PAYCHEX INC - Annual Report: 2018 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

_____________________________

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES

EXCHANGE ACT OF 1934

For the fiscal year ended May 31, 2018

Commission file number 0-11330

 ____________________________

Paychex, Inc.

911 Panorama Trail South

Rochester, New York 14625-2396

(585) 385-6666

A Delaware Corporation

IRS Employer Identification Number: 16-1124166

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes ☑    No ☐

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ☐    No ☑

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes ☑    No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes ☑    No ☐

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10‑K.    ☑

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.    ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes ☐    No ☑

As of November 30, 2017, the last business day of the most recently completed second fiscal quarter, shares held by non-affiliates of the registrant had an aggregate market value of $21,553,152,555 based on the closing price reported for such date on the NASDAQ Global Select Market.

As of June 30, 2018, 358,999,129 shares of the registrant’s common stock, $.01 par value, were outstanding.

Documents Incorporated by Reference

Portions of the registrant’s definitive proxy statement to be issued in connection with its Annual Meeting of Stockholders to be held on or about October 11, 2018, to the extent not set forth herein, are incorporated by reference into Part III, Items 10 through 14, inclusive. 



 

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PAYCHEX, INC.

INDEX TO FORM 10-K

For the fiscal year ended May 31, 2018



 



 

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PART I

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS PURSUANT TO THE UNITED STATES PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

Certain written and oral statements made by management of Paychex, Inc. and its wholly owned subsidiaries (“we,” “our,” “us,” “Paychex,” or the “Company”) 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,” “overview,” “current outlook,” “we look forward to,” “would equate to,” “projects,” “projections,” “projected to be,” “anticipates,” “anticipated,” “we believe,” “believes,” “could be,” 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 conditions 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:





























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Any of these factors, as well as such other factors as discussed in Part I, Item 1A, “Risk Factors” and throughout Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10‑K (“Form 10-K”), as well as in our periodic filings with the Securities and Exchange Commission (the “SEC”), could cause our actual results to differ materially from our anticipated results. The information provided in this Form 10‑K is based upon the facts and circumstances known at this time, and any forward-looking statements made by us in this Form 10‑K 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-K with the SEC to reflect events or circumstances after such date, or to reflect the occurrence of unanticipated events.



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Item 1.    Business

Incorporated in Delaware in 1979, we are a leading provider of integrated human capital management (“HCM”) solutions for payroll, human resource (“HR”), retirement, and insurance services for small- to medium-sized businesses. As of May 31, 2018, we served over 650,000 payroll clients. We maintain our corporate headquarters in Rochester, New York, and serve clients throughout the U.S. and Europe. We report our results of operations and financial condition as one business segment. Our fiscal year ends May 31st.

Company Strategy

Our mission is to be the leading provider of HCM solutions for payroll, HR, retirement, and insurance services for small- to medium-sized businesses by being an essential partner with America’s businesses.  We believe that success in this mission will lead to strong, long-term financial performance.  Our business strategy focuses on the following:

Our Clients

The target market for our integrated HCM solutions is in the small- to mid-market space. Within this space, we serve a diverse base of small- to medium-sized clients operating in a broad range of industries located throughout the U.S. and Europe. Our clients have the option to select the HCM modules they need with the ability to easily add services as they grow. They can also opt for our comprehensive HR and payroll outsourcing solutions, Paychex HR Services. This flexibility allows our clients to define the solution that best meets their needs. We utilize service agreements and arrangements with clients that are generally terminable by the client at any time or upon relatively short notice. For the fiscal year ended May 31, 2018 (“fiscal 2018”), client retention was approximately 81% of our beginning client base for the fiscal year, consistent with a year ago.

We support our small-business clients in reducing the complexity and risk of running their own payroll, while ensuring greater accuracy with up-to-date tax rates and regulatory information. We simplify their payroll with a combination of our dynamic products and customer service options for a quick and easy payday. Clients can choose to have our service team handle everything for them, or can process payroll themselves utilizing our robust Paychex Flex® processing platform or SurePayroll®  online applications. Both products are cloud-based software-as-a-service (“SaaS”) solutions that allow users to do payroll when they want, how they want, and on any device (desktop, tablet, and mobile phone).

With an environment of increasing regulations, the need for HR outsourcing services is moving down-market.  Our small-business clients benefit from our time and attendance products, which allow them to accurately and efficiently manage the gathering and recording of employee hours worked.  Our advanced suite of time and attendance products, including web and mobile tools, assist companies with the scheduling, tracking, and reporting of time.

Our mid-market clients have more complex payroll and employee benefit needs. Our mid-market clients are serviced through our Paychex Flex Enterprise solution, which offers an integrated suite of HCM solutions on the Paychex Flex platform, or through our legacy platform.  All new clients are sold on the Paychex Flex platform.  Clients using Paychex Flex Enterprise are offered a SaaS solution that integrates payroll processing with HR management, employee benefits administration, time and labor management, applicant tracking, and onboarding solutions.  Paychex Flex Enterprise allows mid-market clients to choose the services and software they need to meet the complexity of the business and have them integrated through one HCM solution.

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Description of Services

We offer a comprehensive portfolio of HCM services and products that allow our clients to meet their diverse payroll and HR needs. Clients can select services on an á la carte basis or as part of various product bundles. Our offerings often leverage the information gathered in our base payroll processing service, allowing us to provide comprehensive outsourcing services covering the HCM spectrum.

Our portfolio of HCM and employee benefit-related services are comprised of the following:

Our PEO differs from the ASO in that we serve as a co-employer of our clients’ employees, offer health care coverage to PEO client employees, and assume the risks and rewards of workers’ compensation insurance and certain health insurance offerings. PEO services are sold through our registered and licensed subsidiary, Paychex Business Solutions, LLC and HR Outsourcing Holdings, Inc., which was acquired in August 2017. We are certified under the Small Business Efficiency Act to provide PEO services. We also offer Paychex HR Essentials, which is an ASO product that provides support to our clients over the phone or online to help manage employee-related topics.  As of May 31, 2018, Paychex HR Services was utilized by approximately 41,000 clients with approximately 1,157,000 client worksite employees.

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We also offer comprehensive solutions to help employers and employees with certain mandates under the Affordable Care Act (“ACA”), which sets forth specific coverage and reporting requirements that employers must meet.  Our Paychex Employer Shared Responsibility (“ESR”) Service is aimed at helping clients: 1) determine if the ACA’s ESR provision applies to them; 2) provide ongoing ACA analysis and monitoring, along with automatic alerts, of their employees and hours worked; 3) evaluate if their health care offering meets the minimum coverage requirement; and 4) prepare and file end-of-year reporting.

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Technology and Service Platform

Paychex Flex is our proprietary HCM SaaS platform through which we provide an integrated product suite that covers the employee life cycle from recruiting and hiring to retirement. Paychex Flex streamlines workforce management through innovative technology and flexible choice of service. It uses a single cloud-based platform, with single client and employee records and single sign-on, including self-service options and mobility applications. The HCM product suite integrates recruiting and applicant tracking, employee onboarding, payroll, employee benefits and HR administration, time and attendance, and retirement services. In addition, Paychex Flex presents function-focused analytics throughout the platform, assisting HR leaders with making more informed business decisions.  Paychex Flex also provides technology-enabled service, with options that include self-service, a 24/7 dedicated service center, an individual payroll specialist, and integrated service via a multi-product service center.  In addition, mid-market clients can utilize a relationship manager for more personalized service.  This flexible platform services our small- to medium-sized clients, and our PEO business.

The integration of flexible service options and leading-edge technology allows us to meet our clients' diverse needs by providing them with information and products when, where, and how they want it.  Our Paychex mobile applications add greater value and convenience for our clients and their employees by allowing them instant access and increased productivity.  Paychex Flex uses a mobile-first design throughout our HCM suite, which allows full functionality of all application components, regardless of device or screen size.  Enabling our clients and their employees to have full access to our products offers diverse capabilities and flexibility for both the employer and employee.

Sales and Marketing

We market and sell our services primarily through our direct sales force based in the metropolitan markets we serve. Our direct sales force includes sales representatives who have defined geographical territories and specialize within our portfolio of services. Our sales representatives are also supported by marketing, advertising, public relations, trade shows, and telemarketing programs. We utilize a virtual sales force to service geographical areas where we may not have a local presence, cover inbound leads for certain small-business clients, or for products for which we do not have a local sales force.

In addition to our direct selling and marketing efforts, we utilize other indirect sales channels such as our relationships with existing clients, certified public accountants (“CPAs”), and banks for new client referrals. Greater than 50% of our new small-market payroll clients (excluding business acquisitions) come from these referral sources. Our dedicated business development group drives sales through banking, national associations, and franchise channels.  We also utilize digital marketing as a means to market our services.

We have a long-standing partnership with the American Institute of Certified Public Accountants (“AICPA”) as the preferred payroll provider for its AICPA Business SolutionsTM Program. Our current partnership agreement with the AICPA is in place through September 2021.  We also partner with various state CPA society organizations.

Our website, which is available at www.paychex.com, includes online payroll sales presentations and service and product information.  It also serves as a cost-efficient tool that serves as a source of leads and new sales, while complementing the efforts of our direct and virtual sales forces. This online tool allows us to market to clients and prospective clients in other geographical areas where we do not have a direct sales presence. In addition, the insurance services section of our website, which is accessible at www.paychex.com/group-health-insurance, provides information to help small businesses navigate the insurance industry, and generates leads by allowing interested parties to get in contact with one of our professional insurance agents.

