Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s Discussion and Analysis of Financial Condition and Results of Operations reviews the operating results of Paychex, Inc. and its wholly owned subsidiaries (“Paychex,” the “Company,” “we,” “our,” or “us”) for the three months ended February 28, 2022 (the “third quarter”), the nine months ended February 28, 2022 (the “nine months”), the respective prior year periods ended February 28, 2021 (the “prior year periods”), and our financial condition as of February 28, 2022. The focus of this review is on the underlying business reasons for material changes and trends affecting our revenue, expenses, net income, and financial condition. This review should be read in conjunction with the February 28, 2022 consolidated financial statements and the related Notes to Consolidated Financial Statements (Unaudited) contained in this Quarterly Report on Form 10-Q (“Form 10-Q”). This review should also be read in conjunction with our Annual Report on Form 10-K (“Form 10-K”) for the year ended May 31, 2021 (“fiscal 2021”). Forward-looking statements in this Form 10-Q are qualified by the cautionary statement included under the next sub-heading, “Cautionary Note Regarding Forward-Looking Statements.”

Cautionary Note Regarding Forward-Looking Statements

Certain written and oral statements made by us may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the United States (“U.S.”) Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by such words and phrases as “we expect,” “expected to,” “estimates,” “estimated,” “intend,” “overview,” “outlook,” “guidance,” “we look forward to,” “would equate to,” “projects,” “projections,” “projected,” “projected to be,” “anticipates,” “anticipated,” “we believe,” “believes,” “could be,” “targeting,” and other similar words or phrases. Examples of forward-looking statements include, among others, statements we make regarding operating performance, events, or developments that we expect or anticipate will occur in the future, including statements relating to our outlook, revenue growth, earnings, earnings-per-share growth, or similar projections.

Forward-looking statements are neither historical facts nor assurances of future performance. Instead, they are based only on our current beliefs, expectations, and assumptions regarding the future of our business, future plans and strategies, projections, anticipated events and trends, the economy, and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks, and changes in circumstances that are difficult to predict, many of which are outside our control. Our actual results and financial condition may differ materially from those indicated in the forward-looking statements. Therefore, you should not place undue reliance upon any of these forward-looking statements. Important factors that could cause our actual results and financial condition to differ materially from those indicated in the forward-looking statements include, among others, the following:

our ability to keep pace with changes in technology and to provide timely enhancements to our products and services;

software defects, undetected errors, or development delays for our products;

the possibility of cyberattacks, security vulnerabilities and Internet disruptions, including breaches of data security and privacy leaks, data loss and business interruptions;

the possibility of failure of our operating facilities, computer systems, or communication systems during a catastrophic event;

the failure of third-party service providers to perform their functions;

the possibility that we may be subject to additional risks related to our co-employment relationship with our professional employer organization (“PEO”);

changes in health insurance and workers’ compensation insurance rates and underlying claim trends;

risks related to acquisitions and the integration of the businesses we acquire;

our clients’ failure to reimburse us for payments made by us on their behalf;

the effect of changes in government regulations mandating the amount of tax withheld or the timing of remittances;

our failure to comply with covenants in our debt agreements;

changes in governmental regulations and policies;

our ability to comply with U.S. and foreign laws and regulations;

our compliance with data privacy laws and regulations;

our failure to protect our intellectual property rights;

potential outcomes related to pending or future litigation matters;

the impact of the COVID-19 pandemic on the U.S. and global economy, and in particular on our small- and medium-sized business clients;

volatility in the political and economic environment;

changes in the availability of qualified people; and

the possible effects of negative publicity on our reputation and the value of our brand.

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Any of these factors, as well as other factors discussed in our Form 10-K for fiscal 2021 or in our other periodic filings with the Securities and Exchange Commission (“SEC”), could cause our actual results to differ materially from our anticipated results. The information provided in this Form 10-Q is based upon the facts and circumstances known as of the date of this report, and any forward-looking statements made by us in this Form 10-Q speak only as of the date on which they are made. Except as required by law, we undertake no obligation to update these forward-looking statements after the date of filing this Form 10-Q with the SEC to reflect events or circumstances after such date, or to reflect the occurrence of unanticipated events.

Our investor presentation regarding the financial results for the third quarter is available and accessible on our Paychex Investor Relations portal at https://investor.paychex.com. Information available on our website is not a part of, and is not incorporated into, this Form 10-Q. We intend to make future investor presentations available exclusively on our Paychex Investor Relations portal.

Overview

We are a leading human capital management (“HCM”) software and services company, offering integrated solutions for human resources (“HR”), payroll, benefits, and insurance for small- to medium-sized businesses. We offer a comprehensive portfolio of technology solutions and services, supported by our HR and compliance expertise, that help our clients address the evolving challenges of HR.

