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 August 31, 2022 (the "first quarter"), the prior year period ended
August 31, 2021 (the "prior year period"), and our financial condition as of
August 31, 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 August
31, 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, 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," "overview," "outlook," "guidance," "we look
forward to," "will," "would," "project," "projections," "strategy,"
"anticipate," "believe," "could," "may," "target," "potential," "strive,"
"mission," 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 products and services;
•
software defects, undetected errors, and development delays for our products;
•
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 the COVID-19 pandemic and other 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.
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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 first 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")
software solutions for human resources ("HR"), payroll, benefits, and insurance
services for small- to medium-sized businesses in the United States ("U.S."). 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. Our purpose is to allow our customers the freedom to succeed.
The workplace is evolving, and we lead the way by making complex HR, payroll,
and benefits simple for our clients.
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. 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 solutions to
help our clients plan, manage, and comply with all aspects of HR.
Our portfolio of HCM and employee benefit-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 mission is to be the leading provider of 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. We believe that success in this
mission will lead to strong, long-term financial performance. Our strategy
focuses on providing industry-leading, integrated technology; increasing client
satisfaction; expanding our leadership in HR; growing our client bases; and
engaging in strategic acquisitions.
We continue to focus on driving growth in the number of clients, revenue per
client, total revenue, and profit, while providing industry-leading technology
solutions and 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
leading-edge technology. We believe these investments are critical to our
success. Looking to the future, we believe that investing in our products,
people, and service capabilities will position us to capitalize on opportunities
for long-term growth.
We closely monitor the evolving challenges and needs of small- and mid-sized
businesses. As a leader in innovative technology solutions, we provide employers
with the digital tools and HR expertise to hire, engage, train, and retain top
talent in this challenging workforce environment. We continue to find
opportunities to innovate our HCM solutions to help our customers address these
challenges. An example of our innovative technology is our recently introduced,
industry first, Paychex Voice Assist. Paychex Voice Assist enables payroll
administrators to run payroll through any Google Assistant-compatible device for
a hands-free experience, simplifying and automating the payroll process with the
sound of a verified user's voice. Capabilities of the feature include starting a
pay period or acting on one already in progress, applying standard pay, pay
adjustments, reviewing totals, and submitting payroll for processing through a
robust and resilient artificial intelligence ("AI") assistant with built-in
verifications for user authentication.
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First Quarter Business Highlights
Highlights compared to the prior year period are as follows:
For the three months ended
August 31,
In millions, except per share amounts 2022 2021 Change(2)
Total service revenue $ 1,188.3 $ 1,068.4 11 %
Total revenue $ 1,206.2 $ 1,082.9 11 %
Operating income $ 495.6 $ 442.9 12 %
Net income $ 379.2 $ 333.6 14 %
Adjusted net income(1) $ 371.9 $ 323.2 15 %
Diluted earnings per share $ 1.05 $ 0.92 14 %
Adjusted diluted earnings per share(1) $ 1.03 $ 0.89 16 %
Dividends paid to stockholders $ 284.6 $ 238.1 20 %
(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 first quarter and
prior year period, and our financial position as of August 31, 2022, 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
August 31,
In millions, except per share amounts 2022 2021 Change(1)
Revenue:
Management Solutions $ 905.5 $ 805.5 12 %
PEO and Insurance Solutions 282.8 262.9 8 %
Total service revenue 1,188.3 1,068.4 11 %
Interest on funds held for clients 17.9 14.5 24 %
Total revenue 1,206.2 1,082.9 11 %
Total expenses 710.6 640.0 11 %
Operating income 495.6 442.9 12 %
Other (expense)/income, net (3.6 ) 1.0 n/m %
Income before income taxes 492.0 443.9 11 %
Income taxes 112.8 110.3 (2 ) %
Effective income tax rate 22.9 % 24.9 %
Net income $ 379.2 $ 333.6 14 %
Diluted earnings per share $ 1.05 $ 0.92 14 %
(1) Percentage changes are calculated based on unrounded numbers.
The changes in revenue as compared to the prior year period were primarily
driven by the following factors:
•
Management Solutions revenue: $905.5 million for the first quarter, reflecting
an increase of 12%:
o
Growth in the number of client employees served for HCM and additional worksite
employees for HR Solutions;
o
Improved revenue per client resulting from price realization and higher product
penetration, including strong demand for HR Solutions, retirement, and time and
attendance solutions; and
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o
Expansion of HCM ancillary services.