Paychex also builds on its reputation as an expert in the HCM industry by providing education and assistance to clients and other interested parties. We provide free webinars, white papers, and other information on our website to aid existing and prospective clients with the impacts of regulatory change. We track current regulatory issues that impact the business community and provide a monthly regulatory update. Our Paychex Accountant Knowledge Center is a free online resource available through our website that brings valuable information and time-saving online tools to accounting professionals. Through the Paychex Flex online platform, AccountantHQ offers access to authorized client payroll and HR data and key account contacts, along with an extensive accountant resource library. AccountantHQ drives efficiency by putting accountants in the best position possible to easily access critical client payroll and HR data and powerful reporting tools. Our Paychex WORX website, available at www.paychex.com/worx, is a digital destination for insightful resources useful for businesses at every stage, from entrepreneur to enterprise. Paychex WORX highlights the breadth of our product line, expertise, and ability to help businesses of all sizes with a wide range of HR and financial information for current clients and prospects alike.

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Markets and Competition

We remain focused on servicing small- to medium-sized businesses based upon the growth potential that we believe exists in the markets we serve. Our internal database source indicates that there are approximately 11 million addressable businesses in the geographic markets that we currently serve within the U.S. Of those businesses, approximately 99% have fewer than 100 employees and comprise our primary customers and target market. We believe that there is opportunity for us in the HCM market as the demand is moving down-market to smaller businesses.

The market for HCM services is highly competitive and fragmented. We have one primary national competitor and we also compete with other national, regional, local, and online service providers. In addition to traditional payroll processing and HR service providers, we compete with in-house payroll and HR systems and departments. Payroll and HR systems and software are sold by many vendors. Human Resource Services (“HRS”) products also compete with a variety of providers of HR services, such as retirement services companies, insurance companies, and HR and benefits consulting firms.

Competition in the payroll processing and HR services industry is primarily based on service responsiveness, product quality and reputation, including ease of use and accessibility of technology, breadth of service and product offerings, and price. We believe we are competitive in each of these areas.  We believe that our excellent customer service, together with our leading-edge technology and mobility applications, distinguishes us from our competitors.

Software Maintenance and Development

The ever-changing mandates of federal, state, and local tax and regulatory agencies require us to regularly update our proprietary software to provide payroll and HR services to our clients. We are continually engaged in developing enhancements to and the maintenance of our various software platforms to meet the changing requirements of our clients and the marketplace. We continue to enhance our SaaS solutions and mobility applications to offer our users an integrated and unified experience.  Continued enhancement of the client and client employee experience is important to our future success.

Employees

We believe our ability to attract and retain qualified employees in all areas of our business is important to our future success and growth. As of May 31, 2018, we employed approximately 14,300 people.  None of our employees were covered by collective bargaining agreements.

Intellectual Property

We own or license and use a number of trademarks, trade names, copyrights, service marks, trade secrets, computer programs and software, and other intellectual property rights. Taken as a whole, our intellectual property rights are material to the conduct of our business. Where it is determined to be appropriate, we take measures to protect our intellectual property rights, including, but not limited to, confidentiality/non-disclosure agreements or policies with employees, vendors, and others; license agreements with licensees and licensors of intellectual property; and registration of certain trademarks. We believe that the “Paychex” name, trademark, and logo are of material importance to us.

Seasonality

There is no significant seasonality to our business. However, during our third fiscal quarter, which ends in February, the number of new payroll clients, new retirement services clients, and new Paychex HR Services worksite employees tends to be higher than during the rest of the fiscal year, primarily because many new clients prefer to start using our services at the beginning of a calendar year. In addition, calendar year-end transaction processing and client funds activity are traditionally higher during our third fiscal quarter due to clients paying year-end bonuses and requesting additional year-end services.

Available Information

We are subject to the informational and reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Therefore, we file periodic reports, proxy statements, and other information with the SEC. Such reports may be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at (800) SEC-0330. The SEC also maintains a website (www.sec.gov) that includes our reports, proxy statements, and other information. The information on our website is not incorporated by reference into our Form 10-K.

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Our corporate website, www.paychex.com, provides materials for investors and information about our services. Our Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and other SEC filings, as well as any amendments to such reports and filings, are made available, free of charge, on our website as soon as reasonably practicable after such reports have been filed with or furnished to the SEC. Also, copies of our Annual Report to Stockholders and Proxy Statement, to be issued in connection with our 2018 Annual Meeting of Stockholders, will be made available, free of charge, upon written request submitted to Paychex, Inc., c/o Corporate Secretary, 911 Panorama Trail South, Rochester, New York 14625-2396.

 

Item 1A.    Risk Factors

Our future results of operations are subject to a number of risks and uncertainties. These risks and uncertainties could cause actual results to differ materially from historical and current results, and from our projections. The risk factors described below represent our current view of some of the most important risks facing our business and are important to understanding our business. The risks described below are not the only risks we face. Additional factors not presently known to us or that we currently deem to be immaterial also may adversely affect, possibly to a material extent, our business, cash flows, financial condition, or results of operations in future periods. In addition, you should refer to the description of forward-looking statements at the beginning of Part I of this Form 10-K.

Our services may be adversely impacted by changes in government regulations and policies.    Many of our services, particularly payroll tax administration services and employee benefit plan administration services, are designed according to government regulations that continually change, for example, the ambiguity surrounding the Department of Labor’s fiduciary rule for retirement plan service. Changes in regulations could affect the extent and type of benefits employers are required, or may choose, to provide employees or the amount and type of taxes employers and employees are required to pay. Such changes could reduce or eliminate the need for some of our services and substantially decrease our revenue. Added requirements could also increase our cost of doing business. Failure to educate and assist our clients regarding new or revised legislation that impacts them could have an adverse impact on our reputation. Failure by us to modify our services in a timely fashion in response to regulatory changes could have a material adverse effect on our business and results of operations.

Our business and reputation may be adversely impacted if we fail to comply with U.S. and foreign laws and regulations.  Our services are subject to various laws and regulations, including, but not limited to, the ACA and Anti-Money Laundering rules. The growth of our international operations via acquisition also subjects us to additional risks, such as compliance with the Foreign Corrupt Practices Act and United Kingdom Bribery Act. As of this fiscal year, the financial impact of our international operations to our overall business has been insignificant. However, over time, our international operations may grow and increase their significance to our business. Uncertainty regarding the potential future modifications of existing laws and regulations can also adversely affect our business. There is uncertainty regarding the potential future evolution and modification of the ACA. Failure to update our services to comply with modified or new legislation in the area of health care reform as well as failure to educate and assist our clients regarding this legislation could adversely impact our business reputation and negatively impact our client base. Failure to comply with laws and regulations could result in the imposition of consent orders or civil and criminal penalties, including fines, which could damage our reputation and have an adverse effect on our results of operations or financial condition.  We have policies and procedures to monitor our compliance with U.S. and foreign laws and regulations throughout the business and our acquisitions.

We may not be able to keep pace with changes in technology or provide timely enhancements to our products and services.  The market for our products is characterized by rapid technological advancements, changes in customer requirements, frequent new product introductions, and enhancements and changing industry standards. To maintain our growth strategy, we must adapt and respond to technological advances and technological requirements of our clients. Our future success will depend on our ability to: enhance our current products and introduce new products in order to keep pace with products offered by our competitors; enhance capabilities and increase the performance of our internal systems, particularly our systems that meet our clients’ requirements; and adapt to technological advancements and changing industry standards. We continue to make significant investments related to the development of new technology. If our systems become outdated, we may be at a disadvantage when competing in our industry. There can be no assurance that our efforts to update and integrate systems will be successful. If we do not integrate and update our systems in a timely manner, or if our investments in technology fail to provide the expected results, there could be a material adverse effect to our business and results of operations.

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Our reputation, results of operations, or financial condition may be adversely impacted if we fail to comply with data privacy laws and regulations.  Our services require the storage and transmission of proprietary and confidential information of our clients and their employees, including personal or identifying information, as well as their financial and payroll data.  Our applications are subject to various complex government laws and regulations on the federal, state, and local levels, including those governing personal privacy.  In the U.S., we are subject to rules and regulations promulgated under the authority of the Federal Trade Commission, the Health Insurance Portability and Accountability Act of 1996, the Family Medical Leave Act of 1993, the ACA, federal and state labor and employment laws, and state data breach notification laws. In addition, the European Union’s General Data Privacy Regulation became fully effective in May 2018. Failure to comply with such laws and regulations could result in the imposition of consent orders or civil and criminal penalties, including fines, which could damage our reputation and have an adverse effect on our results of operations or financial condition. The regulatory framework for privacy issues is rapidly evolving and future enactment of more restrictive laws, rules, or regulations and/or future enforcement actions or investigations could have a materially adverse impact on us through increased costs or restrictions on our business and noncompliance could result in regulatory penalties and significant legal liability.

We could be subject to reduced revenues, increased costs, liability claims, or harm to our competitive position as a result of cyberattacks, security vulnerabilities or Internet disruptions.  We rely upon information technology (“IT”) networks, cloud-based platforms, and systems to process, transmit, and store electronic information, and to support a variety of business processes.  Cyberattacks and security threats are a risk to our business and reputation.  A privacy or IT security breach could have a material adverse effect on our business.

Data Security and Privacy Leaks:  We collect, use, and retain increasingly large amounts of personal information about our clients, employees of our clients, and our employees, including:  bank account numbers, credit card numbers, social security numbers, tax return information, health care information, retirement account information, payroll information, system and network passwords, and other sensitive personal and business information.  At the same time, the continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security.  Vulnerabilities, threats, and more sophisticated and targeted computer crimes pose a risk to the security of our systems and networks, and the confidentiality, availability, and integrity of our data.

