filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Item 7. 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 each of the three fiscal years ended May 31, 2019 (“fiscal 2019” or the “fiscal year”), May 31, 2018 (“fiscal 2018”), and May 31, 2017 (“fiscal 2017”), and our financial condition as of May 31, 2019. This review should be read in conjunction with the accompanying consolidated financial statements and the related Notes to Consolidated Financial Statements contained in Item 8 of this Annual Report on Form 10-K (“Form 10-K”) and the “Risk Factors” discussed in Item 1A of this Form 10-K. Forward-looking statements in this review are qualified by the cautionary statement under the heading “Cautionary Note Regarding Forward-Looking Statements Pursuant to the United States Private Securities Litigation Reform Act of 1995” contained at the beginning of Part I of this Form 10-K.
Overview
We are a leading provider of integrated human capital management (“HCM”) solutions for payroll, benefits, human resource (“HR”), and insurance services for small- to medium-sized businesses. We offer a comprehensive portfolio of HCM services and products that allow our clients to meet their diverse payroll and HR needs.
We support small-business companies through our core payroll, utilizing our proprietary, robust, software-as-a-service (“SaaS”) Paychex Flex® platform, and our SurePayroll® SaaS-based products. Mid-market companies typically have more complex payroll and benefits needs, and are serviced through our Paychex Flex Enterprise solution set, which offers an integrated suite of HCM solutions through the Paychex Flex platform, or through our legacy platform. Our SaaS solution through Paychex Flex Enterprise integrates payroll processing with HR management, employee benefits administration, time and labor management, applicant tracking, onboarding solutions, and performance and learning management.
Our portfolio of HCM and employee benefit-related services are as follows:
Management Solutions:
| · | payroll processing services; |
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| · | payroll tax administration services; |
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| · | employee payment services; |
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| · | regulatory compliance services (new-hire reporting and garnishment processing); |
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| · | HR Solutions Administrative Services Organization (“ASO”); |
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| · | retirement services administration; |
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| · | HR administration services, including time and attendance, benefit enrollment, recruiting, and onboarding; |
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| · | other HR services and products; and |
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| · | business services. Our wholly owned subsidiary, Paychex Advance LLC (“Paychex Advance”), provides a portfolio of services to the temporary staffing industry, including payroll funding (via the purchase of accounts receivable) and outsourcing services, which includes payroll processing, invoicing, and tax preparation. |
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Professional Employer Organization (“PEO”) and Insurance Services:
| · | PEO services provided by our licensed subsidiaries, Paychex Business Solutions, LLC, HR Outsourcing Holdings, Inc. (“HROi”), and Oasis Outsourcing Group Holdings, L.P. (“Oasis”); and |
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| · | insurance services provided by our licensed insurance agency, Paychex Insurance Agency, Inc. |
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Our mission is to be the leading provider of payroll, benefits, HR, and insurance services for small and mid-sized companies by being an essential partner with America's businesses. We believe success in this mission will lead to strong long-term financial performance. Our strategy focuses on flexible, convenient service; industry-leading, integrated technology; solid sales execution; providing a comprehensive suite of value-added HCM services; continued service penetration; and engaging in strategic acquisitions.
We continue to focus on driving growth in the number of clients, revenue per client, and revenue and profits, while providing industry-leading 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. 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.
Our financial results for fiscal 2019 reflect another year of continued growth across our major HCM product lines. PEO and Insurance Services revenue continued to experience strong growth of 46% for fiscal 2019 as compared with fiscal 2018. Excluding the acquisition of Oasis, PEO and Insurance Services revenue increased 19% for fiscal 2019. The impact of the acquisition of HROi on PEO and Insurance Services revenue growth for fiscal 2019 was approximately 4%. The remaining increases were driven by growth in clients and client worksite employees across our combined existing PEO business. Management Solutions revenue increased 4% for fiscal 2019 as compared with fiscal 2018, primarily driven by growth in our client base across many of our services, growth in revenue per check, which improved as a result of price increases, net of discounts, and increased revenue per client. As of May 31, 2019, including the Oasis acquisition, we served approximately 670,000 payroll and PEO clients. As of May 31, 2018, we served over 650,000 payroll and PEO clients. Client retention was over 82% of our beginning client base for the fiscal year, in line with our historic best retention rate.
Effective December 20, 2018, the Company acquired Oasis. Upon closing, Oasis became a wholly owned subsidiary of the Company. Oasis is an industry leader in providing HR outsourcing services. The purchase price was $992.2 million, net of $262.3 million in cash acquired, including $132.1 million of restricted cash. The acquisition was financed through a combination of cash on hand and the issuance of long-term private placement debt totaling $800.0 million.
Interest rates available on high-quality financial instruments have gradually increased. Our combined funds held for clients and corporate investment portfolios earned an average rate of return of 1.9% for fiscal 2019, compared to 1.5% for fiscal 2018 and 1.2% for fiscal 2017. The United States (“U.S.”) Federal Reserve raised the Federal Funds rate by a total of 75 basis points during fiscal 2019 to a range of 2.25% to 2.50% as of May 31, 2019. The Federal Funds rate was in the range of 1.50% to 1.75% as of May 31, 2018.
Highlights of our financial results for fiscal 2019, compared to fiscal 2018, are as follows:
| · | Total revenue increased 12% to $3.8 billion. |
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| · | Total service revenue increased 11% to $3.7 billion. |
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| o | Management Solutions revenue increased 4% to $2.9 billion. |
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| o | PEO and Insurance Services revenue increased 46% to $814.2 million. Excluding the acquisition of Oasis, PEO and Insurance Services revenue increased 19%. The impact of the acquisition of HROi on PEO and Insurance Services revenue growth was approximately 4%. |
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| · | Interest on funds held for clients increased 27% to $80.6 million. |
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| · | Operating income increased 6% to $1.4 billion. Adjusted operating income(1) increased 4% to $1.4 billion. |
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| · | Net income increased 4% to $1.0 billion. Adjusted net income(1) increased 11% to $1.0 billion. |
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| · | Diluted earnings per share increased 4% to $2.86 per share. Adjusted diluted earnings per share(1) increased 11% to $2.84 per share. |
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| · | Dividends of $826.8 million were paid to stockholders, representing 80% of net income. |
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| (1) | Adjusted operating income, adjusted net income, and adjusted diluted earnings per share are not U.S. generally accepted accounting principles (“GAAP”) measures. Please refer to the “Non-GAAP Financial Measures” section of this Item 7 for a discussion of these non-GAAP measures and a reconciliation to the most comparable GAAP measures of operating income, net income, and diluted earnings per share. |
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Business Outlook
Our payroll and PEO client base, including all acquisitions, was approximately 670,000 clients as of May 31, 2019. Our payroll and PEO client base, including all acquisitions, exceeded 650,000 clients as of May 31, 2018, and was approximately 605,000 clients as of May 31, 2017.