Paychex Flex® is our proprietary HCM software-as-a-service (“SaaS”) platform that helps clients manage the employee life cycle from recruiting and hiring to retirement. This integrated suite of solutions includes recruiting, onboarding, HR, payroll, time and attendance, and employee benefits. It utilizes a single cloud-based platform, with single client and employee records. Clients can select the modules they need and easily add on services as they grow. In addition, we provide comprehensive HR Outsourcing solutions to help our clients plan, manage, and comply with all aspects of HR.

Our portfolio of HCM and employee benefit-related services is disaggregated into two categories, (1) Management Solutions and (2) PEO and Insurance Solutions, as discussed under the heading “Description of Services” in Part 1, Item 1 of our Form 10-K for fiscal 2021.

Our mission is to be the leading provider of integrated HCM solutions for HR, payroll, benefits, and insurance by being an essential partner to small-and medium-sized businesses across the U.S. and parts of Europe. Our strategy focuses on providing integrated digital technology solutions; increasing client satisfaction; expanding our leadership in HR; growing our client bases; and engaging in strategic acquisitions. We believe that successful execution of our mission and strategies will lead to strong, long-term financial performance.

We focus on driving growth in the number of clients, revenue per client, total revenue, and profits, while providing HCM technology and HR outsourcing and benefits services 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 innovative technology. We believe these investments are critical to our success. Looking to the future, investments in technology, products, and people have positioned us for long-term growth.

We continue to find opportunities to innovate our HCM solutions to help our customers address the challenges of workforce management, including hiring, retention, and employee wellbeing. Most recently, we enhanced functionality within our Paychex Flex Document Management tool to help employers track vaccination status, restrict access, and maintain confidentiality of information. We also partnered with HireRight (NYSE: HRT), a global leader in screening services, to enable Paychex clients to place bulk or small batch orders of rapid COVID-19 test kits that can be easily distributed and administered to their employees. In addition, our enhanced IRIS biometric time clock allows quick identification of employees, with and without a mask, and access to pay adjustments, time-off balances, and more.

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Third Quarter and Year to Date Business Highlights

Highlights compared to the prior year periods are as follows:

For the three months endedFor the nine months ended
February 28,February 28,
In millions, except per share amounts20222021Change**(2)**20222021Change**(2)**
Total service revenue$1,261.6$1,096.615%$3,424.4$2,982.815%
Total revenue$1,276.0$1,111.715%$3,467.4$3,027.615%
Operating income$562.8$468.620%$1,446.0$1,106.931%
Net income$430.7$350.523%$1,096.4$834.531%
Adjusted net income(1)$419.4$348.820%$1,072.4$841.627%
Diluted earnings per share$1.19$0.9723%$3.02$2.3131%
Adjusted diluted earnings per share(1)$1.15$0.9620%$2.95$2.3227%
Dividends paid to stockholders$238.5$223.87%$714.9$670.57%

(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 2 for a discussion of these non-GAAP measures and a reconciliation to the U.S. GAAP measures of net income and diluted earnings per share.

(2)

Percentage changes are calculated based on unrounded numbers.

For further analysis of our results of operations for the third quarter and nine months, the prior year periods, and our financial position as of February 28, 2022, refer to the tables and analysis in the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item 2.

COVID-19 Update

The COVID-19 pandemic recently reached the two-year mark and our priority continues to be the health and safety of our employees. The overall recovery from the COVID-19 pandemic has been uneven and has presented many challenges and risks from general economic uncertainty, changes in consumer demand, disruption of supply chains and challenges with hiring, labor and supply cost inflation. However, as we implemented our phased return to office plan starting in October 2021, we were able to provide greater levels of work flexibility to employees and maintain health and safety standards for employees meeting all regulatory requirements.

We remain committed to proactively supporting our clients through any lingering uncertainties of the COVID-19 pandemic and navigate the challenges of the future business environment. Our unique blend of technology solutions and expertise provides valuable tools and resources to assist our clients and their employees. Our COVID-19 Help Center continues to provide near real-time information and tools to help businesses navigate the constantly evolving business environment, including information on the latest Biden administration COVID-19 requirements. Our Paychex Employee Retention Tax Credit (“ERTC”) service assists businesses in retroactively identifying tax credits and filing amended returns to claim these credits. As of February 28, 2022, we have assisted businesses in securing over $7.0 billion in ERTC and paid leave credits.