Our service platforms enable our clients to store and process personal data on premise or, increasingly, in a cloud-based environment that we host.  The security of our IT infrastructure is an important consideration in our customers’ purchasing decisions. Because the techniques used to obtain unauthorized access, disable or degrade service or sabotage systems change frequently, are increasingly more complex and sophisticated and may be difficult to detect for long periods of time, we may be unable or fail to anticipate these techniques or implement adequate or timely preventative or responsive measures.  As cyber threats continue to evolve, we are focused on ensuring that our operating environments safeguard and protect personal and business information. We may be required to invest significant additional resources to comply with evolving cybersecurity regulations and to modify and enhance our information security and controls, and to investigate and remediate any security vulnerabilities. While we have security systems and IT infrastructure in place designed to detect and protect against unauthorized access to such information, if our security measures are breached, our business could be substantially harmed and we could incur significant liabilities. Any such breach or unauthorized access could negatively affect our ability to attract new clients, cause existing clients to terminate their agreements with us, result in reputational damage, and subject us to lawsuits, regulatory fines, or other actions or liabilities which could materially and adversely affect our business and operating results.  Third parties, including vendors that provide services for our operations, could also be a source of security risk to us in the event of a failure of their own security systems and infrastructure.

Data Loss and Business Interruption:  If our systems are disrupted or fail for any reason, including Internet or systems failure, or if our systems are infiltrated by unauthorized persons, both the Company and our clients could experience data loss, financial loss, harm to reputation, or significant business interruption. We may be required to incur significant costs to protect against damage caused by disruptions or security breaches in the future. Such events may expose us to unexpected liability, litigation, regulatory investigation and penalties, loss of clients’ business, unfavorable impact to business reputation, and there could be a material adverse effect on our business and results of operations.

In the event of a catastrophe, our business continuity plan may fail, which could result in the loss of client data and adversely interrupt operations.    Our operations are dependent on our ability to protect our infrastructure against damage from catastrophe or natural disaster, severe weather including events resulting from climate change, unauthorized security breach, power loss, telecommunications failure, terrorist attack, or other events that could have a significant disruptive effect on our operations. We have a business continuity plan in place in the event of system failure due to any of these events. Our business continuity plan has been tested in the past by circumstances of severe weather, including hurricanes, floods, and snowstorms, and has been successful. However, these past successes are not an indicator of success in the future. If the business continuity plan is unsuccessful in a disaster recovery scenario, we could potentially lose client data or experience material adverse interruptions to our operations or delivery of services to our clients.

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We may be adversely impacted by any failure of third-party service providers to perform their functions.    As part of providing services to clients, we rely on a number of third-party service providers. These service providers include, but are not limited to, couriers used to deliver client payroll checks and banks used to electronically transfer funds from clients to their employees. Failure by these service providers, for any reason, to deliver their services in a timely manner could result in material interruptions to our operations, impact client relations, and result in significant penalties or liabilities to us.

We may be exposed to additional risks related to our co-employment relationship within our PEO business.    Many federal and state laws that apply to the employer-employee relationship do not specifically address the obligations and responsibilities of the “co-employment” relationship. As a result, there is a possibility that we may be subject to liability for violations of employment or discrimination laws by our clients and acts or omissions of client employees, who may be deemed to be our agents, even if we do not participate in any such acts or violations. Although our agreements with clients provide that they will indemnify us for any liability attributable to their own or their employees’ conduct, we may not be able to effectively enforce or collect such contractual obligations. In addition, we could be subject to liabilities with respect to our employee benefit plans if it were determined that we are not the “employer” under any applicable state or federal laws.

We may be adversely impacted by changes in health insurance and workers’ compensation rates and underlying claims trends.    Within our PEO business, we maintain health and workers’ compensation insurance covering worksite employees. The insurance costs are impacted by claims experience and are a significant portion of our PEO costs. If we experience a sudden or unexpected increase in claims activity, our costs could increase. In addition, in the event of expiration or cancellation of existing contracts, we may not be able to secure replacement contracts on competitive terms. Also, as a co-employer in the PEO, we assume or share many of the employer-related responsibilities associated with health care reform, which may result in increased costs.  Increases in costs not incorporated into service fees timely or fully could have a material adverse effect on our results of operations. Incorporating cost increases into service fees could also impact our ability to attract and retain clients.

Our clients could have insufficient funds to cover payments we have made on their behalf, resulting in financial loss to us.  As part of the payroll processing service, we are authorized by our clients to transfer money from their accounts to fund amounts owed to their employees and various taxing authorities.  It is possible that we could be held liable for such amounts in the event the client has insufficient funds to cover them.  We have in the past, and may in the future, make payments on our clients’ behalf for which we may not be reimbursed, resulting in loss to us.

Our interest earned on funds held for clients may be impacted by changes in government regulations mandating the amount of tax withheld or timing of remittance.    We receive interest income from investing client funds collected but not yet remitted to applicable tax or regulatory agencies or to client employees. A change in regulations either decreasing the amount of taxes to be withheld or allowing less time to remit taxes to applicable tax or regulatory agencies could adversely impact interest income.

We may be adversely impacted by volatility in the political and economic environment.    Trade, monetary and fiscal policies, and political and economic conditions may substantially change, and credit markets may experience periods of constriction and variability. When there is a slowdown in the economy, employment levels and interest rates may decrease or become more volatile. These conditions may impact our business due to lower transaction volumes or an increase in the number of clients going out of business. Current or potential clients may decide to reduce their spending on payroll and other outsourcing services. In addition, new business formation may be affected by an inability to obtain credit.

We invest our funds held for clients in high quality, investment-grade marketable securities, money markets, and other cash equivalents. However, these funds held for clients are subject to general market, interest rate, credit, and liquidity risks.  These risks may be exacerbated during periods of unusual financial market volatility.  The interest we earn on funds held for clients may decrease as a result of a decline in funds available to invest and lower interest rates. In addition, during periods of volatility in the credit markets, certain types of investments may not be available to us or may become too risky for us to invest in, further reducing the interest we may earn on client funds.

Constriction in the credit markets may impact the availability of financing, even to borrowers with the highest credit ratings. Historically, we have periodically borrowed against available credit arrangements to meet short-term liquidity needs. However, should we require additional short-term liquidity during days of large outflows of client funds, a credit constriction may limit our ability to access those funds or the flexibility to obtain them at interest rates that would be acceptable to us. Growth in services for funding payrolls of our clients in the temporary staffing industry may be constricted if access to financing becomes limited.  If all of these financial and economic circumstances were to remain in effect for an extended period of time, there could be a material adverse effect on our results of operations and financial condition.



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We may not be able to attract and retain qualified people, which could impact the quality of our services and customer satisfaction.  Our success, growth, and financial results depend in part on our continuing ability to attract, retain, and motivate highly qualified people at all levels, including management, technical, compliance, and sales personnel. Competition for these individuals can be intense, and we may not be able to retain our key people, or attract, assimilate, or retain other highly-qualified individuals in the future, which could harm our future success.

Failure to protect our intellectual property rights may harm our competitive position and litigation to protect our intellectual property rights or defend against third party allegations of infringement may be costly.  Despite our efforts to protect our intellectual property and proprietary information, we may be unable to do so effectively in all cases. Our intellectual property could be wrongfully acquired as a result of a cyberattack or other wrongful conduct by employees or third parties.  To the extent that our intellectual property is not protected effectively by trademarks, copyrights, patents, or other means, other parties with knowledge of our intellectual property, including former employees, may seek to exploit our intellectual property for their own and others’ advantage. Competitors may also misappropriate our trademarks, copyrights or other intellectual property rights or duplicate our technology and products. Any significant impairment or misappropriation of our intellectual property or proprietary information could harm our business and our brand, and may adversely affect our ability to compete.

We are involved in litigation from time to time arising from the operation of our business and, as such, we could incur substantial judgments, fines, legal fees or other costs. We are sometimes the subject of complaints or litigation from customers, employees or other third parties for various actions. From time to time, we are involved in litigation involving claims related to, among other things, breach of contract, tortious conduct and employment and labor law matters. The damages sought against us in some of these litigation proceedings could be substantial. Although we maintain liability insurance for some litigation claims, if one or more of the claims were to greatly exceed our insurance coverage limits or if our insurance policies do not cover a claim, this could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Quantitative and qualitative disclosures about market risk:    Refer to Item 7A of this Form 10-K for a discussion on Market Risk Factors, which could have a material adverse effect on our business and results of operations.

 

Item 1B.    Unresolved Staff Comments

None.



Item 2.    Properties

We owned and leased the following properties as of May 31, 2018:







Our facilities in Rochester, New York house various distribution, processing, and technology functions, certain ancillary functions, a telemarketing unit, and other back-office functions. Facilities outside of Rochester, New York are at various locations throughout the U.S. and house our branch and sales offices, regional service centers, multi-product service centers, and data processing centers. These locations are concentrated in metropolitan areas. Our international locations primarily house our European branch and sales locations. We believe that adequate, suitable lease space will continue to be available to meet our needs.



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Item 3.    Legal Proceedings

We are subject to various claims and legal matters that arise in the normal course of our business. These include disputes or potential disputes related to breach of contract, tort, patent, breach of fiduciary duty, employment-related claims, tax claims, and other matters.