While our HR product offerings provide services to employers and employees beyond payroll, they effectively leverage payroll processing data. Our HR services are included as part of the integrated HCM solution within Paychex Flex or provided through our Prism HR PEO platform. The following table illustrates the growth in selected HR product offerings:
| Balance as of | Growth rates for fiscal year | ||||||||||
| May 31, 2019 | 2019 | 2018 | 2017 | ||||||||
| Management Solutions | |||||||||||
| Paychex HR Solutions client worksite employees | 1,086,000 | 9 | % | 9 | % | 8 | % | ||||
| Paychex HR Solutions clients | 37,000 | 7 | % | 8 | % | 8 | % | ||||
| Retirement services plans | 87,000 | 6 | % | 6 | % | 5 | % | ||||
| PEO and Insurance Services | |||||||||||
| PEO client worksite employees(1) | 405,000 | 150 | % | 50 | % | 9 | % | ||||
| PEO clients(1) | 15,000 | 126 | % | 39 | % | 3 | % | ||||
| Health and benefits services applicants | 189,000 | 7 | % | 9 | % | 8 | % |
| (1) | Oasis is included in the total number of worksite employees and clients for fiscal 2019. HROi is included in the total number of worksite employees and clients for both fiscal 2019 and fiscal 2018. |
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Concentrated effort remains on the continued enhancements of Paychex Flex, our robust cloud-based HCM platform, which allows direct client access to payroll, HR, and benefits information in a streamlined and integrated approach to workplace management. In fiscal 2019, we continued to focus on enhancing the value to clients of our Paychex Flex platform. New offerings and enhancements to our Paychex Flex platform made in fiscal 2019 included:
| · | Paychex Learning, an accessible, low-cost and seamlessly integrated web-based learning management system for providing professional training courses to the workforce; |
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| · | Paychex Flex Assistant, a chatbot programmed to answer commonly asked HR-related questions; |
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| · | Tablet-enabled facial recognition for time and attendance; |
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| · | Retirement-focused product enhancements to both the participant dashboard and advisor portal, designed to simplify the process of enrolling and managing a 401(k) plan; |
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| · | New synchronization functionality between Paychex General Ledger Service and QuickBooks Online, which enhances efficiency and productivity for businesses, as well as the accountants who serve them; and |
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| · | The addition of performance management, workflow approvals, real-time analytics, and a configurable events calendar to the Paychex Flex platform. |
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We continue to strengthen our position as an expert in our industry by serving as a source of education and information to clients, businesses of all sizes, and other interested parties. We provide free webinars, white papers, and other information on our website to aid existing and prospective clients with the impact of regulatory changes. The Paychex Insurance Agency, Inc. website, www.paychex.com/group-health-insurance, helps small-business owners navigate the area of insurance coverage. Both this website and www.paychex.com/worx have sections dedicated to the topic of health care reform.
Financial position and liquidity
Our financial position as of May 31, 2019 remained strong with cash, restricted cash, and total corporate investments of $779.9 million. Total long-term borrowings, net of debt issuance costs, related to our acquisition of Oasis totaled $796.4 million as of May 31, 2019. Our investment strategy continues to focus on protecting principal and optimizing liquidity. We invest predominately in municipal bonds – including general obligation bonds; pre-refunded bonds, which are secured by a U.S. government escrow; and essential services revenue bonds – along with U.S. government agency and treasury securities and corporate bonds. During fiscal 2019, our primary short-term investment vehicles were government agency discount notes, Variable Rate Demand Notes (“VRDNs”) and bank demand deposit accounts.
A majority of our portfolio is invested in high credit quality securities with ratings of AA or higher, and A-1/P-1 ratings on short-term securities. We limit the amounts that can be invested in any single issuer and invest in short- to intermediate-term instruments whose fair values are less sensitive to interest rate changes. We believe that our investments as of May 31, 2019 that were in an unrealized loss position were not other-than-temporarily impaired, nor has any event occurred subsequent to that date that would indicate any other-than-temporary impairment.
Our primary source of cash is generated by our ongoing operations. Cash flows from operations were $1.3 billion for fiscal 2019. Historically, we have funded our operations, capital purchases, business acquisitions, share repurchases, and dividend payments from our operating activities. However, we funded our most recent acquisition of Oasis through a combination of cash and the issuance of long-term private placement debt of $800.0 million. Our positive operating cash flows for fiscal 2019 allowed us to support our business and to pay substantial dividends to our stockholders. In May 2019, our Board of Directors (the “Board”) increased our quarterly dividend by 11% to $0.62 per share from $0.56 per share. Dividends paid to stockholders were 80% of net income for fiscal 2019. It is anticipated that cash, restricted cash, and total corporate investments as of May 31, 2019, along with projected operating cash flows and available short-term financing, will support our normal business operations, capital purchases, share repurchases, and dividend payments for the foreseeable future.
For further analysis of our results of operations for fiscal years 2019, 2018, and 2017, and our financial position as of May 31, 2019, refer to the tables and analysis in the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item 7 and the discussion in the “Critical Accounting Policies” section of this Item 7.
Results of Operations
Summary of Results of Operations for Fiscal Years:
| 2018 | 2017 | |||||||||||||||||
| In millions, except per share amounts | 2019 | Change | As Adjusted(1) | Change | As Adjusted(1) | |||||||||||||
| Revenue: | ||||||||||||||||||
| Management Solutions | $ | 2,877.7 | 4 | % | $ | 2,758.4 | 3 | % | $ | 2,680.7 | ||||||||
| PEO and Insurance Services | 814.2 | 46 | % | 555.8 | 32 | % | 421.7 | |||||||||||
| Total service revenue | 3,691.9 | 11 | % | 3,314.2 | 7 | % | 3,102.4 | |||||||||||
| Interest on funds held for clients | 80.6 | 27 | % | 63.5 | 26 | % | 50.6 | |||||||||||
| Total revenue | 3,772.5 | 12 | % | 3,377.7 | 7 | % | 3,153.0 | |||||||||||
| Combined operating and SG&A expenses | 2,401.2 | 15 | % | 2,086.2 | 10 | % | 1,899.1 | |||||||||||
| Operating income | 1,371.3 | 6 | % | 1,291.5 | 3 | % | 1,253.9 | |||||||||||
| Interest (expense)/income, net | (3.3) | n/m | 8.6 | n/m | 5.2 | |||||||||||||
| Income before income taxes | 1,368.0 | 5 | % | 1,300.1 | 3 | % | 1,259.1 | |||||||||||
| Income taxes | 333.6 | 9 | % | 306.0 | (29) | % | 432.8 | |||||||||||
| Effective income tax rate | 24.4 | % | 23.5 | % | 34.4 | % | ||||||||||||
| Net income | $ | 1,034.4 | 4 | % | $ | 994.1 | 20 | % | $ | 826.3 | ||||||||
| Diluted earnings per share | $ | 2.86 | 4 | % | $ | 2.75 | 21 | % | $ | 2.28 |
| (1) | Amounts have been adjusted to reflect the adoption of Accounting Standards Codification (“ASC”) Topic 606, “Revenue from Contracts with Customers” (“ASC Topic 606”). |
