PAYCHEX INC (PAYX)

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

Management’s Discussion and Analysis of Financial Condition and Results of Operations reviews the operating results of Paychex, Inc. and its wholly owned subsidiaries (“Paychex,” the “Company,” “we,” “our,” or “us”) for our fiscal year ended May 31, 2024 (“fiscal 2024” or the “fiscal year”), as compared to our fiscal year ended May 31, 2023 (“fiscal 2023”), and our financial condition as of May 31, 2024. A detailed review of our fiscal 2023 performance compared to our fiscal year ended May 31, 2022 performance and our financial condition as of May 31, 2023 is set forth in Part II, Item 7 of our Annual Report on Form 10-K (“Form 10-K”) for fiscal 2023. This review should be read in conjunction with the accompanying consolidated financial statements and the related Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K and the “Risk Factors” discussed in Item 1A of this Form 10-K. Forward-looking statements in this review are qualified by the cautionary statement under the heading “Cautionary Note Regarding Forward-Looking Statements” contained at the beginning of Part I of this Form 10-K.

Overview

We are an industry-leading human capital management (“HCM”) company delivering a full suite of technology and advisory services in human resources (“HR”), employee benefits, insurance, and payroll for small- to medium-sized businesses and their employees across the United States (“U.S.”) and parts of Europe.

We offer a full range of integrated HCM solutions covering the employee life cycle for businesses and their employees. Clients may choose from a breadth of solutions that also allow integration with some of the most popular HR, accounting, point-of-sale, and productivity applications on the market today.

We support our small-business clients by utilizing our proprietary, robust, software as a service (“SaaS”) Paychex Flex® platform and the Company’s SurePayroll® SaaS-based solutions. Our medium-sized clients generally have more complex payroll and employee benefit needs, though with the environment of increasing regulations, we believe the need for HR outsourcing services has been moving down-market. Any of our clients on Paychex Flex can opt for the integrated suite of HCM solutions, which allows clients to choose the service and software solutions that will meet the needs of their business.

Our portfolio of technology, HR advisory, and employee benefits-related solutions is disaggregated into two categories, (1) Management Solutions and (2) professional employer organization (“PEO”) and Insurance Solutions, as discussed in Part I, Item 1 of this Form 10-K.

Our mission is to be the leading provider of HR, employee benefits, insurance, and payroll solutions by being an essential partner to small- and medium-sized businesses across the U.S. and parts of Europe. Our strategy focuses on providing industry-leading, integrated technology; delivering superior customer experiences; expanding our leadership in HR; growing our client bases; and engaging in strategic acquisitions. We believe that successfully executing this strategy will lead to strong, long-term financial performance.

We maintain industry-leading margins by managing our personnel costs and expenses while continuing to invest in our business, particularly in sales and marketing and leading-edge technology. We believe these investments are critical to our success. Looking to the future, we believe that investing in our solutions, people, and digital capabilities will position us to capitalize on opportunities for long-term growth.

We closely monitor the evolving challenges and needs of small- and medium-sized businesses, and proactively aid our clients in navigating these challenges. Through our unique blend of innovative technology solutions, backed by our extensive compliance and HR expertise, we help clients more effectively hire, develop, and retain top talent in this challenging workforce environment. Our ongoing investments in our platforms have prepared us well for the demands of the current business and regulatory environments, allowing us to adapt while maintaining strong solutions and support delivery, resulting in high levels of client satisfaction and retention.

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Fiscal 2024 Business Highlights

Highlights compared to fiscal 2023 are as follows:

(1)
Adjusted net income and adjusted diluted earnings per share are not U.S. generally accepted accounting principle (“GAAP”) measures. Adjusted net income and adjusted diluted earnings per share in all periods include an adjustment for net tax windfall benefits related to employee stock-based compensation payments. In fiscal 2024, adjusted net income and adjusted diluted earnings per share also include adjustments for one-time cost optimization initiatives. Refer to the “Non-GAAP Financial Measures” section of this Item 7 for a discussion of non-GAAP measures and a reconciliation to the U.S. GAAP measures of net income and diluted earnings per share.

(2)
Dividends paid to stockholders represented approximately 78% of net income for fiscal 2024 compared to approximately 75% of net income for fiscal 2023.

(3)
Percentage changes are calculated based on unrounded numbers.

For further analysis of our results of operations for fiscal years 2024 and 2023, and our financial position as of May 31, 2024, refer to the tables and analysis in the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item 7.

Business Outlook

Our payroll and PEO client base was greater than 745,000 clients as of May 31, 2024 and approximately 740,000 clients as of May 31, 2023. Client retention remained high in the range of 82% to 83% of our beginning client base for both fiscal 2024 and fiscal 2023 and we have sustained high revenue retention.

We continue to increase penetration of our integrated solutions beyond payroll processing, including our HR outsourcing and employee benefit solutions. These offerings are included as part of the integrated HCM solutions within Paychex Flex or provided through the PEO platform. The following table illustrates selected HR solutions client metrics:

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

In fiscal 2024, we continued to make investments in technology a priority as companies look to leverage technology solutions to maintain operations, stay connected to employees, and increase productivity. We implemented enhancements to our Paychex Flex platform designed to improve the client and client employee experiences from hiring and onboarding through employee retention. We also continue to focus on artificial intelligence (“AI”) and related technology to leverage innovative technology and advanced analytics to gain deeper insights into prospects and clients regarding their behavior, preferences, and evolving needs. In fiscal 2024, we successfully implemented several additional innovative AI models that significantly improved results for Paychex and our clients.

We have further strengthened our position in the industry by serving as a source of education and information to clients, businesses of all sizes, and other interested parties. We provide free webinars, white papers, and other information on our website (www.paychex.com) to aid existing and prospective clients with the impact of regulatory changes. The Paychex Insurance

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Agency, Inc. website, www.paychex.com/group-health-insurance, helps small-business owners navigate the area of insurance coverage.

During the fourth quarter of fiscal 2024 (the "fourth quarter"), we focused on cost optimization initiatives, including further reductions to our geographic footprint, reprioritization of certain technology investments, and headcount optimization. These initiatives are directed at generating additional cost savings for us and providing greater value to our customers.

Results of Operations

Summary of Results of Operations for Fiscal Years:

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

n/m – not meaningful

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

•
Management Solutions revenue: $3.9 billion for fiscal 2024, reflecting an increase of 4%:

o
Increase in the number of clients and clients' employees for HCM solutions and worksite employees for HR solutions;

o
Higher revenue per client resulting from pricing realization and product attachment, including increased demand for HR solutions and retirement solutions; and

o
Lower revenue from ancillary services, primarily due to the expiration of our Employee Retention Tax Credit Service.

•
PEO and Insurance Solutions revenue: $1.3 billion for fiscal 2024, reflecting an increase of 8%:

o
Growth in the number of average PEO worksite employees and increases in average wages per worksite employee;

o
Higher health insurance premiums; and

o
Growth in ancillary services.

•
Interest on funds held for clients: $146.3 million for fiscal 2024, reflecting an increase of 47%:

o
Higher average interest rates;

o
Higher average investment balances; and

o
Lower realized losses on investment sales.

