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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 our fiscal year ended May 31, 2021 (“fiscal 2021” or the “fiscal year”), as compared to our fiscal year ended May 31, 2020 (“fiscal 2020”), and our financial condition as of May 31, 2021. A detailed review of our fiscal 2020 performance compared to our fiscal year ended May 31, 2019 performance and our financial condition as of May 31, 2020 is set forth in Part II, Item 7 of our Annual Report on Form 10-K (“Form 10-K”) for fiscal 2020. 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 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” contained at the beginning of Part I of this Form 10-K.
Overview
We are a leading human resource (“HR”) software and services company, offering HR, payroll, benefits, and insurance services for small- to medium-sized businesses. Within our human capital management (“HCM”) solutions, we offer a comprehensive portfolio of services and products that allow our clients to meet their diverse HR and payroll needs.
We support our small-business clients, reducing the complexity and risk of running their own payroll, while ensuring greater accuracy with up-to-date tax rates and regulatory information. Clients may choose to have our service team handle everything for them, or process payroll themselves utilizing our proprietary, robust software-as-a-service (“SaaS”) Paychex Flex® platform and our SurePayroll® SaaS-based products. Our medium-sized clients generally have more complex payroll and employee benefit needs, though with the environment of increasing regulations, we believe the need for HR outsourcing services has been moving down-market. Any of our clients on Paychex Flex can opt for the integrated suite of HCM solutions, which allows clients to choose the services and software that will meet the needs of their business.
Our portfolio of HCM and employee benefit-related services is disaggregated into two categories, (1) Management Solutions and (2) Professional Employer Organization (“PEO”) and Insurance Solutions, as discussed in Part 1, Item 1 of this Form 10-K.
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 United States (“U.S.”) and parts of Europe. 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.
We continue to focus on driving growth in the number of clients, revenue per client, total 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 sales and marketing and 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.
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 Paychex Flex 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.
Fiscal 2021 Business Highlights
Highlights compared to fiscal 2020 are as follows:
| Fiscal Year | ||||||||||
| In millions, except per share amounts | 2021 | 2020 | Change**(3)** | |||||||
| Total service revenue | $ | 3,997.5 | $ | 3,953.6 | 1 | % | ||||
| Total revenue | $ | 4,056.8 | $ | 4,040.5 | — | % | ||||
| Operating income | $ | 1,460.7 | $ | 1,460.5 | — | % | ||||
| Net income | $ | 1,097.5 | $ | 1,098.1 | — | % | ||||
| Adjusted net income(1) | $ | 1,102.4 | $ | 1,083.2 | 2 | % | ||||
| Diluted earnings per share | $ | 3.03 | $ | 3.04 | — | % | ||||
| Adjusted diluted earnings per share(1) | $ | 3.04 | $ | 3.00 | 1 | % | ||||
| Dividends paid to stockholders(2) | $ | 908.7 | $ | 889.4 | 2 | % |
(1)Adjusted net income and adjusted diluted earnings per share are not U.S. generally accepted accounting principle (“GAAP”) measures. Refer to the “Non-GAAP Financial Measures” section of this Item 7 for a discussion of non-GAAP measures and a reconciliation to the U.S. GAAP measures of net income and diluted earnings per share.
(2)Dividends paid to stockholders represented approximately 83% of net income for fiscal 2021 compared to approximately 81% of net income for fiscal 2020.
(3)Percentage changes are calculated based on unrounded numbers.
For further analysis of our results of operations for fiscal years 2021 and 2020, and our financial position as of May 31, 2021, refer to the tables and analysis in the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item 7.
Business Outlook
Our payroll and PEO client base was greater than 710,000 and 680,000 clients as of May 31, 2021 and May 31, 2020, respectively. Client retention was at record levels of approximately 85% of the beginning client base for fiscal 2021, compared to over 83% for fiscal 2020.
While our HR product offerings provide services to employers and employees beyond payroll, they effectively leverage payroll processing data. These services are included as part of the integrated HCM solution within Paychex Flex or provided through the PEO platform. The following table illustrates the growth in selected HR product offerings:
| $ in billions | |||||||||
| As of May 31, | 2021 | 2020 | Change**(1)** | ||||||
| Paychex HR Solutions and PEO client worksite employees | 1,680,000 | 1,428,000 | 18 | % | |||||
| Paychex HR Solutions and PEO clients | 62,000 | 55,000 | 12 | % | |||||
| Health and benefits services applicants | 205,000 | 182,000 | 13 | % | |||||
| Retirement services plans | 96,000 | 91,000 | 5 | % | |||||
| Asset value of retirement services participants’ funds | $ | 42.0 | $ | 32.3 | 30 | % |
(1)Percentage changes are calculated based on unrounded numbers.
