Paychex, Inc. (NASDAQ:PAYX) Q2 2024 Earnings Call Transcript

Paychex, Inc. (NASDAQ:PAYX) Q2 2024 Earnings Call Transcript December 21, 2023

Paychex, Inc. beats earnings expectations. Reported EPS is $1.08, expectations were $1.07. PAYX isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

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

John Gibson: Thanks, Chelsea. Thank you, everyone, for joining us for our discussion of the Paychex second quarter fiscal 2024 earnings release. Joining me today is Bob Schrader, our Chief Financial Officer. This morning, before the market opened, we released our financial results for the second quarter. You can access our earnings release on our Investor Relations website, and our Form 10-Q will be filed with the SEC within the next day. This teleconference is being broadcast over the Internet and will be archived and available on our website for approximately 90 days. I’m going to start today with a brief update on the business highlights for the second quarter, and then I’ll turn it over to Bob for a financial update, and then, of course, we’ll take your questions.

We had solid results in the second quarter and for the first half of the fiscal year with particularly strong performance in the PEO, mid-market HCM, and retirement. Revenue for the first half was up 6% year-over-year and our adjusted diluted earnings per share was up 10%, double digits. The demand for our HR technology and advisory solutions remained strong as business leaders continue to face a very challenging small and mid-sized business environment. The tight labor market and rising healthcare and benefits costs are forcing many to rethink their HR and benefit strategies, and they can turn to Paychex as a trusted business partner in these times. As we sit here today, the selling season for our mid-market HCM and our PEO teams are in their final phases, and our insurance open enrollment is underway.

All are going well and in-line with our expectations. Our pipelines for these solutions are strong and up from this time last year. In the small business market, selling season is just ramping up. We still have a critical third quarter to go both in terms of selling and delivering for our clients during year-end, but we are fully staffed and well positioned at this critical time of year. Our revenue retention remains above pre-pandemic levels as we continue to focus our resources on acquiring and retaining high value clients. Client retention has improved over last year and retention in our HR outsourcing solutions remains at record levels. I’d like to highlight the success specifically in our PEO business, which we’ve talked about on prior calls.

It has continued to gain momentum with strong results during the first half of the fiscal year. We have seen a back — a shift back towards the PEO offering, both outside and inside our client base. This shift in mix has a long-term positive impact on customer lifetime value in our business model, particularly as clients attach insurance benefits. We previously discussed actions we took to help the PEO recover after last year’s challenges including: one, redesigning our health offerings; second, leveraging AI to revamp our sales and marketing models and to identify and attract high-value prospects; three, putting more focus on upgrading existing HCM and ASO clients to the PEO model; and finally, improved sales execution. As mentioned earlier, our insurance enrollment is underway and the tax rates are up after a challenging year last year.

I want to specifically thank and congratulate our PEO team for all the hard work and success the past year so far. The macro environment and labor environment continue to be challenging for small and mid-sized businesses. Our Small Business Employment Watch continues to show moderation in both job growth and wage inflation, which is indicative of a stable macro environment and that the actions taken by the Fed are having their desired impact. While we haven’t seen any normal signs of a recession in our data, we started to see some softening in seasonal hiring in the quarter, particularly in our large client segments, including our HR outsourcing businesses, many of which typically add seasonal employees at this time of the year. SMBs are still challenged with access to capital, the high cost of capital, inflation and macro uncertainty.

While we certainly don’t see any signs of economic downturn, we are ready to take the required actions if such trends emerge. As one of the best operators in the business, we have demonstrated that we are able to respond and successfully navigate changes in the — any economic environment. I know that AI and related technology advancements remain a hot topic in our industry. As I’ve noted in past calls, AI at Paychex is nothing new. We have over hundreds of and growing models — AI models that are actively working in our business today, designed to provide valuable insights fueled by our vast data assets. The exciting transformation that is now occurring around generative AI opens up the opportunity for us to bring AI solutions to our employees, so they can be more effective and efficient and to our clients.

We are actively investing in GenAI in exploring how it can be used to improve efficiency and the customer experience and provide actual insights to us and our clients to help them succeed. Currently, recently we partnered with Visier, a global leader in people analytics and workforce solutions, to offer new benchmarking reports in AI-powered HR analytics solutions to our customers. This enhances our current reporting and analytics available in Paychex Flex and will perfectly complement our industry-leading HR advisory services. The partnership provides core HR and compensation analytics and compensation in salary benchmarking, an AI-driven model with benchmarks against 750 million market data points. This offering, in addition to our AI-driven Retention Insights Solution that we launched over a year ago, is just the beginning of how we will leverage AI to help businesses succeed.

Partnerships with Visier, like our recruiting and onboarding partnership with Indeed, is another example of how Paychex is bringing together the power of partnerships, our large data assets and integration to improve the customer experience and deliver real value and business outcomes for our clients. We are also pleased that for the seventh consecutive year, we have been positioned in the Leader quadrant as part of the NelsonHall’s 2023 Vendor Evaluation report for payroll service providers. This provides further evidence of our leadership position based upon our robust technology and customer support. We’re also very proud to be recognized in the Sapient Insights Group Voice of the Customer Top Five Vendor Survey for 2023 and 2024, receiving top five ratings in six categories spanning payroll, HR, time and attendance, learning and performance.