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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, 2024, we had no exposure to high-risk or non-liquid investments. Details regarding our combined funds held for clients and corporate cash equivalents and investment portfolios are as follows:

(1)
The net unrealized loss on our investment portfolios was approximately $137.6 million as of July 09, 2024.

(2)
The Federal Funds rate was in the range of 5.25% to 5.50% as of May 31, 2024 and in the range of 5.00% to 5.25% as of May 31, 2023.

(3)
These items exclude the impact of variable rate demand notes (“VRDNs”), as they are tied to short-term interest rates. Refer to the “Market Risk Factors” section contained in Item 7A of this Form 10-K for more information on changing interest rates.

Total expenses: The following table summarizes total combined cost of service revenue and selling, general and administrative expenses for fiscal years:

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

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

•
Compensation-related expenses: $1.8 billion for fiscal 2024, reflecting a 2% increase:

o
Higher compensation costs due to increases in average wages.

•
PEO insurance costs: $471.3 million in fiscal 2024, reflecting a 13% increase:

o
Increase in PEO direct insurance costs related to growth in average worksite employees and wages, and PEO insurance revenues.

•
Cost optimization initiatives: $39.5 million in fiscal 2024:

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o
During the fourth quarter, we focused on cost optimization initiatives, including further reductions to our geographic footprint, reprioritization of certain technology investments, and headcount optimization. These initiatives will provide ongoing savings in rent, facilities maintenance, and wage-related expenses.

Total expenses, excluding one-time cost optimization initiatives noted above, increased approximately 3% compared to the prior year.

Operating income: Fiscal 2024 operating income was $2.2 billion, an increase of 7% compared to fiscal 2023, as a result of revenue growth outpacing expense increases as previously discussed. Adjusted operating income(1) of $2.2 billion, which excludes the impact of one-time costs, reflects an increase of 9%. Operating margin and adjusted operating margin(1) were as follows:

Other income, net: Other income, net increased $28.8 million to $43.9 million in fiscal 2024 as a result of higher average investment balances and average interest rates earned on our corporate investments.

Income taxes: Our effective income tax rate was 23.8% and 24.0% for fiscal years 2024 and 2023, respectively. The effective income tax rates in both periods were impacted by the recognition of net discrete tax benefits related to the volume of stock option exercises and the associated employee stock-based compensation payments. Refer to Note L of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for additional disclosures on income taxes.

Net income and diluted earnings per share: Net income was $1.7 billion and $1.6 billion for fiscal 2024 and fiscal 2023, respectively. Diluted earnings per share was $4.67 per diluted share for fiscal 2024 and $4.30 per diluted share for fiscal 2023. Refer to Note C of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for information on dilutive shares outstanding.

Adjusted net income(1) was $1.7 billion and $1.5 billion for fiscal 2024 and fiscal 2023, respectively, reflecting an increase of 10%. Adjusted diluted earnings per share(1) was $4.72 per diluted share and $4.27 per diluted share for fiscal 2024 and fiscal 2023, respectively, reflecting an increase of 11%.

(1)
Adjusted operating income, adjusted operating margin, adjusted net income and adjusted diluted earnings per share are not U.S. GAAP measures. Refer to the “Non-GAAP Financial Measures” section below for a discussion of these non-GAAP measures and a reconciliation to the most comparable GAAP measure of operating income, operating margin, net income and diluted earnings per share.

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

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

(2)
One-time costs and corresponding tax benefit related to our cost optimization initiatives, including further reductions to our geographic footprint, reprioritization of certain technology investments, and headcount optimization.

(3)
Net tax windfall benefits related to employee stock-based compensation payments recognized in income taxes. This item is subject to volatility and will vary based on employee decisions on exercising employee stock options and fluctuations in our stock price, neither of which is within the control of management.

(4)
The calculation of the impact of non-GAAP adjustments on diluted earnings per share is performed on each line independently. The table may not add down by +/- $0.01 due to rounding.

In addition to reporting operating income, operating margin, net income and diluted earnings per share, which are U.S. GAAP measures, we present adjusted operating income, adjusted operating margin, adjusted net income, adjusted diluted earnings per share, EBITDA and adjusted EBITDA, which are non-GAAP measures. We believe these additional measures are indicators of our core business operations performance period over period. Adjusted operating income, adjusted operating margin, adjusted net income, adjusted diluted earnings per share, EBITDA and adjusted EBITDA, are not calculated through the application of U.S. GAAP and are not required forms of disclosure by the Securities and Exchange Commission (“SEC”). As such, they should not be considered a substitute for the U.S. GAAP measures of net income and diluted earnings per share, and, therefore, they should not be used in isolation but in conjunction with the U.S. GAAP measures. The use of any non-GAAP

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measure may produce results that vary from the U.S. GAAP measure and may not be comparable to a similarly defined non-GAAP measure used by other companies.

Liquidity and Capital Resources

Our financial position as of May 31, 2024 remained strong with cash, restricted cash, and total corporate investments of $1.6 billion. Short-term borrowings of $18.7 million and long-term borrowings of $800.0 million were outstanding as of May 31, 2024. Our unused capacity under our unsecured credit facilities was $2.0 billion as of May 31, 2024. Our primary source of cash is our ongoing operations, which was $1.9 billion for fiscal 2024. Our positive cash flows have allowed us to support our business, pay dividends and fund our acquisition of Alterna Capital Solutions, Inc. We currently anticipate that corporate cash, corporate restricted cash, and total corporate investments as of May 31, 2024, along with projected operating cash flows and available short-term financing, will support our business operations, capital purchases, primarily investment in our technology solutions, share repurchases, dividend payments, and the servicing of long-term debt for the foreseeable future.

For client funds liquidity, we have the ability to borrow on our unsecured credit facilities or use corporate liquidity when necessary to meet short-term funding needs related to client fund obligations. Historically, we have borrowed, typically on an overnight basis, to settle short-term client fund obligations, rather than liquidate previously collected client funds invested in our long-term AFS portfolio. We believe that our investments in an unrealized loss position as of May 31, 2024 were not impaired due to increased credit risk or other valuation concerns, nor has any event occurred subsequent to that date to indicate any change in our assessment. We do not intend to sell these investments until recovery of their amortized cost basis or maturity and further believe that it is not more-than-likely that we would be required to sell these investments prior to that time.

Financing

Short-term financing: We maintain committed and unsecured credit facilities and irrevocable letters of credit as part of our normal and recurring business operations. The purpose of these credit facilities is to meet short-term funding requirements, finance working capital needs, and for general corporate purposes. We typically borrow on an overnight or short-term basis on our credit facilities. Refer to Note M of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for further discussion on our credit facilities.

Details of our credit facilities are as follows:

Amounts outstanding under the PNC credit facility as of May 31, 2024 remain outstanding as of the date of this report.

Details of borrowings under each credit facility during fiscal 2024 were as follows:

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We primarily use short-term borrowings to settle client fund obligations, rather than liquidating previously collected client funds invested in our long-term AFS investment portfolio.