We continue to make investments in technology a priority as companies look to leverage technology solutions to maintain operations, stay connected to employees, and increase productivity. In fiscal 2021, we enhanced our solutions to support businesses as they navigate the federal stimulus programs and engage in digital transformation. We have continued to evolve our products to help business leaders find, hire, and retain employees quickly and effectively with an eye on driving engagement and managing labor costs. Our fiscal 2021 technology and solution developments provide a unique combination of data, technology, and service designed to meet the evolving needs of employers and employees, and include:
Portfolio of Paycheck Protection Program (“PPP”) tools, which include the ability for employers to easily navigate the complexities of the PPP and Employee Retention Tax Credit (“ERTC”). This portfolio contains resources to help small businesses navigate complex regulations and evaluate business decisions during this challenging time as well as tools for PPP loan applications, including access to small business loan providers, and signature-ready PPP loan forgiveness applications. We have continued to update these tools in near real-time throughout the COVID-19 pandemic in response to changes in regulations.
Employee health and safety offerings, including a COVID-19 leave tracking tool to identify employee-submitted issues, a COVID-19 screening tool to give employers a way to initiate employee COVID-19 screenings and track test results within a single platform, and health attestation solutions which enable employers to customize and
digitally distribute a health attestation form to employees daily, securely store responses in real-time, and view advanced analytics for individuals or the entire workforce.
Digital communication solutions, including Paychex Flex HR Connect and HR Conversations, which helps strengthen connections and keep workers engaged no matter their work location. Paychex Flex HR Connect provides the ability to digitally submit questions, requests, and incidents directly to HR through an easy-to-use workflow. HR Conversations enables managers, employees, and HR staff to initiate communications with employees and enhancements to performance assessments allow for 360-degree feedback digitally within the tool.
Pooled Employer Plan, which provides business owners with a plan option that relieves the compliance and administration burdens of a traditional 401(k) plan, giving their employees access to a retirement plan benefit and allowing them to prepare for their future.
Clover® Integration, which streamlines payroll and time and attendance management for business owners using the popular Clover platform from Fiserv. With Paychex Flex available in the Clover App Market, business owners can more efficiently manage the essential tasks of payroll, staffing, time tracking, and scheduling all within a single application to help save time, increase accuracy, and reduce cost.
Paychex Flex Labor Cost Hub, which gives customers and CPAs a holistic, real-time view of total payroll labor job costing and labor distribution in one place, enabling them to see how much they are spending on a significant operational expense - their workforce.
Enhanced Onboarding Self-Service experience, which simplifies the user experience for entering and reviewing new-hire information and includes the ability to invite employees to complete onboarding and documentation digitally.
Enhancements to data analytics and Live Reports throughout the Platform. For example, the Diversity and Equal Pay Live Report 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.
PEO Protection Plus Package reduces risks for business owners by offering insurance coverage related to cyberattacks and employee lawsuits. By offering both Cyber Liability and Employment Practices Liability Insurance coverage as part of our PEO solution, and by leveraging the group plan model of our PEO, the coverage is significantly more affordable to businesses.
We continue to strengthen our position in the 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.
COVID-19 Update
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. A portion of our workforce that initially transitioned to work remotely has voluntarily returned to the office. As vaccination levels continue to increase and masking and social distancing guidelines further relax, we look forward to welcoming more of our employees back to their office locations. We currently anticipate a general return to the office in September 2021, with a greater level of flexibility in response to the feedback our employees have shared with us.
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. 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 over a half million visitors. On June 5, 2020, the PPP Flexibility Act was signed into law, relaxing the original requirements for how businesses could use PPP loans and continue to qualify for forgiveness. Within days of the bill passing, we introduced a PPP Loan Forgiveness Estimator and Forgiveness Report in our cloud-based HR suite, Paychex Flex, to simplify the application process for customers and provide them the accurate information needed to satisfy the new forgiveness requirements. As of May 31, 2021, Paychex customers have secured $65 billion in PPP relief funds and $2.5 billion in combined employee retention tax credits and paid leave credits. 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. Our blend of technology and service provides valuable tools and resources to assist our clients and their employees during this critical time and beyond.