Our strong balance sheet and operational flexibility have allowed us to successfully manage through the ongoing impacts of the COVID-19 pandemic and invest in our business without negatively impacting cash flow and liquidity. The strong results we experienced during the first half of the fiscal year continued through to the third quarter as we maintained double-digit growth in both revenue and earnings over the prior year periods. These results reflected solid internal execution, as we came through our calendar year-end processing and main selling season with strong sales performance and high levels of client retention. This reflects a return on the continued investment in our technology and people. We believe 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, thrive, and adjust to the changes of how, where, and when work gets done.

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We continually evaluate the nature and extent of changes to the market and economic conditions related to the COVID-19 pandemic and assess the potential impact on our business and financial position. Despite the emergence of vaccines and vaccine boosters, less virulent strains of COVID-19 such as the Omicron variant, and reduced positivity rates, the end of the COVID-19 pandemic is still uncertain. As such, we expect that the pandemic may 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 remain difficult to predict at this time.

For further discussion of the risks posed to our business from the COVID-19 pandemic, refer to Item 1A of our Form 10-K for fiscal 2021.

RESULTS OF OPERATIONS

Summary of Results of Operations:

For the three months endedFor the nine months ended
February 28,February 28,
In millions, except per share amounts20222021Change**(1)**20222021Change**(1)**
Revenue:
Management Solutions$959.9$846.813%$2,597.4$2,267.015%
PEO and Insurance Solutions301.7249.821%827.0715.816%
Total service revenue1,261.61,096.615%3,424.42,982.815%
Interest on funds held for clients14.415.1(5)%43.044.8(4)%
Total revenue1,276.01,111.715%3,467.43,027.615%
Total expenses713.2643.111%2,021.41,920.75%
Operating income562.8468.620%1,446.01,106.931%
Other expense, net(8.5)(6.0)41%(10.2)(18.6)(45)%
Income before income taxes554.3462.620%1,435.81,088.332%
Income taxes123.6112.110%339.4253.834%
Effective income tax rate22.3%24.2%23.6%23.3%
Net income$430.7$350.523%$1,096.4$834.531%
Diluted earnings per share$1.19$0.9723%$3.02$2.3131%

(1) Percentage changes are calculated based on unrounded numbers.

The changes in revenue as compared to the prior year periods were primarily driven by the following factors:

Management Solutions revenue: $959.9 million for the third quarter and $2.6 billion for the nine months, reflecting increases of 13% and 15%, respectively:

o

Increase in client bases across HCM offerings resulting from strong sales performance and high levels of retention, with continued strong demand for HR Solutions,

o

Growth in checks per payroll for HCM and higher worksite employees for HR Solutions,

o

Improved revenue per client resulting from enhanced price realization,

o

Expansion of HCM ancillary services; and,

o

Growth in payroll funding and outsourcing services for temporary staffing clients.

PEO and Insurance Solutions revenue: $301.7 million for the third quarter and $827.0 million for the nine months, reflecting increases of 21% and 16%, respectively:

o

Increase in the number of average worksite employees and growth in average wages per worksite employee,

o

Growth in PEO health insurance revenue; and,

o

Higher state unemployment insurance revenue.

Interest on funds held for clients and Corporate investment income: We invest in highly liquid, investment-grade fixed income securities and do not utilize derivative instruments to manage interest rate risk.

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Details regarding our combined funds held for clients and corporate cash equivalents and investment portfolios were as follows:

For the three months endedFor the nine months ended
February 28,February 28,
$ in millions20222021Change**(1)**20222021Change**(1)**
Average investment balances:
Funds held for clients$5,046.0$4,459.613%$4,287.0$3,849.511%
Corporate cash equivalents and investments1,341.61,062.026%1,240.51,016.322%
Total$6,387.6$5,521.616%$5,527.5$4,865.814%
Average interest rates earned (exclusive of net realized gains/(losses)):
Funds held for clients1.1%1.3%1.3%1.5%
Corporate cash equivalents and investments0.2%0.1%0.1%0.2%
Combined funds held for clients and corporate cash equivalents and investments0.9%1.1%1.1%1.2%
Total net realized gains$0.0$0.3$0.1$1.0

(1) Percentage changes are calculated based on unrounded numbers.

February 28,May 31,
$ in millions20222021
Net unrealized (losses)/gains on available for sale (“AFS”) securities (1)$(30.9)$79.3
Federal Funds rate (2)0.25%0.25%
Total fair value of AFS securities$3,921.7$3,020.2
Weighted-average duration of AFS securities in years (3)3.23.3
Weighted-average yield-to-maturity of AFS securities (3)1.8%1.9%

(1) The net unrealized loss on our investment portfolio was approximately $105.9 million as of March 29, 2022.

