Paychex, Inc. (NASDAQ:PAYX) Q1 2024 Earnings Call Transcript

Paychex, Inc. (NASDAQ:PAYX) Q1 2024 Earnings Call Transcript September 27, 2023

Paychex, Inc. beats earnings expectations. Reported EPS is $1.16, expectations were $1.12.

Operator: Good day, everyone, and welcome to today’s Paychex First Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, you will have the opportunity to ask questions during the question-and-answer session. [Operator Instructions] Please note, this call is being recorded, and I will be standing by if you should need any assistance. It is now my pleasure to turn the conference over to John Gibson.

John Gibson: Thank you, Shelby. Thank you, everyone, for joining us for our discussion of the Paychex first quarter fiscal year ’24 earnings release. Joining me today is Efrain Rivera, our Chief Financial Officer; and Bob Schrader, Vice President of Finance and Investor Relations. This morning before the market opened, we released our financial results for the first quarter. You can access our earnings release on our Investor Relations website. Our Form 10-Q will be filed with the SEC within the next day. The teleconference is being broadcast online and will be archived and available on our website for approximately 90 days. I will start the call with an update on the business highlights for the first quarter. I’ll then turn it over to Efrain and Bob for a financial update, and then, we’ll open it up for your questions.

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But before getting into the discussion of our earnings results, I want to take a brief moment here to make a few brief comments to acknowledge Efrain Rivera, who announced his intention to retire as CFO effective October 12, 2023; though he will remain as a Senior Advisor at least through the end of the calendar year. Efrain has been a valuable member of this senior leadership team at Paychex for the past 12 years. He has provided strong financial stewardship, but more importantly, great strategic leadership as well. During his time with Paychex, the company has transformed into a technology-enabled services company and we significantly expanded our HR Solutions and capabilities. Efrain has been a key strategic advisor and a catalyst for this transformation.

Efrain, I think you know how truly I appreciate your intellectual wisdom, your integrity, the guidance you’ve given me personally over my decade here and to the company. And we are all in great gratitude for what you’ve done for each one of us personally and for the company. Our customers, our employees and our shareholders are better off because you were here. So, thank you. Joining us today is Bob Schrader, who will succeed Efrain as CFO. Bob joined Paychex back in 2014 and is taking on progressive leadership roles over the past nine years, including over the last year and a half since I was named President and subsequent CEO of being co-lead of many of our strategic review efforts and strategic initiatives. Bob’s promotion is a part of a strategic succession plan to bring in an innovative leader who will continue to guide the company going forward.

I want to congratulate Bob and, Bob, I look forward to continuing to work with you as I have in the last 10 years, I mean, as we continue to — continue our track record of delivering strong financial results and continuing to position Paychex as a leader and innovator and a company that you can count on for predictable and sustainable results. Now, moving on to the first quarter results, speaking of predictability and sustainability. We have begun the fiscal year ’24 with solid growth of 7% in total revenue and 11% in adjusted diluted earnings per share. We’ve seen operating margin expansion approximately 60 basis points year-over-year, while still investing in our business to drive future growth. Our first quarter reflected solid execution by our sales, service and all of our teams across Paychex.

The demand for our HR technology and advisory solutions continued, resulting in strong quarter new sales, revenue growth, we saw positive trends in client, revenue and HR outsourcing worksite employee retention during the quarter, and we continue to focus our resources on acquiring and retaining high-value clients. We are starting to see improvements in some of our key PEO and insurance metrics during the quarter, with good results across sales activity, insurance attachment and retention. We will know more after our open enrollment season is completed, which primarily runs from October through January, but at this time, we believe that the actions we have taken in response to the headwinds we faced in 2023 are beginning to gain traction. Employment levels within our client base have remained stable.

Small businesses, which are central to the U.S. economy, continue to show the resiliency. Our Small Business Employment Watch has shown that small businesses continue to add workers at sustained, but modest rates, also the trend in wages is showing some cooling in wage growth consistent with overall inflation. Our data indicate a continued stable macro-environment for small and mid-sized businesses. We continue to monitor our leading indicators and are prepared to take appropriate actions to navigate any changes. But again, at this time, we don’t see any material change to the macro-environment. Small businesses have faced challenges getting access to capital and managing cash flows in this environment. This has continued to drive demand for our full-service Employee Retention Tax Credit Service.