The effects of the COVID-19 pandemic impacted our results and year-over-year comparisons, however, our client base continued to grow with sales performance and client retention that was 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 ended this year with strong momentum having navigated through a fiscal year of unprecedented challenge and the uncertain environment of the COVID-19 pandemic. We are well-positioned with a broad portfolio of innovative technology and products along with our unparalleled expertise to meet the continuing needs of businesses and help them succeed and thrive as they begin to bring employees back to work and adjust to the changes of how, where, and when work gets done.
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. Despite improving macroeconomic conditions and the emergence of vaccines, surges in COVID-19 cases, including variants of the strain, such as those recently experienced in Europe and the U.S., may cause people to self-quarantine or governments to shut down nonessential businesses again. We expect that the pandemic will continue to have an effect on our results, although the magnitude, duration, and full effects of the pandemic on our future results of operations or cash flows are not possible to predict at this time.
For further information on the risks posed to our business from the COVID-19 pandemic, refer to Item 1A of this Form 10-K.
Results of Operations
Summary of Results of Operations for Fiscal Years:
| In millions, except per share amounts | 2021 | 2020 | Change**(1)** | ||||||||
| Revenue: | |||||||||||
| Management Solutions | $ | 3,023.4 | $ | 2,963.0 | 2 | % | |||||
| PEO and Insurance Solutions | 974.1 | 990.6 | (2) | % | |||||||
| Total service revenue | 3,997.5 | 3,953.6 | 1 | % | |||||||
| Interest on funds held for clients | 59.3 | 86.9 | (32) | % | |||||||
| Total revenue | 4,056.8 | 4,040.5 | — | % | |||||||
| Total expenses | 2,596.1 | 2,580.0 | 1 | % | |||||||
| Operating income | 1,460.7 | 1,460.5 | — | % | |||||||
| Other expense, net | (26.5) | (23.4) | n/m | ||||||||
| Income before income taxes | 1,434.2 | 1,437.1 | — | % | |||||||
| Income taxes | 336.7 | 339.0 | (1) | % | |||||||
| Effective income tax rate | 23.5 | % | 23.6 | % | |||||||
| Net income | $ | 1,097.5 | $ | 1,098.1 | — | % | |||||
| Diluted earnings per share | $ | 3.03 | $ | 3.04 | — | % |
(1)Percentage changes are calculated based on unrounded numbers.
n/m – not meaningful
The changes in revenue as compared to the prior year period were primarily driven by the following factors:
Management Solutions revenue: $3.0 billion for fiscal 2021, reflecting an increase of 2%:
oPayroll client base growth of approximately 4%, due to solid sales performance and record client retention, and
oIncreased penetration of our suite of solutions, including HR Solutions, Retirement Services, and Time and Attendance, and growth in ancillary products and services due to higher transaction volumes, offset by
oDecline in check volumes experienced during the first three quarters of our fiscal year from an overall reduction in the number of clients processing payrolls due to lower employment levels during the pandemic.
PEO and Insurance Solutions revenue: $974.1 million for fiscal 2021, reflecting a decrease of 2%:
oDecrease in the number of worksite employees at our clients in the first three quarters, offset by growth in the fourth quarter, and
oLower workers’ compensation premiums driven by reduced wages and softening of market rates, offset by
oIncrease in the number of health and benefit clients.
Interest on funds held for clients: $59.3 million for fiscal 2021, reflecting a decrease of 32%:
oLower average interest rates, due to historically low federal funds rates, and
oLower realized gains, which primarily resulted from our decision to strategically reposition our client fund portfolio at the end of fiscal 2020 to enhance liquidity in response to the economic uncertainties caused by COVID-19.
oAverage investment balances were consistent.
