filings.toolsItem 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, 2023 (the “third quarter”), the nine months ended February 28, 2023 (the “nine months”), the respective prior year periods ended February 28, 2022 (the “prior year periods”), and our financial condition as of February 28, 2023. 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, 2023 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, 2022 (“fiscal 2022”). 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 “expect,” “estimate,” “intend,” “outlook,” “will,” “would,” “project,” “projections,” “strategy,” “anticipate,” “believe,” “could,” “may,” “potential,” “purpose,” 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 or provide timely enhancements to our solutions and support;
software defects, undetected errors, and development delays for our solutions;
the possibility of cyberattacks, security vulnerabilities or Internet disruptions, including data security and privacy leaks and data loss and business interruptions;
the possibility of failure of our business continuity plan during a catastrophic event;
the failure of third-party service providers to perform their functions;
the possibility that we may be exposed to additional risks related to our co-employment relationship with our professional employer organization (“PEO”) business;
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 macroeconomic factors 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, including rising inflation;
changes in the availability and retention of qualified people; and
the possible effects of negative publicity on our reputation and the value of our brand.
Any of these factors, as well as other factors discussed in our Form 10-K for fiscal 2022 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 provider of integrated human capital management (“HCM”) solutions for human resources (“HR”), payroll, benefits, and insurance for small- to medium-sized businesses and their employees across the United States (“U.S.”) and parts of Europe. We offer a comprehensive portfolio of technology solutions and HR advisory services that help our clients address the evolving challenges of HR. Our purpose is to empower our clients to focus on their success and help them navigate the complexities of HR and payroll.
Paychex Flex® is our proprietary HCM software-as-a-service (“SaaS”) platform that unites HR, payroll, time and attendance, and benefits processes to maximize efficiency and savings. Paychex Flex helps clients manage the employee life cycle from recruiting and hiring to retirement through an integrated suite of solutions and digital support capabilities. It utilizes a single cloud-based platform, with single client and employee records that allows a client to customize their set of solutions and modify it as their needs change. In addition, we provide comprehensive HR solutions and advisory services to help our clients plan, manage, and comply with all aspects of HR.
Our portfolio of technology, HR advisory, and employee benefits-related solutions is disaggregated into two categories, (1) Management Solutions and (2) PEO and Insurance Solutions, as discussed under the heading “Description of Solutions” in Part I, Item 1 of our Form 10-K for fiscal 2022.
Our strategy focuses on providing industry-leading, integrated technology; delivering superior customer experiences; expanding our leadership in HR; growing our client bases; and engaging in strategic acquisitions. We believe that successfully executing this strategy will lead to strong, long-term financial performance.
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 solutions, people, and digital capabilities will position us to capitalize on opportunities for long-term growth.
We closely monitor the evolving challenges and needs of small- and mid-sized businesses, and proactively aid our clients in navigating these challenges . Through our unique blend of innovative technology solutions, backed by our extensive compliance and HR expertise, we help clients more effectively hire, engage, train, and retain top talent in this challenging workforce environment. As businesses operate in a tight labor market, having an online portal for employee self-service that is intuitive and easy-to-use helps increase employee retention and efficiency for our clients. Recent enhancements to our Paychex Flex platform were designed to improve the client and employee experiences from hiring and onboarding through employee retention.
Third Quarter and Year to Date Business Highlights
Highlights compared to the prior year periods are as follows:
| For the three months ended | For the nine months ended | |||||||||||||||||||||||||||||||||
| February 28, | February 28, | |||||||||||||||||||||||||||||||||
| In millions, except per share amounts | 2023 | 2022 | Change**(2)** | 2023 | 2022 | Change**(2)** | ||||||||||||||||||||||||||||
| Total service revenue | $ | 1,345.7 | $ | 1,261.6 | 7 | % | $ | 3,702.6 | $ | 3,424.4 | 8 | % | ||||||||||||||||||||||
| Total revenue | $ | 1,381.0 | $ | 1,276.0 | 8 | % | $ | 3,777.5 | $ | 3,467.4 | 9 | % | ||||||||||||||||||||||
| Operating income | $ | 611.9 | $ | 562.8 | 9 | % | $ | 1,579.8 | $ | 1,446.0 | 9 | % | ||||||||||||||||||||||
| Net income | $ | 467.4 | $ | 430.7 | 9 | % | $ | 1,206.9 | $ | 1,096.4 | 10 | % | ||||||||||||||||||||||
| Adjusted net income(1) | $ | 466.7 | $ | 419.4 | 11 | % | $ | 1,198.0 | $ | 1,072.4 | 12 | % | ||||||||||||||||||||||
| Diluted earnings per share | $ | 1.29 | $ | 1.19 | 8 | % | $ | 3.33 | $ | 3.02 | 10 | % | ||||||||||||||||||||||
| Adjusted diluted earnings per share(1) | $ | 1.29 | $ | 1.15 | 12 | % | $ | 3.31 | $ | 2.95 | 12 | % | ||||||||||||||||||||||
| Dividends paid to stockholders | $ | 284.8 | $ | 238.5 | 19 | % | $ | 854.1 | $ | 714.9 | 19 | % |
(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 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, 2023, refer to the tables and analysis in the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item 2.