Our management currently believes that resolution of outstanding legal matters will not have a material adverse effect on our financial position or results of operations. However, legal matters are subject to inherent uncertainties and there exists the possibility that the ultimate resolution of these matters could have a material adverse impact on the Company’s financial position and the results of operations in the period in which any such effect is recorded.



Item 4.    Mine Safety Disclosures

Not applicable.



PART II



Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Our common stock trades on the NASDAQ Global Select Market under the symbol “PAYX”. Dividends have historically been paid on our common stock in August, November, February, and May. The level and continuation of future dividends are dependent on our future earnings and cash flows, and are subject to the discretion of our Board of Directors (the “Board”).

As of June 30, 2018, there were 11,262 holders of record of our common stock, which includes registered holders and participants in the Paychex, Inc. Dividend Reinvestment and Stock Purchase Plan. There were also 4,661 participants in the Paychex, Inc. Employee Stock Purchase Plan and 4,386 participants in the Paychex, Inc. Employee Stock Ownership Plan.

The high and low sales prices for our common stock as reported on the NASDAQ Global Select Market and dividends for fiscal 2018 and the fiscal year ended May 31, 2017 (“fiscal 2017”) are as follows:







The closing price of our common stock as of May 31, 2018, as reported on the NASDAQ Global Select Market, was $65.58 per share.



During fiscal 2018, we maintained a common stock repurchase program authorized by the Board in July 2016 which expires on May 31, 2019. In addition, during fiscal 2017, we maintained a second common stock repurchase plan authorized by the Board in May 2014 which expired on May 31, 2017. Both programs allow us to repurchase up to $350.0 million of our common stock. Shares repurchased under these programs during fiscal 2018 and fiscal 2017 were as follows:



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As of May 31, 2018, the approximate dollar value of common stock shares available for repurchase under the program authorized in July 2016 is $100.5 million. All amounts authorized under the program in May 2014 were fully repurchased. All shares of stock repurchased during fiscal 2018 and fiscal 2017 were retired.



The following graph shows a five-year comparison of the total cumulative returns of investing $100 on May 31, 2013, in Paychex common stock, the S&P 500 Index, and a Peer Group Index. All comparisons of stock price performance shown assume reinvestment of dividends. We are a participant in the S&P 500 Index, a market group of companies with a larger than average market capitalization. Our Peer Group is a group of companies with comparable revenue and net income, who are in a comparable industry, or who are direct competitors of Paychex (as detailed below).









There can be no assurance that our stock performance will continue into the future with the same or similar trends depicted in the graph above. We neither make nor endorse any predictions as to future stock performance.

Our Peer Group for fiscal 2018 is comprised of the following companies:







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Item 6.    Selected Financial Data















 

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s Discussion and Analysis of Financial Condition and Results of Operations reviews the operating results of Paychex, Inc. and its wholly owned subsidiaries (“Paychex,” the “Company,” “we,” “our,” or “us”) for each of the three fiscal years ended May 31, 2018 (“fiscal 2018” or the “fiscal year”), May 31, 2017 (“fiscal 2017”), and May 31, 2016 (“fiscal 2016”), and our financial condition as of May 31, 2018. This review should be read in conjunction with the accompanying consolidated financial statements and the related notes to consolidated financial statements contained in Item 8 of this Annual Report on Form 10-K (“Form 10-K”) and the “Risk Factors” discussed in Item 1A of this Form 10-K. Forward-looking statements in this review are qualified by the cautionary statement under the heading “Cautionary Note Regarding Forward-Looking Statements Pursuant to the United States Private Securities Litigation Reform Act of 1995” contained at the beginning of Part I of this Form 10-K.

Overview

We are a leading provider of integrated human capital management (“HCM”) solutions for payroll, human resource (“HR”), retirement, and insurance services for small- to medium-sized businesses. We offer a comprehensive portfolio of HCM services and products that allow our clients to meet their diverse payroll and HR needs. Our payroll processing services, the foundation of our service model, include:

We support small-business companies through our core payroll, utilizing our proprietary, robust, software-as-a-service (“SaaS”) Paychex Flex® platform, and our SurePayroll® SaaS-based products. Mid-market companies typically have more sophisticated payroll and benefits needs, and are serviced through our Paychex Flex Enterprise solution set, which offers an integrated suite of HCM solutions through the Paychex Flex platform, or through our legacy platform.  Our SaaS solution through Paychex Flex Enterprise integrates payroll processing with HR management, employee benefits administration, time and labor management, applicant tracking, and onboarding solutions.

We offer a suite of complementary Human Resource Services (“HRS”) products including:

Our wholly owned subsidiary, Paychex Advance LLC (“Paychex Advance”), provides a portfolio of services to the temporary staffing industry. This includes the purchasing of accounts receivable as a means of providing payroll funding to these clients.

Our mission is to be the leading provider of payroll, HR, and employee benefits services for small and mid-sized companies by being an essential partner with America's businesses.  We believe success in this mission will lead to strong long-term financial performance.  Our strategy focuses on flexible, convenient service; industry-leading, integrated technology; solid sales execution; providing a comprehensive suite of value-added HCM services; continued service penetration; and engaging in strategic acquisitions, when possible.

We continue to focus on driving growth in the number of clients, revenue, and profits, while providing industry-leading service and technology solutions to our clients and their employees. We maintain industry-leading margins by managing our personnel costs and expenses while continuing to invest in our business, particularly in leading-edge technology. We believe these investments are critical to our success. Looking to the future, we believe that investing in our products, people, and service capabilities will position us to capitalize on opportunities for long-term growth.

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Our financial results for fiscal 2018 reflect another year of steady growth.  HRS revenue continued to experience strong growth of 14% for fiscal 2018 as compared with fiscal 2017. HRS revenue growth was primarily driven by increases in client bases across the following HCM services:  comprehensive HR outsourcing services, including HR Outsourcing Holdings, Inc. (“HROI”) acquired in fiscal 2018; retirement services; time and attendance; and insurance services.  Payroll service revenue increased 2% for fiscal 2018 as compared with fiscal 2017, primarily driven by growth in revenue per check, which improved as a result of our price increases, net of discounts. As of May 31, 2018, including the Lessor Group (“Lessor”) acquisition, we served over 650,000 payroll clients.  As of May 31, 2017, we served approximately 605,000 payroll clients.  Client retention was approximately 81% of our beginning client base for the fiscal year, consistent with a year ago.

Interest rates available on high-quality financial instruments are gradually increasing. Our combined funds held for clients and corporate investment portfolios earned an average rate of return of 1.5% for fiscal 2018, compared to 1.2% for fiscal 2017 and 1.1% for fiscal 2016.  The United States (“U.S.”) Federal Reserve raised the Federal Funds rate by a total of 75 basis points during fiscal 2018 to a range of 1.50% to 1.75% as of May 31, 2018.  In June 2018, the Federal Funds rate was raised an additional 25 basis points to a range of 1.75% to 2.0%.  The Federal Funds rate was in the range of 0.75% to 1.0% as of May 31, 2017.

Highlights of our financial results for fiscal 2018, compared to fiscal 2017, are as follows:

Business Outlook

Our payroll client base, including Lessor, exceeded 650,000 clients as of May 31, 2018, and was approximately 605,000 clients as of May 31, 2017 and May 31, 2016.  Excluding Lessor, our payroll client base was relatively flat for fiscal 2018 as compared to fiscal 2017.

While HRS products provide services to employers and employees beyond payroll, they effectively leverage payroll processing data.  Our HR administration services are included as part of the integrated HCM solution within Paychex Flex.  The following table illustrates the growth in selected HRS service offerings:





(1) The total number of worksite employees and clients for fiscal 2018 include HROI.

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In fiscal 2018, we expanded our commitment to delivering superior technology and service solutions to our Paychex clients.  New offerings introduced in fiscal 2018 included:

Concentrated effort remains on the continued enhancements of Paychex Flex, our robust cloud-based HCM platform, which allows direct client access to payroll, HR, and benefits information in a streamlined and integrated approach to workplace management.

We continue to strengthen our position as an expert in our industry by serving as a source of education and information to clients, small businesses, and other interested parties.  We provide free webinars, white papers, and other information on our website to aid existing and prospective clients with the impact of regulatory changes.  The Paychex Insurance Agency, Inc. website, www.paychex.com/group-health-insurance, helps small-business owners navigate the area of insurance coverage.  Both this website and www.paychex.com/worx have sections dedicated to the topic of health care reform.

Financial position and liquidity

Our financial position as of May 31, 2018 remained strong with cash and total corporate investments of $719.7 million and no debt. Our investment strategy continues to focus on protecting principal and optimizing liquidity.  We invest predominately in municipal bonds – including general obligation bonds; pre-refunded bonds, which are secured by a U.S. government escrow; and essential services revenue bonds – along with U.S. government agency securities and corporate bonds. During fiscal 2018, our primary short-term investment vehicles were Variable Rate Demand Notes (“VRDNs”) and bank demand deposit accounts.

A majority of our portfolio is invested in high credit quality securities with ratings of AA or higher, and A-1/P-1 ratings on short-term securities. We limit the amounts that can be invested in any single issuer and invest in short- to intermediate-term instruments whose fair values are less sensitive to interest rate changes. We believe that our investments as of May 31, 2018 that were in an unrealized loss position were not other-than-temporarily impaired, nor has any event occurred subsequent to that date that would indicate any other-than-temporary impairment.