On April 12, 2024, we and Paychex of New York LLC, a Delaware limited liability company (“PoNY”), entered into an amendment (the “2019 Credit Facility Amendment”) to our $1.0 billion, five-year, unsecured, revolving credit facility (the “2019 Credit Facility”), for which JPM acts as Administrative Agent. The 2019 Credit Facility Amendment, among other things, (a) extended the maturity date of the 2019 Credit Facility from July 31, 2024 to April 12, 2029, (b) amended the interest rate provisions under the 2019 Credit Facility, (c) amended the lenders under the syndication and (d) made other ministerial changes to the 2019 Credit Facility.

On April 12, 2024, we and PoNY entered into an amendment (the “2017 Credit Facility Amendment”) to our $750.0 million, five-year, unsecured, revolving credit facility (the “2017 Credit Facility”), for which JPM acts as Administrative Agent. The 2017 Credit Facility Amendment, among other things, (a) amended the interest rate provisions under the 2017 Credit Facility, and (b) made other ministerial changes to the 2017 Credit Facility.

Subsequent to May 31, 2024, there were no additional overnight borrowings under our PNC and JPM credit facilities.

We expect to have access to the amounts available under our current credit facilities to meet our ongoing financial needs. However, if we experience reductions in our operating cash flows due to any of the risk factors outlined in, but not limited to, Item 1A in this Form 10-K and other SEC filings, we may need to adjust our capital, operating, and other discretionary spending to realign our working capital requirements with the capital resources available to us. Furthermore, if we determine the need for additional short-term liquidity, there is no assurance that such financing, if pursued and obtained, would be adequate or on terms acceptable to us.

Letters of credit: As of May 31, 2024, we had irrevocable standby letters of credit available totaling $168.5 million, required to secure commitments for certain insurance policies. The letters of credit expire at various dates between June 26, 2024 and September 29, 2025. No amounts were outstanding on these letters of credit during fiscal 2024 or fiscal 2023, or as of May 31, 2024 and May 31, 2023. Subsequent to May 31, 2024, one letter of credit expiring on June 26, 2024, was renewed for a one year term.

Long-term financing: We have borrowed $800.0 million through the issuance of long-term private placement debt (“Senior Notes”). Refer to Note N of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for further discussion on our long-term financing.

Other commitments: The Company has various long-term contractual obligations as of May 31, 2024, which include:

•
operating leases for $73.2 million;

•
purchase obligations for $211.2 million;

•
workers’ compensation estimated obligations for $218.6 million; and

•
long-term Senior Notes debt obligations for $800.0 million, plus interest payments of $117.6 million.

Refer to Notes A, I, N, and Q of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for more information on these areas.

The liability for uncertain tax positions, including interest and net of federal benefits, was approximately $86.4 million as of May 31, 2024. Refer to Note L of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for more information on income taxes. We are not able to reasonably estimate the timing of future cash flows related to this liability.

We are a limited partner in three venture capital fund arrangements and have committed to contribute a maximum amount of $30.0 million for investment in equity and debt securities of start-up entities primarily in the financial technology sector. As of May 31, 2024, we have contributed $23.4 million of the total funding commitment. The timing of future contributions to be made to these venture capital funds cannot be specifically or reasonably determined. Our investments in these venture capital funds are not considered part of our ongoing operations, are accounted for under the equity method, and represented less than one percent of our total assets as of May 31, 2024.

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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 commitment. We have also entered into indemnification agreements with our officers, directors, and non-officer fiduciaries of our pooled employer plan retirement offering, which require us to defend and, if necessary, indemnify these individuals for certain pending or future legal claims as they relate to their services provided to us.

We currently self-insure the deductible portion of various insured exposures under certain corporate and PEO employee health and medical benefit plans. Our estimated loss exposure under these insurance arrangements is recorded in other current liabilities on our Consolidated Balance Sheets. Historically, the amounts accrued have not been material and were not material as of May 31, 2024. We also maintain corporate insurance coverage in addition to our purchased primary insurance policies for gap coverage for employment practices liability, errors and omissions, warranty liability, theft and embezzlement, cyber threats, and acts of terrorism; and capacity for deductibles and self-insured retention through our captive insurance company.

Operating, Investing, and Financing Cash Flow Activities

Primary sources of cash, restricted cash, and equivalents are through collections for services rendered to our customers and interest earned on funds held for clients and corporate investments. Primary uses of cash include employee compensation and contractual obligations related to business operations, cash dividends paid, share repurchases, purchases of property and equipment, and acquisitions.

Our investment portfolio incorporates both corporate cash and funds held for clients. Interest rates, market conditions, and our volatile cash flows are among several factors influencing our investment strategy directing the mix between long-term and VRDN AFS securities vs. short-term restricted cash and cash equivalents held in the portfolio. A portfolio strategy that favors larger balances held in restricted cash and cash equivalents will impact our investing activities due to the offsetting activity in the purchases and sales/maturities of AFS investments.

Our cash flows include certain activities that are short-term in nature and have an impact on short-term cash flows due to timing of collection and settlement of obligations as follows:

•
PEO receivables and worksite-employee ("WSE") accrued compensation: PEO receivables and WSE accrued compensation fluctuate based on either/both: (1) the timing of the payroll cut-off date and the Company’s month-end close, and (2) the timing of when cash is collected from the customer, and it is remitted to either the WSE for wages earned or applicable tax or regulatory agencies for payroll taxes. PEO accounts receivable collections and compensation payments to WSEs and applicable tax or regulatory agencies are settled through our corporate cash and the fluctuations impact our operating activities.

•
Client fund obligations: Client fund obligations liability will vary based on the timing of when cash is collected from the clients and when it is remitted to employees of the clients utilizing employee payment services or applicable tax or regulatory agencies for payroll tax administration services. Collections from clients are typically remitted from one to 30 days after receipt, with some items extending to 90 days. Fluctuations in client fund obligations impact financing activities.

Summarized cash operating, investing, and financing cash flow information is as follows for fiscal 2024 and fiscal 2023:

(1)
The consolidated statement of cash flows for the fiscal year ended May 31, 2023 includes a revision to previously reported amounts related to the presentation of cash flows associated with short-term receivables purchased from our clients under non-recourse arrangements, net of funding reserves. Refer to Note A of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for a discussion on the revision.

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The changes in our cash flows for fiscal 2024 and fiscal 2023 were primarily the result of the following key drivers:

Operating Cash Flow Activities

Fiscal 2024

•
Net income attributable to the reasons discussed in the “Results of Operations” section of this Item 7;

•
Net changes in PEO assets and liabilities as a result of the timing of cash collected and the settlement of payroll taxes;

•
Net realized losses on the disposal of assets primarily due to our cost optimization initiatives; and

•
Increase in income tax reserves related to unrecognized tax positions taken for years still subject to audit by regulatory bodies; offset by

•
Decrease in accrued corporate compensation primarily due to a decrease in incentive compensation tied to performance measures and the timing of payroll payments at month-end.

Fiscal 2023

•
Net income attributable to the reasons discussed in the “Results of Operations” section of this Item 7;

•
Increase in deferred revenue primarily due to set-up fees related to our pooled employer plan option, which we began offering to our clients during fiscal 2022 and amortize over 4 years; and

•
Change in accrued income taxes due to the impact of an increase in our unrecognized tax position related to ongoing regulatory audits, offset by an increase in prepaid income taxes as a result of changes to the deductibility of research and development costs; offset by

•
Increase in non-PEO related trade receivables primarily due to timing related to our payroll cut-off and month-end, as well as the timing of cash collections for other ancillary services; and

•
Payment of federal payroll taxes deferred under the Coronavirus Aid, Relief and Economic Security Act.