(2) The Federal Funds rate was in the range of 0.00% to 0.25% as of February 28, 2022 and May 31, 2021. Effective March 17, 2022, the Federal Reserve increased the Federal Funds rate to a range of 0.25% to 0.50%.

(3) These items exclude the impact of variable rate demand notes (“VRDNs”) as they are tied to short-term interest rates.

Total expenses: The following table summarizes the total combined cost of service revenue and selling, general and administrative expenses for the periods below:

For the three months endedFor the nine months ended
February 28,February 28,
In millions20222021Change**(1)**20222021Change**(1)**
Compensation-related expenses$414.9$374.411%$1,192.0$1,127.66%
PEO insurance costs105.186.522%301.3259.416%
Depreciation and amortization48.446.44%142.7144.6(1)%
Cost-saving initiatives(2)——n/m—32.2n/m
Other expenses144.8135.87%385.4356.98%
Total expenses$713.2$643.111%$2,021.4$1,920.75%

(1) Percentage changes are calculated based on unrounded numbers.

(2) One-time costs recognized during fiscal 2021 related to the acceleration of cost-saving initiatives, including the long-term strategy to reduce our geographic footprint and optimize headcount. These events are not expected to recur.

n/m – not meaningful

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Total expenses increased 11% to $713.2 million for the third quarter and 5% to $2.0 billion for the nine months compared to the prior year periods. Excluding one-time costs of $32.2 million incurred in the prior year period, total expenses increased 7% for the nine months compared to the prior year period. Total expenses increased as a result of the following:

Compensation-related expenses: $414.9 million for the third quarter and $1.2 billion for the nine months, reflecting increases of 11% and 6%, respectively, due to increases in headcount and wage rates, performance-based compensations, and fringe benefits.

PEO insurance costs: $105.1 million for the third quarter and $301.3 million for the nine months, reflecting increases of 22% and 16%, respectively, as a result of growth in number of PEO worksite employees and health insurance revenue.

Other expenses: $144.8 million for the third quarter and $385.4 million for the nine months, reflecting increases of 7% and 8%, respectively, due to further investment in product development and information technology and increases in advertising expense during peak selling season.

Operating income: Operating income increased 20% to $562.8 million for the third quarter and 31% to $1.4 billion for the nine months, as a result of double-digit revenue growth which outpaced expense increases as previously discussed.

Adjusted operating income(1), which excluded the impact of one-time costs related to the acceleration of cost-saving initiatives, including our long-term strategy to reduce geographic footprint and optimize headcount, increased 27% to $1.4 billion for the nine months. Operating margin (operating income as a percentage of total revenue) and adjusted operating margin(1) (operating income, adjusted for one-time costs, as a percentage of total revenue) were as follows:

For the three months endedFor the nine months ended
February 28,February 28,
2022202120222021
Operating margin44.1%42.2%41.7%36.6%
Adjusted operating margin (1)44.1%42.2%41.7%37.6%

Fluctuations in these metrics were attributable to the factors previously discussed.

(1) Adjusted operating income and adjusted operating margin are not U.S. GAAP measures. Refer to the “Non-GAAP Financial Measures” section of this Item 2 for a discussion of these non-GAAP measures and a reconciliation to the most comparable GAAP measures of operating income.

Income taxes: Our effective income tax rate was 22.3% for the third quarter and 23.6% for the nine months, compared to 24.2% and 23.3%, respectively, for the prior year periods. All periods were impacted by the recognition of net discrete tax benefits related to employee stock-based compensation payments. The effective tax rates for the current periods were also impacted by the recording of a tax benefit related to prior and current years' research and development expenses incurred in the production of customer-facing software. The increase in the effective tax rate for the nine months was partially impacted by an increase in state income taxes.

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Non-GAAP Financial Measures: Adjusted operating income, adjusted net income, adjusted diluted earnings per share, earnings before interest, taxes, depreciation, and amortization (“EBITDA”), and adjusted EBITDA are summarized as follows:

For the three months endedFor the nine months ended
February 28,February 28,
$ in millions20222021Change20222021Change
Operating income$562.8$468.620%$1,446.0$1,106.931%
Non-GAAP adjustments:
Cost-saving initiatives(1)———32.2
Total non-GAAP adjustments———32.2
Adjusted operating income$562.8$468.620%$1,446.0$1,139.127%
Net income$430.7$350.523%$1,096.4$834.531%
Non-GAAP adjustments:
Excess tax benefit related to employee stock-based compensation payments(2)(5.2)(1.7)(17.9)(17.2)
Tax benefit derived from research and development costs (3)(6.1)—(6.1)—
Cost-saving initiatives(1)———24.3
Total non-GAAP adjustments(11.3)(1.7)(24.0)7.1
Adjusted net income$419.4$348.820%$1,072.4$841.627%
Diluted earnings per share(4)$1.19$0.9723%$3.02$2.3131%
Non-GAAP adjustments:
Excess tax benefit related to employee stock-based compensation payments(2)(0.01)(0.00)(0.05)(0.05)
Tax benefit derived from research and development costs (3)(0.02)—(0.02)—
Cost-saving initiatives(1)———0.07
Total non-GAAP adjustments(0.03)(0.00)(0.07)0.02
Adjusted diluted earnings per share$1.15$0.9620%$2.95$2.3227%
Net income$430.7$350.523%$1,096.4$834.531%
Non-GAAP adjustments:
Interest expense, net8.58.526.425.4
Income taxes123.6112.1339.4253.8
Depreciation and amortization expense48.346.4142.7144.6
Total non-GAAP adjustments180.4167.0508.5423.8
EBITDA611.1517.518%1,604.91,258.328%
Cost-saving initiatives(1)———32.2
Adjusted EBITDA$611.1$517.518%$1,604.9$1,290.524%

(1) One-time costs and corresponding tax benefit recognized during fiscal 2021 related to the acceleration of cost-saving initiatives, including the long-term strategy to reduce our geographic footprint and optimize headcount. These events are not expected to recur.

(2) 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.

(3) Non-recurring tax benefit derived from prior years' research and development costs incurred in the production of customer-facing software.

(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.

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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 operating margin, adjusted net income, adjusted diluted earnings per share, 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 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

As of February 28, 2022, our financial position remained strong with cash, restricted cash, and total corporate investments of $1.4 billion. Total short-term and long-term borrowings, net of debt issuance costs, were $806.3 million as of February 28, 2022. Our primary source of cash is generated by our ongoing operations. Cash flow from operations was $1.2 billion for the nine months. Our positive cash flows have allowed us to support our business and pay dividends. We currently anticipate that cash, restricted cash, and total corporate investments as of February 28, 2022, 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 February 28, 2022 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 under our credit facilities. Refer to Note M of the Notes to Consolidated Financial Statements contained in Item 8 of our Form 10-K for fiscal 2021 for further discussion on our credit facilities.

Details of our credit facilities as of February 28, 2022 were as follows:

MaximumFebruary 28, 2022
AmountOutstandingAvailable
$ in millionsExpiration DateAvailableAmountAmount
Credit facilities:
JP Morgan Chase Bank, N.A. (“JPM”)July 31, 2024$1,000.0$-$1,000.0
JPMSeptember 17, 2026$750.0-750.0
PNC Bank, National Association (“PNC”)February 6, 2023$250.08.7241.3
Total Lines of Credit Outstanding and Available$8.7$1,991.3

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Amounts outstanding under the PNC credit facility as of February 28, 2022 remain outstanding as of the date of this report.

On September 17, 2021, we amended our $500.0 million credit facility with JPM. The amendment increased the credit facility’s maximum borrowing capacity to $750.0 million, extended the term through September 17, 2026, with the option to extend for two additional one-year periods, and amended interest rate provisions to phase out the use of the London Interbank Offered Rate (“LIBOR”). In addition, we also amended our $1.0 billion credit facility with JPM. The amendment phases out the use of LIBOR and adopts other administrative changes to maintain consistency with our other credit facilities.

Details of borrowings under each credit facility during the third quarter and the prior year period were as follows:

For the three months ended February 28, 2022
Credit Facility
$1 Billion$750 Million$250 Million
$ in millionsJPMJPMPNC
Number of days borrowed——90
Maximum amount borrowed$—$—$8.8
Weighted-average amount borrowed$—$—$8.6
Weighted-average interest rate—%—%1.25%
For the three months ended February 28, 2021
Credit Facility
$1 Billion$500 Million$250 Million
$ in millionsJPMJPMPNC
Number of days borrowed——90
Maximum amount borrowed$—$—$7.2
Weighted-average amount borrowed$—$—$7.1
Weighted-average interest rate—%—%1.24%

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 investment portfolio.

Subsequent to February 28, 2022, there were no overnight borrowings under our PNC and JPM credit facilities.

