(EDGAR Online via COMTEX) -- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Management's Discussion and Analysis of Financial Condition and Results of Operations reviews the operating results of Paychex, Inc. and its wholly owned subsidiaries ("Paychex," the "Company," "we," "our," or "us") for the three months ended February 28, 2021 (the "third quarter"), the nine months ended February 28, 2021 (the "nine months"), the respective prior year periods ended February 29, 2020, and our financial condition as of February 28, 2021. The focus of this review is on the underlying business reasons for material changes and trends affecting our revenue, expenses, net income, and financial condition. This review should be read in conjunction with the February 28, 2021 consolidated financial statements and the related Notes to Consolidated Financial Statements (Unaudited) contained in this Quarterly Report on Form 10-Q ("Form 10-Q"). This review should also be read in conjunction with our Annual Report on Form 10-K ("Form 10-K") for the year ended May 31, 2020 ("fiscal 2020"). Forward-looking statements in this review are qualified by the cautionary statement included under the next sub-heading, "Cautionary Note Regarding Forward-Looking Statements".
Cautionary Note Regarding Forward-Looking Statements
Certain written and oral statements made by us may constitute "forward-looking statements" within the meaning of the safe harbor provisions of the United States ("U.S.") Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by such words and phrases as "we expect," "expected to," "estimates," "estimated," "intend," "overview," "outlook," "guidance," "we look forward to," "would equate to," "projects," "projections," "projected," "projected to be," "anticipates," "anticipated," "we believe," "believes," "could be," "targeting," and other similar words or phrases. Examples of forward-looking statements include, among others, statements we make regarding operating performance, events, or developments that we expect or anticipate will occur in the future, including statements relating to our outlook, revenue growth, earnings, earnings-per-share growth, or similar projections.
Forward-looking statements are neither historical facts nor assurances of future performance. Instead, they are based only on our current beliefs, expectations, and assumptions regarding the future of our business, future plans and strategies, projections, anticipated events and trends, the economy, and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks, and changes in circumstances that are difficult to predict, many of which are outside our control. Our actual results and financial condition may differ materially from those indicated in the forward-looking statements. Therefore, you should not place undue reliance upon any of these forward-looking statements. Important factors that could cause our actual results and financial condition to differ materially from those indicated in the forward-looking statements include, among others, the following:
�the impact of the COVID-19 pandemic on the U.S. and global economy, and in particular on our small- and medium-sized business clients;
�changes in governmental regulations and policies;
�our ability to comply with U.S. and foreign laws and regulations;
�our ability to keep pace with changes in technology and to provide timely enhancements to our products and services;
�our compliance with data privacy laws and regulations;
�the possibility of cyberattacks, security vulnerabilities, and Internet disruptions, including breaches of data security and privacy leaks, data loss, and business interruptions;
�the possibility of failure of our operating facilities, computer systems, or communication systems during a catastrophic event;
�the failure of third-party service providers to perform their functions;
�the possibility that we may be subject to additional risks related to our co-employment relationship with our professional employer organization ("PEO");
�changes in health insurance and workers' compensation insurance rates and underlying claim trends;
�our clients' failure to reimburse us for payments made by us on their behalf;
�the effect of changes in government regulations mandating the amount of tax withheld or the timing of remittances;
�volatility in the political and economic environment;
�risks related to acquisitions and the integration of the businesses we acquire;
�our failure to comply with covenants in our debt agreements;
�changes in the availability of qualified people, including management, technical, compliance, and sales personnel;
�our failure to protect our intellectual property rights;
�the possible effects of negative publicity on our reputation and the value of our brand; and
�potential outcomes related to pending or future litigation matters.
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Any of these factors, as well as such other factors as discussed in our Form 10-K for fiscal 2020 or in our other periodic filings with the Securities and Exchange Commission ("SEC"), could cause our actual results to differ materially from our anticipated results. The information provided in this Form 10-Q is based upon the facts and circumstances known as of the date of this report, and any forward-looking statements made by us in this Form 10-Q speak only as of the date on which they are made. Except as required by law, we undertake no obligation to update these forward-looking statements after the date of filing this Form 10-Q with the SEC to reflect events or circumstances after such date, or to reflect the occurrence of unanticipated events.