Our primary source of cash is generated by our ongoing operations. Cash flows from operations were $1.3 billion for fiscal 2018.   Historically, we have funded our operations, capital purchases, business acquisitions, share repurchases, and dividend payments from our operating activities.  Our positive operating cash flows for fiscal 2018 allowed us to support our business and to pay substantial dividends to our stockholders. In April 2018 and July 2017, our Board of Directors (the “Board”) increased our quarterly dividend by 12% to $0.56 per share from $0.50 per share, and 9% to $0.50 per share from $0.46 per share, respectively.  Dividends paid to stockholders were 79% of net income for fiscal 2018. It is anticipated that cash and total corporate investments as of May 31, 2018, along with projected operating cash flows and available short-term financing, will support our normal business operations, capital purchases, share repurchases, dividend payments, and business acquisitions, if any, for the foreseeable future.

For further analysis of our results of operations for fiscal years 2018,  2017, and 2016, and our financial position as of May 31, 2018, refer to the tables and analysis in the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item 7 and the discussion in the “Critical Accounting Policies” section of this Item 7.

 



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Results of Operations



Summary of Results of Operations for Fiscal Years:







We invest in highly liquid, investment-grade fixed income securities and do not utilize derivative instruments to manage interest rate risk. As of May 31, 2018, we had no exposure to high-risk or illiquid investments. Details regarding our combined funds held for clients and corporate investment portfolios are as follows:











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Payroll service revenue:  Payroll service revenue was $1.8 billion for fiscal 2018 and $1.8 billion for fiscal 2017, reflecting growth of 2% and 3%, respectively, compared to each of the prior fiscal year periods.  Both fiscal 2018 and fiscal 2017 benefited from increases in revenue per check, which improved as a result of price increases, net of discounts.  The impact of the acquisition of Lessor on payroll service revenue growth for fiscal 2018 was insignificant.  The acquisition of Paychex Advance contributed approximately 1% to payroll service revenue growth for fiscal 2017.

As of May 31, 2018, including the Lessor acquisition, we served over 650,000 payroll clients.  For fiscal 2017, our total payroll client base of 605,000 was comparable to fiscal 2016.  Client retention was approximately 81% of the beginning client base for fiscal 2018, consistent with fiscal 2017.  Client retention was approximately 82% of the beginning of the year client base for fiscal 2016.

Human Resource Services revenue:  HRS revenue was $1.5 billion for fiscal 2018 and $1.3 billion for fiscal 2017, reflecting growth of 14% and 12%, respectively, compared to each of the prior fiscal year periods. HROI contributed approximately 6% to the growth in HRS revenue for fiscal 2018 and Paychex Advance contributed approximately 1% to the growth in HRS revenue for fiscal 2017.

For both fiscal 2018 and fiscal 2017, HRS revenue growth was primarily driven by increases in client bases across all major HCM services, including: comprehensive HR outsourcing services (including HROI), retirement services, time and attendance, and insurance services.  HRS product key statistics are as follows:



(1) The total number of worksite employees and clients for fiscal 2018 include HROI.

We continue to experience strong demand for our Paychex HR Services, our largest HRS revenue stream, as evidenced by the continued strong growth in client worksite employees for both our ASO and PEO. Retirement services revenue growth for fiscal 2018 and fiscal 2017 benefited from an increase in asset fee revenue earned on the asset value of participant funds, along with an increase in the number of plans served. Insurance services revenue growth for both fiscal 2018 and fiscal 2017 benefited from growth in the number of health and benefits applicants.  In addition, for fiscal 2017, revenue was positively impacted by higher average premiums in our workers’ compensation insurance product.



Total service revenue:  Total service revenue increased 7% for both fiscal 2018 and fiscal 2017, attributable to the factors previously discussed.

Interest on funds held for clients:  Interest on funds held for clients increased 26% for fiscal 2018 and 10% for fiscal 2017 to $63.5 million and $50.6 million, respectively.  For both fiscal 2018 and fiscal 2017, the increases were primarily due to higher average interest rates earned.

Average investment balances for funds held for clients decreased approximately 1% for fiscal 2018, primarily due to the impact of the Tax Cut and Jobs Act of 2017 (the “Tax Act”) on employee withholdings and changes in client mix, which offset the impact of wage inflation.  Average investment balances for funds held for clients decreased approximately 1% for fiscal 2017 primarily due to the impacts of timing of certain remittances due to taxing authorities and client mix. 

Refer to the “Market Risk Factors” section contained in Item 7A of this Form 10-K for more information on changing interest rates.

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Combined operating and SG&A expenses:  The following table summarizes total combined operating and SG&A expenses for fiscal years:







Total expenses increased 10% for fiscal 2018 and 6% for fiscal 2017.  For fiscal 2018, compensation-related expenses increased due to higher headcount reflecting accelerated investment in technology, sales teams, and the impact of the acquisitions of Lessor and HROI.  In addition, compensation-related expenses in fiscal 2018 included a one-time bonus paid to non-management employees.  For fiscal 2017, compensation-related expenses increased due to higher headcount in operations, partially offset by lower variable selling costs. As of May 31, 2018, we had approximately 14,300 employees, including Lessor, compared with 13,700 employees as of May 31, 2017.

Depreciation expense is primarily related to buildings, furniture and fixtures, data processing equipment, and software. Amortization of intangible assets is primarily related to client list acquisitions, which are amortized using either straight-line or accelerated methods.  The increase in depreciation and amortization for fiscal 2018 and fiscal 2017 was primarily driven by an increase in internally developed software that was placed in service over the past two years as well as changes to the useful life of certain assets which accelerated depreciation expense recognition.

Expense growth for fiscal 2018 and fiscal 2017 was impacted by continued growth in our PEO. Other expenses include items such as non-capital equipment, delivery, forms and supplies, communications, travel and entertainment, professional services, and other costs incurred to support our business.  Continued investment in product development and supporting technology impacted other expense growth for both fiscal 2018 and fiscal 2017.  For fiscal 2018, other expenses also reflect a one-time expense of $32.6 million related to the termination of certain license agreements.  In addition, the combined acquisitions of HROI and Lessor contributed approximately 5% to the total expense growth for fiscal 2018 compared to fiscal 2017.  The acquisition of Paychex Advance contributed approximately 1% to the growth in total expenses for fiscal 2017.

Operating income:  Operating income increased 4% to $1.3 billion for fiscal 2018 and 8% to $1.2 billion for fiscal 2017.   The fluctuations in operating income were attributable to the factors previously discussed.  Operating income, as a percent of total revenue, was 38.1%, 39.3%, and 38.8% for the fiscal years 2018, 2017, and 2016, respectively.  Adjusted operating income increased 6% to $1.3 billion for fiscal 2018 and 8% to $1.2 billion for fiscal 2017.  See the “Non-GAAP Financial Measures” section of this Item 7 for further discussion of this non-GAAP measure.

Investment income, net:  Investment income, net, primarily represents earnings from our cash and cash equivalents and investments in available-for-sale securities. Investment income does not include interest on funds held for clients, which is included in total revenue. Investment income, net, increased 66% for fiscal 2018 primarily due to higher average interest rates earned.  The increase in average investment balances for fiscal 2018 was the result of higher net income partially offset by share repurchases, business acquisitions, and an increase in the rate for quarterly dividend payments.  Investment income, net, increased 13% for fiscal 2017 primarily due to higher average interest rates earned, partially offset by a 2% decrease in average investment balances.

Income taxes:  Our effective income tax rate was 28.0% for fiscal 2018 and was 34.3% for both fiscal 2017 and fiscal 2016.  The effective income tax rate for fiscal 2018 was significantly impacted by the Tax Act.  As a result of the Tax Act, we recorded a non-recurring net tax benefit of $25.5 million for fiscal 2018 for the revaluation of our net deferred tax liabilities. This amount impacted diluted earnings per share by approximately $0.07 per share for fiscal 2018.  In addition, as it relates to the Tax Act, our effective income tax rate for fiscal 2018 benefited from a reduced statutory tax rate applied to our current year taxable income.  The effective income tax rates were impacted by additional discrete tax items recognized during fiscal 2018, fiscal 2017, and fiscal 2016.  Effective June 1, 2016, we early-adopted new accounting guidance related to employee stock-based compensation payments which resulted in discrete tax benefits recognized in income tax expense.  This discrete tax benefit impacted diluted earnings per share by approximately $0.04 per diluted share for fiscal 2018 and $0.05 per diluted share for fiscal 2017.  During fiscal 2018, we recognized a tax benefit as a result of the termination of certain license agreements, which increased diluted earnings per share by approximately $0.02 per diluted share.  During fiscal 2016, we recognized a net tax benefit on income derived in prior tax years related to customer-facing software that we produced which increased diluted earnings per share by approximately $0.06 per diluted share.  Additional discrete tax items recognized during each respective period are insignificant.  Refer to Note K of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for additional disclosures on income taxes.

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Net income and diluted earnings per share:  Net income increased 14% to $933.7 million for fiscal 2018 and 8% to $817.3 million for fiscal 2017.  Diluted earnings per share increased 15% to $2.58 per diluted share for fiscal 2018 and 8% to $2.25 per diluted share for fiscal 2017.  These fluctuations were attributable to the factors previously discussed. Adjusted net income increased 15% to $920.0 million for fiscal 2018 and increased 9% to $799.0 million for fiscal 2017.  Adjusted diluted earnings per share was $2.55 per diluted share for fiscal 2018 and $2.20 per diluted share for fiscal 2017, reflecting increases of 16% and 8%, respectively.  Refer to the “Non-GAAP Financial Measures” section that follows for a discussion of these non-GAAP measures.

Non-GAAP Financial Measures: Adjusted operating income, adjusted net income, and adjusted diluted earnings per share are summarized as follows:

















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In addition to reporting operating income, net income, and diluted earnings per share, which are U.S. GAAP measures, we present adjusted operating income, adjusted net income, and adjusted diluted earnings per share, which are non-GAAP measures.  We believe adjusted operating income, adjusted net income, and adjusted diluted earnings per share are appropriate additional measures, as they are indicators of our core business operations performance period over period.  Adjusted operating income, adjusted net income, and adjusted diluted earnings per share are not calculated through the application of GAAP and are not a required form of disclosure by the Securities and Exchange Commission (“SEC”).  As such, they should not be considered as a substitute for the GAAP measures of operating income, net income, and diluted earnings per share, and therefore should not be used in isolation, but in conjunction with, the GAAP measures.  The use of any non-GAAP measure may produce results that vary from the GAAP measure and may not be comparable to a similarly defined non-GAAP measure used by other companies.



 

Liquidity and Capital Resources

Our financial position as of May 31, 2018 remained strong with cash and total corporate investments of $719.7 million and no debt. We believe that our investments in an unrealized loss position as of May 31, 2018 were not other-than-temporarily impaired, nor has any event occurred subsequent to that date to indicate any other-than-temporary impairment. We anticipate that cash and total corporate investments as of May 31, 2018, along with projected operating cash flows and available short-term financing, will support our normal business operations, capital purchases, business acquisitions, if any, share repurchases, and dividend payments for the foreseeable future.

Short-Term Financing



We maintain credit facilities, letters of credit, and lines of credit as part of our normal and recurring business operations.



Credit Facilities:  We maintain three committed, unsecured credit facilities as follows:













For all credit facilities, obligations under any facility are guaranteed by the Company and certain of its subsidiaries and will

bear interest at competitive rates based on options provided to the borrower.  Upon the expiration date, any borrowings outstanding will mature and be payable on such date.



JPM $1 Billion Credit Facility: There were no borrowings outstanding under this credit facility as of May 31, 2018.  Details of borrowings under this credit facility are as follows:





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We typically borrow on an overnight basis.  In addition to overnight borrowings, we also borrowed:







Subsequent to May 31, 2018, we borrowed two times, on an overnight basis, $171.8 million on a weighted-average basis

under this line.



JPM $500 Million Credit Facility:  There were no borrowings outstanding under this credit facility as of May 31, 2018.  Details of borrowings under this credit facility are as follows:











In addition to overnight borrowings, during fiscal 2018, we borrowed $300.0 million for seven days and $75.0 million for 30 days at weighted average LIBOR-based interest rates of 2.13% and 2.19%, respectively.  Subsequent to May 31, 2018, we borrowed three times, on an overnight basis, $103.5 million on a weighted-average basis under this line.



PNC $150 Million Credit Facility:  There were no borrowings outstanding under this credit facility as of May 31, 2018.  Details of borrowings under this credit facility are as follows:







Subsequent to May 31, 2018, we borrowed approximately $56.8 million under this line, which remains outstanding as of the date of this report.

All of our credit facilities contain various financial and operational covenants that are usual and customary for such arrangements. We were in compliance with all of these covenants as of May 31, 2018.



Certain lenders under these credit facilities, and their respective affiliates, have performed, and may in the future perform for us, various commercial banking, investment banking, underwriting, and other financial advisory services, for which they have received, and will continue to receive in the future, customary fees and expenses.



Letters of credit:  As of May 31, 2018, we had irrevocable standby letters of credit available totaling $56.8 million, required to secure commitments for certain insurance policies. The letters of credit expire at various dates between July 2018 and May 2019. No amounts were outstanding on these letters of credit during fiscal 2018 or as of May 31, 2018.  Subsequent to May 31, 2018, the letter of credit expiring in July 2018 was renewed through July 2019, and the total amount available under the letters of credit was increased $4.1 million to $60.9 million.

Lines of credit: Effective August 17, 2017, we terminated four uncommitted, secured, short-term lines of credit totaling $900.0 million.  The lines of credit were available to us at market rates of interest and were primarily used to meet short-term funding requirements related to deposit account overdrafts and client fund obligations arising from electronic payment transactions made on behalf of our clients in the ordinary course of business.  There were no amounts outstanding under these lines of credit during fiscal 2018 or as of May 31, 2018.  We do not have any other open lines of credit as of the date of this report.



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Other commitments:  We have entered into various operating leases and purchase obligations that, under GAAP, are not reflected on the Consolidated Balance Sheets as of May 31, 2018. The table below summarizes our estimated annual payment obligations under these commitments as of May 31, 2018:





The liability for uncertain tax positions, including interest and net of federal benefits, was approximately $14.7 million as of May 31, 2018. Refer to Note K of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for more information on income taxes. We are not able to reasonably estimate the timing of future cash flows related to this liability and have excluded it from the table above.

Certain deferred compensation plan obligations and other long-term liabilities reported in our Consolidated Balance Sheets amounting to $84.8 million as of May 31, 2018 are excluded from the table above because the timing of actual payments cannot be specifically or reasonably determined due to the variability in assumptions required to project the timing of future payments.  In addition, during fiscal 2017 we entered into a limited partnership agreement to contribute a maximum amount of $10.0 million to a venture capital fund in the financial technology sector, of which approximately $4.2 million has been contributed as of May 31, 2018.  The timing of future contributions to be made to the venture capital fund cannot be specifically or reasonably determined and thus have been excluded from the table above.

In the normal course of business, we make representations and warranties that guarantee the performance of services under service arrangements with clients. Historically, there have been no material losses related to such guarantees. In addition, we have entered into indemnification agreements with our officers and directors, which require us to defend and, if necessary, indemnify these individuals for certain pending or future legal claims as they relate to their services provided to us.

We currently self-insure the deductible portion of various insured exposures under certain employee benefit plans. Our estimated loss exposure under these insurance arrangements is recorded in other current liabilities on our Consolidated Balance Sheets. Historically, the amounts accrued have not been material and are not material as of the reporting date. We also maintain 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.



In August 2017, we announced our plan for a new multi-building Paychex campus based in Rochester, NY.  This involves the purchase of five buildings and the renovation of over 300,000 square feet of existing space for an estimated cost of $60.0 million.  We completed the purchase of these buildings during the three months ended November 30, 2017, for a combined cost of approximately $34.7 million and placed approximately $16.0 million in escrow for the building renovations, which are in-process.  Renovations on the buildings purchased are in-process, and are expected to be substantially completed during the fiscal year ending May 31, 2019. In addition, in September 2017, we entered into a transaction with the County of Monroe Industrial Development Agency for purposes of obtaining public benefits and inducements, expiring on December 31, 2039.  The public inducements include exemption from sales and use taxes for goods and services directly related to the renovations of the new multi-building campus.

Off-Balance Sheet Arrangements

As part of our ongoing business, we do not participate in transactions with unconsolidated entities which would have been established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. We do maintain investments as a limited partner in both low-income housing projects and a venture capital fund focused on the financial technology sector.  These are not considered part of our ongoing operations. These investments are accounted for under the equity method of accounting and represented less than one percent of our total assets as of May 31, 2018.

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Operating Cash Flow Activities





The increase in our operating cash flows for fiscal 2018 compared to fiscal 2017 is the result of higher net income and adjustments for non-cash items, and an increase in cash provided by fluctuations in our operating assets and liabilities. The increase in net income in fiscal 2018 was impacted by the enactment of the Tax Act.  The decrease in operating cash flows for fiscal 2017 compared to fiscal 2016 is primarily the result of net cash outflows from fluctuations in our operating assets and liabilities, partially offset by higher net income and adjustments for non-cash items.  The increase in non-cash adjustments for fiscal 2018 and for fiscal 2017 was largely due to higher depreciation expense related to an increase in internally developed software placed in service over the last three years.  The fluctuations in our operating assets and liabilities between all periods were impacted by the timing of collections from clients and payments for compensation, PEO payroll, income tax, and other liabilities.  In addition, the larger outflows in fiscal 2017 were impacted by higher accounts receivable balances related to growth in our payroll funding business for temporary staffing agency clients.   

Investing Cash Flow Activities





Funds held for clients and corporate investments:  Funds held for clients consist of short-term funds and available-for-sale securities. Corporate investments are primarily comprised of available-for-sale securities. The portfolio of funds held for clients and corporate investments is detailed in Note F of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K.

Fluctuations in the net change in funds held for clients and corporate investments are largely due to timing within the client funds portfolio.  Specific timing impacting cash flows for fiscal years 2018,  2017, and 2016 are discussed further in the financing cash flows discussion of net changes in client fund obligations.  Fiscal 2018 and fiscal 2017 had greater purchases of short-term or available-for-sale investments of client collections than sales of investments to fund client fund remittances, whereas fiscal 2016 reflected more sales of investments than purchases.  For fiscal 2016, the client fund timing impacts reflected in the net change in funds held for clients and corporate investments were somewhat offset by a change in mix of investments.  Fiscal 2016 had more funds invested in VRDN securities and less in cash equivalents.

In general, fluctuations in the net change in funds held for clients and corporate investments primarily relate to timing of purchases, sales, or maturities of investments. The amount of funds held for clients will vary based upon the timing of collection of client funds, and the related remittance of funds to applicable tax or regulatory agencies for payroll tax administration services and to employees of clients utilizing employee payment services.  Additional discussion of interest rates and related risks is included in the “Market Risk Factors” section contained in Item 7A of this Form 10-K.