And really what I’m most proud of is that the Sapient report is actually based on actual voices of our customers and customers from across the competitors, which demonstrates our leadership position across the industry. As we head into selling season in calendar year-end, I’m confident in our global Paychex team and that they will constantly deliver and consistently deliver for our clients. We remain driven to be the trusted partner for small and mid-sized businesses that deliver industry leading HCM technology and advisory solutions that help our clients succeed. I’ll now turn it over to Bob to give you a brief update on our financial results in the quarter. Bob?

Bob Schrader: Thanks, John, and good morning, everyone. I’d like to remind everyone that today’s commentary will contain forward-looking statements that refer to future events and involve some level of risks. I’ll refer you to our customary disclosures in our press release as well as our Investor Relations presentation that should be on our website. I will start by providing a summary of our second quarter financial results. Total revenue for the quarter increased 6% to $1.3 billion. Management Solutions revenue increased 4% to $931 million that was primarily driven by growth in a number of our clients served across our suite of HCM solutions, price realization, an increased product penetration and growth in ancillary services.

PEO and Insurance Solutions revenue increased 8% to $296 million that was driven primarily by higher revenue per client, including higher insurance revenues and average worksite employees. As John mentioned, our PEO saw continued momentum in sales activity and medical plan purchase volumes during the second quarter. Interest on funds held for clients increased 44% to $31 million that was primarily due to higher average interest rates. Total expenses increased 5% to $752 million. Expense growth was largely attributable to higher compensation costs, PEO direct insurance costs and continued investments in sales, marketing and technology. Operating income increased 7% to $506 million for the quarter, with an operating margin of 40.2%, that’s a 50 basis point expansion over the prior-year period.

And both diluted earnings per share and adjusted diluted earnings per share increased 9% to $1.08 per share. I will now quickly touch on the results for the first six months of the year. Total revenue grew 6% to $2.5 billion. Management Solutions revenue in the first half of the year increased 5% to $1.9 billion. PEO and Insurance Solutions was up 7% to $593 million. And interest on funds held for clients increased 62% to $64 million. Our total expenses for the first half of the year were up 5% to $1.5 billion. And our operating margins for this first six months were 41%, and that was a 60 basis point improvement over the prior year. Diluted earnings per share and adjusted diluted earnings per share both increased 10% to $2.24 and $2.23, respectively.

I’ll take you through a quick overview of the company’s financial position. As you all know, we maintain a strong financial position with high quality cash flows and earnings. Our balance for cash, restricted cash and total corporate investments was more than $1.4 billion and our total borrowings were approximately $812 million as of the end of November. Cash flow for operations for the six — first six months of the year were $1 billion, and that’s up 40% compared to the same period last year. This was primarily driven by higher net income and fluctuations in working capital. Do want to call out, similar to last quarter, there were some timing differences there based on where the quarter ended, ended on a collection day, that’s having higher operating cash flows, that’s why you see the 40% level.

That will moderate as we move through the year. We returned a total of $811 million to shareholders during the first six months that includes $642 million of dividends and $169 million of share repurchases. And our 12-month rolling return on equity remains strong at 47%. I’ll now turn to our guidance for the fiscal year ended May 31, 2024. We’ve raised guidance on certain measures based on performance this past quarter. For other measures, I will also provide some color on where we now expect to be within the ranges and certainly we can provide some more detail when we get into the Q&A. The outlook assumes the current macro and competitive environment, which had some uncertainty, particularly as it relates to future interest rate changes in the economy.

So, our current outlook is as follows: Management Solutions is unchanged with growth in the range of 5% to 6%, although we do anticipate it will now be at the low end of the range. PEO and Insurance Solutions is now expected to grow in the range of 7% to 9%, that’s up from our previous guidance, which was 6% to 9% expectation. Interest on funds held for clients is not changed. We still expect that to be in the range of $140 million to $150 million. Total revenue is expected to grow in the range of 6% to 7%, but we now expect it to be more in the middle of the range. I know last quarter, we thought that might be a bit stronger. We now expect the total revenue guidance to be more aligned with our original guidance of 6% to 7%. Operating income margin is expected to be in the range of 41% to 42%.

Although we now anticipate that will probably be toward the upper end of that range. Other income net is expected to be income in the range of $35 million to $40 million, and that’s raised from our previous guidance of $30 million to $35 million. No change to the effective income tax rate. We still expect that to be between 24% and 25%. And then, adjusted diluted earnings per share is now expected to grow in the range of 10% to 11%. So, we raised that last quarter to 9% to 11% just based on what we’re seeing. We expect that to be a bit stronger and we’re raising that guidance to 10% to 11%. Now, I’m going to turn to the third quarter to give you a little color on the third quarter. We are currently anticipating total revenue growth for the third quarter to be in the range of 5% to 6%, and operating margins to be in the range of 44% to 45%.