Investing Cash Flow Activities

Fiscal 2024

•
Cash used for the acquisition of Alterna Capital Solutions, LLC and settlement of its outstanding debt at closing. Refer to Note D of the Notes to the Consolidated Financial Statements for additional discussion on this transaction;

•
Cash used to develop and enhance our client-facing internal-use software and the acquisition of third-party customer lists; and

•
Net purchases of short-term accounts receivable due to an increase in our client base, and funding to existing client base, and the timing of net cash collections; offset by

•
Net sales from AFS securities primarily due to a shift from investing in VRDNs to reinvesting in cash and cash equivalents due to more favorable interest rates. Our VRDN holdings were $- at May 31, 2024 compared to $344.1 million at May 31, 2023.

Fiscal 2023

•
Net sales from AFS securities primarily due to a shift from investing in VRDNs to reinvesting in cash and cash equivalents due to more favorable interest rates. Our VRDN holdings were $344.1 million at May 31, 2023 compared to $1.2 billion at May 31, 2022; and

•
Proceeds received from the sale of two commercial buildings; offset by

•
Cash used to develop and enhance our client-facing internal-use software and the acquisition of third-party customer lists.

Financing Cash Flow Activities

Fiscal 2024

•
Cumulative dividends paid at $3.65 per share for fiscal 2024. The payment of future dividends is dependent on our future earnings and cash flow and is subject to the discretion of our Board of Directors;

•
Decrease in client fund obligations related to the timing of collections and remittances of semi-weekly tax payments that were deferred at the end of fiscal 2023 as a result of the Memorial Day holiday; and

•
Repurchases of 1.5 million shares of our common stock at a weighted-average price of $115.37. These shares were retired immediately upon purchase; offset by

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•
Cash activity related to equity-based plans.

Fiscal 2023

•
Cumulative dividends paid at $3.26 per share for fiscal 2023. The payment of future dividends is dependent on our future earnings and cash flow and is subject to the discretion of our Board of Directors; and

•
Cash activity related to equity-based plans; offset by

•
Increase in client fund obligations due to the timing of collections and remittances of semi-weekly tax payments that were deferred at the end of fiscal 2023 due to the Memorial Day holiday.

Other

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

Critical Accounting Policies and Estimates

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

Revenue recognition: Revenues are primarily attributable to fees for providing services as well as investment income earned on funds held for clients. Fees associated with services are recognized when control of the contracted services is transferred to our clients, in an amount that reflects the consideration we expect to receive in exchange for such services. Our service revenue is largely attributable to processing services where the fee is based on a fixed amount per processing period or a fixed amount per processing period plus a fee per employee or transaction processed. Insurance Solutions revenues are recognized when commissions are earned on premiums billed and collected. Fees earned for the purchase of client's accounts receivable under non-recourse arrangements are based on a percentage of funding amounts as specified in the client contract. These fees are then recognized over the average collection period of 40 to 60 days for clients in the temporary staffing agency market and approximately 5 to 15 days for other clients. The revenue earned from delivery service for the distribution of certain client payroll checks and reports is included in service revenue, and the costs for the delivery are included in cost of service revenue on the Consolidated Statements of Income and Comprehensive Income.

We receive advance payments for set-up fees from our clients. Advance payments received for certain of our service offerings for set-up fees are considered a material right. Therefore, we defer the revenue associated with these advance payments, recognizing the revenue and related expenses over the expected period to which the material right exists.

PEO Solutions revenue is included in service revenue and is reported net of certain pass-through costs billed and incurred, which include payroll wages, payroll taxes, including federal and state unemployment insurance, and certain health insurance benefit premiums, primarily costs related to our guaranteed cost benefit plans. Direct costs related to workers’ compensation and certain benefit plans where we retain risk are recognized as cost of service revenue rather than as a reduction in service revenue.

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

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Assets Recognized from the Costs to Obtain and Fulfill Contracts: We recognize an asset for the incremental costs of obtaining a contract with a client if it is expected that the economic benefit and amortization period will be longer than one year. Incremental costs of obtaining a contract include only those costs that are directly related to the acquisition of new contracts and that would not have been incurred if the contract had not been obtained. We do not incur incremental costs to obtain a contract renewal. We determined that certain sales commissions and bonuses, including related fringe benefits, meet the capitalization criteria under Accounting Standards Codification (“ASC”) Subtopic 340-40, “Other Assets and Deferred Costs: Contracts with Customers” (“ASC 340-40”). We also recognize an asset for the costs to fulfill a contract with a client if the costs are specifically identifiable, generate or enhance resources used to satisfy future performance obligations, and are expected to be recovered. We determined that substantially all costs related to implementation activities are administrative in nature and meet the capitalization criteria under ASC 340-40. These capitalized costs to fulfill a contract principally relate to upfront direct costs that are expected to be recovered and enhance our ability to satisfy future performance obligations.

The assets related to both costs to obtain and costs to fulfill contracts with clients are capitalized and amortized using an accelerated method over an eight-year life to closely align with the pattern of client attrition over the estimated life of the client relationship. We regularly review our deferred costs for potential impairment and did not recognize an impairment loss during the fiscal years ended May 31, 2024 or May 31, 2023.

PEO insurance reserves: As part of our PEO solution, we offer workers’ compensation insurance and health insurance to clients for the benefit of client employees. Workers’ compensation insurance is primarily provided under fully insured high deductible workers’ compensation insurance policies. Workers’ compensation insurance reserves are established to provide for the estimated costs of paying claims up to per occurrence liability limits. These reserves include estimates of certain expenses associated with processing and settling these claims. In establishing the PEO workers’ compensation insurance reserves, we use an independent actuarial estimate of undiscounted future cash payments that would be made to settle claims. The determination of estimated ultimate losses by our independent actuary are based on accepted actuarial methods and assumptions. The estimated ultimate losses are primarily based upon loss development factors, and other factors such as the nature of employees’ job responsibilities, the historical frequency and severity of workers’ compensation claims, and an estimate of future cost trends. Each reporting period, changes in actuarial assumptions resulting from changes in actual claims experience and other trends are incorporated into our workers’ compensation claims cost estimates.

With respect to our PEO health insurance, we offer various health insurance plans that take the form of either fully insured guaranteed cost plans or fully insured insurance arrangements where we retain risk. A reserve for insurance arrangements where we retain risk is established to provide for the payment of claims in accordance with our service contract with the carrier. The claims liability includes estimates for reported losses, plus amounts for those claims incurred but not reported, and estimates of certain expenses associated with processing and settling the claims.

Estimating the ultimate cost of future claims is an uncertain and complex process based upon historical loss experience and accepted actuarial methods and assumptions, and is subject to change due to multiple factors, including economic trends, changes in legal liability law, and damage awards, all of which could materially impact the reserves as reported in the consolidated financial statements. Accordingly, final claim settlements may vary from the present estimates, particularly with workers’ compensation insurance where those payments may not occur until well into the future. We regularly review the adequacy of our estimated insurance reserves. Adjustments to previously established reserves are reflected in the results of operations for the period in which the adjustment is identified. Such adjustments could possibly be significant, reflecting any combination of new and adverse or favorable trends. Adjustments to previously established reserves were not material for fiscal 2024 or 2023.