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n/m – not meaningful
We invest in highly liquid, investment-grade fixed income securities and do not utilize derivative instruments to manage interest rate risk. As of May 31, 2019, we had no exposure to high-risk or illiquid investments. Details regarding our combined funds held for clients and corporate investment portfolios are as follows:
| Year ended May 31, | ||||||||||||
| $ in millions | 2019 | 2018 | 2017 | |||||||||
| Average investment balances: | ||||||||||||
| Funds held for clients | $ | 3,969.7 | $ | 4,040.8 | $ | 4,066.3 | ||||||
| Corporate investments | 848.4 | 915.1 | 906.7 | |||||||||
| Total | $ | 4,818.1 | $ | 4,955.9 | $ | 4,973.0 | ||||||
| Average interest rates earned (exclusive of net realized gains): | ||||||||||||
| Funds held for clients | 2.0 | % | 1.6 | % | 1.2 | % | ||||||
| Corporate investments | 1.6 | % | 1.3 | % | 1.1 | % | ||||||
| Combined funds held for clients and corporate investments | 1.9 | % | 1.5 | % | 1.2 | % | ||||||
| Total net realized gains | $ | — | $ | 0.1 | $ | 0.1 |
| $ in millions | ||||||||||||
| As of May 31, | 2019 | 2018 | 2017 | |||||||||
| Net unrealized gains/(losses) on available-for-sale securities(1) | $ | 19.7 | $ | (38.3) | $ | 32.0 | ||||||
| Federal Funds rate(2) | 2.50 | % | 1.75 | % | 1.00 | % | ||||||
| Total fair value of available-for-sale securities | $ | 3,620.8 | $ | 3,104.8 | $ | 4,613.2 | ||||||
| Weighted-average duration of available-for-sale securities in years(3) | 2.9 | 3.1 | 3.2 | |||||||||
| Weighted-average yield-to-maturity of available-for-sale securities(3) | 2.1 | % | 1.9 | % | 1.7 | % |
| (1) | The net unrealized gain on our investment portfolios was approximately $31.6 million as of July 17, 2019. |
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| (2) | The Federal Funds rate was in the range of 2.25% to 2.50% as of May 31, 2019, in the range of 1.50% to 1.75% as of May 31, 2018, and in the range of 0.75% to 1.00% as of May 31, 2017. |
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| (3) | These items exclude the impact of VRDNs, as they are tied to short-term interest rates. |
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Management Solutions revenue: Management Solutions revenue was $2.9 billion for fiscal 2019 and $2.8 billion for fiscal 2018, reflecting growth of 4% and 3%, respectively, compared to each of the prior fiscal year periods. Both fiscal 2019 and fiscal 2018 benefited from growth in our client base across many of our services and growth in revenue per client, which improved as a result of price increases, net of discounts, and increased product penetration. Paychex HR Solutions revenue growth for both fiscal 2019 and fiscal 2018 was driven by strong growth in client base and in client worksite employees. Retirement services revenue growth for both fiscal 2019 and 2018 benefited from an increase in the number of plans served, along with an increase in revenue earned on the asset value of participants’ 401(k) funds. The impact of the acquisition of Lessor Group (“Lessor”) on Management Solutions revenue growth for fiscal 2019 and fiscal 2018 was insignificant. Payroll revenue represented approximately 64% and 66% of Management Solutions revenue for fiscal 2019 and fiscal 2018, respectively. Management Solutions key statistics are as follows:
| $ in billions | |||||||||||||||
| As of May 31, | 2019 | Change | 2018 | Change | 2017 | ||||||||||
| Paychex HR Solutions client worksite employees | 1,086,000 | 9 | % | 995,000 | 9 | % | 912,000 | ||||||||
| Paychex HR Solutions clients | 37,000 | 7 | % | 35,000 | 8 | % | 32,000 | ||||||||
| Retirement services plans | 87,000 | 6 | % | 82,000 | 6 | % | 78,000 | ||||||||
| Asset value of retirement services participants’ funds | $ | 31.0 | 1 | % | $ | 30.6 | 12 | % | $ | 27.4 |
PEO and Insurance Services revenue: PEO and Insurance Services revenue was $814.2 million for fiscal 2019 and $555.8 million for fiscal 2018, reflecting growth of 46% and 32%, respectively, compared to each of the prior fiscal year periods. Excluding the impact of Oasis, PEO and Insurance Services revenue increased 19% in fiscal 2019 when compared to fiscal 2018. PEO and Insurance Services revenue growth for fiscal 2019, excluding Oasis, was driven by growth in clients and client worksite employees across our combined existing PEO business. Demand for our existing PEO services, along with growth within our client base, resulted in double-digit growth in the number of client worksite employees served. The impact of the acquisition of HROi on PEO and Insurance Services revenue growth for fiscal 2019 was approximately 4%. For fiscal 2018, PEO and Insurance Services revenue growth was also primarily driven by increases in clients and client worksite employees across our combined
existing PEO business. For fiscal 2018, HROi contributed approximately 18% to the growth in PEO and Insurance Services revenue. PEO revenue represented approximately 77% and 67% of PEO and Insurance Services revenue for fiscal 2019 and fiscal 2018, respectively.
Insurance Services revenue growth for both fiscal 2019 and fiscal 2018 benefited from an increase in the number of health and benefit clients and applicants across our payroll client base. For fiscal 2019, revenue growth was impacted by softness in the workers’ compensation market as state insurance fund rates declined. Insurance Services revenue represented approximately 23% and 33% of PEO and Insurance Services revenue for fiscal 2019 and fiscal 2018, respectively.
PEO and Insurance Services key statistics are as follows:
| As of May 31, | 2019 | Change | 2018 | Change | 2017 | ||||||||||
| PEO client worksite employees(1) | 405,000 | 150 | % | 162,000 | 50 | % | 109,000 | ||||||||
| PEO clients(1) | 15,000 | 126 | % | 6,000 | 39 | % | 5,000 | ||||||||
| Health and benefits services applicants | 189,000 | 7 | % | 177,000 | 9 | % | 162,000 |
(1)Oasis is included in the total number of worksite employees and clients for fiscal 2019. HROi is included in the total number of worksite employees and clients for both fiscal 2019 and fiscal 2018.
Total service revenue: Total service revenue increased 11% and 7% for fiscal 2019 and fiscal 2018, respectively, attributable to the factors previously discussed. The acquisitions of Oasis, HROi, and Lessor contributed approximately 6% to the growth in total service revenue for fiscal 2019 as compared with fiscal 2018. The acquisitions of HROi and Lessor contributed less than 3% to the growth in total service revenue for fiscal 2018 as compared with fiscal 2017.
As of May 31, 2019, including the Oasis and Lessor acquisitions, we served approximately 670,000 payroll and PEO clients. Our total payroll and PEO client base exceeded 650,000, including the Lessor acquisition, for fiscal 2018 and was approximately 605,000 for fiscal 2017. Client retention was over 82% for fiscal 2019, in line with our historic best retention rate. Client retention was approximately 81% of the beginning client base for fiscal 2018 and fiscal 2017.
Interest on funds held for clients: Interest on funds held for clients increased 27% for fiscal 2019 and 26% for fiscal 2018 to $80.6 million and $63.5 million, respectively. For both fiscal 2019 and fiscal 2018, the increases were primarily due to higher average interest rates earned.
Average investment balances for funds held for clients decreased approximately 2% and 1% for fiscal 2019 and fiscal 2018, respectively, primarily driven by the impact of lower client withholdings as a result of the Tax Cut and Jobs Act of 2017 (the “Tax Act”), and changes in client base mix, partially offset by the impact of wage inflation.
Refer to the “Market Risk Factors” section contained in Item 7A of this Form 10-K for more information on changing interest rates.