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 our Form 10-K for fiscal 2021 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 determine 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 February 28, 2022, we had irrevocable standby letters of credit available totaling $139.7 million, required to secure commitments for certain insurance policies. The letters of credit expire at various dates between April 1, 2022 and February 5, 2023. No amounts were outstanding on these letters of credit during the third quarter or as of February 28, 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 our Senior Notes are as follows:

Senior NotesSenior Notes
Series ASeries B
Stated interest rate4.07%4.25%
Effective interest rate4.15%4.31%
Interest rate typeFixedFixed
Interest payment datesSemi-annual, in arrearsSemi-annual, in arrears
Principal payment datesMarch 13, 2026March 13, 2029
Note typeUnsecuredUnsecured

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Refer to Note N of the Notes to Consolidated Financial Statements contained in Item 8 of our Form 10-K for fiscal 2021 for further discussion on our long-term financing.

Other commitments: We had outstanding commitments under existing workers’ compensation insurance agreements and legally binding contractual arrangements, which included immaterial leases that have yet to commence. We also entered into various purchase commitments with vendors in the ordinary course of business and had outstanding commitments to purchase approximately $5.6 million of capital assets as of February 28, 2022. In addition, we are involved in three limited partnership agreements to contribute a maximum of $30.0 million to venture capital funds in the financial technology sector. As of February 28, 2022, we have contributed approximately $15.9 million of the total funding commitment.

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 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 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 February 28, 2022. We also maintain 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

For the nine months ended
February 28,
In millions20222021Change
Net cash provided by operating activities$1,168.3$870.6$297.7
Net cash used in investing activities(1,168.1)(600.3)(567.8)
Net cash (used in)/provided by financing activities(33.4)122.1(155.5)
Net change in cash, restricted cash, and equivalents$(33.2)$392.4$(425.6)
Cash dividends per common share$1.98$1.86

The changes in our cash flow for the nine months compared to the prior year period were primarily the result of the following key drivers:

Operating Cash Flow Activities

Higher net income attributable to the reasons discussed in the “Results of Operations” section of this Item 2.

Changes in receivables due to funding for temporary staffing clients; and,

Decrease in income tax payments; offset by,

Increase in cash payments for worksite employee compensation; and,

Higher incentive compensation payments and payment of deferred payroll taxes.

Investing Cash Flow Activities

The increase in cash used was primarily related to an increase in purchases of VRDNs;

Our recent completion of an immaterial business acquisition; and,

Greater investment in technology as we continued to introduce new product solutions and enhancements.

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Fluctuations in the net purchases and sales/maturities of AFS securities are also due to timing within the client funds portfolio and market conditions. 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 of this Item 2.

Financing Cash Flow Activities

Increase in net cash outflows from changes in client fund obligations due the timing of collections and remittances client funds,

Dividends paid increased $44.4 million compared to the prior year period due to an increase in our cumulative quarterly dividends from $1.86 per share to $1.98 per share. The payment of future dividends is dependent on our future earnings and cash flow and is subject to the discretion of our Board of Directors, and

Decrease in equity-based plan activity as 1.2 million shares of our common stock were exercised or vested during the nine months compared to 2.4 million shares exercised or vested in the prior year period; partially offset by,

Decrease in the repurchase of common shares as we did not repurchase any shares in the nine months versus 0.9 million shares repurchased in the prior year period. Refer to Part II, Item 2 of this Form 10-Q for further discussion on our common stock repurchase programs.

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.

MARKET RISK FACTORS

Changes in interest rates and interest rate risk: Funds held for clients are primarily comprised of short-term funds and AFS securities. Corporate investments are primarily comprised of AFS securities. As a result of our investing activities, we are exposed to changes in interest rates that may materially affect our results of operations and financial position. Changes in interest rates will impact the earnings potential of future investments and will cause fluctuations in the fair value of our longer-term AFS securities. We follow an investment strategy of protecting principal and optimizing liquidity. A substantial portion of our portfolios is invested in high credit quality securities with ratings of AA or higher, and A-1/P-1 ratings on short-term securities. We invest predominantly in municipal bonds; corporate bonds; U.S. government agency securities; and VRDNs. We limit the amounts that can be invested in any single issuer and invest primarily in short- to intermediate-term instruments whose fair value is less sensitive to interest rate changes. We manage the AFS securities to a benchmark duration of two and one-half to three and three-quarters years.

During the nine months ended February 28, 2022, our primary short-term investment vehicles were bank demand deposit accounts and VRDNs. We have no exposure to high-risk or non-liquid investments. We have insignificant exposure to European investments. We have not and do not utilize derivative financial instruments to manage our interest rate risk.

During the nine months ended February 28, 2022, the average interest rate earned on our combined funds held for clients and corporate cash equivalents and investment portfolios was 1.1% compared to 1.2% for the prior year period. When interest rates are rising, the full impact of higher interest rates will not immediately be reflected in net income due to the interaction of short- and long-term interest rate changes. During a rising interest rate environment, earnings will increase from our short-term investments, and over time, increase from our longer-term AFS securities. Earnings from AFS securities, which as of February 28, 2022 had an average duration of 3.2 years, would not reflect increases in interest rates until the investments are sold or mature and the proceeds are reinvested at higher rates.