Our investor presentation regarding the financial results for the third quarter is available and accessible on our Paychex Investor Relations page at https://investor.paychex.com . Information available on our website is not a part of, and is not incorporated into, this Form 10-Q. We intend to make future investor presentations available exclusively on our Paychex Investor Relations page.
We are a leading provider of integrated human capital management ("HCM") solutions for human resources ("HR"), payroll, benefits, and insurance services for small- to medium-sized businesses. The workplace is evolving, and we lead the way by making complex HR, payroll, and benefits simple for our clients. Our purpose is to allow our clients the freedom to succeed. Our mission is to be the leading provider of HR, payroll, benefits, and insurance solutions by being an essential partner to small- and medium-sized businesses across the U.S. and parts of Europe, and we believe that success in this mission will lead to strong, long-term financial performance. Our strategy focuses on providing industry-leading, integrated technology; increasing client satisfaction; expanding our leadership in HR; growing our client base; and engaging in strategic acquisitions.
Within our HCM solutions we offer a comprehensive portfolio of services and products that cover the spectrum of the employee life cycle and allow our clients to meet their diverse HR and payroll needs. Clients can select services on an � la carte basis or as part of various product bundles. We can customize our offering to the client's business, whether it is small or large, simple or complex.
Our portfolio of HCM and employee benefit-related solutions is disaggregated into two categories, Management Solutions and PEO and Insurance Solutions, as discussed in Part 1, Item 1 of our Form 10-K for fiscal 2020. Our solutions bring together payroll and HCM software with flexible, personalized, technology-enabled service capabilities. Paychex Flex(R), our proprietary HCM software-as-a-service platform, unites HR, payroll, time and attendance, and benefits processes to manage the employee life cycle from recruiting and hiring to retirement. Clients can select the modules they need and easily add on additional solutions as they grow. Paychex Flex provides function-focused analytics throughout to assist HR leaders in making informed business decisions. Paychex Flex mobility and self-service capabilities allow clients and their employees access anywhere, at any time, on any device. We also provide comprehensive HR outsourcing solutions through our administrative services organization and PEO solutions. Our HCM and HR outsourcing solutions are supported with our HR and Compliance expertise and our technology-enabled service capabilities.
We continue to focus on driving growth in the number of clients, revenue per client, total revenue and profits, while delivering superior service and technology solutions to our clients and their employees. We maintain industry-leading margins by managing our personnel costs and expenses while continuing to invest in our business, particularly in leading-edge technology and go-to-market tools and resources. We believe these investments are critical to our success. Looking to the future, we believe that investing in our products, people, and service capabilities will position us to capitalize on opportunities for long-term growth.
A key component of our service delivery strategy is to be a proactive partner with our clients and to develop and release integrated solutions within our Paychex Flex platform to meet their current and future needs. Our ongoing investments in our platforms have prepared us well for the demands of the current business and regulatory environments, allowing us to adapt while maintaining strong service delivery, resulting in high levels of client satisfaction and retention. We continue to make investments in leading-edge technology a priority as companies are looking to leverage technology solutions to maintain operations, stay connected to employees, and increase productivity. Our most recent round of product releases features solutions designed to help business leaders secure critical funding, meet shifting employee expectations, make data-driven decisions, and create a more equitable workforce, include:
?Pooled Employer Plan, which provides business owners with a cost-effective plan option that relieves the compliance and administration burdens of a traditional 401(k) plan, giving their employees access to a robust retirement plan benefit and allowing them to confidently prepare for their future;
?A new integration with Fiserv Inc.'s Clover(R) platform, which allows small business retailers using Clover's point of sale system to integrate with Paychex Flex to more efficiently manage the essential task of payroll, staffing, time tracking, and scheduling while helping save time, increase accuracy, and reduce cost;
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?Biz2Credit Integration for the Paycheck Protection Program ("PPP"), which allows fintech provider Biz2Credit, whose subsidiary Itria Ventures LLC, has secured more PPP loans(1) than any U.S. lender, to obtain required payroll data for the loan application form from Paychex Flex, streamlining the PPP loan application process;
?Diversity and Equal Pay Live Report, which builds upon a recently released Equal Employment Opportunity-1 compliance solution and gives administrators the ability to analyze their pay and diversity data via a simple, customizable report. With improved access to this critical data, businesses are better positioned to uncover opportunities to create a more diverse and equitable workforce, while also meeting compliance requirements;
?General Ledger Live Report, which dynamically expands visibility of general ledger data, and provides options to customize, drill-down, and segment report information; and
?Enhanced Live Report Functionality, which expands the existing thresholds feature in Live Reports to help customers more effectively monitor how key business metrics are performing against benchmarks and goals.