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, 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:
| Year ended May 31, | ||||||||
| $ in millions | 2021 | 2020 | ||||||
| Average investment balances: | ||||||||
| Funds held for clients | $ | 3,941.9 | $ | 3,931.3 | ||||
| Corporate cash equivalents and investments | 1,043.3 | 870.7 | ||||||
| Total | $ | 4,985.2 | $ | 4,802.0 | ||||
| Average interest rates earned (exclusive of net realized gains/(losses)): | ||||||||
| Funds held for clients | 1.5 | % | 1.9 | % | ||||
| Corporate cash equivalents and investments | 0.2 | % | 1.4 | % | ||||
| Combined funds held for clients and corporate cash equivalents and investments | 1.2 | % | 1.8 | % | ||||
| Total net realized gains | $ | 1.2 | $ | 11.3 |
| $ in millions | ||||||||
| As of May 31, | 2021 | 2020 | ||||||
| Net unrealized gains on AFS securities(1) | $ | 79.3 | $ | 100.0 | ||||
| Federal Funds rate(2) | 0.25 | % | 0.25 | % | ||||
| Total fair value of AFS securities | $ | 3,020.2 | $ | 2,757.2 | ||||
| Weighted-average duration of AFS securities in years(3) | 3.3 | 2.9 | ||||||
| Weighted-average yield-to-maturity of AFS securities(3) | 1.9 | % | 2.1 | % |
(1)The net unrealized gain on our investment portfolios was approximately $77.4 million as of July 14, 2021.
(2)The Federal Funds rate was in the range of 0.00% to 0.25% as of both May 31, 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.
Refer to the “Market Risk Factors” section contained in Item 7A of this Form 10-K for more information on changing interest rates.
Total expenses: The following table summarizes total combined cost of service revenue and selling, general and administrative expenses for fiscal years:
| In millions | 2021 | 2020 | Change**(1)** | ||||||
| Compensation-related expenses | $ | 1,521.8 | $ | 1,480.8 | 3 | % | |||
| PEO insurance costs | 352.1 | 334.7 | 5 | % | |||||
| Depreciation and amortization | 192.0 | 209.7 | (8) | % | |||||
| Cost-saving initiatives | 32.2 | — | n/m | ||||||
| Other expenses | 498.0 | 554.8 | (10) | % | |||||
| Total expenses | $ | 2,596.1 | $ | 2,580.0 | 1 | % |
(1)Percentage changes are calculated based on unrounded numbers.
The changes in total expenses as compared to the prior year period were primarily driven by the following factors:
Compensation-related expenses: $1.5 billion for fiscal 2021, reflecting a 3% increase:
oHigher performance-based compensation due to stronger than anticipated performance in fiscal 2021 and unusually low performance-based compensation in 2020 due to the COVID-19 pandemic, offset by
oLower wage-related costs due to lower headcount. As of May 31, 2021, we had approximately 15,000 employees as compared to approximately 15,800 employees at May 31, 2020.
PEO insurance costs: $352.1 million in fiscal 2021, reflecting a 5% increase:
oIncrease in workers’ compensation costs and claims estimates and expansion of health insurance offerings to more clients.
Depreciation and amortization: $192.0 million in fiscal 2021, reflecting an 8% decrease:
oLower amortization driven by intangible assets amortized using accelerated methodologies.
Cost-saving initiatives: $32.2 million in fiscal 2021:
oAcceleration of our long-term strategy to reduce our geographic footprint and headcount optimization. These initiatives will provide us ongoing savings in rent, facilities maintenance, and wage-related expenses.
Other expenses: $498.0 million in fiscal 2021, reflecting a 10% decrease:
oLower discretionary and facilities spend due to office closures and restrictions due to the pandemic.
Operating income: Fiscal 2021 operating income was $1.5 billion and comparable to fiscal 2020. Adjusted operating income(1) of $1.5 billion, which excludes the impact of one-time costs, reflects an increase of 2% and higher adjusted operating margin(1). Operating margin and adjusted operating margin are as follows:
| Fiscal Year | ||||||||
| 2021 | 2020 | |||||||
| Operating Margin (operating income as a percentage of total revenue) | 36.0 | % | 36.1 | % | ||||
| Adjusted operating margin (operating income, adjusted for one-time items, as a percentage of total revenue) | 36.8 | % | 36.1 | % |
Fluctuations in these metrics were attributable to the factors previously discussed.
Income taxes: Our effective income tax rate was 23.5% and 23.6% for fiscal years 2021 and 2020, respectively. The effective income tax rates in both periods were impacted by the recognition of net discrete tax benefits related to the volume of stock option exercises and the associated employee stock-based compensation payments. Refer to Note L 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 was $1.1 billion for both fiscal 2021 and fiscal 2020. Diluted earnings per share was $3.03 per diluted share for fiscal 2021 and $3.04 per diluted share for fiscal 2020. Refer to Note C of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for information on dilutive shares outstanding.
Adjusted net income(1) was $1.1 billion for both fiscal 2021 and fiscal 2020, reflecting an increase of 2%. Adjusted diluted earnings per share(1) was $3.04 per diluted share and $3.00 per diluted share for fiscal 2021 and fiscal 2020 respectively, reflecting an increase of 1%.
(1)Adjusted operating income, adjusted operating margin, adjusted net income, and adjusted diluted earnings per share are not U.S. GAAP measures. Refer to the “Non-GAAP Financial Measures” section below for a discussion of these non-GAAP measures and a reconciliation to the most comparable GAAP measure of operating income, net income, and diluted earnings per share.
Non-GAAP Financial Measures: Adjusted operating income, adjusted net income, adjusted diluted earnings per share, EBITDA, and adjusted EBITDA are summarized as follows:
| $ in millions | 2021 | 2020 | Change**(1)** | ||||||
| Operating income | $ | 1,460.7 | $ | 1,460.5 | — | % | |||
| Non-GAAP adjustments: | |||||||||
| Cost-saving initiatives(2) | 32.2 | — | |||||||
| Total non-GAAP adjustments | 32.2 | — | |||||||
| Adjusted operating income | $ | 1,492.9 | $ | 1,460.5 | 2 | % | |||
| Net income | $ | 1,097.5 | $ | 1,098.1 | — | % | |||
| Non-GAAP adjustments: | |||||||||
| Excess tax benefit related to employee stock-based compensation payments(3) | (19.4) | (14.9) | |||||||
| Cost-saving initiatives(2) | 24.3 | — | |||||||
| Total non-GAAP adjustments | 4.9 | (14.9) | |||||||
| Adjusted net income | $ | 1,102.4 | $ | 1,083.2 | 2 | % | |||
| Diluted earnings per share(4) | $ | 3.03 | $ | 3.04 | — | % | |||
| Non-GAAP adjustments: | |||||||||
| Excess tax benefit related to employee stock-based compensation payments(3) | (0.05) | (0.04) | |||||||
| Cost-saving initiatives(2) | 0.07 | — | |||||||
| Total non-GAAP adjustments | 0.01 | (0.04) | |||||||
| Adjusted diluted earnings per share | $ | 3.04 | $ | 3.00 | 1 | % | |||
| Net income | $ | 1,097.5 | $ | 1,098.1 | — | % | |||
| Non-GAAP adjustments: | |||||||||
| Interest expense, net | 33.5 | 26.5 | |||||||
| Income taxes | 336.7 | 339.0 | |||||||
| Depreciation and amortization expense | 192.0 | 209.7 | |||||||
| Total non-GAAP adjustments | 562.2 | 575.2 | |||||||
| EBITDA | 1,659.7 | 1,673.3 | (1) | % | |||||
| Cost-saving initiatives(2) | 32.2 | - | |||||||
| Adjusted EBITDA | $ | 1,691.9 | $ | 1,673.3 | 1 | % | |||
(1)Percentage changes are calculated based on unrounded numbers.
(2)One-time costs and corresponding tax benefit recognized related to the acceleration of cost-saving initiatives, including the long-term strategy to reduce our geographic footprint and headcount optimization. These events are not expected to recur.
(3)Net tax windfall 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.
(4)The calculation of the impact of non-GAAP adjustments on diluted earnings per share is performed on each line independently. The table may not add down by +/- $0.01 due to rounding.
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 operating margin, adjusted net income, adjusted diluted earnings per share, earnings before interest, taxes, depreciation, and amortization (“EBITDA”), and adjusted EBITDA, which are non-GAAP measures. We believe these additional measures are indicators of our core business operations performance period over period. Adjusted operating income, adjusted operating margin, adjusted net income, adjusted diluted earnings per share, EBITDA, and adjusted EBITDA, are not calculated through the application of U.S. GAAP and are not required forms of disclosure by the Securities and Exchange Commission (“SEC”). As such, they should not be considered a substitute for the U.S. GAAP measures of operating income, net income, and diluted earnings per share, and, therefore, they 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, 2021 remained strong with cash, restricted cash, and total corporate investments of $1.1 billion. Total short-term and long-term borrowings, net of debt issuance costs, were $804.7 million as of May 31, 2021. Our primary source of cash is generated by our ongoing operations. Cash flows from operations were $1.3 billion for fiscal 2021. Our positive cash flows for fiscal 2021 allowed us to support our business and pay dividends of approximately $909.0 million. We currently anticipate that cash, restricted cash, and total corporate investments as of May 31, 2021, along with projected operating cash flows and available short-term financing, will support our business operations, capital purchases, share repurchases, and dividend payments for the foreseeable future.