I know there’s been some recent news of the IRS pause in ERTC processing in order for them to perform increased audits. This is not expected to have an impact on our ability to provide the service, though it may take longer for our clients to receive their funds. We continue to communicate this opportunity to existing clients and prospects and we continue to file amended returns with the IRS on their behalf. We anticipate that ERTC revenue will be a slight tailwind for the first half of the fiscal year and then turn to a headwind in the back half as the program ends. We are seeing greater adoption of HR software as businesses look to digitize their HR efforts to support the complexities of managing today’s workforce in a more efficient manner.

We also continue to see strong demand for our HR advisory solutions as businesses deal with the continued challenges of being an employer in today’s challenging employment world. Paychex is uniquely positioned to offer a continuum of HR products, technology and services from do-it-yourself payroll all the way to full-service PEO HR outsourcing. All of these products deliver a strong return on investment for our clients. For the 13th year in a row, we were named the leading retirement record-keeper by number of plans by PLANSPONSOR Magazine. Our leadership position in retirement makes us an excellent resource for small businesses and we continue to educate and execute on this opportunity. There have — there has certainly been a lot of excitement about AI and related technology and advancement around the monetization of large datasets.

At Paychex, as we’ve talked on prior calls, this isn’t anything new or it’s not a fact. We have been using artificial intelligence to transform our business for over a decade. We have over 200 AI models that are actively working on our business today, designed to provide valuable insights, fueled by our vast data assets. Our award-winning Retention Insights tool uses AI-based predictive analytics to provide HR leaders with early insights into potential employee retention issues. Our Flex Intelligence Engine is an embedded AI chat capability within our Flex platform that allows the customer to get quick answers to over 900 of the most common questions and access over 1,200 instructional resources. Companies like Paychex with large amounts of data will clearly be the winner with AI, and we will continue to harness the power of AI and leverage our extensive data to drive internal efficiencies and provide actionable insights and solutions to our clients.

This quarter, we continued to be recognized for our innovation, service and the positive impact we are having on our customers, our industry and the world. For the third time, Paychex has been recognized by TrustRadius with a 2023 Tech Cares Award for the company’s Corporate Social Responsibility programs and our community impact. We also received an award from Selling Power for our commitment to fostering a diverse and inclusive workforce, and from Forbes as one of the Best Employers for Women in 2023. On the product and service side, NelsonHall, once again, identified Paychex as the leader in its 2023 Next Generation HCM Technology Market Report. We also earned at silver Brandon Hall Group 2023 HR Excellence Award for breadth and depth of training that we provide our HR advisors to keep them up to speed on the ever-changing complexities of the employer-employee relationship.

Paychex was also named the 2023 Constellation Research on their ShortList for best payroll for North American small and mid-sized businesses. The depth and breadth of our product suite provide American businesses the freedom to succeed with the technology and advice that they desperately need to remain competitive in a very complicated world. I want to thank our over 16,000 global employees who consistently deliver for our clients and our shareholders. It’s because of them that we are off to such a good start this fiscal year. I’ll now turn it over to Bob Schrader to give you a brief update on our financial results for the first quarter. Bob?

Bob Schrader: Yeah, thanks, John, and good morning. It’s good to be here with you this morning, and I certainly look forward to working with each of you as we move forward. I’d like to remind everyone that today’s commentary will contain forward-looking statements; obviously, those involve risk. And we will refer to some non-GAAP measures. I’ll refer you to our customary disclosures in our press release and our investor presentation that will be posted later today. I’ll start providing a summary of our first quarter results and I’m going to turn it over to Efrain, he’ll give an update on our financial position and updated guidance for the year. Total revenue for the quarter increased 7% to $1.3 billion. Management Solutions revenue increased 6% to $956 million, primarily driven by higher clients and client employees, product penetration, price realization and HR ancillary services.