•
PEO and Insurance Solutions revenue: $282.8 million for the first quarter,
reflecting an increase of 8%:
o
Growth in the number of average worksite employees; and
o
Increase in PEO health insurance revenue.
•
Interest on funds held for clients and Corporate investment income: $17.9
million for the first quarter, reflecting an increase of 24% due to higher
average invested balances and 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
August 31,
$ in millions 2022 2021 Change(1)
Average investment balances:
Funds held for clients $ 4,118.0 $ 3,897.5 6 %
Corporate cash equivalents and
investments 1,394.6 1,197.1 16 %
Total $ 5,512.6 $ 5,094.6 8 %
Average interest rates earned (exclusive
of net realized gains):
Funds held for clients 1.7 % 1.5
%
Corporate cash equivalents and
investments 1.5 % 0.1
%
Combined funds held for clients and
corporate cash equivalents and
investments 1.7 % 1.1 %
Total net realized gains $ 0.1 $ 0.1
(1) Percentage changes are calculated based on unrounded numbers.
August 31, May 31,
$ in millions 2022 2022
Net unrealized losses on available for sale ("AFS")
securities (1)
$ (175.6 ) $ (136.3 )
Federal Funds rate (2) 2.50 % 1.00 %
Total fair value of AFS securities $ 2,724.8 $
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) 1.9 % 1.9 %
(1) The net unrealized loss on our investment portfolio was approximately $244.6
million as of September 27, 2022.
(2) The Federal Funds rate was in the range of 2.25% to 2.50% as of August 31,
2022 and in the range of 0.75% to 1.00% as of May 31, 2022. Effective September
22, 2022, the Federal Reserve increased the Federal Funds rate to a range of
3.00% to 3.25%.
(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 period
below:
For the three months ended
August 31,
In millions 2022 2021 Change(1)
Compensation-related expenses $ 426.6 $ 382.9 11 %
PEO insurance costs 104.5 96.0 9 %
Depreciation and amortization 44.0 45.7 (4 ) %
Other expenses 135.5 115.4 17 %
Total expenses $ 710.6 $ 640.0 11 %
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(1) Percentage changes are calculated based on unrounded numbers.
Total expenses increased 11% to $710.6 million for the first quarter compared to
the prior year period. Total expenses increased as a result of the following:
•
Compensation-related expenses: $426.6 million for the first quarter, reflecting
an increase of 11%, due to increases in headcount and wage rates.
•
PEO insurance costs: $104.5 million for the first quarter, reflecting an
increase of 9%, as a result of higher health insurance enrollment.
•
Other expenses: $135.5 million for the first quarter, reflecting an increase and
17%, due to general cost increases to support business growth.
Operating income: Operating income increased 12% to $495.6 million for the first
quarter, as a result of double-digit revenue growth which outpaced expense
increases as previously discussed.
Operating margin (operating income as a percentage of total revenue) was as
follows:
For the three months ended
August 31,
2022 2021
Operating margin 41.1 % 40.9 %
Fluctuations in this metric was attributable to the factors previously
discussed.
Income taxes: Our effective income tax rate was 22.9% for the first quarter,
compared to 24.9%, for the prior year period. Both periods were impacted by the
recognition of excess tax benefits related to employee stock-based compensation
payments. The prior year period was also impacted by an increase in state taxes.
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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
August 31,
$ in millions 2022 2021 Change
Net income $ 379.2 $ 333.6 14 %
Non-GAAP adjustments:
Excess tax benefits related to employee
stock-based compensation payments(1) (7.3 ) (10.4 )
Adjusted net income $ 371.9 $
323.2 15 %
Diluted earnings per share(2) $ 1.05 $ 0.92 14 %
Non-GAAP adjustments:
Excess tax benefits related to employee
stock-based compensation payments(1) (0.02 ) (0.03 )
Adjusted diluted earnings per share $ 1.03 $ 0.89 16 %
Net income $ 379.2 $ 333.6 14 %
Non-GAAP adjustments:
Interest expense, net 3.7 9.0
Income taxes 112.8 110.3
Depreciation and amortization expense 44.0 45.7
Total non-GAAP adjustments 160.5 165.0
EBITDA $ 539.7 $ 498.6 8 %
(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.
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 August 31, 2022, our financial position remained strong with cash,
restricted cash, and total corporate investments of $1.3 billion. Total
short-term and long-term borrowings, net of debt issuance costs, were $808.1
million as of August 31, 2022. Our primary source of cash is our ongoing
operations. Cash flow from operations was $364.3 billion for the first quarter.
