Paychex, Inc. — Form 10-Q Summary
Business Context and Reporting Period
Paychex provides payroll, human resource, employee benefits, retirement, insurance, and related outsourcing services primarily to small and medium-sized U.S. businesses, with an immaterial German operation. The filing covers the three and six months ended November 30, 2010, representing the second quarter and first six months of fiscal 2011. The financial statements are unaudited and prepared under U.S. GAAP.
Key Financial Metrics
| Metric | Three Months Ended Nov. 30, 2010 | Year-over-Year Change | Six Months Ended Nov. 30, 2010 | Year-over-Year Change |
|---|---|---|---|---|
| Total service revenue | $500.0 million | 4% | $1,006.2 million | 4% |
| Total revenue | $512.0 million | 3% | $1,030.3 million | 3% |
| Operating income | $203.9 million | 6% | $404.7 million | 6% |
| Operating margin | 39.8% | Approximately 1 percentage point improvement | 39.3% | Approximately 1 percentage point improvement |
| Net income | $133.9 million | 6% | $265.8 million | 7% |
| Diluted earnings per share | $0.37 | 6% | $0.73 | 6% |
| Operating cash flow | Not separately provided | — | $319.2 million | Up from $279.1 million |
Payroll service revenue increased 1% to $354.8 million for the quarter and $715.5 million for the six months. Human Resource Services revenue increased 10% to $145.2 million and $290.7 million, respectively. Interest on funds held for clients declined 12% to $12.0 million for the quarter and $24.1 million for the six months.
Operating income, excluding interest on funds held for clients, was $191.9 million for the quarter and $380.6 million for the six months, representing 7% year-over-year growth. This is a non-GAAP measure and should be considered alongside GAAP operating income.
As of November 30, 2010, cash and cash equivalents were $233.2 million, corporate investments were $230.3 million, and long-term corporate investments were $226.4 million. Management reported total cash and corporate investments of $689.9 million and no debt. Funds held for clients were $3.26 billion, with corresponding client fund obligations of $3.20 billion.
Material Changes Versus Prior Comparable Period
- Checks per client increased 2.5% in the quarter and 1.8% for the six months, compared with declines in the prior-year period.
- Client losses decreased 12% year over year in both the quarter and six-month period. The payroll client base remained 2.2% below the prior-year level, although it increased slightly from May 31, 2010.
- Human Resource Services growth was supported by increased PEO activity, retirement services, health and benefits services, client additions, and pricing. Excluding the sale of the Stromberg time-and-attendance operations in October 2009, Human Resource Services revenue growth was 11% for the quarter and 12% for the six months.
- Combined operating and selling, general and administrative expenses increased 1% for the quarter and 2% for the six months, primarily due to investments in sales, customer service, and technology. Productivity improvements and lower operating headcount partly offset these costs.
- Investment income increased 34% for the quarter and 44% for the six months because of higher average corporate investment balances.
- The effective income tax rate declined to 34.8% from 35.2%.
- Operating cash flow increased by $40.1 million year over year to $319.2 million. Capital expenditures increased to $44.1 million from $23.1 million, reflecting technology and infrastructure investment.
- Funds held for clients and corporate investments totaled $3.717 billion at November 30, 2010, down from $3.914 billion at May 31, 2010. Available-for-sale securities increased to $2.612 billion from $2.152 billion, while money market securities and other cash equivalents decreased.
Guidance, Outlook, Risks, and Unusual Items
Management improved its fiscal 2011 outlook, assuming current economic and interest-rate conditions continue. Guidance calls for payroll service revenue growth of 1% to 2%, Human Resource Services revenue growth of 10% to 13%, total service revenue growth of 3% to 5%, interest on funds held for clients declining 17% to 12%, investment income increasing 29% to 32%, and net income increasing 4% to 6%. Operating income, net of certain items, is expected to grow at a rate similar to the first half, with a margin of approximately 36% of total service revenue. The expected effective tax rate is approximately 35%.
The low-interest-rate environment remains a significant earnings headwind. The combined portfolio yield was 1.5%, down from 1.7% in the prior-year periods. Management expects the fiscal 2011 average portfolio return to be approximately 1.4%; a 25-basis-point change in short-term rates could affect after-tax earnings by approximately $3.5 million over twelve months.
Fiscal 2011 capital expenditures were revised to $95 million to $100 million. Depreciation is projected at $65 million to $70 million and intangible amortization at approximately $20 million.
On December 9, 2010, Paychex agreed to acquire SurePayroll, a software-as-a-service payroll processor, for approximately $115.0 million, subject to customary conditions and regulatory approval. Management expected closing by the end of calendar 2010, with less than 1% expected revenue contribution and approximately $0.01 of fiscal 2011 earnings-per-share dilution.
Paychex had four uncommitted secured lines of credit totaling $900 million, with no borrowings outstanding. Standby letters of credit totaled $47.5 million, also with no amounts outstanding. Capital purchase commitments were approximately $19.3 million, including a pending Rochester building purchase.
Key risks include interest-rate and investment-credit risk, changes in employment and wage levels, demand and competitive pressures, regulatory changes affecting payroll and benefits, workers’ compensation claims, technology or operational disruptions, third-party service-provider failures, internal-control failures, and legal contingencies. Management believes current legal matters will not materially affect the company, but acknowledges that outcomes are uncertain. PEO workers’ compensation reserves are subject to actuarial and legal uncertainties.
Most Important Facts for Investors to Verify
- Whether service-revenue growth and improving checks per client offset continued weakness in payroll client counts.
- The effect of persistently low interest rates on interest income, investment income, portfolio reinvestment yields, and fiscal 2011 earnings.
- Execution and financial impact of the SurePayroll acquisition, including closing conditions, purchase accounting, amortization, and integration.
- Whether planned technology, sales-force, employee-benefit, and infrastructure investments result in the projected operating margin.
- The composition, liquidity, credit quality, duration, and unrealized gains or losses of the $3.7 billion funds-held-for-clients and corporate investment portfolio.
- Potential changes in PEO workers’ compensation reserves, legal matters, regulatory requirements, and other contingencies.
- Future dividend sustainability and capital allocation given the $224.2 million of dividends paid during the first six months and planned capital expenditures.