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The amortized cost and fair value of AFS securities that had stated maturities as of February 28, 2022 are shown below by expected maturity.

February 28, 2022
AmortizedFair
In millionscostvalue
Maturity date:
Due in one year or less$319.2$321.2
Due after one year through three years682.2690.2
Due after three years through five years1,227.21,213.9
Due after five years1,724.01,696.4
Total$3,952.6$3,921.7

VRDNs are primarily categorized as due after five years in the table above as the contractual maturities on these securities are typically 20 to 30 years. Although these securities are issued as long-term securities, they are priced and traded as short-term instruments because of the liquidity provided through the tender feature.

As of February 28, 2022, the Federal Funds rate was in the range of 0.00% to 0.25%. Effective March 17, 2022, the Federal Reserve raised the Federal Funds rate 25 basis points placing it in the range of 0.25% to 0.50%. There continues to be uncertainty in the changing market and economic conditions, including the possibility of additional measures that could be taken by the Federal Reserve and other government agencies, related to the COVID-19 pandemic and concerns over inflation risk. We will continue to monitor the market and economic conditions.

Calculating the future effects of changing interest rates involves many factors. These factors include, but are not limited to:

governmental action resulting from the COVID-19 pandemic;

daily interest rate changes;

seasonal variations in investment balances;

actual duration of short-term and AFS securities;

the proportion of taxable and tax-exempt investments;

changes in tax-exempt municipal rates versus taxable investment rates, which are not synchronized or simultaneous; and

financial market volatility and the resulting effect on benchmark and other indexing interest rates.

Subject to these factors and under normal financial market conditions, a 25-basis-point change in taxable interest rates generally affects our tax-exempt interest rates by approximately 17 basis points. Under normal financial market conditions, the impact to earnings from a 25-basis-point change in short-term interest rates would be approximately $4.0 million to $4.5 million, after taxes, for a twelve-month period. Such a basis point change may or may not be tied to changes in the Federal Funds rate.

Our total investment portfolio (funds held for clients and corporate cash equivalents and investments) is expected to average approximately $5.6 billion for the year ended May 31, 2022. Our anticipated allocation is approximately 50% invested in short-term securities and VRDNs with an average duration of less than 30 days and 50% invested in AFS securities, with an average duration of two and one-half to three and three-quarters years.

The combined funds held for clients and corporate AFS securities reflected net unrealized losses of $30.9 million as of February 28, 2022 and net unrealized gains of $79.3 million as of May 31, 2021. During the nine months ended February 28, 2022, the net unrealized loss and gain on our investment portfolios ranged from a $45.3 million loss to a $89.2 million gain. These fluctuations were driven by changes in market rates of interest. The net unrealized loss on our investment portfolio was approximately $105.9 million as of March 29, 2022.

As of February 28, 2022 and May 31, 2021, we had $3.9 billion and $3.0 billion, respectively, invested in AFS securities at fair value. The weighted-average yield-to-maturity was 1.8% as of February 28, 2022 and 1.9% as of May 31, 2021. The weighted-average yield-to-maturity excludes AFS securities tied to short-term interest rates, such as VRDNs. Assuming a hypothetical increase in longer-term interest rates of 25 basis points, the resulting potential decrease in fair value for our portfolio of AFS securities as of February 28, 2022, would be in the range of $20.0 million to $25.0 million.

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Conversely, a corresponding decrease in interest rates would result in a comparable increase in fair value. This hypothetical increase or decrease in the fair value of the portfolio would be recorded as an adjustment to the portfolio’s recorded value, with an offsetting amount recorded in stockholders’ equity. These fluctuations in fair value would have no related or immediate impact on our results of operations unless any declines in fair value are due to credit related concerns and an impairment loss is recognized.

Credit risk: We are exposed to credit risk in connection with these investments through the possible inability of the borrowers to meet the terms of their bonds. We regularly review our investment portfolios to determine if any investment is impaired due to increased credit risk or other valuation concerns and we believe that the investments we held as of February 28, 2022 were not impaired as a result of the previously discussed reasons. While $1.3 billion of our AFS securities had fair values that were below amortized cost, we believe that it is probable that the principal and interest will be collected in accordance with the contractual terms, and that the gross unrealized losses of $47.6 million were due to changes in interest rates and were not due to increased credit risk or other valuation concerns. Most of the AFS securities in an unrealized loss position as of February 28, 2022 and May 31, 2021 had an AA rating or better. We do not intend to sell these investments until the recovery of their amortized cost basis or maturity, and further believe that it is not more-likely-than-not that we will be required to sell these investments prior to that time. Our assessment that an investment is not impaired due to increased credit risk or other valuation concerns could change in the future due to new developments, including changes in our strategies or assumptions related to any particular investment.