We continue to see increased attachment and demand for our HR Solutions, retirement, and time and attendance solutions. PEO and Insurance Solutions revenue increased 5% to $298 million, driven primarily by higher revenue per client and higher average worksite employees. As John mentioned, we definitely saw some positive momentum in the PEO in the first quarter as it relates to both sales activity in medical plan participation and attachment, those were obviously headwinds last year, and we are definitely seeing some positive signs as we move through the first quarter here. Interest on funds held for clients increased 83% to $33 million, primarily due to higher average interest rates. Total expenses increased 5% to $750 million. Expense growth was largely attributable to higher compensation costs, PEO direct insurance costs and investments that we’ve made into the business.

Operating income increased 8% to $536 million, with an operating margin of 41.7%, that’s a 60 basis point improvement versus the prior-year period. And diluted earnings per share increased 10% to $1.16 per share, and adjusted diluted earnings per share increased 11% for the quarter to $1.14 per share. I’ll now turn it over to Efrain to take you through our financial position and our updated guidance for the year.

Efrain Rivera: Thanks, Bob, and good morning to everyone on the call. Before I start, just wanted to say thank you, John, for the generous words. It’s been an absolute professional privilege and honor to have been with Paychex during all this time. As you all know, we maintain a strong financial position with high quality cash and earnings. Our balance for cash, restricted cash, and total corporate investments with more than $1.7 billion. Total borrowings were approximately $812 million as of August 21, 2023. Cash flows from operations were $656 million for the first quarter, was driven by net income and changes in working capital. There was some influence of timing there. It wasn’t quite as strong as the percentages would indicate, but nonetheless, it was a very solid quarter.

As you know, our earnings quality, which many — some of you have pointed out, is among the best candidly in the entirety of the S&P 500. In the first quarter, we acquired a small company that purchases outstanding accounts receivable of their customers under non-recourse arrangements. This acquisition is a good strategic fit with another business that we have called Paychex Advance, and that business purchases accounts receivable for temporary staffing clients. This acquisition will provide an opportunity for our small business clients to manage working capital challenges. As John alluded to earlier, we’ve seen over the last several years that access to financing is very important for small and medium-sized businesses. We think this plays well into our — in our portfolio of businesses that we have.

I’m very excited to have it. The acquisition, at this stage, is not anticipated to have a material impact on our financial results this year. We paid a total of $322 million in dividends during the first quarter. Our 12-month rolling return on equity was a stellar, superb, amazing 47%. Now, let me turn to guidance for the fiscal year ending May 31, 2024. I’m going to give you color on not only the full year, the first half and the second half, and we typically do that at this stage. As you noted, we have raised guidance for interest on funds held for clients and for adjusted EPS, but I want to go through a little bit of color as we go through to give you a sense of what our thinking is. Our current outlook is as follows: You saw that Management Solutions still expected to grow in the range of 5% to 6%.

PEO and Insurance Solutions expected to grow in the range of 6% to 9%. Interest on funds held for clients now, as I have mentioned, expected to be in the range of $140 million to $150 million, raised from our previous guide of $135 million to $145 million. And before I get the question, are we anticipated a range — are we anticipating a range of additional increases, no, we are poised looking at what the Fed is doing just like everyone else is, but this is our best estimate of, at least some additional activity by the Fed, but not — likely not contemplating all of it to the extent that the Fed does something now. We’ll have a conversation later in the year. Maybe the Fed will decide that they actually do want to pause, but at this point, that’s where we anticipate being.

Total revenue is expected to grow in the range of 6% to 7%, but now we think this is likely towards the high end of the range. So, operating income margin is expected to be in the range of 41% to 42%. Other income net is expected to be income in the range of $30 million to $35 million. The effective income tax expected to be in the range of $24 million to $25 million. Adjusted diluted earnings per share is expected to grow in the range of 9% to 11%, and this is raised from our previous guide of 9% to 10%. This full year outlook assumes current macroeconomic conditions, which has some uncertainty surrounding future interest rate changes and their impact on the economy. And I would just say, it’s been almost — I would say, at least six quarters where we keep saying, “Hey, we don’t know what’s going to happen in the back half of the year and it could change our outlook.” I think John summarized it very well.