Other investing activities:  To support our continued client and ancillary product growth, purchases of property and equipment were made for data processing equipment and software, and for the expansion and upgrade of various operating facilities. During fiscal years 2018,  2017, and 2016, we purchased approximately $0.5 million, $0.6 million, and $4.9 million, respectively, of data processing equipment and software from EMC Corporation. The former Chairman, President, and Chief Executive Officer of EMC Corporation is a member of our Board.

The net cash outflow for purchases of property and equipment during fiscal 2018 includes the purchase of five buildings and ongoing renovations of over 300,000 square feet of existing space in Rochester, NY.  This new multi-building Paychex campus, announced in August 2017, will result in the consolidation of current leased space in the Rochester area.

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Acquisition of businesses, net of cash acquired, reflects our acquisitions of Lessor in February 2018, our acquisition of HROI in August 2017, and our acquisition of Advance Partners in December 2015. The Lessor and Advance Partners acquisition consideration was cash while the HROI acquisition was a combination of cash and common stock. 

Purchases of other assets relates primarily to client list acquisitions. During fiscal 2018, we resolved a contractual dispute with certain licensees. As it relates to this agreement, we acquired rights to certain client lists for approximately $30.0 million.

Financing Cash Flow Activities





Net change in client fund obligations:  The client fund obligations liability will vary based on the timing of collecting client funds, and the related required remittance of funds to applicable tax or regulatory agencies for payroll tax administration services and to employees of clients utilizing employee payment services. Collections from clients are typically remitted from one to 30 days after receipt, with some items extending to 90 days.

Client fund obligation balances are significantly impacted by the timing of the period end.  Fluctuations in the net change in client fund obligations for the years presented are primarily the result of timing of collections and remittances and overall trends in client fund balances.  May 31, 2018 fell on a Thursday, which is a significant collection day for direct pay funds.  These funds were then paid out on Friday June 1, 2018.  May 31, 2017 fell on a Wednesday compared to May 31, 2016 which was a Tuesday.  Payroll tax funds continued to be collected on Wednesday, May 31, 2017, yet the federal semi-weekly tax payment was delayed until Thursday, June 1, 2017 due to the Memorial Day holiday weekend.  As such, a higher client fund obligation existed on May 31, 2017 than May 31, 2016.  The timing of the Memorial Day holiday in May 2016 prompted many clients to remit their payrolls before the holiday weekend, resulting in lower direct deposit funds as of May 31, 2016.  In addition, May 31, 2016 was a Tuesday, a larger cash outflow day due to clearing of Readychex and tax payments.

Dividends paid:  In April 2018 and July 2017, our Board increased our quarterly dividend to shareholders by 12% to $0.56 per share from $0.50 per share, and by 9% to $0.50 per share from $0.46 per share, respectively. The dividends paid as a percentage of net income totaled 79%, 81%, and 80% for fiscal years 2018,  2017, and 2016, respectively. The payment of future dividends is dependent on our future earnings and cash flow, and is subject to the discretion of our Board.

Repurchases of common shares:   In July 2016, our Board approved a program to repurchase up to $350.0 million of our common stock, authorized through May 31, 2019 (the “July 2016 Program”).  The purpose of the July 2016 Program is to manage common stock dilution.  During fiscal 2018, we repurchased 2.5 million shares for a total of $143.1 million.  During fiscal 2017, we repurchased 2.9 million shares for a total of $166.2 million.  Of the shares repurchased during fiscal 2017, $59.7 million was repurchased under a previously authorized common stock repurchase program. During fiscal 2016, we purchased 2.2 million shares for a total of $107.9 million, all under the previously authorized common stock repurchase program.  Shares repurchased were retired.   

Activity related to equity-based plans:  The decrease in cash flows related to stock-based awards for fiscal 2018 compared to fiscal 2017 and the increase for fiscal 2017 compared to fiscal 2016 were largely driven by changes in proceeds received from the exercise of stock options.  Shares of common stock issued through the exercise of stock options were 0.6 million shares, 1.4 million shares, and 0.9 million shares for fiscal years 2018,  2017, and 2016, respectively. Refer to Note E of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for additional disclosures on our stock-based compensation plans.

 

Other

Recently adopted accounting pronouncements:  Refer to Note A of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for a discussion of recently adopted accounting pronouncements.

Recently issued accounting pronouncements:  Refer to Note A of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for a discussion of recently issued accounting pronouncements.

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Critical Accounting Policies

Note A of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K discusses the significant accounting policies of Paychex. Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates, judgments, and assumptions that affect reported amounts of assets, liabilities, revenue, and expenses. On an ongoing basis, we evaluate the accounting policies and estimates used to prepare the consolidated financial statements. We base our estimates on historical experience, future expectations, and assumptions believed to be reasonable under current facts and circumstances. Actual amounts and results could differ from these estimates. Certain accounting policies that are deemed critical to our results of operations or financial position are discussed below.

Revenue recognition:  Service revenue is recognized in the period services are rendered and earned under service arrangements with clients where service fees are fixed or determinable and collectability is reasonably assured. Certain processing services are provided under annual service arrangements with revenue recognized ratably over the service period. Our service revenue is largely attributable to processing services where the fee is based on a fixed amount per processing period or a fixed amount per processing period plus a fee per employee or transaction processed. Fees earned for funding of temporary staffing clients’ payrolls via purchase of accounts receivable are based on a percentage of funding amounts as specified in the client contract.  The revenue earned from delivery service for the distribution of certain client payroll checks and reports is included in service revenue, and the costs for delivery are included in operating expenses on the Consolidated Statements of Income and Comprehensive Income.

For certain of our service offerings, we receive advance payments for set-up fees from our clients. We defer revenue associated with these advance payments, recognizing the revenue and related expenses over the expected life of clients.

PEO revenue is included in service revenue and is reported net of certain direct pass-through costs billed and incurred, which primarily include payroll wages, payroll taxes, and certain benefit premiums.  Direct costs related to certain benefit plans where we retain risk are recognized as operating expenses rather than as a reduction in service revenue.

Interest on funds held for clients is earned primarily on funds that are collected from clients before due dates for payroll tax administration services and for employee payment services, and invested until remittance to the applicable tax or regulatory agencies or client employees. These collections from clients are typically remitted from one to 30 days after receipt, with some items extending to 90 days. The interest earned on these funds is included in total revenue on the Consolidated Statements of Income and Comprehensive Income because the collecting, holding, and remitting of these funds are components of providing these services. Interest on funds held for clients also includes net realized gains and losses from the sales of available-for-sale securities.

 PEO insurance reserves:  As part of the PEO service, we offer workers’ compensation insurance and health insurance to client companies for the benefit of client employees.  Workers' compensation insurance is provided under a fully insured high deductible workers’ compensation insurance policy with a national insurance carrier. Workers’ compensation insurance reserves are established to provide for the estimated costs of paying claims up to per occurrence liability limits. In establishing the PEO workers' compensation insurance reserves, we use an independent actuarial estimate of undiscounted future cash payments that would be made to settle the claims.

With respect to our PEO health insurance, we offer various health insurance plans that take the form of either fully insured fixed cost plans with various national insurance carriers or a fully insured minimum premium insurance arrangement with coverage provided through a single national carrier. Under the minimum premium insurance arrangement, our health benefits insurance reserves are established to provide for the payment of claims liability charges in accordance with our service contract with the carrier. The claims liability charges include estimates for reported losses, plus amounts for those claims incurred but not reported, and estimates of certain expenses associated with processing and settling the claims.

Estimating the ultimate cost of future claims is an uncertain and complex process based upon historical loss experience and actuarial loss projections, and is subject to change due to multiple factors, including economic trends, changes in legal liability law, and damage awards, all of which could materially impact the reserves as reported in the consolidated financial statements. Accordingly, workers' compensation final claim settlements may vary from the present estimates, particularly when those payments may not occur until well into the future.  We regularly review the adequacy of our estimated insurance reserves. Adjustments to previously established reserves are reflected in the results of operations for the period in which the adjustment is identified. Such adjustments could possibly be significant, reflecting any combination of new and adverse or favorable trends.

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Goodwill and other intangible assets:  Goodwill is not amortized, but instead is tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change in a way to indicate that there has been a potential decline in the fair value of the reporting unit.  We perform our annual impairment testing in our fiscal fourth quarter.  For fiscal 2018, it was determined that the Company has three reporting units. A qualitative analysis was performed for all reporting units in fiscal 2018, to determine if it is more-likely-than-not that the fair value of the reporting units had declined below its carrying value. The qualitative assessment considered various financial, macroeconomic, industry, and reporting unit specific qualitative factors. Based on the results of our testing, no impairment loss was recognized in the results of operations for fiscal 2018, 2017, or 2016. Subsequent to the latest review, there have been no events or circumstances that indicate any potential impairment of the Company’s goodwill balance.

We also test intangible assets for potential impairment when events or changes in circumstances indicate that the carrying value may not be recoverable.

Impairment of Long-Lived Assets: Long-lived assets, including intangible assets with finite lives, are reviewed for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the estimated fair value of the asset. We have determined that there is no impairment of long-lived assets for the fiscal 2018, 2017, or 2016.

Stock-based compensation costs:  All stock-based awards to employees, including grants of stock options, are recognized as compensation costs in our consolidated financial statements based on their fair values measured as of the date of grant. We estimate the fair value of stock option grants using a Black-Scholes option pricing model. This model requires various assumptions as inputs including expected volatility of the Paychex stock price and expected option life. We estimate volatility based on a combination of historical volatility using stock prices over a period equal to the expected option life and implied market volatility. Expected option life is estimated based on historical exercise behavior.  We periodically reassess our assumptions as well as our choice of valuation model and will reconsider use of this model if additional information becomes available in the future indicating that another model would provide a more accurate estimate of fair value, or if characteristics of future grants would warrant such a change.

The fair value of stock awards is determined based on the stock price at the date of grant.  For grants that do not accrue dividends or dividend equivalents, the fair value is the stock price reduced by the present value of estimated dividends over the vesting period or performance period.

We estimate forfeitures and only record compensation costs for those awards that are expected to vest. Our assumptions for forfeitures were determined based on type of award and historical experience. Forfeiture assumptions are adjusted at the point in time a significant change is identified, with any adjustment recorded in the period of change, and the final adjustment at the end of the requisite service period to equal actual forfeitures.

The assumptions of volatility, expected option life, and forfeitures all require significant judgment and are subject to change in the future due to factors such as employee exercise behavior, stock price trends, and changes to type or provisions of stock-based awards. Any change in one or more of these assumptions could have a material impact on the estimated fair value of a future award.

Refer to Note E of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for further discussion of our stock-based compensation plans.

Income taxes:  We account for deferred taxes by recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the fiscal year in which the differences are expected to reverse. We record a deferred tax asset related to the stock-based compensation costs recognized for certain stock-based awards. With the early-adoption of Accounting Standards Update No. 2016-09, at the time of the exercise of non-qualified stock options or vesting of stock awards, we recognize any excess tax benefit within income taxes in the Consolidated Statements of Income and Comprehensive Income.  Previously, we accounted for the resulting tax deduction by reducing our accrued income tax liability with an offset to the deferred tax asset and any excess of the tax benefit over the deferred tax asset as an increase to additional paid-in capital in the Consolidated Balance Sheets.

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The Tax Act enacted in December 2017 was the most comprehensive tax reform legislation approved in more than two decades and makes broad and complex changes to the U.S. federal corporate income taxation, including, but not limited to: (i) reducing the statutory corporate tax rate from 35% to 21% (a blended statutory tax rate of 29.2% for fiscal 2018); (ii) creating new or furthering limitations to the deductibility of officer compensation, interest, meals, entertainment, and other expenses; and (iii) changing from a worldwide to a territorial taxation system.  As a result of the Tax Act, we made a one-time revaluation of our net deferred tax liabilities and made a change in the Company’s annual effective income tax rate applied to income before income taxes for the first six months of fiscal 2018.

We maintain a reserve for uncertain tax positions. We evaluate tax positions taken or expected to be taken in a tax return for recognition in its consolidated financial statements. Prior to recording the related tax benefit in our consolidated financial statements, we must conclude that tax positions will be more-likely-than-not to be sustained, assuming those positions will be examined by taxing authorities with full knowledge of all relevant information. The benefit recognized in our consolidated financial statements is the amount we expect to realize after examination by taxing authorities. If a tax position drops below the more-likely-than-not standard, the benefit can no longer be recognized. Assumptions, judgment, and the use of estimates are required in determining if the more-likely-than-not standard has been met when developing the provision for income taxes and in determining the expected benefit. A change in the assessment of the more-likely-than-not standard could materially impact our results of operations or financial position. Refer to Note K of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for further discussion of our reserve for uncertain tax positions.

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Item 7A.    Quantitative and Qualitative Disclosures About Market Risk

Market Risk Factors

Changes in interest rates and interest rate risk:    Funds held for clients are primarily comprised of short-term funds and available-for-sale securities. Corporate investments are primarily comprised of available-for-sale 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 available-for-sale securities. We follow an investment strategy of protecting principal and optimizing liquidity. A substantial portion of our portfolio is invested in high credit quality securities with ratings of AA or higher, and A-1/P-1 ratings on short-term securities. We invest predominately in municipal bonds – including general obligation bonds; pre-refunded bonds, which are secured by a U.S. government escrow; and essential services revenue bonds – along with U.S. government agency securities and corporate bonds. 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 available-for-sale securities to a benchmark duration of two and one-half to three and three-quarters years.

During fiscal 2018, our primary short-term investment vehicles were VRDNs and bank demand deposit accounts. We have no exposure to high-risk or illiquid 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 fiscal 2018, the average interest rate earned on our combined funds held for clients and corporate investment portfolios was 1.5%, compared to 1.2% and 1.1% for fiscal years 2017 and 2016, respectively. 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 increase from our short-term investments, and over time increase earnings from our longer-term available-for-sale securities. Earnings from the available-for-sale securities, which as of May 31, 2018 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 available-for-sale securities that had stated maturities as of May 31, 2018 are shown below by contractual maturity. Expected maturities can differ from contractual maturities because borrowers may have the right to prepay obligations without prepayment penalties.







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.

After almost seven years of no movement in the Federal Funds rate, the Federal Reserve has raised the rate by 25 basis points six times since December 2015.  As of May 31, 2018, the Federal Funds rate was in the range of 1.50% to 1.75% as compared to in the range of 0.75% to 1.00% as of May 31, 2017, and in the range of 0.25% to 0.50% as of May 31, 2016.  On June 13, 2018, the Federal Funds rate was raised an additional 25 basis points to a range of 1.75% to 2.0%.

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

•    daily interest rate changes;

•    seasonal variations in investment balances;

•    actual duration of short-term and available-for-sale securities;

•    the proportion of taxable and tax-exempt investments;

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•    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 $3.0 million to $4.0 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 investments) averaged approximately $5.0 billion for fiscal 2018. 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 available-for-sale securities with an average duration of two and one-half to three and three-quarters years.

The combined funds held for clients and corporate available-for-sale securities reflected a net unrealized loss of $38.3 million as of May 31, 2018, compared with a net unrealized gain of $32.0 million as of May 31, 2017.   Refer to Note G of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for additional disclosures on fair value measurements.

During fiscal 2018, the net unrealized gain or loss on our investment portfolios ranged from an unrealized gain of $41.4 million to an unrealized loss of $54.5 million. During fiscal 2017, the net unrealized loss or gain on our investment portfolios ranged from an unrealized loss of $30.5 million to an unrealized gain of $69.5 million. The net unrealized loss on our investment portfolios was approximately $33.0 million as of July 18, 2018.

As of May 31, 2018 and 2017, we had $3.1 billion and $4.6 billion, respectively, invested in available-for-sale securities at fair value. The weighted-average yield-to-maturity was 1.9% and 1.7% as of May 31, 2018 and 2017, respectively. The weighted-average yield-to-maturity excludes available-for-sale securities tied to short-term interest rates such as the 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 available-for-sale securities as of May 31, 2018, 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 the results of operations, unless any declines in fair value were considered to be other-than-temporary and an impairment loss 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 other-than-temporarily impaired due to changes in credit risk or other potential valuation concerns. We believe that the investments we held as of May 31, 2018 were not other-than-temporarily impaired. While $2.2 billion of our available-for-sale 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 unrealized losses of $40.7 million were due to changes in interest rates and were not due to increased credit risk or other valuation concerns. A significant portion of these securities in an unrealized loss position as of May 31, 2018 and 2017 held 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 other-than-temporarily impaired could change in the future due to new developments or changes in our strategies or assumptions related to any particular investment.



We have some credit risk exposure in connection with our purchase of accounts receivable as a means of providing payroll funding to clients in the temporary staffing industry.  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. 

 

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Item 8.    Financial Statements and Supplementary Data

TABLE OF CONTENTS



 

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REPORT ON MANAGEMENT’S ASSESSMENT OF

INTERNAL CONTROL OVER FINANCIAL REPORTING

Management of Paychex, Inc. (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the financial statements for external purposes in accordance with generally accepted accounting principles.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of the Company’s internal control over financial reporting as of May 31, 2018. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in “Internal Control — Integrated Framework” (2013). Based on our assessment, management determined that the Company maintained effective internal control over financial reporting as of May 31, 2018.

The Company’s independent registered public accounting firm, PricewaterhouseCoopers LLP, is appointed by the Company’s Audit Committee. PricewaterhouseCoopers LLP has audited the Consolidated Financial Statements included in this Annual Report on Form 10-K and the effectiveness of the Company's internal control over financial reporting as of May 31, 2018, and as a part of their integrated audit, has issued their report, included herein, on the effectiveness of the Company’s internal control over financial reporting.





 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the Board of Directors and Shareholders of Paychex, Inc.



Opinions on the Financial Statements and Internal Control over Financial Reporting



We have audited the accompanying consolidated balance sheets of Paychex, Inc. and its subsidiaries as of May 31, 2018 and 2017, and the related consolidated statements of income and comprehensive income, of stockholders’ equity, and of cash flows for each of the three years in the period ended May 31, 2018, including the related notes and financial statement schedule listed in the accompanying index (collectively referred to as the “consolidated financial statements”).  We also have audited the Company's internal control over financial reporting as of May 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 



In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of May 31, 2018 and 2017, and the results of their operations and their cash flows for each of the three years in the period ended May 31, 2018 in conformity with accounting principles generally accepted in the United States of America.  Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of May 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO.



Basis for Opinions



The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report on Management’s Assessment of Internal Control over Financial Reporting.  Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits.  We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.



We conducted our audits in accordance with the standards of the PCAOB.  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. 



Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks.  Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements.  Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements.  Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk.  Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.



Definition and Limitations of Internal Control over Financial Reporting



A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.





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Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.



/s/ PricewaterhouseCoopers LLP





Rochester, New York

July 20, 2018



We have served as the Company’s auditor since 2013.