We have some credit risk exposure relating to the purchase of accounts receivable as a means of providing payroll funding to clients in the temporary staffing industry. There is also credit risk exposure relating to our trade accounts receivable. This credit risk exposure is diversified amongst multiple client arrangements and all such arrangements are regularly reviewed for potential write-off. No single client is material in respect to total accounts receivable, service revenue, or results of operations as of February 28, 2022.

CRITICAL ACCOUNTING POLICIES

Our critical accounting policies are described in Item 7 of our Form 10-K for fiscal 2021, filed with the SEC on July 16, 2021. On an ongoing basis, we evaluate the critical accounting policies used to prepare our consolidated financial statements, including, but not limited to, those related to:

revenue recognition;

assets recognized from the costs to obtain and fulfill contracts;

PEO insurance reserves;

goodwill and other intangible assets;

impairment of long-lived assets;

stock-based compensation costs; and

income taxes.

There have been no material changes in these aforementioned critical accounting policies.

NEW ACCOUNTING PRONOUNCEMENTS

Recently adopted accounting pronouncements: Refer to Note A of the Notes to Consolidated Financial Statements (Unaudited) contained in Item 1 of this Form 10-Q for a discussion of recently adopted accounting pronouncements.

Recently issued accounting pronouncements: Refer to Note A of the Notes to Consolidated Financial Statements (Unaudited) contained in Item 1 of this Form 10-Q for a discussion of recently issued accounting pronouncements.

Ite****m 3. Quantitative and Qualitative Disclosures of Market Risk

The information called for by this item is provided under the caption “Market Risk Factors” under Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations and is incorporated herein by reference.

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Ite****m 4. Controls and Procedures

Disclosure Controls and Procedures: Disclosure controls and procedures are designed with the objective of ensuring that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), such as this report, is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to the Company’s management, including the Company’s principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures: As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s principal executive officer and principal financial officer, of the effectiveness of disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based on such evaluation, the Company’s principal executive officer and principal financial officer have concluded that as of February 28, 2022, the end of the period covered by this report, our disclosure controls and procedures were effective at a reasonable assurance level.

Changes in Internal Control over Financial Reporting: The Company also carried out an evaluation of the internal control over financial reporting to determine whether any changes occurred during the fiscal quarter ended February 28, 2022. Based on such evaluation, there have been no changes in the Company’s internal control over financial reporting that occurred during the Company’s most recently completed fiscal quarter ended February 28, 2022, that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PAR****T II. OTHER INFORMATION

I****tem 2. Unregistered Sales of Equity Securities and Use of Proceeds

The Company maintains two programs to repurchase up to $400 million of the Company’s common stock under each program, with authorization expiring on May 31, 2022 and January 31, 2024, respectively. The purpose of these programs is to manage common stock dilution. There were no shares repurchased during the third quarter and $472.4 million remains available for share repurchases in total under both programs.

Ite****m 6. Exhibits

INDEX TO EXHIBITS

Exhibit numberDescription
*31.1Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
*31.2Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
*32.1Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
*32.2Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
*101.INSInline XBRL Instance Document– the instance document does not appear in the Interactive Data File because XBRL tags are embedded within the Inline XBRL document.
*101.SCHInline XBRL Taxonomy Extension Schema Document
*101.CALInline XBRL Taxonomy Extension Calculation Linkbase Document
*101.LABInline XBRL Taxonomy Extension Label Linkbase Document
*101.PREInline XBRL Taxonomy Extension Presentation Linkbase Document
*101.DEFInline XBRL Taxonomy Extension Definition Linkbase Document
*104Cover Page Interactive Data File (embedded within the Inline XBRL document)
  • Exhibit filed with this report

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SIGNA****TURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

PAYCHEX, INC.

Date:March 31, 2022/s/ Martin Mucci
Martin Mucci
Chairman of the Board of Directors and Chief Executive Officer
(Principal Executive Officer)
Date:March 31, 2022/s/ Efrain Rivera
Efrain Rivera
Senior Vice President, Chief Financial Officer and Treasurer
(Principal Financial Officer)
Date:March 31, 2022/s/ Robert L. Schrader Robert L. Schrader Vice President and Controller (Principal Accounting Officer)

Previous: Item 1. Financial Statements