We believe that our investments in an unrealized loss position as of May 31, 2021 were not impaired due to increased credit risk or other valuation concerns, nor has any event occurred subsequent to that date to indicate any change in our assessment.
Financing
Short-term financing: We maintain committed and unsecured credit facilities and irrevocable letters of credit as part of our normal and recurring business operations. The purpose of these credit facilities is to meet short-term funding requirements, finance working capital needs, and for general corporate purposes. We typically borrow on an overnight or short-term basis on our credit facilities. Refer to Note M of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for further discussion on our credit facilities.
Details of our credit facilities are as follows:
| Maximum | May 31, 2021 | ||||||||||
| Amount | Outstanding | Available | |||||||||
| $ in millions | Expiration Date | Available | Amount | Amount | |||||||
| Credit facilities: | |||||||||||
| JP Morgan Chase Bank, N.A. ("JPM") | July 31, 2024 | $ | 1,000.0 | $ | — | $ | 1,000.0 | ||||
| JPM | August 17, 2022 | $ | 500.0 | — | 500.0 | ||||||
| PNC Bank, National Association (“PNC”) | February 6, 2023 | $ | 250.0 | 7.4 | 242.6 | ||||||
| Total Lines of Credit Outstanding and Available | $ | 7.4 | $ | 1,742.6 | |||||||
Amounts outstanding under the PNC credit facility as of May 31, 2021 remain outstanding as of the date of this report.
Details of borrowings under each credit facility during the fiscal years ended 2021 and 2020 were as follows:
| Year ended May 31, 2021 | ||||||||||||
| Credit Facility | ||||||||||||
| $1 Billion | $500 Million | $250 Million | ||||||||||
| $ in millions | JPM | JPM | PNC | |||||||||
| Number of days borrowed | 4 | — | 365 | |||||||||
| Maximum amount borrowed | $ | 217.5 | $ | — | $ | 246.9 | ||||||
| Weighted-average amount borrowed | $ | 147.0 | $ | — | $ | 11.1 | ||||||
| Weighted-average interest rate | 3.25 | % | — | % | 1.12 | % |
| Year ended May 31, 2020 | ||||||||||||
| Credit Facility | ||||||||||||
| $1 Billion | $500 Million | $250 Million | ||||||||||
| $ in millions | JPM | JPM | PNC | |||||||||
| Number of days borrowed | 17 | 29 | 362 | |||||||||
| Maximum amount borrowed | $ | 694.0 | $ | 450.0 | $ | 246.0 | ||||||
| Weighted-average amount borrowed | $ | 343.2 | $ | 307.8 | $ | 54.2 | ||||||
| Weighted-average interest rate | 5.06 | % | 3.30 | % | 2.50 | % |
Short-term borrowings are primarily used for the settlement of client fund obligations, rather than liquidating previously collected client funds that have been invested in AFS securities allocated to our long-term portfolio.
We expect to have access to the amounts available under our current credit facilities to meet our ongoing financial needs. However, if we experience reductions in our operating cash flows due to any of the risk factors outlined in, but not limited to, Item 1A in this Form 10-K and other SEC filings, we may need to adjust our capital, operating, and other discretionary spending to realign our working capital requirements with the capital resources available to us. Furthermore, if we determined the need for additional short-term liquidity, there is no assurance that such financing, if pursued and obtained, would be adequate or on terms acceptable to us.
Letters of credit: As of May 31, 2021, we had irrevocable standby letters of credit available totaling $180.4 million, required to secure commitments for certain insurance policies. The letters of credit expire at various dates between June 2021 and July 2022. No amounts were outstanding on these letters of credit during fiscal 2021 or as of May 31, 2021. Subsequent to May 31, 2021, letters of credit expiring in June 2021 were renewed through June 2022.
Long-term financing: We have borrowed $800.0 million through the issuance of long-term private placement debt (“Senior Notes”). 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 | 4.15% | 4.31% | ||
| 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 |
Refer to Note N of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for further discussion on our long-term financing.
Other commitments: The Company has various long-term contractual obligations as of May 31, 2021, which include:
operating leases for $127.4 million;
purchase obligations for $162.7 million;
workers’ compensation estimated obligations for $183.1 million; and
long-term Senior Notes debt obligations for $800.0 million, plus interest payments of $217.5 million.
Refer to Notes I, N, and Q of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for more information on these areas.
The liability for uncertain tax positions, including interest and net of federal benefits, was approximately $20.4 million as of May 31, 2021. Refer to Note L 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.
We are involved in two limited partnership agreements and committed to contribute a maximum amount of $20.0 million to venture capital funds in the financial technology sector. As of May 31, 2021, we have contributed approximately $12.0 million of the total funding commitment. The timing of future contributions to be made to these venture capital funds cannot be specifically or reasonably determined. Our investments in venture capital funds are not considered part of our ongoing operations, are accounted for under the equity method, and represented less than one percent of our total assets as of May 31, 2021.
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. We have also 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 and PEO employee health and medical 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 were not material as of May 31, 2021. 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.
Operating, Investing, and Financing Cash Flow Activities
| Year ended May 31, | ||||||||||
| In millions | 2021 | 2020 | Change | |||||||
| Net cash provided by operating activities | $ | 1,260.3 | $ | 1,440.9 | $ | (180.6) | ||||
| Net cash (used in)/provided by investing activities | (460.6) | 771.9 | (1,232.5) | |||||||
| Net cash used in financing activities | (636.4) | (1,488.2) | 851.8 | |||||||
| Net change in cash, restricted cash, and equivalents | $ | 163.3 | $ | 724.6 | $ | (561.3) | ||||
| Cash dividends per common share | $ | 2.52 | $ | 2.48 |
The changes in our cash flows for fiscal 2021 and fiscal 2020 were primarily the result of the following key drivers:
Operating Cash Flow Activities
Cash provided by operating activities decreased $180.6 million.
Increases in purchased receivable balances in fiscal 2021 due to our clients’ continued recovery from the COVID-19 pandemic and growth in our business; and
Timing of estimated income tax payments. Payments normally due in fiscal 2020 were deferred until fiscal 2021 under the Coronavirus Aid, Relief, and Economic Security Act; offset by,
Increases in accrued worksite employee compensation as PEO clients’ employees returned to work; and
Increases in accrued corporate compensation due to higher performance-based compensation in fiscal 2021.
Investing Cash Flow Activities
Cash used in investing activities increased $1.2 billion.
Increases in Client Fund Assets as clients continue to recover from the COVID-19 pandemic;
At the end of fiscal 2020, we increased our liquidity by selling AFS securities due to the uncertainties of the COVID-19 pandemic and its impact on the market and our business. As economic conditions improved throughout fiscal 2021, we started to opportunistically reposition back into AFS securities, and
Reduced availability of targeted high quality VRDNs in the market led to fewer AFS securities held and more cash equivalent balances during fiscal 2021.
Fluctuations in the net purchases and sales/maturities of AFS securities are also due to timing within the client funds portfolio and market conditions. Specific timing items impacting cash flows for fiscal 2021 and fiscal 2020 are discussed further in the financing cash flows discussion of net changes in client fund obligations. Amounts will vary based upon the timing of collection from clients, and the related remittance to applicable tax or regulatory agencies for payroll tax administration services and to employees of clients utilizing employee payment services.
Discussion of interest rates and related risks is included in the “Market Risk Factors” section contained in Item 7A of this Form 10-K.
Financing Cash Flow Activities
Cash used in financing activities decreased $851.8 million.
Increases in client fund obligations in fiscal 2021 was due to our clients’ continued recovery from the COVID-19 pandemic and the timing of the Federal holiday. Funds collected on Friday May 28, 2021 were not remitted to client employees or tax and regulatory agencies until June 2021;
Cash flows from equity-based plans increased largely due to higher proceeds from the exercise or vesting of stock awards. 2.7 million shares of our common stock were exercised or vested in fiscal 2021 compared to 1.5 million shares in fiscal 2020;
During fiscal 2021 and fiscal 2020, we repurchased 1.7 million shares and 2.0 million shares, respectively. As of May 31, 2021, $72.4 million remains available under the common stock repurchase program. Refer to Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities contained in Item 5 of this Form 10-K for further discussion on our common stock repurchase programs, and
Dividend payments increased in fiscal 2021 due to a 6% increase in our dividend rate beginning in May 2021. The payment of future dividends is dependent on our future earnings and cash flows and is subject to the discretion of our Board.