(1) Refer to the "Paycheck Protection Program (PPP) Report - Approvals through 02/28/2021" found at https://www.sba.gov/document/report-paycheck-protection-program-weekly-reports-2021 for further discussion.
Third Quarter Financial Highlights
Results of operations for the third quarter continued to be impacted by the COVID-19 pandemic, however, we continue to see moderate improvement in key indicators. Refer to the "COVID-19 Update" section of this Item 2 for further discussion on the ongoing impact of the COVID-19 pandemic along with our response to the pandemic.
Financial highlights for the third quarter compared to the corresponding prior year period are as follows:
?Total service revenue decreased 2% to $1.1 billion.
?Total revenue decreased 3% to $1.1 billion.
?Operating income was comparable at $468.6 million.
?Diluted earnings per share and adjusted diluted earnings per share(1) each decreased 1% to $0.97 per share, and to $0.96 per share, respectively.
(1) Adjusted diluted earnings per share is not a U.S. generally accepted accounting principles ("GAAP") measure. Refer to the "Non-GAAP Financial Measures" section within the "Results of Operations" section of this Item 2 for a discussion of this non-GAAP measure and a reconciliation to the most comparable GAAP measure.
For further analysis of our results of operations for the third quarter and nine months, and our financial position as of February 28, 2021, refer to the tables and analysis in the "Results of Operations" and "Liquidity and Capital Resources" sections of this Item 2.
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As the global COVID-19 pandemic has continued to evolve, our priority has been and continues to be, the health and safety of our employees. We have brought back a small portion of our workforce to the office on a volunteer-only basis. We will continue to evaluate our business continuity plan against observed results and will adjust the plan accordingly.
As our clients continue to manage through the COVID-19 pandemic, we remain committed to helping them adapt and thrive, not only through the uncertainties of the COVID-19 pandemic, but the transition to the future business environment. Our blend of technology and service provides valuable tools and resources to assist our clients and their employees during this critical time. The technology investments we made to our Paychex Flex payroll and HR suite of products positions us to service our clients and support them in managing a remote workforce. We have brought a multifaceted response to the pandemic and delivered resources and services to help our clients respond and adapt. The COVID-19 Help Center on our website continues to provide support throughout every stage of the pandemic. Since the help center's launch in March 2020, it has been viewed by nearly a half million visitors. To continue to support customers as they navigate the impacts of the COVID-19 pandemic and navigate the future of work, we have introduced several new products in the third quarter which are discussed in the "Overview" section of this Item 2. As the global economy continues to evolve, whether due to legislative changes, the pandemic, or other factors, we are committed to supporting our clients to help them navigate these challenges.
The effects of the COVID-19 pandemic impacted our results and year-over-year comparisons, however, client retention remains strong and at record levels. Our strong balance sheet and operational flexibility have allowed us to successfully manage through the ongoing impacts of the COVID-19 pandemic to date while protecting our cash flow and liquidity. In addition, during the first half of this fiscal year, we substantially completed cost-saving initiatives, including an acceleration of our long-term strategy to reduce our geographic footprint and headcount optimization. We continue to evaluate the nature and extent of changes to the market and economic conditions related to the COVID-19 pandemic and will assess the potential impact on our business and financial position. We expect that the pandemic will continue to have an adverse effect on our results, although the magnitude, duration and full effects of the pandemic are not possible to predict at this time.