Combined operating and SG&A expenses: The following table summarizes total combined operating and SG&A expenses for fiscal years:
| 2018 | 2017 | ||||||||||||||
| In millions | 2019 | Change(1) | As Adjusted(2) | Change(1) | As Adjusted(2) | ||||||||||
| Compensation-related expenses | $ | 1,396.8 | 13 | % | $ | 1,235.2 | 5 | % | $ | 1,175.9 | |||||
| Depreciation and amortization | 181.5 | 32 | % | 138.0 | 9 | % | 126.9 | ||||||||
| PEO insurance costs | 286.7 | 40 | % | 205.2 | 44 | % | 142.2 | ||||||||
| Other expenses | 536.2 | 6 | % | 507.8 | 12 | % | 454.1 | ||||||||
| Total expenses | $ | 2,401.2 | 15 | % | $ | 2,086.2 | 10 | % | $ | 1,899.1 |
| (1) | Calculated using actual amounts |
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| (2) | Amounts have been adjusted to reflect the adoption of ASC Topic 606. |
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Total expenses increased 15% for fiscal 2019 and 10% for fiscal 2018. The acquisitions of Oasis, HROi, and Lessor, contributed 10% and 5% to the growth in total expenses for fiscal 2019 and fiscal 2018, respectively.
Compensation-related expenses increased 13% for fiscal 2019 and 5% for fiscal 2018. The acquisitions of Oasis, HROi and Lessor contributed 6% and 1% to the growth in compensation-related expenses for fiscal 2019 and fiscal 2018, respectively. For both fiscal 2019 and 2018, the increases in compensation-related expenses were driven by increased headcount due to incremental investments in sales force, technology resources, and operations to support the growth in business and increased performance-based pay. In addition, the increase in compensation-related expenses for fiscal 2018 was impacted by a one-time bonus paid to non-management employees. As of May 31, 2019, we had approximately 15,600 employees, including Oasis, compared with 14,300 employees as of May 31, 2018.
Depreciation expense is primarily related to buildings, furniture and fixtures, data processing equipment, and both purchased and internally developed software. Amortization of intangible assets is primarily related to client list acquisitions, including intangible assets recorded for the Oasis acquisition, which are amortized using either straight-line or accelerated methods. The growth in depreciation and amortization for fiscal 2019 was primarily driven by an increase in intangible assets related to the acquisitions of Oasis and Lessor. The increase in depreciation and amortization for fiscal 2018 was primarily driven by an increase in internally developed software that was placed in service over the prior two years as well as the amortization of customer lists and other intangibles related to the acquisitions of HROi and Lessor.
PEO insurance costs include workers’ compensation and minimum premium health insurance benefit plans and self-insured dental and vision plans where we retain risk. Growth in our combined PEO business, including the acquisitions of Oasis and HROi, contributed to the growth in PEO insurance costs for both fiscal 2019 and fiscal 2018.
Other expenses include items such as non-capital equipment, delivery, forms and supplies, communications, travel and entertainment, professional services, and other costs incurred to support our business. Continued investment in product development, supporting technology, and the acquisitions of Oasis and HROi impacted other expense growth for both fiscal 2019 and fiscal 2018. For fiscal 2018, other expenses also reflect a one-time expense of $32.6 million related to the termination of certain license agreements.
Operating income: Operating income increased 6% to $1.4 billion for fiscal 2019 and 3% to $1.3 billion for fiscal 2018. The fluctuations in operating income were attributable to the factors previously discussed. Operating income, as a percent of total revenue, was 36.3%, 38.2%, and 39.8% for the fiscal years 2019, 2018, and 2017, respectively. Adjusted operating income increased 4% to $1.4 billion for fiscal 2019 and 6% to $1.3 billion for fiscal 2018. See the “Non-GAAP Financial Measures” section of this Item 7 for further discussion of this non-GAAP measure.
Interest (expense)/income, net: Interest (expense)/income, net, primarily represents interest expense incurred on our debt instruments, netted against earnings from our cash and cash equivalents and corporate investments in available-for-sale securities. Investment income does not include interest on funds held for clients, which is included in total revenue. We recognized $3.3 million of net interest expense for fiscal 2019 and $8.6 million of net investment income for fiscal 2018. Interest expense, net in fiscal 2019 included $13.7 million of interest expense related to financing used to partially fund the acquisition of Oasis. In addition, average investment balances decreased in fiscal 2019 as corporate investments were liquidated to partially fund the Oasis acquisition. This decrease was partially offset by higher average interest rates earned. Investment income, net increased from $5.2 million for fiscal 2017 to $8.6 million for fiscal 2018. This increase was primarily due to higher average interest rates earned and an increase in average investment balances, which was the result of higher net income partially offset by share repurchases, business acquisitions, and an increase in the rate for quarterly dividend payments.
Income taxes: Our effective income tax rate was 24.4% for fiscal 2019, 23.5% for fiscal 2018, and was 34.4% for fiscal 2017. The effective income tax rates for both fiscal 2019 and fiscal 2018 benefited from the enactment of the Tax Act. In fiscal 2018, as a result of the Tax Act, we recorded a non-recurring net tax benefit for the revaluation of our net deferred tax liabilities. This amount impacted diluted earnings per share by approximately $0.23 per diluted share for fiscal 2018. In addition, as it relates to the Tax Act, our effective income tax rate for both fiscal 2019 and fiscal 2018 benefited from a reduced statutory tax rate applied to taxable income. The effective income tax rates in all periods were impacted by recognition of net discrete tax benefits related to employee stock-based compensation payments. Additional discrete tax items recognized during each respective period are insignificant. Refer to Note K of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for additional disclosures on income taxes.
Net income and diluted earnings per share: Net income increased 4% to $1.0 billion for fiscal 2019 and 20% to $994.1 million for fiscal 2018. Diluted earnings per share increased 4% to $2.86 per diluted share for fiscal 2019 and 21% to $2.75 per diluted share for fiscal 2018. These fluctuations were attributable to the factors previously discussed. Adjusted net income increased 11% to $1.0 billion for fiscal 2019 and increased 14% to $922.4 million for fiscal 2018. Adjusted diluted earnings per share was $2.84 per diluted share for fiscal 2019 and $2.55 per diluted share for fiscal 2018, reflecting increases of 11% and 14%, respectively. Refer to the “Non-GAAP Financial Measures” section that follows for a discussion of these non-GAAP measures.