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 August 31, 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 August 31,
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.
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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 August 31, 2022 were as follows:
Maximum August 31, 2022
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 February
("PNC") 6, 2023 $ 250.0 10.3 239.7
Total Lines of Credit Outstanding and
Available $ 10.3 $ 1,989.7
Amounts outstanding under the PNC credit facility as of August 31, 2022 remain
outstanding as of the date of this report.
Details of borrowings under each credit facility during the first quarter and
the prior year period were as follows:
For the three
months ended August 31, 2022
Credit Facility
$1 Billion $750 Million $250 Million
$ in millions JPM JPM PNC
Number of days borrowed - - 92
Maximum amount borrowed $ - $ - $ 10.6
Weighted-average amount borrowed $ - $ - $ 10.2
Weighted-average interest rate - % - % 3.15 %
For the three months ended August 31, 2021
Credit Facility
$1 Billion $750 Million $250 Million
$ in millions JPM JPM PNC
Number of days borrowed - - 92
Maximum amount borrowed $ - $ - $ 106.5
Weighted-average amount borrowed $ - $ - $ 8.3
Weighted-average interest rate - % - % 1.15 %
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 August 31, 2022, 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.
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Letters of credit: As of August 31, 2022, we had irrevocable standby letters of
credit available totaling $140.2 million, required to secure commitments for
certain insurance policies. The letters of credit expire at various dates
between November 9, 2022 and August 24, 2023. No amounts were outstanding on
these letters of credit during the first quarter or as of August 31, 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 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 $7.6 million of capital
assets as of August 31, 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 August 31, 2022, we have
contributed approximately $19.0 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 August 31, 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 three months ended
August 31,
In millions 2022 2021 Change
Net cash provided by operating activities $ 364.3 $ 385.6 $ (21.3 )
Net cash provided by/(used in) investing
activities 1,223.1 (22.3 ) 1,245.4
Net cash used in financing activities (809.7 ) (211.7 ) (598.0 )
Net change in cash, restricted cash, and
equivalents $ 777.7 $
151.6 $ 626.1
Cash dividends per common share $ 0.79 $ 0.66
The changes in our cash flow for the first quarter 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; partially offsets
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•
Cash outflow for changes in funding for temporary staffing clients; and
•
Cash outflow for 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 VRDNs, that were reinvested into cash/money market accounts due to more
favorable interest rates;
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 of client funds,
•
Dividends paid increased compared to the prior year period due to an increase in
our quarterly dividend from $0.66 per share to $0.79 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 cash inflows from 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 first quarter, 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 first quarter, the average interest rate earned on our combined funds
held for clients and corporate cash equivalents and investment portfolios was
1.7% 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 August 31, 2022 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.
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The amortized cost and fair value of AFS securities that had stated maturities
as of August 31, 2022 are shown below by expected maturity.
August 31, 2022
Amortized Fair
In millions cost value
Maturity date:
Due in one year or less $ 289.4 $ 288.4
Due after one year through three years 746.9 728.0
Due after three years through five years 1,421.1 1,312.3
Due after five years 443.0 396.1
Total $ 2,900.4 $ 2,724.8
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 August 31, 2022, the Federal Funds rate was in the range of 2.25% to
2.50%. Effective September 22, 2022, the Federal Reserve raised the Federal
Funds rate 75 basis points placing it in the range of 3.00% to 3.25%. 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. 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;
•
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 $4.5 million to $5.0 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 ended May 31, 2023. 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 $175.6 million as of August 31, 2022 and $136.3 million as
of May 31, 2022. During the first quarter, the net unrealized loss on our
investment portfolios ranged from a loss of $126.5 million to a loss of $197.3
million. These fluctuations were driven by changes in market rates of interest.
The net unrealized loss on our investment portfolio was approximately $244.6
million as of September 27, 2022.
As of August 31, 2022 and May 31, 2022, we had $2.7 billion and $4.0 billion,
respectively, invested in AFS securities at fair value. The weighted-average
yield-to-maturity was 1.9% as of August 31, 2022 and as of May 31, 2022,
respectively. 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
August 31, 2022, would be in the range of $20.0 million to $25.0 million.
25
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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 August 31, 2022 were not
impaired as a result of the previously discussed reasons. While $2.7 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
$175.6 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 August 31, 2022 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 is material in respect to total accounts
receivable, service revenue, or results of operations as of August 31, 2022.
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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