For further discussion on the risks posed to our business from the COVID-19 pandemic, refer to Item 1A of our Form 10-K for fiscal 2020.
RESULTS OF OPERATIONS Summary of Results of Operations: For the three months ended For the nine months ended February 28, February 29, February 28, February 29, In millions, except per share amounts 2021 2020 Change(1) 2021 2020 Change(1) Revenue: Management Solutions $ 846.8 $ 850.0 - % $ 2,267.0 $ 2,301.2 (1) % PEO and Insurance Solutions 249.8 271.5 (8) % 715.8 762.6 (6) % Total service revenue 1,096.6 1,121.5 (2) % 2,982.8 3,063.8 (3) % Interest on funds held for clients 15.1 21.2 (29) % 44.8 61.6 (27) % Total revenue 1,111.7 1,142.7 (3) % 3,027.6 3,125.4 (3) % Total expenses 643.1 672.6 (4) % 1,920.7 1,964.5 (2) % Operating income 468.6 470.1 - % 1,106.9 1,160.9 (5) % Other expense, net (6.0) (5.9) n/m (18.6) (15.4) n/m Income before income taxes 462.6 464.2 - % 1,088.3 1,145.5 (5) % Income taxes 112.1 109.7 2 % 253.8 268.1 (5) % Effective income tax rate 24.2 % 23.6 % 23.3 % 23.4 % Net income $ 350.5 $ 354.5 (1) % $ 834.5 $ 877.4 (5) % Diluted earnings per share $ 0.97 $ 0.98 (1) % $ 2.31 $ 2.43 (5) %
(1) Percentage changes are calculated based on unrounded numbers.
n/m - not meaningful
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We invest in highly liquid, investment-grade fixed income securities and do not utilize derivative instruments to manage interest rate risk. As of February 28, 2021, we had no exposure to high-risk or non-liquid investments. Details regarding our combined funds held for clients and corporate cash equivalents and investment portfolios are as follows:
For the three months ended For the nine months ended February 28, February 29, February 28, February 29, $ in millions 2021 2020 Change(1) 2021 2020 Change(1) Average investment balances: Funds held for clients $ 4,459.6 $ 4,454.3 - % $ 3,849.5 $ 3,975.0 (3) % Corporate cash equivalents and investments 1,062.0 837.9 27 % 1,016.3 829.5 23 % Total $ 5,521.6 $ 5,292.2 4 % $ 4,865.8 $ 4,804.5 1 % Average interest rates earned (exclusive of net realized gains/(losses)): Funds held for clients 1.3 % 1.9 % 1.5 % 2.0 % Corporate cash equivalents and investments 0.1 % 1.5 % 0.2 % 1.7 % Combined funds held for clients and corporate cash equivalents and investments 1.1 % 1.8 % 1.2 % 1.9 % Total net realized gains $ 0.3 $ 0.6 $ 1.0 $ 2.4
(1) Percentage changes are calculated based on unrounded numbers.
February 28, May 31, $ in millions 2021 2020 Net unrealized gains on AFS securities (1) $ 82.1 $ 100.0 Federal Funds rate (2) 0.25 % 0.25 % Total fair value of AFS securities $ 3,207.4 $ 2,757.2 Weighted-average duration of AFS securities in years (3) 3.4 2.9 Weighted-average yield-to-maturity of AFS securities (3) 1.9 % 2.1 %
(1) The net unrealized gain on our investment portfolio was approximately $62.7 million as of April 2, 2021.
(2) The Federal Funds rate was in the range of 0.00% to 0.25% as of February 28, 2021 and May 31, 2020.
(3) These items exclude the impact of variable rate demand notes ("VRDNs") as they are tied to short-term interest rates.
Management Solutions revenue: Management Solutions revenue was $846.8 million for the third quarter, consistent with the prior year period. For the nine months management solutions revenue was $2.3 billion, reflecting a decrease of 1% compared to the prior year period. Both periods were impacted by solid growth from new services and product offerings, increases in our client base and increased penetration of our suite of solutions, particularly HR outsourcing, retirement services, and time and attendance. These increases were offset by a decline in check volumes, which had a larger impact during the first quarter and has shown improvement in the second and third quarters. Lower check volumes also impacted annual calendar year-end revenues as clients continue to operate with fewer employees.