Non-GAAP Financial Measures: Adjusted operating income, adjusted net income, and adjusted diluted earnings per share are summarized as follows:
| $ in millions | 2018 | 2017 | |||||||||||||
| 2019 | Change | As adjusted(1) | Change | As adjusted(1) | |||||||||||
| Operating income | $ | 1,371.3 | 6 | % | $ | 1,291.5 | 3 | % | $ | 1,253.9 | |||||
| Non-GAAP adjustments: | |||||||||||||||
| Termination of license agreements(2) | — | 32.6 | — | ||||||||||||
| Total non-GAAP adjustments | — | 32.6 | — | ||||||||||||
| Adjusted operating income | $ | 1,371.3 | 4 | % | $ | 1,324.1 | 6 | % | $ | 1,253.9 | |||||
| Net income | $ | 1,034.4 | 4 | % | $ | 994.1 | 20 | % | $ | 826.3 | |||||
| Non-GAAP adjustments: | |||||||||||||||
| Excess tax benefit related to employee stock-based compensation payments(3) | (8.3) | (12.9) | (18.3) | ||||||||||||
| Revaluation of net deferred tax liabilities(4) | 1.7 | (83.5) | — | ||||||||||||
| Termination of license agreements(2) | — | 24.7 | — | ||||||||||||
| Total non-GAAP adjustments | (6.6) | (71.7) | (18.3) | ||||||||||||
| Adjusted net income | $ | 1,027.8 | 11 | % | $ | 922.4 | 14 | % | $ | 808.0 | |||||
| Diluted earnings per share | $ | 2.86 | 4 | % | $ | 2.75 | 21 | % | $ | 2.28 | |||||
| Non-GAAP adjustments: | |||||||||||||||
| Excess tax benefit related to employee stock-based compensation payments(3) | (0.02) | (0.04) | (0.05) | ||||||||||||
| Revaluation of net deferred tax liabilities(4) | — | (0.23) | — | ||||||||||||
| Termination of license agreements(2) | — | 0.07 | — | ||||||||||||
| Total non-GAAP adjustments | (0.02) | (0.20) | (0.05) | ||||||||||||
| Adjusted diluted earnings per share | $ | 2.84 | 11 | % | $ | 2.55 | 14 | % | $ | 2.23 |
| (1) | Amounts have been adjusted to reflect the adoption of ASC Topic 606. |
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| (2) | Additional expense and corresponding tax benefit recognized as a result of the termination of certain license agreements. This event is not expected to recur. |
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| (3) | Net tax windfall or shortfall benefits related to employee stock-based compensation payments recognized in income taxes. This item is subject to volatility and will vary based on employee decisions on exercising employee stock options and fluctuations in our stock price, neither of which is within the control of management. |
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| (4) | Non-recurring tax benefits recognized as a result of the Tax Act related to the revaluation of net deferred tax liabilities and the one-time tax charge as a result of updated guidance on Internal Revenue Code Section 162(m). |
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In addition to reporting operating income, net income, and diluted earnings per share, which are U.S. GAAP measures, we present adjusted operating income, adjusted net income, and adjusted diluted earnings per share, which are non-GAAP measures. We believe adjusted operating income, adjusted net income, and adjusted diluted earnings per share are appropriate additional measures, as they are indicators of our core business operations performance period over period. Adjusted operating income, adjusted net income, and adjusted diluted earnings per share are not calculated through the application of U.S. GAAP and are not required forms of disclosure by the SEC. As such, they should not be considered as a substitute for the U.S. GAAP measures of operating income, net income, and diluted earnings per share, and therefore should not be used in isolation, but in conjunction with the U.S. GAAP measures. The use of any non-GAAP measure may produce results that vary from the U.S. GAAP measure and may not be comparable to a similarly defined non-GAAP measure used by other companies.
Liquidity and Capital Resources
Our financial position as of May 31, 2019 remained strong with cash, restricted cash, and total corporate investments of $779.9 million and total long-term debt of $796.4 million. We believe that our investments in an unrealized loss position as of May 31, 2019 were not other-than-temporarily impaired, nor has any event occurred subsequent to that date to indicate any other-than-temporary impairment. We anticipate that cash, restricted cash, and total corporate investments as of May 31, 2019, along with projected operating cash flows and available short-term financing, will support our normal business operations, capital purchases, share repurchases, and dividend payments for the foreseeable future.
Financing
We maintain credit facilities and letters of credit as part of our normal and recurring business operations.
Credit Facilities: We maintain three committed, unsecured credit facilities as follows:
| Bank | Borrower (1) | Date Entered | Expiration Date | Maximum Amount Available | Purpose | |||||
| JP Morgan Chase Bank, N.A.(2) | Paychex of New York, LLC | August 5, 2015 | August 5, 2020 | $1 Billion | To meet short-term funding requirements. | |||||
| JP Morgan Chase Bank, N.A.(2) | Paychex of New York, LLC | August 17, 2017 | August 17, 2022 | $500 Million | To meet short-term funding requirements. | |||||
| PNC Bank, National Association (“PNC”) | Paychex Advance, LLC | March 17, 2016 | March 17, 2020 | $150 Million | To finance working capital needs and general corporate purposes. |
| (1) | Borrower is a wholly owned subsidiary of the Company. |
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| (2) | JP Morgan Chase Bank, N.A. (“JPM”) acts as the administrative agent for this syndicated credit facility. |
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For all credit facilities, obligations under any facility are guaranteed by the Company and certain of its subsidiaries and will
bear interest at competitive rates based on options provided to the borrower. Upon the expiration date, any borrowings outstanding will mature and be payable on such date.
JPM $1 Billion Credit Facility: There were no borrowings outstanding under this credit facility as of May 31, 2019. Details of borrowings under this credit facility are as follows:
| Year ended May 31, | ||||||||
| $ in millions | 2019 | 2018 | ||||||
| Number of days borrowed | 95 | 22 | ||||||
| Maximum amount borrowed | $ | 483.0 | $ | 700.0 | ||||
| Weighted-average amount borrowed | $ | 387.7 | $ | 319.1 | ||||
| Weighted-average interest rate | 3.64 | % | 4.27 | % |
We typically borrow on an overnight basis. In addition to overnight borrowings, we also borrowed:
| · | Fiscal 2019 - $400.0 million for 84 days at a weighted-average LIBOR-based interest rate of 3.45% to temporarily fund the acquisition of Oasis. This temporary borrowing was subsequently refinanced as outlined in Note N to the financial statements; |
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| · | Fiscal 2018 - $100.0 million for a three-day period at a weighted-average interest rate of 4.25%. |
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Subsequent to May 31, 2019, we borrowed two times, on an overnight basis, $187.8 million on a weighted-average basis under this line.
JPM $500 Million Credit Facility: There were no borrowings outstanding under this credit facility as of May 31, 2019. Details of borrowings under this credit facility are as follows:
| Year ended May 31, | ||||||||
| $ in millions | 2019 | 2018 | ||||||
| Number of days borrowed | 92 | 42 | ||||||
| Maximum amount borrowed | $ | 400.0 | $ | 400.0 | ||||
| Weighted-average amount borrowed | $ | 375.6 | $ | 144.8 | ||||
| Weighted-average interest rate | 3.55 | % | 2.80 | % |
We typically borrow on an overnight basis. In addition to overnight borrowings, we also borrowed:
| · | Fiscal 2019 – $400 million for 84 days at a weighted-average LIBOR-based interest rate of 3.45% to temporarily fund the acquisition of Oasis. This temporary borrowing was subsequently refinanced as outlined in Note N to the financial statements; |
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| · | Fiscal 2018 – $300.0 million for seven days and $75.0 million for 30 days at weighted average LIBOR-based interest rates of 2.13% and 2.19%, respectively. |
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Subsequent to May 31, 2019, we borrowed two times, on an overnight basis, $178.0 million on a weighted-average basis under this line.
PNC $150 Million Credit Facility: There were no borrowings outstanding under this credit facility as of May 31, 2019. Details of borrowings under this credit facility are as follows:
| Year ended May 31, | ||||||||
| $ in millions | 2019 | 2018 | ||||||
| Number of days borrowed | 359 | 358 | ||||||
| Maximum amount borrowed | $ | 58.9 | $ | 59.9 | ||||
| Weighted-average amount borrowed | $ | 56.1 | $ | 57.2 | ||||
| Weighted-average interest rate | 2.81 | % | 1.94 | % |
Subsequent to May 31, 2019, we borrowed approximately $54.9 million under this line, which remains outstanding as of the date of this report.
All of our credit facilities contain various financial and operational covenants that are usual and customary for such arrangements. We were in compliance with all of these covenants as of May 31, 2019.