At this point, things look pretty stable. So, we are feeling directionally more and more confident in the back half. Projecting the second half of the year, we anticipate total revenue growth of approximately 7% and operating margin in the range of 42% to 43%. I heard some comments after — first — when we released guidance that we have a ramp in the back half of the year. I wouldn’t describe our current guidance as a significant ramp in the back half of the year. Obviously, there are differences in the back half of the year that we’ll navigate through and talk to you, but the difference between first half and second half is not dramatic. Of course, all of these comments are subject to our current assumptions, which are subject to change. We will update you again on the second quarter call.

So, let me just repeat a couple of things to make sure. First half 2024 total revenue growth in the range of 6% to 7%, operating margin in the range of 40% to 41%. And then, in the second half at this point, we anticipate total revenue growth to be approximately 7%, operating margin in the range of 42% to 43%. I refer you to our investor slides on the website for additional information. Before handing things back over to John, I would just like to say that, I appreciate the relationship I’ve built with each of you during my time here at Paychex. We’ve had a long time together and it’s time to hand the reins over to someone else who I think we’ll do an even better job than I have. One of the things that strikes me during that entire time, and many of you have been here for the entire ride, I got a call and someone — or I got note and someone said, “Efrain you’re making me old, because I’ve retired two CFOs at Paychex.” So, I think that’s unfortunately true.

We are all getting a little bit older. But one of the things that always strikes me is that we are covered by the best group of analysts in the business. I’d say that even though I have disagreed with some of you over the years and I still think you have us rated too low, but be that as it may, I can’t argue with some of the things that you write. And in a separate note, I just want to say this, I’ve worked with Bob Schrader for many years, both here and prior to Paychex. I know that I’m leaving you in very capable hands. And I’m sure that Bob will do an even better job than the one that I do. And with that, let me turn it back to John.

John Gibson: Well, thank you, Efrain. Before I open the call for questions, probably two things. One, we have a lot of people here and the last time Efrain did a great job of providing rules on questions, particularly on compound questions and multiple follow-ups. So, we could just follow the Efrain rule in honor of Efrain’s retirement. I know he would greatly appreciate it, and maybe we can create a new tradition here. But no, feel free to answering your questions. But I would like to also add, make everyone aware, there’s many ways you can learn more about Paychex, and really the amazing success stories and the impact that we are having on the world. We’ve recently launched a series of reports that you can find on our Investor page both our annual report, our ESG report and a new client impact report, and very shortly, you’ll be seeing a new Investor Relations 101 Presentation that will be launched on the website prior to our Annual Meeting in the coming weeks.

And again, I think these documents provide a lot more color and really a lot more insights of just how significant, how broad our products are, how big an impact we are having on our customers, how big an impact we are having on our employees, how and why Paychex is known as one of the most admired, most ethical and most innovative companies in the world, and I encourage you to check that out. So, with that advertisement of our Investor website, Shelby, you can now turn it over for questions.

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Q&A Session

Operator: [Operator Instructions] And we’ll take our first question from Ramsey El-Assal with Barclays. Your line is open.

Ramsey El-Assal: Hi. Thank you for taking my question, and congratulations to you, Efrain.

Efrain Rivera: Thank you.

Ramsey El-Assal: We will miss hearing your voice on these calls certainly. I was wondering if you could comment on the interest from corporate investments was relatively high in the first quarter, and it doesn’t necessarily feel like that’s going to flow through for — to the full year guide in terms of maybe recurring each quarter. So, maybe if you could talk about that contribution to other income and just how you might see it trending the rest of the year?

Efrain Rivera: Yeah. So, Ramsey, there’s a couple of things that go into that line beyond just — so for everyone who isn’t focusing on that line that much. So that’s a combination of our interest expense, our interest income from corporate portfolios primarily, and also some gains and losses on investments that we have in small investment fund that we have. Those things can swing a bit during the year and are subject to whatever we think the balance is going to be on corporate funds during the year. We made an acquisition, so we expect that. During the year, our average corporate balances will be lower. So that will generate lower interest income. And then, the other part of that, Ramsey, is gains and losses on that other investments as the mark-to-market can change from quarter-to-quarter.

