersecurity and system failures, dependence on third-party providers, client-related employment liabilities, legal matters, and acquisition integration.
Insurance reserves, particularly workers’ compensation and health-benefit reserves, depend on actuarial estimates and may change materially. The company reported no material legal contingencies but noted that legal outcomes are inherently uncertain. Revenue-recognition guidance is scheduled for adoption in fiscal 2019; Paychex anticipates primarily deferring additional contract acquisition and fulfillment costs and expects no material impact on revenue timing or amount, subject to final evaluation.
Investor verification points
- Verify the effect of HROI on fiscal 2018 HRS growth, margins, and integration costs.
- Monitor interest-rate changes, investment yields, portfolio duration, and unrealized gains or losses.
- Reconcile client funds held with client fund obligations and assess period-end collection and remittance timing effects on cash flow.
- Track the Rochester campus spending against the $60 million estimate and the $180 million to $190 million fiscal-year capital expenditure guidance.
- Distinguish GAAP EPS of $0.63 from adjusted EPS of $0.62 and assess the recurring nature of stock-based compensation tax benefits.
- Review exposure to PEO insurance reserves, cybersecurity events, regulatory changes, litigation, and acquisition-related risks.