Paychex, Inc. Form 10-Q Summary
Reporting period: Third quarter and first nine months of fiscal 2011 ended February 28, 2011, compared with the corresponding fiscal 2010 periods. The filing was signed March 23, 2011. Although the request identifies “2010 Q3,” the filing covers fiscal 2011 third quarter.
Business Context
Paychex provides payroll, human resources, employee benefits, retirement, insurance, and related outsourcing services primarily to small and medium-sized businesses in the United States. The company reports one operating segment, with Germany contributing less than 1% of revenue. Paychex completed the $115.3 million, net-of-cash, acquisition of SurePayroll on February 8, 2011.
Financial Performance and Position
| Metric | Three months ended February 28, 2011 | Year-over-year change | Nine months ended February 28, 2011 | Year-over-year change |
|---|---|---|---|---|
| Total service revenue | $519.6 million | 5% | $1,525.8 million | 4% |
| Total revenue | $531.3 million | 5% | $1,561.6 million | 4% |
| Operating income | $198.9 million | 18% | $603.6 million | 10% |
| Net income | $130.6 million | 17% | $396.4 million | 10% |
| Diluted EPS | $0.36 | 16% | $1.09 | 9% |
| Operating margin on total revenue | 37% | Up from 33% | 39% | Up from 37% |
| Net margin on total revenue | 25% | Up from 22% | 25% | Up from 24% |
Payroll service revenue increased 2% to $366.4 million in the quarter and $1,081.9 million for the nine months. Human Resource Services revenue increased 13% to $153.2 million in the quarter and 11% to $443.9 million for the nine months. Interest on funds held for clients declined 16% in the quarter and 13% for the nine months because lower yields more than offset higher investment balances.
Cash flow from operations was $552.9 million for the nine months, compared with $503.0 million in the prior-year period. Capital expenditures were $79.0 million, acquisition spending was $115.3 million, dividends paid were $336.4 million, and ending cash and cash equivalents were $236.0 million.
As of February 28, 2011, cash and total corporate investments totaled $652.3 million and the company reported no debt. Funds held for clients were $4.19 billion, client fund obligations were $4.15 billion, total assets were $5.96 billion, total liabilities were $4.49 billion, and stockholders’ equity was $1.47 billion. The company had $900 million of unused capacity under four uncommitted secured short-term credit lines.
Material Changes Versus the Prior Comparable Period
- Checks per client increased 2.8% in the quarter and 2.1% for the nine months, while payroll client losses declined 9% for the nine months. The payroll client base excluding SurePayroll remained 1.6% below the prior-year level.
- Human Resource Services growth was supported by higher Paychex HR Solutions activity, PEO workers’ compensation revenue, retirement services, and health and benefits services. Health and benefits revenue increased 27% in the quarter and 32% for the nine months.
- Operating expenses declined 2% in the quarter but were approximately flat for the nine months. Excluding the prior-year $18.7 million litigation reserve charge, expenses increased 4% in the quarter and 2% for the nine months because of investments in sales, customer service, and technology.
- The prior-year litigation reserve charge did not recur, contributing to reported operating income and earnings growth.
- The SurePayroll acquisition added approximately $87.0 million of nondeductible goodwill and increased intangible assets. Its contribution to fiscal 2011 results was not expected to be material.
- Combined funds held for clients and corporate investments increased to $4.61 billion from $3.91 billion at May 31, 2010. The portfolio was primarily investment-grade, with more than 95% rated AA or better.
Guidance, Outlook, Risks, and Unusual Items
Management’s fiscal 2011 guidance assumes current economic and interest-rate conditions continue. Expected year-over-year changes are: payroll service revenue up 1% to 2%; Human Resource Services revenue up 10% to 11%; total service revenue up 3% to 5%; interest on funds held for clients down 17% to 12%; investment income up 29% to 32%; and net income up 4% to 6%.
Management expects fiscal 2011 operating income, net of certain items, to equal approximately 36% of total service revenue and the effective tax rate to approximate 35%. SurePayroll is expected to increase revenue by less than 1% and dilute earnings by less than $0.01 per share. Capital expenditures are projected at $95 million to $100 million, depreciation at $65 million to $70 million, and intangible amortization at approximately $20 million.
The low-rate environment remains a significant earnings headwind. The combined investment portfolio earned 1.2% in the quarter versus 1.4% in the prior-year quarter. Management expects approximately 20% of the long-term portfolio to mature over the next 12 months and anticipates reinvestment at an average rate of approximately 1.1%. A 25-basis-point short-term interest-rate change would affect annual after-tax earnings by approximately $3.5 million.
Key risks include employment and wage trends, interest rates and investment valuations, competition, demand for services, regulatory changes affecting payroll and benefits, workers’ compensation claims, technology and system failures, third-party service-provider performance, internal controls, and litigation. Management believes outstanding legal matters will not materially affect results, but acknowledges that outcomes are uncertain.
At February 28, 2011, available-for-sale securities had a $46.4 million net unrealized gain. Securities with $242.0 million of fair value were in an unrealized loss position, with aggregate unrealized losses of $2.8 million; management concluded these securities were not other-than-temporarily impaired. The company had $47.4 million of standby letters of credit and approximately $6.0 million of capital-asset purchase commitments.
Important Facts for Investors to Verify
- Confirm that fiscal 2011 guidance, particularly service-revenue growth, net-income growth, and the expected decline in client-fund interest income, was achieved or updated in subsequent filings.
- Assess the sustainability of margin expansion after excluding the prior-year $18.7 million litigation reserve charge.
- Monitor payroll client counts, checks per client, new business starts, and the performance and integration of SurePayroll.
- Evaluate sensitivity to persistently low interest rates, reinvestment yields, municipal securities valuations, and credit risk.
- Review PEO workers’ compensation reserves and claims trends, which may change materially based on actuarial, legal, and economic developments.
- Verify the company’s liquidity, unused credit capacity, dividend funding, investment portfolio composition, and absence of debt in subsequent reports.