The client fund obligations liability will also 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.
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 and Estimates
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. Insurance Solutions revenues are recognized when commissions are earned on premiums billed and collected. Fees earned for funding payrolls of our clients in the temporary staffing industry via the purchase of accounts receivable are based on a percentage of funding amounts as specified in the client contract. These fees are then recognized over the average collection period of 35 to 45 days. 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 the delivery are included in cost of service revenue on the Consolidated Statements of Income and Comprehensive Income.
We receive advance payments for set-up fees from our clients. Advance payments received for certain of our service offerings for set-up fees are considered a material right. Therefore, we defer the revenue associated with these advance payments, recognizing the revenue and related expenses over the expected period to which the material right exists.
PEO Solutions revenue is included in service revenue and is reported net of certain pass-through costs billed and incurred, which include payroll wages, payroll taxes, including federal and state unemployment insurance, and certain health insurance benefit premiums, primarily costs related to our guaranteed cost benefit plans. Direct costs related to workers’ compensation and certain benefit plans where we retain risk are recognized as cost of service revenue 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.
Assets Recognized from the Costs to Obtain and Fulfill Contracts: We recognize an asset for the incremental costs of obtaining a contract with a client if it is expected that the economic benefit and amortization period will be longer than one year. Incremental costs of obtaining a contract include only those costs that are directly related to the acquisition of new contracts and that would not have been incurred if the contract had not been obtained. We do not incur incremental costs to obtain a contract renewal. The Company determined that certain sales commissions and bonuses, including related fringe benefits, meet the capitalization criteria under Accounting Standards Codification (“ASC”) Subtopic 340-40, “Other Assets and Deferred Costs: Contracts with Customers” (“ASC 340-40”). We also recognize an asset for the costs to fulfill a contract with a client if the costs are specifically identifiable, generate or enhance resources used to satisfy future performance obligations, and are expected to be recovered. We determined that substantially all costs related to implementation activities are administrative in nature and meet the capitalization criteria under ASC 340-40. These capitalized costs to fulfill a contract principally relate to upfront direct costs that are expected to be recovered and enhance our ability to satisfy future performance obligations.
The assets related to both costs to obtain and costs to fulfill contracts with clients are capitalized and amortized using an accelerated method over an eight-year life to closely align with the pattern of client attrition over the estimated life of the client relationship. We regularly review our deferred costs for potential impairment and did not recognize an impairment loss during the fiscal years ended May 31, 2021 or May 31, 2020.
PEO insurance reserves: As part of our PEO solution, 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. These reserves include estimates of certain expenses associated with processing and settling these claims. 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 claims. The determination of estimated ultimate losses by our independent actuary are based on accepted actuarial methods and assumptions. The estimated ultimate losses are primarily based upon loss development factors, and other factors such as the nature of employees’ job responsibilities, the historical frequency and severity of workers’ compensation claims, and an estimate of future cost trends. Each reporting period, changes in actuarial assumptions resulting from changes in actual claims experience and other trends are incorporated into our workers’ compensation claims cost estimates.
With respect to our PEO health insurance, we offer various health insurance plans that take the form of either fully insured guaranteed cost plans or fully insured insurance arrangements where we retain risk. A reserve for insurance arrangements where we retain risk is 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 independent 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 with workers’ compensation insurance where 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 fiscal 2021 or 2020.
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. A qualitative analysis was performed for all reporting units in fiscal 2021 and 2020, 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 2021 or 2020. 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 on an annual basis and between annual tests if events or changes in circumstances change in a way that 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 2021 or 2020.
Impairment of Long-Lived Assets: Long-lived assets, including intangible assets with finite lives and operating lease right-of-use assets, 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 2021 or 2020.
Stock-based compensation costs: All stock-based awards to employees 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. Volatility is estimated 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. We 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 material 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.
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 materially impact our results of operations or financial position. Refer to Note L 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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