As it stands right now, we would expect to pretty much be in the middle of those two ranges. And I’d like to remind everyone that we’ve talked about this in the past that ERTC becomes a headwind in the back half of the year. If I go back and look over the last two-and-a-half years that we’ve been selling ERTC, Q3 of last year was the largest quarter that we had with ERTC. And so that’s a bit more of a headwind in Q3 than Q4, but will be a headwind in the back half of the year. Of course, all of this is based on our current assumptions, which are subject to change. We’ll come back and update you again on the third quarter call. As I mentioned, our investor slides are posted on the website, so I’ll refer you there for additional information. And with that, I will turn it back over to John.

John Gibson: Okay. Thank you, Bob. We will now open it up — the call for questions. Chelsea?

Operator: [Operator Instructions] And our first question will come from Kevin McVeigh with UBS.

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Q&A Session

Kevin McVeigh: Thanks you so much, and congratulations as you close out the year, John, Bob, and I want to thank Efrain, because I think this is the last quarter Efrain will be on the call too. So, John or Bob, I think you talked about revenue retention at record levels and client retention improving. Can you maybe dimensionalize that a little bit? And — because it feels like that’s getting a little bit better, but the revenue maybe more the middle of the range. So, what’s driving the improvement, and then, kind of maybe just the tweak on the revenue expectations overall?

John Gibson: Yeah. Kevin, I’ll start off on retention and we can talk a little bit about the revenue expectations. Bob will add some color on that, then I’ll jump in. Look, we continue to be very pleased with where we are on revenue retention. I think as we continually talked about, we’ve really been highly focused on having an impact in those critical areas where it counts and that’s our high-value segments and that’s what we’ve seen. Our HR outsourcing business, both ASO and PEO, record levels of retention. And we’re very pleased with that. Client retention across the business was actually better in the first half of this fiscal year than it was last fiscal year. And that’s really attributable to the team’s great job of really managing the controllables.

We’re continuing to see on the lower end of the market, bankruptcies out of businesses and non-controllable losses being higher year-over-year. That’s not surprising to me when you see the level of business starts that we’ve seen during the COVID period really at elevated levels. And we just know, out of those small companies that started out two years ago, most of those have trouble financially. And so, overall revenue retention continues to be at pre-pandemic levels, which I would remind you was at near historic highs for the company.

Bob Schrader: Yeah, Kevin, I’ll just add on the guide. As you guys remember, at the end of Q1, I think where we ended the quarter, we had said we expected to be towards the high end of the range. I think there were a couple of reasons at that time why we felt confident in saying that. I would say, one, the positive trends that we were seeing in the PEO business. I think we wanted to wait another quarter before we raised the PEO guidance. But we definitely saw some positive trends really going back to the end of last year. That continued into Q1. I’d say that gave us a little bit of confidence. And as you guys know, we did do a small acquisition at the end of Q1, not a big contributor to growth. But I think those two things combined really gave us a bit of confidence that we thought we might be towards the upper end of the range, I’d say, as we got through Q2.

The one thing that I’ll highlight, I think John made reference to it, although we didn’t have big growth assumptions in the plan related to employment growth, particularly in our larger employee sizes across both Management Solutions and the PEO. We typically get some seasonal hiring. We expected to see some growth there that didn’t materialize to the level that we expected and certainly what we’ve seen in the past. And so that’s given us a little bit of pause. And as I mentioned, that was across both categories, Management Solutions and PEO and Insurance. The PEO and Insurance, for the most part, they’ve been able to outrun that I would say, just given the strength of the business. John talked about the strong demand there. And some of the action plans that we’ve taken have really paid off there.

But on the Management Solutions side, it’s been a little bit of a headwind. And that is kind of what you see in the quarter as well as kind of the fine-tuning of the guidance ranges that I just provided.

Kevin McVeigh: Very helpful. Thank you so much.

Operator: Thank you. Our next question will come from Andrew Nicholas with William Blair.

Andrew Nicholas: Hi, good morning, thanks for taking my question. Really strong quarter on the PEO front. I wanted to ask about pricing dynamics there. And in health insurance, more specifically, we’ve heard from some competitors within the space that there are certain players that are being more aggressive on the health side during this year’s renewal cycle. I’m just kind of wondering if you’ve seen that. How Paychex is navigating that environment stacking up in terms of rate increases relative to those peers and maybe just how you’re faring broadly on the pricing side?

John Gibson: Yeah. So, thanks for the question, Andrew. I’ll say this, the PEO, you can tell by the growth numbers, continued to improve as the year has gone on. And I would tell you that our pipeline is very strong in comparison to last year. So, whatever the competitors are doing, our value proposition is resonating. I can assure you that we’re not using cheap health as that part of the value proposition. So, we go at it more as a comprehensive HR outsourcing value proposition. And if clients are looking for cheap health, they’re probably — we’re probably not engaging in that conversation very long. We have the capability, as you know, to also leverage our insurance agency within our PEO as well. But very pleased with where we are on — with the PEO right now, very strong performance.

The pipeline is solid. We are in the final stages. As you can imagine. That in the mid-market, as you know, typically the selling season is much earlier, it’s pretty much in the final innings. And both pipelines, I would say, for the PEO are very, very strong, both in terms of insurance attachment and in terms of sales.