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 a reporting unit. We perform our annual impairment testing in our fiscal fourth quarter. During fiscal 2024 and 2023, a qualitative analysis was performed for all reporting units. 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 2024 or 2023. Subsequent to the latest review, there have been no events or circumstances that indicate any potential impairment of the Company’s goodwill balance.

We also test intangible assets with indefinite useful lives for potential impairment on an annual basis and between annual tests if events or changes in circumstances change in a way that indicate that the carrying value may not be recoverable. We have determined that there is no impairment of intangible assets with indefinite useful lives for fiscal 2024 or 2023 as a result of the qualitative analyses performed.

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Impairment of Long-Lived Assets: Long-lived assets, including intangible assets with finite lives and operating lease right-of-use assets, are reviewed for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the estimated fair value of the asset. We have determined that there is no impairment of long-lived assets for fiscal 2024 or as of May 31, 2024.

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

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

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

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

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

Income taxes: We account for deferred taxes by recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the fiscal year in which the differences are expected to reverse. We record a deferred tax asset related to the stock-based compensation costs recognized for certain stock-based awards. At the time of the exercise of non-qualified stock options or vesting of stock awards, we recognize any excess tax benefit within income taxes in the Consolidated Statements of Income and Comprehensive Income.

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

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

Management’s Discussion and Analysis of Financial Condition and Results of Operations reviews the operating results of Paychex, Inc. and its wholly owned subsidiaries (“Paychex,” the “Company,” “we,” “our,” or “us”) for our fiscal year ended May 31, 2023 (“fiscal 2023” or the “fiscal year”), as compared to our fiscal year ended May 31, 2022 (“fiscal 2022”), and our financial condition as of May 31, 2023. A detailed review of our fiscal 2022 performance compared to our fiscal year ended May 31, 2021 performance and our financial condition as of May 31, 2022 is set forth in Part II, Item 7 of our Annual Report on Form 10-K (“Form 10-K”) for fiscal 2022. This review should be read in conjunction with the accompanying consolidated financial statements and the related Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K and the “Risk Factors” discussed in Item 1A of this Form 10-K. Forward-looking statements in this review are qualified by the cautionary statement under the heading “Cautionary Note Regarding Forward-Looking Statements” contained at the beginning of Part I of this Form 10-K.

Overview

We are a leading provider of integrated human capital management (“HCM”) solutions for human resources (“HR”), payroll, benefits, and insurance for small- to medium-sized businesses and their employees across the United States (“U.S.”) and parts of Europe. We offer a comprehensive portfolio of HCM technology and HR advisory solutions that help our clients address the evolving challenges of HR.

We support our small-business clients, reducing the complexity and risk of running their own payroll, while ensuring greater accuracy with up-to-date tax rates and regulatory information. Clients may choose to have our support team handle everything for them, or process payroll themselves utilizing our proprietary, robust Paychex Flex® and SurePayroll® SaaS-based solutions. Our medium-sized clients generally have more complex payroll and employee benefit needs, though with the environment of increasing regulations, we believe the need for HR outsourcing services has been moving down-market. Any of our clients on Paychex Flex can opt for the integrated suite of HCM solutions, which allows clients to choose the service and software solutions that will meet the needs of their business.

Our portfolio of technology, HR advisory, and employee benefits-related solutions is disaggregated into two categories, (1) Management Solutions and (2) professional employer organization (“PEO”) and Insurance Solutions, as discussed in Part I, Item 1 of this Form 10-K.

Our mission is to be the leading provider of HR, payroll, benefits, and insurance solutions by being an essential partner to small- and medium-sized businesses across the U.S. and parts of Europe. Our strategy focuses on providing industry-leading, integrated technology; delivering superior customer experiences; expanding our leadership in HR; growing our client bases; and engaging in strategic acquisitions. We believe that successfully executing this strategy will lead to strong, long-term financial performance.

We maintain industry-leading margins by managing our personnel costs and expenses while continuing to invest in our business, particularly in sales and marketing and leading-edge technology. We believe these investments are critical to our success. Looking to the future, we believe that investing in our solutions, people, and digital capabilities will position us to capitalize on opportunities for long-term growth.

We closely monitor the evolving challenges and needs of small- and mid-sized businesses, and proactively aid our clients in navigating these challenges. Through our unique blend of innovative technology solutions, backed by our extensive compliance and HR expertise, we help clients more effectively hire, engage, train, and retain top talent in this challenging workforce environment. Our ongoing investments in our platforms have prepared us well for the demands of the current business and regulatory environments, allowing us to adapt while maintaining strong solutions and support delivery, resulting in high levels of client satisfaction and retention.

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Fiscal 2023 Business Highlights

Highlights compared to fiscal 2022 are as follows:

(1)
Adjusted net income and adjusted diluted earnings per share are not U.S. generally accepted accounting principle (“GAAP”) measures. Refer to the “Non-GAAP Financial Measures” section of this Item 7 for a discussion of non-GAAP measures and a reconciliation to the U.S. GAAP measures of net income and diluted earnings per share.

(2)
Dividends paid to stockholders represented approximately 75% of net income for fiscal 2023 compared to approximately 72% of net income for fiscal 2022.

(3)
Percentage changes are calculated based on unrounded numbers.

For further analysis of our results of operations for fiscal years 2023 and 2022, and our financial position as of May 31, 2023, refer to the tables and analysis in the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item 7.

Business Outlook

Our payroll and PEO client base was approximately 740,000 and greater than 730,000 clients as of May 31, 2023 and 2022, respectively. Client retention remained high in the range of 82% to 83% of our beginning client base for fiscal 2023, compared to approximately 84% for fiscal 2022.

While our HR solution offerings provide services to employers and employees beyond payroll, they effectively leverage payroll processing data. These services are included as part of the integrated HCM solution within Paychex Flex or provided through the PEO platform. The following table illustrates selected HR solution offerings:

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

We continue to make investments in technology a priority as companies look to leverage technology solutions to maintain operations, stay connected to employees, and increase productivity. Our fiscal 2023 technology enhancements to our Paychex Flex platform were designed to improve the client and employee experiences from hiring and onboarding through employee retention.

We have further strengthened our position in the industry by serving as a source of education and information to clients, businesses of all sizes, and other interested parties. We provide free webinars, white papers, and other information on our website (www.paychex.com) 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.

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Results of Operations

Summary of Results of Operations for Fiscal Years:

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

n/m – not meaningful

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

•
Management Solutions revenue: $3.7 billion for fiscal 2023, reflecting an increase of 8%:

o
Increase in the number of clients and clients' employees for HCM and worksite employees for HR Solutions;

o
Higher revenue per client resulting from pricing realization and product attachment, including increased demand for HR Solutions, retirement, and time and attendance solutions; and

o
Continued growth in HCM ancillary services.