Certain lenders under these credit facilities, and their respective affiliates, have performed, and may in the future perform for us, various commercial banking, investment banking, underwriting, and other financial advisory services, for which they have received, and will continue to receive in the future, customary fees and expenses.
Long-term financing: On March 13, 2019, we borrowed $800.0 million to replace short-term borrowings under the JPM credit facilities used to fund the acquisition of Oasis through the issuance of the following long-term private placement debt:
| May 31, | |||
| In millions | 2019 | ||
| Senior Notes, Series A | $ | 400.0 | |
| Senior Notes, Series B | 400.0 | ||
| Total long-term borrowings | 800.0 | ||
| Less: Debt issuance costs, net of accumulated amortization | (3.6) | ||
| Long-term borrowings, net of debt issuance costs | $ | 796.4 |
Certain information related to the Senior Notes are as follows:
| Senior Notes | Senior Notes | |||
| Series A | Series B | |||
| Stated interest rate | 4.07% | 4.25% | ||
| Effective interest rate | 4.16% | 4.32% | ||
| Interest rate type | Fixed | Fixed | ||
| Interest payment dates | Semi-annual, in arrears | Semi-annual, in arrears | ||
| Principal payment dates | March 13, 2026 | March 13, 2029 | ||
| Note type | Unsecured | Unsecured |
The effective interest rates for each note series includes the interest on the note and amortization of debt issuance costs.
The Senior Notes contain customary representations, warranties, affirmative and negative covenants, including financial covenants that are usual and customary for such arrangements. We were in compliance with all of these covenants as of May 31, 2019.
Letters of credit: As of May 31, 2019, we had irrevocable standby letters of credit available totaling $148.9 million, required to secure commitments for certain insurance policies. The letters of credit expire at various dates between July 2019 and July 2020. No amounts were outstanding on these letters of credit during fiscal 2019 or as of May 31, 2019. Subsequent to May 31, 2019, the letter of credit expiring in July 2019 was renewed through July 2020.
Other commitments: The following table summarizes our significant contractual obligations as of May 31, 2019:
| Payments due by period | |||||||||||||||
| Less than | More than | ||||||||||||||
| In millions | Total | 1 year | 1-3 years | 4-5 years | 5 years | ||||||||||
| Operating leases(1) | $ | 123.9 | $ | 37.7 | $ | 51.2 | $ | 24.3 | $ | 10.7 | |||||
| Purchase obligations(2) | 119.2 | 105.1 | 13.8 | 0.3 | — | ||||||||||
| Workers' compensation estimated obligations | 170.7 | 71.1 | 50.2 | 18.6 | 30.8 | ||||||||||
| Debt service obligations(3) | 1,084.0 | 33.3 | 66.6 | 66.5 | 917.6 | ||||||||||
| Total | $ | 1,497.8 | $ | 247.2 | $ | 181.8 | $ | 109.7 | $ | 959.1 |
| (1) | Operating leases are primarily for office space and equipment used in our branch operations. |
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| (2) | Purchase obligations include our estimate of the minimum outstanding commitments under purchase orders to buy goods and services and legally binding contractual arrangements with future payment obligations. Included in the total purchase obligations is $5.6 million of commitments to purchase capital assets. Amounts actually paid under certain of these arrangements may be different due to variable components of these agreements. |
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| (3) | Includes principal and interest payments on our Senior Notes. Refer to Note N of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for more information. |
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The liability for uncertain tax positions, including interest and net of federal benefits, was approximately $21.6 million as of May 31, 2019. Refer to Note K of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for more information on income taxes. We are not able to reasonably estimate the timing of future cash flows related to this liability and have excluded it from the table above.
During fiscal 2017 we entered into a limited partnership agreement to contribute a maximum amount of $10.0 million to a venture capital fund in the financial technology sector, of which approximately $6.1 million has been contributed as of May 31, 2019. In late fiscal 2019, we entered into a second limited partnership agreement to contribute a maximum amount of $10.0 million to a venture capital fund in the financial technology sector, of which $0.1 million has been contributed as of May 31, 2019. The timing of future contributions to be made to these venture capital funds cannot be specifically or reasonably determined and thus have been excluded from the table above.
In the normal course of business, we make representations and warranties that guarantee the performance of services under service arrangements with clients. Historically, there have been no material losses related to such guarantees. In addition, we have entered into indemnification agreements with our officers and directors, which require us to defend and, if necessary, indemnify these individuals for certain pending or future legal claims as they relate to their services provided to us.
We currently self-insure the deductible portion of various insured exposures under certain corporate employee benefit plans. Our estimated loss exposure under these insurance arrangements is recorded in other current liabilities on our Consolidated Balance Sheets. Historically, the amounts accrued have not been material and are not material as of the reporting date. We also maintain corporate insurance coverage in addition to our purchased primary insurance policies for gap coverage for employment practices liability, errors and omissions, warranty liability, theft and embezzlement, cyber threats, and acts of terrorism; and capacity for deductibles and self-insured retentions through our captive insurance company.
We have substantially completed our plan for a new multi-building Paychex campus, including the renovation of over 300,000 square feet based in Rochester, NY. In fiscal 2018, we completed the purchase of five buildings for a combined cost of approximately $34.7 million and placed approximately $16.0 million in escrow for the building renovations. There was no remaining balance in escrow as of May 31, 2019, and building renovations are expected to be completed later this calendar year.
Off-Balance Sheet Arrangements
As part of our ongoing business, we do not participate in transactions with unconsolidated entities which would have been established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. We do maintain investments as a limited partner in both low-income housing projects and venture capital funds focused on the financial technology sector. These are not considered part of our ongoing operations. These investments are accounted for under the equity method of accounting and represented less than one percent of our total assets as of May 31, 2019.
Operating Cash Flow Activities
| Year ended May 31, | |||||||||
| 2018 | 2017 | ||||||||
| In millions | 2019 | As Adjusted(1) | As Adjusted(1) | ||||||
| Net income | $ | 1,034.4 | $ | 994.1 | $ | 826.3 | |||
| Non-cash adjustments to net income | 464.9 | 389.0 | 431.7 | ||||||
| Cash used in changes in operating assets and liabilities | (227.8) | (106.7) | (297.6) | ||||||
| Net cash provided by operating activities | $ | 1,271.5 | $ | 1,276.4 | $ | 960.4 |
(1) Amounts have been adjusted to reflect the adoption of ASC Topic 606.
The changes in our operating cash flows for both fiscal 2019 and fiscal 2018 compared to the prior fiscal year periods were due to higher net income. Net income in both fiscal 2019 and fiscal 2018 benefited from the enactment of the Tax Act. The change in our operating cash flows for fiscal 2019 was also due to higher adjustments for non-cash items, offset by fluctuations in our operating assets and liabilities. The increase in non-cash adjustments for fiscal 2019 was primarily due to a higher provision for deferred income taxes and higher amortization expense related to intangible assets acquired through the acquisitions of Oasis and Lessor. The fluctuations in our operating assets and liabilities between all periods were impacted by the timing of collections from PEO clients and payments, PEO payroll, income tax, and other liabilities. In addition, the larger outflows in fiscal 2019 and fiscal 2017 were impacted by higher accounts receivable balances related to growth in our payroll funding business for temporary staffing agency clients.
Investing Cash Flow Activities
| Year ended May 31, | |||||||||
| 2018 | 2017 | ||||||||
| In millions | 2019 | As Adjusted(1) | As Adjusted(1) | ||||||
| Net change in purchases and sales/maturities of available-for-sale securities | $ | (507.0) | $ | 1,372.7 | $ | (559.3) | |||
| Purchases of property and equipment | (123.8) | (154.0) | (94.3) | ||||||
| Acquisition of businesses, net of cash acquired | (992.2) | (180.4) | — | ||||||
| Purchases of other assets | (5.3) | (39.8) | (8.6) | ||||||
| Net cash (used in)/provided by investing activities | $ | (1,628.3) | $ | 998.5 | $ | (662.2) |
(1) Amounts have been adjusted to reflect the adoption of Accounting Standards Update No. 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash (a consensus of the Financial Accounting Standards Board Emerging Issues Task Force).”
Purchases and sales/maturities of available-for-sale securities: Available-for-sale securities include funds held for clients and corporate investments. The portfolio of funds held for clients and corporate investments is detailed in Note G of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K.
Fluctuations in the net change in purchases and sales/maturities of available-for-sale securities are largely due to timing within the client funds portfolio. The amount of funds held for clients will vary based upon the timing of collection of client funds, and the related remittance of funds to applicable tax or regulatory agencies for payroll tax administration services and to employees of clients utilizing employee payment services. Specific timing impacting cash flows for fiscal years 2019, 2018, and 2017 are discussed further in the financing cash flows discussion of net changes in client fund obligations. For fiscal 2019, in addition to timing fluctuations, the net change in funds held for clients was impacted by changes in investment mix. Fiscal 2018 experienced greater sales of investments to fund client remittances than purchases of investments, whereas fiscal 2017 reflected greater purchases of investments than sales.
Additional discussion of interest rates and related risks is included in the “Market Risk Factors” section contained in Item 7A of this Form 10-K.
Other investing activities: To support our continued client and ancillary product growth, purchases of property and equipment were made for data processing equipment and software, and for the expansion and upgrade of various operating facilities.
The net cash outflow for purchases of property and equipment during fiscal 2018 includes the purchase of five buildings and ongoing renovations of over 300,000 square feet of existing space in Rochester, NY.
Acquisition of businesses, net of cash acquired, reflects our acquisitions of Oasis in December 2018, Lessor in February 2018, and HROi in August 2017. For the Oasis and Lessor acquisitions consideration was cash while the HROi acquisition was a combination of cash and common stock.
Purchases of other assets relates primarily to client list acquisitions. During fiscal 2018, we resolved a contractual dispute with certain licensees. As it relates to this agreement, we acquired rights to certain client lists for approximately $30.0 million.
Financing Cash Flow Activities
| Year ended May 31, | |||||||||
| In millions, except per share amounts | 2019 | 2018 | 2017 | ||||||
| Net change in client fund obligations | $ | (950.6) | $ | 462.4 | $ | 317.3 | |||
| Net proceeds from long-term borrowings | 796.3 | — | — | ||||||
| Dividends paid | (826.8) | (739.7) | (662.3) | ||||||
| Repurchases of common shares | (56.9) | (143.1) | (166.2) | ||||||
| Activity related to equity-based plans | 29.5 | (3.4) | 28.5 | ||||||
| Net cash used in financing activities | $ | (1,008.5) | $ | (423.8) | $ | (482.7) | |||
| Cash dividends per common share | $ | 2.30 | $ | 2.06 | $ | 1.84 |
Net change in client fund obligations: The client fund obligations liability will vary based on the timing of collecting client funds, and the related required remittance of funds to applicable tax or regulatory agencies for payroll tax administration services and to employees of clients utilizing employee payment services. Collections from clients are typically remitted from one to 30 days after receipt, with some items extending to 90 days.
Client fund obligation balances are significantly impacted by the timing of the period end. Fluctuations in the net change in client fund obligations for the years presented are primarily the result of timing of collections and remittances and overall trends in client fund balances. May 31, 2019 fell on a Friday, which is a significant disbursement day for direct pay funds. May 31, 2018 fell on a Thursday, which is a significant collection day for direct pay funds. These funds were then paid out on Friday June 1, 2018. May 31, 2017 fell on a Wednesday which is not a significant collection day for payroll tax funds but the federal semi-weekly tax payment was delayed until Thursday, June 1, 2017 due to the Memorial Day holiday weekend. As such, a higher than expected client fund obligation existed on May 31, 2017.
Net proceeds from long-term borrowings: In fiscal 2019, we financed $800.0 million related to the acquisition of Oasis through the issuance of long-term private placement debt. Refer to Note N of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for additional disclosures on our long-term financing.
Dividends paid: In May 2019 and April 2018, our Board increased our quarterly dividend to shareholders by 11% to $0.62 per share from $0.56 per share, and by 12% to $0.56 per share from $0.50 per share, respectively. The dividends paid as a percentage of net income totaled 80%, 79%, and 81% for fiscal years 2019, 2018, and 2017, respectively. The payment of future dividends is dependent on our future earnings and cash flow, and is subject to the discretion of our Board.
Repurchases of common shares: In July 2016, our Board approved a program to repurchase up to $350.0 million of our common stock, authorized through May 31, 2019. During fiscal 2019, we repurchased 0.7 million shares for a total of $56.9 million. During fiscal 2018, we repurchased 2.5 million shares for a total of $143.1 million. During fiscal 2017, we repurchased 2.9 million shares for a total of $166.2 million, of which $59.7 million was repurchased under a previously authorized common stock repurchase program. All shares repurchased were retired. In May 2019, our Board approved a program to repurchase up to $400.0 million of our common stock, with authorization running from June 1, 2019 through May 31, 2022. The purpose of these programs is to manage common stock dilution.
Activity related to equity-based plans: The increase in cash flows related to stock-based awards for fiscal 2019 compared to fiscal 2018 and the decrease for fiscal 2018 compared to fiscal 2017 were largely driven by changes in proceeds received from the exercise of stock options. Shares of common stock issued through the exercise of stock options were 0.9 million shares, 0.6 million shares, and 1.4 million shares for fiscal years 2019, 2018, and 2017, respectively. Refer to Note F of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for additional disclosures on our stock-based compensation plans.
Other
Recently issued accounting pronouncements: Refer to Note A of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for a discussion of recently issued accounting pronouncements.
Critical Accounting Policies
Note A of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K discusses the significant accounting policies of Paychex. Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates, judgments, and assumptions that affect reported amounts of assets, liabilities, revenue, and expenses. On an ongoing basis, we evaluate the accounting policies and estimates used to prepare the consolidated financial statements. We base our estimates on historical experience, future expectations, and assumptions believed to be reasonable under current facts and circumstances. Actual amounts and results could differ from these estimates. Certain accounting policies that are deemed critical to our results of operations or financial position are discussed below.
Revenue recognition: Service revenue is recognized in the period services are rendered and earned under service arrangements with clients where service fees are fixed or determinable and collectability is reasonably assured. Our service revenue is largely attributable to processing services where the fee is based on a fixed amount per processing period or a fixed amount per processing period plus a fee per employee or transaction processed. Fees earned for funding of temporary staffing clients’ payrolls via purchase of accounts receivable are based on a percentage of funding amounts as specified in the client contract. The revenue earned from delivery service for the distribution of certain client payroll checks and reports is included in service revenue, and the costs for delivery are included in operating expenses on the Consolidated Statements of Income and Comprehensive Income.