So, there could be a little bit of lumpiness in that number, but it might be a little bit different. I would say one other thing just by way of color on that line. We ended up with a fairly high cash balance that was influenced by timing. I think, I called that out,, or if I didn’t, let me call it out now. It just really had to do with the day on which we closed the quarter so our cash balances were higher. They are likely to be a bit lower — not a bit lower, but lower as we progress through the year. So, you might see that number change a bit.

Ramsey El-Assal: Okay. Fantastic. And a quick follow-up. If you could talk about SECURE Act 2.0? How you see that evolving? And how you see that potentially — presumably benefiting the business over time?

John Gibson: Yeah, look, SECURE Act 2.0, I think is a great action and great step that the government has taken is encouraging and helping small and mid-sized businesses, provide for the retirement of their employees. We are certainly out there educating the market on the opportunity. It really provides an opportunity for them to add a 401(k) plan or get a tax credit back for the implementation fees or the set-up fees of the plan. And then allows them to actually do a match for their employees and get that back into a tax credit as well. So, we are very happy our 401(k) business has continued — has very, very strong growth, that has continued. The thing I continue to remind people, we have some experience in this in other state mandates and what we realized is that there’s a lot of education that has to go on to get the market educated about the cost of a 401(k) plan, the benefits of a 401(k) plan.

And certainly, we are out actively in the market, educating the market, educating our strategic partners on that, and we believe that the SECURE Act 2.0 is going to allow us to continue to sustain the double-digit growth rates that we’ve seen in the retirement business over the last several years.

Ramsey El-Assal: Fantastic. Thank you very much.

Operator: And we’ll take our next question from Andrew Nicholas with William Blair. Your line is open.

Daniel Maxwell: Hey, good morning, guys. This is Daniel Maxwell on for Andrew today. To start off, I was hoping you could dig in a little on any changes to the dynamic between ASO and PEO, and whether over the past couple of months, you’ve seen any preferences shift on that. You called it out the last couple of quarters, and I was wondering, if anything changed.

John Gibson: Yeah. So, I would say this, we continue to see strong demand for our HR outsourcing solutions across the board. And I would say that the balance is probably more back to prior to ’23, where we saw a little shift to ASO. We’ve seen more of what — more traditional balance of ASO to the PEO. As we mentioned on our last call, we’ve made some changes I think to our product portfolio in the PEO that I think is balanced that out a little bit. The other thing that I would point to that we mentioned on the prior call is that when we over-index with ASO in the prior year, we always look at that as a great opportunity for us to go back to those customers and then upgrade them or selective them into our PEOs product. And we started doing that.

We actually — that’s a good example of AI, where we are actually using AI tools to be able to go into the ASO base and find clients that we believe there’s going to be a valuable value proposition to be in the PEO relationship for multitude of different reasons, and that program actually has shown results in the first quarter. It’s early in the process, but I would tell you that our transition of ASO to PEO customers, the number of customers that we transitioned this first quarter versus last first quarter was nearly 2x the number of clients. So, exactly what we thought could happen, which was we over-indexed when ASO in the prior fiscal year. We continue to sell outside to new logos and that was also double-digit strong in PEO in the first quarter.

So, we have both benefits. We had strong outside the base growth in PEO in the first quarter, and we had good migration or upgrades ASO to PEO, which was a good start to the first quarter. We still got three quarters to go and we are in the middle of our open enrollment, which is critical there. But good early signs. We had good signs in the PEO in the fourth quarter, and we’ve talked about that on the last call, and that just accelerated in the first quarter. So, now we just got to see if that can continue into the core selling season.

Daniel Maxwell: Great. Good to hear. And then for my follow-up, any detail you can give on the increase to the direct insurance costs from workers’ comp? Any color or any reminder of your exposure to any volatility in that area?