•
PEO and Insurance Solutions revenue: $1.2 billion for fiscal 2023, reflecting an increase of 6%:

o
Growth in the number of average PEO worksite employees and increases in average wages per worksite employee;

o
Higher state unemployment insurance revenue and health insurance premiums; and

o
Growth in ancillary services.

•
Interest on funds held for clients: $99.8 million for fiscal 2023, reflecting an increase of 73%:

o
Higher average interest rates, and

o
Higher average investment balances, partially offset by

o
Realized losses on investment sales as we repositioned a portion of our long-term investment portfolio.

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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, 2023, we had no exposure to high-risk or non-liquid investments. Details regarding our combined funds held for clients and corporate cash equivalents and investment portfolios are as follows:

(1)
The net unrealized loss on our investment portfolios was approximately $198.8 million as of July 12, 2023.

(2)
The Federal Funds rate was in the range of 5.00% to 5.25% as of May 31, 2023 and in the range of 0.75% to 1.00% as of May 31, 2022.

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

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

Total expenses: The following table summarizes total combined cost of service revenue and selling, general and administrative expenses for fiscal years:

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

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

•
Compensation-related expenses: $1.8 billion for fiscal 2023, reflecting a 9% increase:

o
Higher compensation costs due to increases in headcount and average wage rates.

•
Depreciation and amortization: $176.6 million for fiscal 2023, reflecting a decrease of 8%:

o
Lower amortization expense on intangible assets which use accelerated amortization methods.

•
Other expenses: $598.0 million in fiscal 2023, reflecting a 10% increase:

o
Continued investment in product development, technology, and marketing.

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Operating income: Fiscal 2023 operating income was $2.0 billion, an increase of 10% compared to fiscal 2022, as a result of revenue growth outpacing expense increases as previously discussed. Operating margin (operating income as a percentage of total revenue) was as follows:

Other income/(expense): Other income/(expense) increased $30.5 million to $15.1 million in fiscal 2023 as a result of higher average interest rates earned on our corporate investments.

Income taxes: Our effective income tax rate was 24.0% and 23.7% for fiscal years 2023 and 2022, respectively. Both periods include the recognition of excess tax benefits related to employee stock-based compensation payments. The prior year was also impacted by the recording of a tax benefit related to prior years' research and development expenses incurred in the production of customer-facing software. 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.

Net income and diluted earnings per share: Net income was $1.6 billion and $1.4 billion for fiscal 2023 and fiscal 2022, respectively. Diluted earnings per share was $4.30 per diluted share for fiscal 2023 and $3.84 per diluted share for fiscal 2022. Refer to Note C of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for information on dilutive shares outstanding.

Adjusted net income(1) was $1.5 billion and $1.4 billion for fiscal 2023 and fiscal 2022, respectively, reflecting an increase of 13%. Adjusted diluted earnings per share(1) was $4.27 per diluted share and $3.77 per diluted share for fiscal 2023 and fiscal 2022, respectively, reflecting an increase of 13%.

(1)
Adjusted net income and adjusted diluted earnings per share are not U.S. GAAP measures. Refer to the “Non-GAAP Financial Measures” section below for a discussion of these non-GAAP measures and a reconciliation to the most comparable GAAP measure of net income and diluted earnings per share.

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

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

(2)
Net tax windfall benefits related to employee stock-based compensation payments recognized in income taxes. This item is subject to volatility and will vary based on employee decisions on exercising employee stock options and fluctuations in our stock price, neither of which is within the control of management.

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

(4)
The calculation of the impact of non-GAAP adjustments on diluted earnings per share is performed on each line independently. The table may not add down by +/- $0.01 due to rounding.

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

Liquidity and Capital Resources

Our financial position as of May 31, 2023 remained strong with cash, restricted cash, and total corporate investments of $1.6 billion. Total short-term and long-term borrowings, net of debt issuance costs, were $808.4 million as of May 31, 2023. Our primary source of cash is our ongoing operations. Cash flows from operations were $1.7 billion for fiscal 2023. Our positive cash flows for fiscal 2023 allowed us to support our business and pay dividends of approximately $1.2 billion. We currently anticipate that cash, restricted cash, and total corporate investments as of May 31, 2023, along with projected operating cash flows and available short-term financing, will support our business operations, capital purchases, share repurchases, and dividend payments for the foreseeable future.

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We believe that our investments in an unrealized loss position as of May 31, 2023 were not impaired due to increased credit risk or other valuation concerns, nor has any event occurred subsequent to that date to indicate any change in our assessment.

Financing

Short-term financing: We maintain committed and unsecured credit facilities and irrevocable letters of credit as part of our normal and recurring business operations. The purpose of these credit facilities is to meet short-term funding requirements, finance working capital needs, and for general corporate purposes. We typically borrow on an overnight or short-term basis on our credit facilities. Refer to Note L of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for further discussion on our credit facilities.

Details of our credit facilities are as follows:

Amounts outstanding under the PNC credit facility as of May 31, 2023 remain outstanding as of the date of this report.

Details of borrowings under each credit facility during the fiscal years ended 2023 and 2022 were as follows:

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Short-term borrowings are primarily used for the settlement of client fund obligations, rather than liquidating previously collected client funds that have been invested in AFS securities allocated to our long-term portfolio.

On February 3, 2023, we and Paychex Advance LLC, a Paychex subsidiary and New York limited liability company, entered into Amendment No. 2 (the “Amendment”) to the $250 million, three-year, unsecured, revolving credit facility established on February 6, 2020 (the “2020 Credit Facility”) for which PNC Bank, N.A. acts as administrative agent.

The Amendment, among other things, extended the maturity date of the 2020 Credit Facility from February 6, 2023 to February 6, 2026 at which time all borrowings thereunder will terminate. Except for extending the maturity date and making ministerial changes to the 2020 Credit Facility, the Amendment did not change the existing terms of the 2020 Credit Facility.

Subsequent to May 31, 2023, there were no additional overnight borrowings under our PNC and JPM credit facilities.

We expect to have access to the amounts available under our current credit facilities to meet our ongoing financial needs. However, if we experience reductions in our operating cash flows due to any of the risk factors outlined in, but not limited to, Item 1A in this Form 10-K and other SEC filings, we may need to adjust our capital, operating, and other discretionary spending to realign our working capital requirements with the capital resources available to us. Furthermore, if we determine the need for additional short-term liquidity, there is no assurance that such financing, if pursued and obtained, would be adequate or on terms acceptable to us.

Letters of credit: As of May 31, 2023, we had irrevocable standby letters of credit available totaling $141.7 million, required to secure commitments for certain insurance policies. The letters of credit expire at various dates between June 9, 2023 and May 25, 2024. No amounts were outstanding on these letters of credit during fiscal 2023 or fiscal 2022, or as of May 31, 2023 and May 31, 2022. Subsequent to May 31, 2023, letters of credit expiring on June 9, 2023, June 15, 2023, and June 26, 2023 were renewed for one year terms.

Long-term financing: We have borrowed $800.0 million through the issuance of long-term private placement debt (“Senior Notes”). Certain information related to the Senior Notes is as follows:

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

Other commitments: The Company has various long-term contractual obligations as of May 31, 2023, which include:

•
operating leases for $81.7 million;

•
purchase obligations for $228.9 million;

•
workers’ compensation estimated obligations for $195.8 million; and

•
long-term Senior Notes debt obligations for $800.0 million, plus interest payments of 150.8 million.