We receive advance payments for set-up fees on some of our service offerings from our clients. Advance payments received for certain of our service offerings are considered a material right. We defer the revenue associated with these advance payments, recognizing the revenue and related expenses over the expected period to which the right exists.
PEO revenue is included in service revenue and is reported net of certain pass-through costs billed and incurred, which primarily include payroll wages, payroll taxes, including federal and state unemployment insurance, and certain guaranteed cost benefit premiums. Direct costs related to workers’ compensation and certain benefit plans where we retain risk are recognized as operating expenses rather than as a reduction in service revenue.
Interest on funds held for clients is earned primarily on funds that are collected from clients before due dates for payroll tax administration services and for employee payment services, and invested until remittance to the applicable tax or regulatory agencies or client employees. These collections from clients are typically remitted from one to 30 days after receipt, with some items extending to 90 days. The interest earned on these funds is included in total revenue on the Consolidated Statements of Income and Comprehensive Income because the collecting, holding, and remitting of these funds are components of providing these services.
PEO insurance reserves: As part of the PEO service, we offer workers’ compensation insurance and health insurance to clients for the benefit of client employees. Workers' compensation insurance is primarily provided under fully insured high deductible workers’ compensation insurance policies. Workers’ compensation insurance reserves are established to provide for the estimated costs of paying claims up to per occurrence liability limits. In establishing the PEO workers' compensation insurance reserves, we use an independent actuarial estimate of undiscounted future cash payments that would be made to settle the claims.
With respect to our PEO health insurance, we offer various health insurance plans that take the form of either fully insured guaranteed cost plans with various national insurance carriers or a fully insured minimum premium insurance arrangement with coverage provided through a single national carrier. Under the minimum premium insurance arrangement, our health benefits insurance reserves are established to provide for the payment of claims in accordance with our service contract with the carrier. The claims liability includes estimates for reported losses, plus amounts for those claims incurred but not reported, and estimates of certain expenses associated with processing and settling the claims.
Estimating the ultimate cost of future claims is an uncertain and complex process based upon historical loss experience and actuarial loss projections, and is subject to change due to multiple factors, including economic trends, changes in legal liability law, and damage awards, all of which could materially impact the reserves as reported in the consolidated financial statements. Accordingly, final claim settlements may vary from the present estimates, particularly when those payments may not occur until well into the future. We regularly review the adequacy of our estimated insurance reserves. Adjustments to previously established reserves are reflected in the results of operations for the period in which the adjustment is identified. Such adjustments could possibly be significant, reflecting any combination of new and adverse or favorable trends. Adjustments to previously established reserves were not material for the fiscal years 2019, 2018, or 2017.
Goodwill and other intangible assets: Goodwill is not amortized, but instead is tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change in a way to indicate that there has been a potential decline in the fair value of the reporting unit. We perform our annual impairment testing in our fiscal fourth quarter. For fiscal 2019, it was determined that the Company has three reporting units. A qualitative analysis was performed for all reporting units in fiscal 2019, to determine if it is more-likely-than-not that the fair value of the reporting units had declined below its carrying value. The qualitative assessment considered various financial, macroeconomic, industry, and reporting unit specific qualitative factors. Based on the results of our testing, no impairment loss was recognized in the results of operations for fiscal 2019, 2018, or 2017. Subsequent to the latest review, there have been no events or circumstances that indicate any potential impairment of the Company’s goodwill balance.
We also test intangible assets with indefinite useful lives for potential impairment when events or changes in circumstances indicate that the carrying value may not be recoverable. We have determined that there is no impairment of intangible assets with indefinite useful lives for fiscal 2019, 2018, or 2017.
Impairment of Long-Lived Assets: Long-lived assets, including intangible assets with finite lives, are reviewed for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the estimated fair value of the asset. We have determined that there is no impairment of long-lived assets for fiscal 2019, 2018, or 2017.
Stock-based compensation costs: All stock-based awards to employees, including grants of stock options, are recognized as compensation costs in our consolidated financial statements based on their fair values measured as of the date of grant. We estimate the fair value of stock option grants using a Black-Scholes option pricing model. This model requires various assumptions as inputs including expected volatility of the Paychex stock price and expected option life. We estimate volatility based on a combination of historical volatility using stock prices over a period equal to the expected option life and implied market volatility. Expected option life is estimated based on historical exercise behavior. We periodically reassess our assumptions as well as our choice of valuation model and will reconsider use of this model if additional information becomes available in the future indicating that another model would provide a more accurate estimate of fair value, or if characteristics of future grants would warrant such a change.
The fair value of stock awards is determined based on the stock price at the date of grant. For grants that do not accrue dividends or dividend equivalents, the fair value is the stock price reduced by the present value of estimated dividends over the vesting period or performance period.
We estimate forfeitures and only record compensation costs for those awards that are expected to vest. Our assumptions for forfeitures were determined based on type of award and historical experience. Forfeiture assumptions are adjusted at the point in time a significant change is identified, with any adjustment recorded in the period of change, and the final adjustment at the end of the requisite service period to equal actual forfeitures.
The assumptions of volatility, expected option life, and forfeitures all require significant judgment and are subject to change in the future due to factors such as employee exercise behavior, stock price trends, and changes to type or provisions of stock-based awards. Any change in one or more of these assumptions could have a material impact on the estimated fair value of a future award.
Refer to Note F of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for further discussion of our stock-based compensation plans.
Income taxes: We account for deferred taxes by recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the fiscal year in which the differences are expected to reverse. We record a deferred tax asset related to the stock-based compensation costs recognized for certain stock-based awards. At the time of the exercise of non-qualified stock options or vesting of stock awards, we recognize any excess tax benefit within income taxes in the Consolidated Statements of Income and Comprehensive Income.
The Tax Act enacted in December 2017 was the most comprehensive tax reform legislation approved in more than two decades and made broad and complex changes to the U.S. federal corporate income taxation, including, but not limited to: (i) reducing the statutory corporate tax rate from 35% to 21% (a blended statutory tax rate of 29.2% for fiscal 2018); (ii) creating new or furthering limitations to the deductibility of officer compensation, interest, meals, entertainment, and other expenses; and (iii) changing from a worldwide to a territorial taxation system. As a result of the Tax Act, we made a one-time revaluation of our net deferred tax liabilities and made a change in the Company’s annual effective income tax rate applied to income before income taxes for the first six months of fiscal 2018. Refer to Note K of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for further details.
We maintain a reserve for uncertain tax positions. We evaluate tax positions taken or expected to be taken in a tax return for recognition in our consolidated financial statements. Prior to recording the related tax benefit in our consolidated financial statements, we must conclude that tax positions will be more-likely-than-not to be sustained, assuming those positions will be examined by taxing authorities with full knowledge of all relevant information. The benefit recognized in our consolidated financial statements is the amount we expect to realize after examination by taxing authorities. If a tax position drops below the more-likely-than-not standard, the benefit can no longer be recognized. Assumptions, judgment, and the use of estimates are required in determining if the more-likely-than-not standard has been met when developing the provision for income taxes and in determining the expected benefit. A change in the assessment of the more-likely-than-not standard could impact our results of operations or financial position. Refer to Note K of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for further discussion of our reserve for uncertain tax positions.
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