RESULTS OF OPERATIONS
Summary of Results of Operations:
| For the three months ended | For the nine months ended | |||||||||||||||||||||||||||||||||
| February 28, | February 28, | |||||||||||||||||||||||||||||||||
| In millions, except per share amounts | 2023 | 2022 | Change**(1)** | 2023 | 2022 | Change**(1)** | ||||||||||||||||||||||||||||
| Revenue: | ||||||||||||||||||||||||||||||||||
| Management Solutions | $ | 1,024.5 | $ | 959.9 | 7 | % | $ | 2,825.3 | $ | 2,597.4 | 9 | % | ||||||||||||||||||||||
| PEO and Insurance Solutions | 321.2 | 301.7 | 6 | % | 877.3 | 827.0 | 6 | % | ||||||||||||||||||||||||||
| Total service revenue | 1,345.7 | 1,261.6 | 7 | % | 3,702.6 | 3,424.4 | 8 | % | ||||||||||||||||||||||||||
| Interest on funds held for clients | 35.3 | 14.4 | 144 | % | 74.9 | 43.0 | 74 | % | ||||||||||||||||||||||||||
| Total revenue | 1,381.0 | 1,276.0 | 8 | % | 3,777.5 | 3,467.4 | 9 | % | ||||||||||||||||||||||||||
| Total expenses | 769.1 | 713.2 | 8 | % | 2,197.7 | 2,021.4 | 9 | % | ||||||||||||||||||||||||||
| Operating income | 611.9 | 562.8 | 9 | % | 1,579.8 | 1,446.0 | 9 | % | ||||||||||||||||||||||||||
| Other income/(expense), net | 5.5 | (8.5 | ) | n/m | 4.8 | (10.2 | ) | n/m | ||||||||||||||||||||||||||
| Income before income taxes | 617.4 | 554.3 | 11 | % | 1,584.6 | 1,435.8 | 10 | % | ||||||||||||||||||||||||||
| Income taxes | 150.0 | 123.6 | 21 | % | 377.7 | 339.4 | 11 | % | ||||||||||||||||||||||||||
| Effective income tax rate | 24.3 | % | 22.3 | % | 23.8 | % | 23.6 | % | ||||||||||||||||||||||||||
| Net income | $ | 467.4 | $ | 430.7 | 9 | % | $ | 1,206.9 | $ | 1,096.4 | 10 | % | ||||||||||||||||||||||
| Diluted earnings per share | $ | 1.29 | $ | 1.19 | 8 | % | $ | 3.33 | $ | 3.02 | 10 | % |
(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: $1.0 billion for the third quarter and $2.8 billion for the nine months, reflecting increases of 7% and 9%, respectively:
o
Increase in the number of clients and clients' employees served for HCM and worksite employees for HR Solutions;
o
Higher revenue per client resulting from pricing and higher product attachment, including increased demand for HR Solutions, retirement, and time and attendance solutions; and
o
Continued growth in HCM ancillary services.
PEO and Insurance Solutions revenue: $321.2 million for the third quarter and $877.3 million for the nine months, reflecting increases of 6% and 6%, respectively led by:
o
Growth in the number of average worksite employees and average wages per worksite employee; and
o
Higher state unemployment insurance revenues.
Interest on funds held for clients: $35.3 million for the third quarter and $74.9 million for the nine months, reflecting increases of 144% and 74%, respectively, due primarily to higher average interest rates earned.
We invest in highly liquid, investment-grade fixed income securities and do not utilize derivative instruments to manage interest rate risk.
Details regarding our combined funds held for clients and corporate cash equivalents and investment portfolios were as follows:
| For the three months ended | For the nine months ended | |||||||||||||||||||||||||||||||||
| February 28, | February 28, | |||||||||||||||||||||||||||||||||
| $ in millions | 2023 | 2022 | Change**(1)** | 2023 | 2022 | Change**(1)** | ||||||||||||||||||||||||||||
| Average investment balances: | ||||||||||||||||||||||||||||||||||
| Funds held for clients | $ | 4,935.7 | $ | 5,046.0 | (2 | ) | % | $ | 4,355.5 | $ | 4,287.0 | 2 | % | |||||||||||||||||||||
| Corporate cash equivalents and investments | 1,508.0 | 1,341.6 | 12 | % | 1,411.3 | 1,240.5 | 14 | % | ||||||||||||||||||||||||||
| Total | $ | 6,443.7 | $ | 6,387.6 | 1 | % | $ | 5,766.8 | $ | 5,527.5 | 4 | % | ||||||||||||||||||||||
| Average interest rates earned (exclusive of net realized gains): | ||||||||||||||||||||||||||||||||||
| Funds held for clients | 2.9 | % | 1.1 | % | 2.3 | % | 1.3 | % | ||||||||||||||||||||||||||
| Corporate cash equivalents and investments | 3.9 | % | 0.2 | % | 2.9 | % | 0.1 | % | ||||||||||||||||||||||||||
| Combined funds held for clients and corporate cash equivalents and investments | 3.1 | % | 0.9 | % | 2.4 | % | 1.1 | % | ||||||||||||||||||||||||||
| Total net realized gains | $ | 0.0 | $ | 0.0 | $ | 0.1 | 0.1 |
(1) Percentage changes are calculated based on unrounded numbers.
| February 28, | May 31, | |||||||||||
| $ in millions | 2023 | 2022 | ||||||||||
| Net unrealized losses on available for sale (“AFS”) securities (1) | $ | (230.5 | ) | $ | (136.3 | ) | ||||||
| Federal Funds rate (2) | 4.75 | % | 1.00 | % | ||||||||
| Total fair value of AFS securities | $ | 3,460.9 | $ | 4,029.2 | ||||||||
| Weighted-average duration of AFS securities in years (3) | 3.1 | 3.2 | ||||||||||
| Weighted-average yield-to-maturity of AFS securities (3) | 2.5 | % | 1.9 | % |
(1) The net unrealized loss on our investment portfolio was approximately $179.0 million as of March 27, 2023. Refer to Note E in the Notes to Consolidated Financial Statements contained in this Form 10-Q for more information regarding AFS securities held in an unrealized loss position.
(2) The Federal Funds rate was in the range of 4.50% to 4.75% as of February 28, 2023 and in the range of 0.75% to 1.00% as of May 31, 2022. Effective March 23, 2023, the Federal Reserve increased the Federal Funds rate to a range of 4.75% to 5.00%.
(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 ended | For the nine months ended | |||||||||||||||||||||||||||||
| February 28, | February 28, | |||||||||||||||||||||||||||||
| In millions | 2023 | 2022 | Change**(1)** | 2023 | 2022 | Change**(1)** | ||||||||||||||||||||||||
| Compensation-related expenses | $ | 453.7 | $ | 414.9 | 9 | % | $ | 1,323.1 | $ | 1,192.0 | 11 | % | ||||||||||||||||||
| PEO insurance costs | 105.2 | 105.1 | 0 | % | 312.6 | 301.3 | 4 | % | ||||||||||||||||||||||
| Depreciation and amortization | 44.2 | 48.4 | (9 | ) | % | 132.5 | 142.7 | (7 | ) | % | ||||||||||||||||||||
| Other expenses | 166.0 | 144.8 | 15 | % | 429.5 | 385.4 | 11 | % | ||||||||||||||||||||||
| Total expenses | $ | 769.1 | $ | 713.2 | 8 | % | $ | 2,197.7 | $ | 2,021.4 | 9 | % |
(1) Percentage changes are calculated based on unrounded numbers.
Total expenses increased 8% to $769.1 million for the third quarter and 9% to $2.2 billion for the nine months compared to the prior year periods. Total expenses increased as a result of the following:
Compensation-related expenses: $453.7 million for the third quarter and $1.3 billion for the nine months, reflecting an increase 9% for the third quarter and 11% for the nine months, due to increases in headcount and average wage rates.
Other expenses: $166.0 million for the third quarter and $429.5 million for the nine months, reflecting an increase of 15% for the third quarter and 11% for the nine months, due to general cost increases to support business growth, including marketing support during the selling season and other strategic initiatives.
Operating income: Operating income increased 9% to $611.9 million for the third quarter and 9% to $1.6 billion for the nine months, as a result of revenue growth outpacing expense increases as previously discussed.
Operating margin (operating income as a percentage of total revenue) was as follows:
| For the three months ended | For the nine months ended | |||||||||||||||||||||
| February 28, | February 28, | |||||||||||||||||||||
| 2023 | 2022 | 2023 | 2022 | |||||||||||||||||||
| Operating margin | 44.3 | % | 44.1 | % | 41.8 | % | 41.7 | % |
Income taxes: Our effective income tax rate was 24.3% for the third quarter and 23.8% for the nine months ended February 28, 2023, compared to 22.3% and 23.6%, for the prior year periods. All periods included the recognition of excess tax benefits related to employee stock-based compensation payments. The prior year periods were also impacted by the recording of a tax benefit related to research and development expenses incurred in the production of customer-facing software. The effective tax rate for the prior year nine months was also impacted by an increase in state income taxes.
Non-GAAP Financial Measures: Adjusted net income, adjusted diluted earnings per share, and earnings before interest, taxes, depreciation, and amortization (“EBITDA”) are summarized as follows:
| For the three months ended | For the nine months ended | |||||||||||||||||||||||||||||
| February 28, | February 28, | |||||||||||||||||||||||||||||
| $ in millions | 2023 | 2022 | Change | 2023 | 2022 | Change | ||||||||||||||||||||||||
| Net income | $ | 467.4 | $ | 430.7 | 9 | % | $ | 1,206.9 | $ | 1,096.4 | 10 | % | ||||||||||||||||||
| Non-GAAP adjustments: | ||||||||||||||||||||||||||||||
| Excess tax benefits related to employee stock-based compensation payments(1) | (0.7 | ) | (5.2 | ) | (8.9 | ) | (17.9 | ) | ||||||||||||||||||||||
| Tax benefit derived from research and development costs (3) | — | (6.1 | ) | — | (6.1 | ) | ||||||||||||||||||||||||
| Total non-GAAP adjustments | (0.7 | ) | (11.3 | ) | (8.9 | ) | (24.0 | ) | ||||||||||||||||||||||
| Adjusted net income | $ | 466.7 | $ | 419.4 | 11 | % | $ | 1,198.0 | $ | 1,072.4 | 12 | % | ||||||||||||||||||
| Diluted earnings per share(2) | $ | 1.29 | $ | 1.19 | 8 | % | $ | 3.33 | $ | 3.02 | 10 | % | ||||||||||||||||||
| Non-GAAP adjustments: | ||||||||||||||||||||||||||||||
| Excess tax benefits related to employee stock-based compensation payments(1) | — | (0.01 | ) | (0.02 | ) | (0.05 | ) | |||||||||||||||||||||||
| Tax benefit derived from research and development costs (3) | — | (0.02 | ) | — | (0.02 | ) | ||||||||||||||||||||||||
| Total non-GAAP adjustments | — | (0.03 | ) | (0.02 | ) | (0.07 | ) | |||||||||||||||||||||||
| Adjusted diluted earnings per share | $ | 1.29 | $ | 1.15 | 12 | % | $ | 3.31 | $ | 2.95 | 12 | % | ||||||||||||||||||
| Net income | $ | 467.4 | $ | 430.7 | 9 | % | $ | 1,206.9 | $ | 1,096.4 | 10 | % | ||||||||||||||||||
| Non-GAAP adjustments: | ||||||||||||||||||||||||||||||
| Interest (income)/expense, net | (5.8 | ) | 8.5 | (3.0 | ) | 26.4 | ||||||||||||||||||||||||
| Income taxes | 150.0 | 123.6 | 377.7 | 339.4 | ||||||||||||||||||||||||||
| Depreciation and amortization expense | 44.2 | 48.4 | 132.5 | 142.7 | ||||||||||||||||||||||||||
| Total non-GAAP adjustments | 188.4 | 180.5 | 507.2 | 508.5 | ||||||||||||||||||||||||||
| EBITDA | $ | 655.8 | 611.2 | 7 | % | $ | 1,714.1 | $ | 1,604.9 | 7 | % |
(1) Excess tax 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.
(2) 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.
(3) Non-recurring tax benefit derived from prior years' research and development costs incurred in the production of customer-facing software.
In addition to reporting net income and diluted earnings per share, which are U.S. GAAP measures, we present adjusted net income, adjusted diluted earnings per share, and EBITDA, which are non-GAAP measures. We believe these additional measures are indicators of our core business operations’ performance period over period. Adjusted net income, adjusted diluted earnings per share, and 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 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, 2023, our financial position remained strong with cash, restricted cash, and total corporate investments of $1.6 billion. Total short-term and long-term borrowings, net of debt issuance costs, were $808.3 million as of February 28, 2023. Our primary source of cash is our ongoing operations. Cash flow from operations was $1.3 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, 2023, 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, 2023 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 L of the Notes to Consolidated Financial Statements contained in Item 8 of our Form 10-K for fiscal 2022 for further discussion on our credit facilities.
Details of our credit facilities as of February 28, 2023 were as follows:
| Maximum | February 28, 2023 | ||||||||||||||||
| 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 | September 17, 2026 | $ | 750.0 | - | 750.0 | ||||||||||||
| PNC Bank, National Association (“PNC”) | February 6, 2026 | $ | 250.0 | 10.2 | 239.8 | ||||||||||||
| Total Lines of Credit Outstanding and Available | $ | 10.2 | $ | 1,989.8 |
Amounts outstanding under the PNC credit facility as of February 28, 2023 remain outstanding as of the date of this report.
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, 2023 | ||||||||||||||||||
| Credit Facility | ||||||||||||||||||
| $1 Billion | $750 Million | $250 Million | ||||||||||||||||
| $ in millions | JPM | JPM | PNC | |||||||||||||||
| Number of days borrowed | — | — | 90 | |||||||||||||||
| Maximum amount borrowed | $ | — | $ | — | $ | 10.2 | ||||||||||||
| Weighted-average amount borrowed | $ | — | $ | — | $ | 10.0 | ||||||||||||
| Weighted-average interest rate | — | % | — | % | 5.52 | % |
| For the three months ended February 28, 2022 | ||||||||||||||||||
| Credit Facility | ||||||||||||||||||
| $1 Billion | $750 Million | $250 Million | ||||||||||||||||
| $ in millions | JPM | JPM | PNC | |||||||||||||||
| Number of days borrowed | — | — | 90 | |||||||||||||||
| Maximum amount borrowed | $ | — | $ | — | $ | 8.8 | ||||||||||||
| Weighted-average amount borrowed | $ | — | $ | — | $ | 8.6 | ||||||||||||
| Weighted-average interest rate | — | % | — | % | 1.25 | % |
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.
On February 3, 2023, we and Paychex Advance LLC, a Paychex subsidiary and New York limited liability company, entered into Amendment No. 2 (the “Amendment”) to the $250 million, three-year, unsecured, revolving credit facility established on February 6, 2020 (the “2020 Credit Facility”) for which PNC Bank, N.A. acts as administrative agent.
The Amendment, among other things, extended the maturity date of the 2020 Credit Facility from February 6, 2023 to February 6, 2026 at which time all borrowings thereunder will terminate. Except for extending the maturity date and making ministerial changes to the 2020 Credit Facility, the Amendment did not change the existing terms of the 2020 Credit Facility.
Subsequent to February 28, 2023, there were no additional 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 2022 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, 2023, we had irrevocable standby letters of credit available totaling $141.7 million, required to secure commitments for certain insurance policies. The letters of credit expire at various dates between April 1, 2023 and February 5, 2024. No amounts were outstanding on these letters of credit during the third quarter or as of February 28, 2023.
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 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 M of the Notes to Consolidated Financial Statements contained in Item 8 of our Form 10-K for fiscal 2022 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 $10.2 million of capital assets as of February 28, 2023. 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, 2023, we have contributed approximately $21.9 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, 2023. 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 millions | 2023 | 2022 | Change | ||||||||||||
| Net cash provided by operating activities | $ | 1,290.1 | $ | 1,168.3 | $ | 121.8 | |||||||||
| Net cash provided by/(used in) investing activities | 362.4 | (1,168.1 | ) | 1,530.5 | |||||||||||
| Net cash used in financing activities | (218.5 | ) | (33.4 | ) | (185.1 | ) | |||||||||
| Net change in cash, restricted cash, and equivalents | $ | 1,434.0 | $ | (33.2 | ) | $ | 1,467.2 | ||||||||
| Cash dividends per common share | $ | 2.37 | $ | 1.98 |
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; and
Changes in funding for temporary staffing clients; partially offset by
Net changes in PEO assets and liabilities as a result of increase in worksite employee headcount and the timing of settlement of payroll taxes; and
Various changes in other assets and liabilities.
Investing Cash Flow Activities
The increase in cash provided was primarily related to an increase in the net sales of AFS securities.
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 to the timing of collections and remittances of client funds,
Dividends paid increased compared to the prior year period due to an increase in our cumulative dividend from $1.98 per share to $2.37 per share for the nine months. 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
Change in cash activity related to equity-based plans primarily due to a decrease in the number of stock options exercised during the fiscal 2023 period when compared with the fiscal 2022 period.
The client fund obligations liability will vary based on the timing of collecting client funds and the related required remittance of funds to applicable tax or regulatory agencies for payroll tax administration services and to employees of clients utilizing employee payment services. Collections from clients are typically remitted from one to 30 days after receipt, with some items extending to 90 days.
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, 2023, our primary short-term investment vehicles were bank demand deposit accounts, VRDNs, and commercial paper. 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, 2023, the average interest rate earned on our combined funds held for clients and corporate cash equivalents and investment portfolios was 2.4% compared to 1.1% 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, 2023 had an average duration of 3.1 years, would not reflect increases in interest rates until the investments are sold or mature and the proceeds are reinvested at higher rates.
The amortized cost and fair value of AFS securities that had stated maturities as of February 28, 2023 are shown below by expected maturity.
| February 28, 2023 | ||||||||||
| Amortized | Fair | |||||||||
| In millions | cost | value | ||||||||
| Maturity date: | ||||||||||
| Due in one year or less | $ | 388.8 | $ | 384.7 | ||||||
| Due after one year through three years | 846.6 | 803.7 | ||||||||
| Due after three years through five years | 1,844.3 | 1,695.6 | ||||||||
| Due after five years | 611.7 | 576.9 | ||||||||
| Total | $ | 3,691.4 | $ | 3,460.9 |
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, 2023, the Federal Funds rate was in the range of 4.50% to 4.75%. Effective March 23, 2023, the Federal Reserve raised the Federal Funds rate 25 basis points placing it in the range of 4.75% to 5.00%. 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 concerns over inflation risk and the failure of financial institutions. 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 to address inflation and/or intervene to support financial markets;
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 $6.0 billion for the year ending May 31, 2023. Our anticipated allocation is approximately 40% invested in short-term securities and VRDNs with an average duration of less than 30 days and 60% 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 $230.5 million as of February 28, 2023 and $136.3 million as of May 31, 2022. During the nine months ended February 28, 2023, the net unrealized loss on our investment portfolios ranged from a loss of $126.5 million to a loss of $263.6 million. These fluctuations were driven by changes in market rates of interest. The net unrealized loss on our investment portfolio was approximately $179.0 million as of March 27, 2023.
As of February 28, 2023 and May 31, 2022, we had $3.5 billion and $4.0 billion, respectively, invested in AFS securities at fair value. The weighted-average yield-to-maturity was 2.5% as of February 28, 2023 and 1.9% as of May 31, 2022. 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, 2023, would be in the range of $20.0 million to $25.0 million.
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.
We are also exposed to interest rate risk through the use of our credit facilities as outlined in the Liquidity and Capital Resources section of this Form 10-Q. If interest rates were to increase, or we increase the frequency or amounts borrowed under these credit facilities, we could experience additional interest expense and a corresponding decrease in earnings.
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, 2023 were not impaired as a result of the previously discussed reasons. While $3.2 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 $231.3 million were due to changes in interest rates and were not due to increased credit risk or other valuation concerns. A substantial portion of the AFS securities in an unrealized loss position as of February 28, 2023 and May 31, 2022 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 was material in respect to total accounts receivable, service revenue, or results of operations as of February 28, 2023.
Market risk: Subsequent to February 28, 2023, the U.S. banking market has experienced increased volatility as a result of several highly publicized distressed or closed banks, the most significant of these being Silicon Valley Bank. We have an ongoing monitoring system for financial institutions we conduct business with and maintain cash balances at large well-capitalized (as defined by their regulators) financial institutions. We continue to closely monitor this situation and take appropriate measures, when necessary, to minimize potential risk exposure to our client’s and our cash and investment balances. We have not realized any losses as a result of this increased market volatility.
CRITICAL ACCOUNTING POLICIES
Our critical accounting policies are described in Item 7 of our Form 10-K for fiscal 2022, filed with the SEC on July 15, 2022. 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.
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