Refer to Notes A, H, M, and P of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for more information on these areas.

The liability for uncertain tax positions, including interest and net of federal benefits, was approximately $69.4 million as of May 31, 2023. 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.

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We are a limited partner in three venture capital fund arrangements and have committed to contribute a maximum amount of $30.0 million for investment in equity and debt securities of start-up entities primarily in the financial technology sector. As of May 31, 2023, we have contributed $22.2 million of the total funding commitment. The timing of future contributions to be made to these venture capital funds cannot be specifically or reasonably determined. Our investments in these venture capital funds are not considered part of our ongoing operations, are accounted for under the equity method, and represented less than one percent of our total assets as of May 31, 2023.

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

We currently self-insure the deductible portion of various insured exposures under certain corporate and PEO employee health and medical benefit plans. Our estimated loss exposure under these insurance arrangements is recorded in other current liabilities on our Consolidated Balance Sheets. Historically, the amounts accrued have not been material and were not material as of May 31, 2023. We also maintain corporate insurance coverage in addition to our purchased primary insurance policies for gap coverage for employment practices liability, errors and omissions, warranty liability, theft and embezzlement, cyber threats, and acts of terrorism; and capacity for deductibles and self-insured retention through our captive insurance company.

Operating, Investing, and Financing Cash Flow Activities

The changes in our cash flows for fiscal 2023 and fiscal 2022 were primarily the result of the following key drivers:

Operating Cash Flow Activities

•
Higher net income attributable to the reasons discussed in the “Results of Operations” section of this Item 7;

•
Changes in funding for temporary staffing clients, offset by

•
Change in accrued income taxes as a result of the impacts of higher cumulative quarterly tax payments and higher income tax expense related to higher taxable income and effective tax rates over the prior year.

Investing Cash Flow Activities

•
Increase in the net proceeds from the sales of AFS securities;

•
Increase in proceeds received from the sales of buildings and furniture and fixtures; and

•
Decrease in cash payments for the acquisitions of businesses.

Fluctuations in the net purchases and sales/maturities of AFS securities are also due to timing within the client funds portfolio and market conditions. Specific timing items impacting cash flows for fiscal 2023 and fiscal 2022 are discussed further in the financing cash flows discussion of net changes in client fund obligations. Amounts will vary based upon the timing of collection from clients, and the related remittance to applicable tax or regulatory agencies for payroll tax administration services and to employees of clients utilizing employee payment services.

Discussion of interest rates and related risks is included in the “Market Risk Factors” section contained in Item 7A of this Form 10-K.

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Financing Cash Flow Activities

•
Increase in cash inflows from changes in client fund obligations due to the timing of collections and remittances of client funds; and

•
Decrease in cash payments for repurchases of common shares. There were no shares repurchased during fiscal 2023 compared to 1.2 million for $145.2 million during fiscal year 2022; offset by

•
Increase in dividends paid of $175.4 million compared to the prior year period due to an increase in our aggregate annual dividends from $2.77 per share to $3.26 per share. The payment of future dividends is dependent on our future earnings and cash flow and is subject to the discretion of our Board; and

•
Change in cash activity related to equity-based plans primarily due to a decrease in the number of stock options exercised during fiscal 2023 when compared with fiscal 2022.

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

Other

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

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Critical Accounting Policies and Estimates

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

Revenue recognition: Revenues are primarily attributable to fees for providing services as well as investment income earned on funds held for clients. Fees associated with services are recognized when control of the contracted services is transferred to our clients, in an amount that reflects the consideration we expect to receive in exchange for such services. Our service revenue is largely attributable to processing services where the fee is based on a fixed amount per processing period or a fixed amount per processing period plus a fee per employee or transaction processed. Insurance Solutions revenues are recognized when commissions are earned on premiums billed and collected. Fees earned for funding payrolls of our clients in the temporary staffing industry via the purchase of accounts receivable are based on a percentage of funding amounts as specified in the client contract. These fees are then recognized over the average collection period of 41 to 44 days. The revenue earned from delivery service for the distribution of certain client payroll checks and reports is included in service revenue, and the costs for the delivery are included in cost of service revenue on the Consolidated Statements of Income and Comprehensive Income.

We receive advance payments for set-up fees from our clients. Advance payments received for certain of our service offerings for set-up fees are considered a material right. Therefore, we defer the revenue associated with these advance payments, recognizing the revenue and related expenses over the expected period to which the material right exists.

PEO Solutions revenue is included in service revenue and is reported net of certain pass-through costs billed and incurred, which include payroll wages, payroll taxes, including federal and state unemployment insurance, and certain health insurance benefit premiums, primarily costs related to our guaranteed cost benefit plans. Direct costs related to workers’ compensation and certain benefit plans where we retain risk are recognized as cost of service revenue rather than as a reduction in service revenue.

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

Assets Recognized from the Costs to Obtain and Fulfill Contracts: We recognize an asset for the incremental costs of obtaining a contract with a client if it is expected that the economic benefit and amortization period will be longer than one year. Incremental costs of obtaining a contract include only those costs that are directly related to the acquisition of new contracts and that would not have been incurred if the contract had not been obtained. We do not incur incremental costs to obtain a contract renewal. We determined that certain sales commissions and bonuses, including related fringe benefits, meet the capitalization criteria under Accounting Standards Codification (“ASC”) Subtopic 340-40, “Other Assets and Deferred Costs: Contracts with Customers” (“ASC 340-40”). We also recognize an asset for the costs to fulfill a contract with a client if the costs are specifically identifiable, generate or enhance resources used to satisfy future performance obligations, and are expected to be recovered. We determined that substantially all costs related to implementation activities are administrative in nature and meet the capitalization criteria under ASC 340-40. These capitalized costs to fulfill a contract principally relate to upfront direct costs that are expected to be recovered and enhance our ability to satisfy future performance obligations.

The assets related to both costs to obtain and costs to fulfill contracts with clients are capitalized and amortized using an accelerated method over an eight-year life to closely align with the pattern of client attrition over the estimated life of the client relationship. We regularly review our deferred costs for potential impairment and did not recognize an impairment loss during the fiscal years ended May 31, 2023 or May 31, 2022.

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PEO insurance reserves: As part of our PEO solution, we offer workers’ compensation insurance and health insurance to clients for the benefit of client employees. Workers’ compensation insurance is primarily provided under fully insured high deductible workers’ compensation insurance policies. Workers’ compensation insurance reserves are established to provide for the estimated costs of paying claims up to per occurrence liability limits. These reserves include estimates of certain expenses associated with processing and settling these claims. In establishing the PEO workers’ compensation insurance reserves, we use an independent actuarial estimate of undiscounted future cash payments that would be made to settle claims. The determination of estimated ultimate losses by our independent actuary are based on accepted actuarial methods and assumptions. The estimated ultimate losses are primarily based upon loss development factors, and other factors such as the nature of employees’ job responsibilities, the historical frequency and severity of workers’ compensation claims, and an estimate of future cost trends. Each reporting period, changes in actuarial assumptions resulting from changes in actual claims experience and other trends are incorporated into our workers’ compensation claims cost estimates.