PEO and Insurance Solutions revenue: PEO and Insurance Solutions revenue was $249.8 million for the third quarter and $715.8 million for the nine months, reflecting decreases of 8% and 6%, respectively, compared to the prior year periods. The decreases in both periods were primarily driven by a decline in the number of our clients' worksite employees, and a decrease in state unemployment insurance margins within our PEO driven by rising unemployment costs. Insurance Solutions revenue declined in both periods as a result of lower workers' compensation premiums driven by reduced wages and softening of market rates.
Interest on funds held for clients: Interest on funds held for clients was $15.1 million for the third quarter and $44.8 million for the nine months, reflecting decreases of 29% and 27%, respectively, compared to the prior year periods. The decreases in both periods resulted from lower average interest rates and realized gains, offset slightly in the third quarter by sequential improvements in average investment balances driven by wage inflation and the timing of collections and remittances.
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Total expenses: Total expenses were $643.1 million for the third quarter and $1.9 billion for the nine months, reflecting decreases of 4% and 2%, respectively, compared to the prior year periods. The following table summarizes total combined cost of service revenue and selling, general and administrative expenses:
For the three months ended For the nine months ended February 28, February 29, February 28, February 29, In millions 2021 2020 Change(1) 2021 2020 Change(1) Compensation-related expenses $ 374.4 $ 381.3 (2) % $ 1,127.6 $ 1,117.7 1 % PEO insurance costs 86.5 90.2 (4) % 259.4 263.9 (2) % Depreciation and amortization 46.4 50.1 (7) % 144.6 158.0 (8) % Cost-saving initiatives - - n/m 32.2 - n/m Other expenses 135.8 151.0 (10) % 356.9 424.9 (16) % Total expenses $ 643.1 $ 672.6 (4) % $ 1,920.7 $ 1,964.5 (2) %
(1) Percentage changes are calculated based on unrounded numbers.
n/m - not meaningful
The change in total expenses during the third quarter and nine months as compared to the prior year periods were primarily driven by the following factors:
?Compensation-related expenses: Lower wages as a result of headcount optimization initiatives, offset by an increase in incentive compensation expenses due to better attainment of performance measures. The impact of headcount optimization initiatives was more significant during the third quarter as compared to the respective prior year period.
?PEO insurance costs: Lower workers' compensation subject wages and claims estimates, and lower enrollment in some of our health insurance offerings. This is offset by the expansion of our health insurance offerings to certain PEO clients.
?Other expenses: Lower discretionary spending in all areas, but more substantial within travel and entertainment expenses, and facilities costs.
Operating income: Operating income was $468.6 million for the third quarter, consistent with the prior year period, and $1.1 billion for the nine months, a decrease of 5% compared to the prior year period. Operating margin (operating income as a percentage of total revenue) was 42.2% for the third quarter and 36.6% for the nine months, compared to 41.1% and 37.1% for the respective prior year periods. Adjusted operating income(1), which excludes the impact of one-time costs, was $1.1 billion for the nine months, reflecting a decrease of 2% compared to the prior year period. Adjusted operating margin(1) (operating income, adjusted for one-time non-recurring items, as a percentage of total revenue), was 42.2% for the third quarter and 37.6% for the nine months, compared to 41.1% and 37.1% for the respective prior year periods.
(1) Adjusted operating income and adjusted operating income margin are not U.S. GAAP measures. Refer to the "Non-GAAP Financial Measures" section within the "Results of Operations" section of this Item 2 for a discussion of this non-GAAP measure and a reconciliation to the most comparable GAAP measure of operating income.
Other expense, net: Other expense, net primarily represents interest expense incurred on our debt instruments and credit facilities borrowings, netted against earnings from our corporate cash and cash equivalents and investments in available-for-sale ("AFS") securities and other equity method investments. Other . . .
Apr 07, 2021
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