With respect to our PEO health insurance, we offer various health insurance plans that take the form of either fully insured guaranteed cost plans or fully insured insurance arrangements where we retain risk. A reserve for insurance arrangements where we retain risk is established to provide for the payment of claims in accordance with our service contract with the carrier. The claims liability includes estimates for reported losses, plus amounts for those claims incurred but not reported, and estimates of certain expenses associated with processing and settling the claims.

Estimating the ultimate cost of future claims is an uncertain and complex process based upon historical loss experience and accepted actuarial methods and assumptions, and is subject to change due to multiple factors, including economic trends, changes in legal liability law, and damage awards, all of which could materially impact the reserves as reported in the consolidated financial statements. Accordingly, final claim settlements may vary from the present estimates, particularly with workers’ compensation insurance where those payments may not occur until well into the future. We regularly review the adequacy of our estimated insurance reserves. Adjustments to previously established reserves are reflected in the results of operations for the period in which the adjustment is identified. Such adjustments could possibly be significant, reflecting any combination of new and adverse or favorable trends. Adjustments to previously established reserves were not material for fiscal 2023 or 2022.

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 a reporting unit. We perform our annual impairment testing in our fiscal fourth quarter. During fiscal 2023, a qualitative analysis was performed for all reporting units. During fiscal 2022, a qualitative assessment was performed for our Paychex, Inc., excluding Purchased Receivables, reporting unit, and a quantitative assessment was performed on the Purchased Receivable reporting unit to determine if it is more-likely-than-not that the fair value of the reporting units had declined below their 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 2023 or 2022. Subsequent to the latest review, there have been no events or circumstances that indicate any potential impairment of the Company’s goodwill balance.

We also test intangible assets with indefinite useful lives for potential impairment on an annual basis and between annual tests if events or changes in circumstances change in a way that indicate that the carrying value may not be recoverable. We have determined that there is no impairment of intangible assets with indefinite useful lives for fiscal 2023 or 2022 as a result of the qualitative analyses performed.

Impairment of Long-Lived Assets: Long-lived assets, including intangible assets with finite lives and operating lease right-of-use (“ROU”) assets, are reviewed for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the estimated fair value of the asset. We have determined that there is no impairment of long-lived assets for fiscal 2023 or as of May 31, 2023.

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

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

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

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

Refer to Note 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. At the time of the exercise of non-qualified stock options or vesting of stock awards, we recognize any excess tax benefit within income taxes in the Consolidated Statements of Income and Comprehensive Income.

We maintain a reserve for uncertain tax positions. We evaluate tax positions taken or expected to be taken in a tax return for recognition in our consolidated financial statements. Prior to recording the related tax benefit in our consolidated financial statements, we must conclude that tax positions will be more-likely-than-not to be sustained, assuming those positions will be examined by taxing authorities with full knowledge of all relevant information. The benefit recognized in our consolidated financial statements is the amount we expect to realize after examination by taxing authorities. If a tax position drops below the more-likely-than-not standard, the benefit can no longer be recognized. Assumptions, judgment, and the use of estimates are required in determining if the more-likely-than-not standard has been met when developing the provision for income taxes and in determining the expected benefit. A change in the assessment of the more-likely-than-not standard could materially impact our results of operations or financial position. Refer to Note 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 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s Discussion and Analysis of Financial Condition and Results of Operations reviews the operating results of Paychex, Inc. and its wholly owned subsidiaries (“Paychex,” the “Company,” “we,” “our,” or “us”) for our fiscal year ended May 31, 2022 (“fiscal 2022” or the “fiscal year”), as compared to our fiscal year ended May 31, 2021 (“fiscal 2021”), and our financial condition as of May 31, 2022. A detailed review of our fiscal 2021 performance compared to our fiscal year ended May 31, 2020 performance and our financial condition as of May 31, 2021 is set forth in Part II, Item 7 of our Annual Report on Form 10-K (“Form 10-K”) for fiscal 2021. This review should be read in conjunction with the accompanying consolidated financial statements and the related Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K and the “Risk Factors” discussed in Item 1A of this Form 10-K. Forward-looking statements in this review are qualified by the cautionary statement under the heading “Cautionary Note Regarding Forward-Looking Statements” contained at the beginning of Part I of this Form 10-K.

Overview

We are a leading HCM software and services company, offering integrated solutions for HR, payroll, benefits, and insurance services for small- to medium-sized businesses. We offer a comprehensive portfolio of technology solutions and services, supported by HR and compliance expertise, that help our clients address the evolving challenges of HR. Our purpose is to allow our customers the freedom to succeed. The workplace is evolving, and we lead the way by making complex HR, payroll, and benefits simple for our clients.

We support our small-business clients, reducing the complexity and risk of running their own payroll, while ensuring greater accuracy with up-to-date tax rates and regulatory information. Clients may choose to have our service team handle everything for them, or process payroll themselves utilizing our proprietary, robust SaaS Paychex Flex® platform and our SurePayroll® SaaS-based products. Our medium-sized clients generally have more complex payroll and employee benefit needs, though with the environment of increasing regulations, we believe the need for HR outsourcing services has been moving down-market. Any of our clients on Paychex Flex can opt for the integrated suite of HCM solutions, which allows clients to choose the services and software that will meet the needs of their business.

Our portfolio of HCM and employee benefit-related services is disaggregated into two categories, (1) Management Solutions and (2) PEO and Insurance Solutions, as discussed in Part I, Item 1 of this Form 10-K.

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

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

A key component of our service delivery strategy is to be a proactive partner with our clients and to develop and release integrated solutions within Paychex Flex to meet their current and future needs. Our ongoing investments in our platforms have prepared us well for the demands of the current business and regulatory environments, allowing us to adapt while maintaining strong service delivery, resulting in high levels of client satisfaction and retention.

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Fiscal 2022 Business Highlights

Highlights compared to fiscal 2021 are as follows:

(1)
Adjusted net income and adjusted diluted earnings per share are not U.S. generally accepted accounting principle (“GAAP”) measures. Refer to the “Non-GAAP Financial Measures” section of this Item 7 for a discussion of non-GAAP measures and a reconciliation to the U.S. GAAP measures of net income and diluted earnings per share.

(2)
Dividends paid to stockholders represented approximately 72% of net income for fiscal 2022 compared to approximately 83% of net income for fiscal 2021.

(3)
Percentage changes are calculated based on unrounded numbers.

For further analysis of our results of operations for fiscal years 2022 and 2021, and our financial position as of May 31, 2022, refer to the tables and analysis in the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item 7.

Business Outlook

Our payroll and PEO client base was greater than 730,000 and 710,000 clients as of May 31, 2022 and 2021, respectively. Client retention beat our expectations and pre-pandemic levels at approximately 84% of the beginning client base for fiscal 2022, compared to over 85% for fiscal 2021, which was a record.

While our HR product offerings provide services to employers and employees beyond payroll, they effectively leverage payroll processing data. These services are included as part of the integrated HCM solution within Paychex Flex or provided through the PEO platform. The following table illustrates the growth in selected HR product offerings: