Paychex, Inc. (NASDAQ:PAYX) Q3 2023 Earnings Call Transcript

Paychex, Inc. (NASDAQ:PAYX) Q3 2023 Earnings Call Transcript March 29, 2023

Operator: Good day, everyone, and welcome to today’s Paychex Third 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. Please note, this call will be recorded, and I will be standing by if you should need any assistance. It is now my pleasure to turn the conference over to Mr. John Gibson. Please go ahead, sir.

John Gibson: Thank you, Todd. Thank you, everyone, for joining us for our discussion of the paychex third quarter fiscal year ’23 earnings release. Joining me today is Efrain Rivera, our Chief Financial Officer. This morning, before the market opened, we released our financial results for the third quarter ending February 28. 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. 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 the call today with an update on the business highlights and then Efrain will review our financial results and outlook for fiscal year ’23.

We’ll then open it up for any of your questions. As you saw in our press release, we delivered solid financial results for the third quarter with total revenue of 8% and adjusted diluted earnings per share growth of 12%. Thanks to the outstanding efforts of our employees we completed a successful selling and calendar year-end season with strong sales volumes and revenue retention for the quarter. We continue to see a stable macro environment and demand for our solutions. Our unique value proposition is clearly resonating in the market. Small and midsized businesses continue to show remarkable resilience as seen in our job at index in the last two months as they contend with a constantly changing labor market, inflation, increasing regulations and rising interest rates.

Before we get into the third quarter results, I want to take a minute to address the recent volatility in the U.S. banking market as a result of two highly publicized bank closings. We have no cash, restricted cash and investments deposited within Silicon Valley Bank or Signature Bank, and we’ve met all client fund obligations related to employee payment services and remittances to applicable tax or regulatory agencies. We continue to monitor this situation and believe that our existing client funds held cash, cash equivalents and investment balances are more than sufficient to meet all client fund obligations. We remain ready as we were when the crisis was unfolding to help businesses and their employees whose payroll processing or direct deposits may have been impacted by these bank closures.

Paychex has a long-standing track record for being a stable place for customers, employees and investors during all types of macroeconomic situations and crisis, and we demonstrated that once again. The selling season was positive in terms of both revenue and volumes in a very highly competitive environment. In particular, demand has remained strong for our HR outsourcing solutions though as we’ve reported in prior quarters, we continue to see a trend of client shifting preferences for our ASO model over the PEO model. In the third quarter, we saw revenue retention remaining near record levels and normalization of uncontrollable losses at the very low end of the market. The focus and investment we continue to put in our high-value clients is making the difference in the customer experience.

In addition, the advisory assistance we provide our clients is critical in these challenging times. Our retention for our HR outsourcing businesses, both ASO and PEO stand at an all-time record high year-to-date. PEO and Insurance Solutions continue to show lower health insurance attachment and enrollment inside those clients that are attaching. This is specifically impacting our PEO in the Florida market and the softer rates for workers’ compensation insurance continue to impact the property and casualty part of our insurance agency. We expect these trends to continue early into the next fiscal year and normalize as the year progresses. Paychex is uniquely positioned with a continuum of solutions designed to help businesses in any macro environment.

We help them recruit and train employees gain access to capital and provide valuable benefit packages such as insurance and retirement. Through our innovative technology, compliance and HR expertise, we are here to help businesses drive efficiency within their HR processes, which therefore frees a valuable time for them to focus on growing the business. Competing for and retaining employees remain a challenge for today’s workforce. And I want to commend Congress and the President for signing the recent SECURE Act 2.0, which will introduce a range of new opportunities for businesses looking to introduce a retirement benefit and make their employee value proposition more competitive. We have begun to launch campaigns to educate the market on the SECURE Act 2.0 and continue to position Paychex as the industry leader in retirement plans that we are.

Photo by Damir Kopezhanov on Unsplash

We are working on strategies to leverage our strength in this market and capitalize on this opportunity in the years ahead. As higher interest rates and disruptions in the banking system have both impacted the cost and access of capital for many small and midsized businesses, we have fully embraced this challenge to help them out by proactively assisting our clients and prospects with obtaining financial assistance available to them through non-traditional financial partnerships and through government programs such as PPP and the ERTC program. We continue to see strong demand for our full-service ERTC solution. Many of the businesses we’ve helped are leveraging their new financial flexibility to reinvest in new solutions, such as a retirement plan, or one of our integrated HCM technologies.

Recently, our ERTC service was recognized with a Stevie Award for helping businesses obtain critical financial support. In uncertain times, people look for stable, trusted advisers to help them succeed. I am proud that we have recently been recognized as one of the most admired, one of the most ethical and one of the most innovative companies by several prominent and respected brands. We remain one of Fortune’s most Admired Companies in 2023. And for the 15th time, we were named among one of the most ethical companies in the world by Ethisphere. This is a select group of companies that show exceptional commitment to ethical operations, compliance performance and governance and risk practices, including strong commitments to ESG and diversity, equity and inclusion.

And today, we are announcing that we have been named to Fortune’s list of America’s most innovative companies for 2023 due to the innovation we’ve shown in our products, processes and culture. These awards are the result of the dedication of our 16,000-plus employees who daily are supporting our clients and helping them succeed and doing business the right way every day. Very proud of the team, and I’m very proud of Paychex. There’s no question that we are a well-managed and stable market leader that people can depend on. We have a long-standing track record of being there for our customers when they need us most, and we continue to be well positioned to help them through the HR challenges they are facing and whatever comes their way in the future.

Now, I’ll turn it over to Efrain who will take you through our financial results for the third quarter.

Efrain Rivera: Thanks, John. Good morning to everyone on the call. I’d like to remind you the customary things I remind you that during these conversations, we’re going to talk about forward-looking statements. Items like EBITDA, non-GAAP measures, please refer to our press release for more information on these topics. I’ll start by providing some of the key points for the quarter and finish up with a review of our fiscal 2023 outlook. Total revenue for the quarter, as you saw, grew 8% to $1.4 billion. Total service revenue increased 7% to $1.3 billion. Obviously, we’re benefiting from increase in interest rates. Management Solutions revenue increased 7% to $1 billion, driven by additional product attachment, HR ancillary services.

It’s largely what we’ve discussed previously, our ERTC product and price realization, we continue to see strong attachment of our HR solutions, retirement and time and attendance products. Demand for our ERTC service remains strong and contributed approximately 1% to revenue growth in the quarter. Demand for this product along with our internal execution, have continued to exceed our expectations, while ERTC has been a tailwind, and we expect demand to continue into fiscal year ’24. It will eventually become — will eventually moderate and become a headwind as we progress through next year — next fiscal year. Beyond Insurance Solutions revenue increased 6% to $321 million, driven by higher revenue per client and growth in average worksite employees.

The rate of growth was impacted by factors previously discussed, including lower medical plan sales and participant volumes, along with the mix shift to ASO as John called out. We expect these trends to normalize as we progress through fiscal 2020, meaning a little bit more of a balance between PEO and ASO. Interest on funds held for clients increased significantly to $35 million in the quarter, primarily due, as you know, to higher average interest rates. Total expenses were up 8% to $769 million. Expense growth was largely attributable to higher headcount, wage rates in general course to support growth in our business. Op income increased 9% to $612 million, with an operating margin of 44.3%, a slight expansion over the prior year period.

Our effective tax rate for the quarter was 24.3% compared to 22.3% in the prior year period. The prior year period included a higher volume of stock-based comp — and stock-based comp payments and the recognition of a tax credit related to our development of client-facing software that generated the difference in rates. Net income increased 9% to $467 million and diluted earnings per share increased 8% to $1.29 per share. Adjusted diluted earnings per share increased 12% for the quarter to $1.29 per share. Let me quickly summarize the results for the first nine months of the fiscal year. Performance has been strong. Total service revenue increased 8% to $3.7 billion, and total revenue was up 9% to $3.8 billion. Management Solutions was up 9% to $2.8 billion.

PEO and Insurance Solutions up 6% to $877 million. Op income increased 9% with a margin of 41.8%. Adjusted net income and adjusted diluted earnings per share both increased 12% to $1.2 billion and $3.31 per share. Our financial position remains strong, as you can see, with cash, restricted cash and total corporate investments of more than $1.6 billion. Total borrowings of approximately $808 million as of February 28, 2023, cash flow from operations, again, solid for the first nine months was at $1.3 billion and with an increase from priority driven by higher net income and changes in working capital. We’ve had our quarterly dividends at $0.79 per share for a total of $854 million during the nine months of fiscal 2023 year 12-month rolling return on equity was the seller superb for 47%.

Now let me turn to our guidance. For the current fiscal year ending May 31, 2023, our current outlook incorporates our results for the first nine months in our view of the evolving macroeconomic environment. We have raised guidance on certain measures based on performance this past quarter, updated guidance is as follows: Management Solutions revenue now expected to grow slightly above 8%. We previously guided to a range of 7% to 8%. PEO and Insurance Solutions outlook is unchanged at growth in the range of 5% to 7%, although we anticipate it to be towards the lower end of the range. We expect Q4 PEO and Insurance Solutions growth to be below 5% due to the factors that we’ve talked about through much of the year. Interest on funds held for clients is expected to be in the range of $100 million to $105 million.

Total revenue is expected to grow approximately 8%. Other income and expense net is now expected to be income of $10 million to $15 million, obviously due to higher interest rates. Remember, we met interest income there with our expense on the debt. Adjusted diluted earnings per share is now expected to grow in the range of 13% to 14%. We previously guided to growth of 12% to 14%. So we tightened the range, obviously, one quarter left. Guidance for margins and effective tax rates are unchanged, but we do anticipate being on the higher end of the range for operating margin and the lower end of the range for effective tax rate. We currently are in the middle of our annual budget process and are working on expectations for next fiscal year. As you know, this is challenging for a number of different reasons, not the least of which are expected outcomes in terms of interest rates and also economic environment.

We’ll provide final guidance for fiscal 2023 during fiscal 2023’s fourth quarter earnings call in June. However, let me share some of our preliminary thought process around fiscal 2024. On a preliminary basis, we believe that the exit rate in the fourth quarter is a decent approximation for total revenue growth for 2024. This should result somewhere in the range of 6% to 7%. And again, we got more to do there, but just giving you what our thought process is at the moment. And it’s heavily dependent on what we think will happen with interest rates during the year. And at this point, our assumptions are conservative. Management Solutions is expected to be lower as a result of moderating ERTC revenues. We called that out last year didn’t happen.

It actually went the other way. We do think it’s going to happen next year. And then PEO and Insurance revenue growth is expected to trend higher as we progress through the year with moderation in some of the headwinds we have experienced this year primarily around insurance attachment and also, as we called out mix shift to ASO. We remain committed to improving margins and we anticipate that operating margin will expand at this stage in the range of 25 to 50 basis points for fiscal 2024. Of course, all of this is subject to our current assumptions, which can change, especially if there are significant changes to the macro environment, which at this stage, we are not seeing. I’ll refer you to our investor slides on our website for more information.

And now, let me turn the call back over to John.

John Gibson: Thank you, Efrain. With that now being complete, Todd, we’ll open up the call for any questions people have.

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Q&A Session

Operator: Our first question comes from Kevin McVeigh with Credit Suisse.

Kevin McVeigh: Congratulations. Just really, really strong results here. I don’t know, John or Efrain, maybe — and I know it’s preliminary Efrain, but the 2024 looks pretty similar to ’23, and there’s a lot of crosscurrents from a macro perspective. And you folks tend to be pretty conservative. Maybe help us understand some of the puts and takes? Is it maybe there’s a little bit more pricing and just any base underlying assumptions around unemployment because, again, just really, really outcome. I’m just trying to understand maybe that a little bit more.

Efrain Rivera: Yes. Let me — I’ll let John talk a little bit more to kind of what our thinking is from a macro perspective. But Kevin, just to kind of address some of the higher level assumptions that go into the plan. I called out the fact that ERTC is not going to be the headwind — I’m sorry, the tailwind that it was this year. We called that out last year, but definitely going to happen next year or I wouldn’t say definitely. I will say, we have a very high degree of belief that we won’t see it. However, you’re going to see that more in the second half of the year than the first half of the year. So, that’s the first thing, thing I’d say. If we look back at where we started this year, we’re getting a nice macro uplift from employment as we started the year.

That seems to have run its course. It is not going the other way. But at this stage, what we’re seeing is that there’s been a pretty significant moderation in terms of employee adds and that’s happened as we progress through the year. So, those two things are — will become headwinds as we go through the year. Interest rates I called out. The first half of the year, I think we’ve got some sense of where we are. So, where we’re at, the market does too, what is really hard to understand what happens in the second half of the year and whether we start going in reverse on interest rates. We’re taking steps to position the portfolio to be able to deal with that. That’s what happens. But no one1 knows there. Now that’s all the stuff that’s headwind.

No positives. We think HR continues to be strong. We think as John pointed out, we think retirement continues to be strong, where we think that HCM continues to proceed well. We think PEO, which has been a little bit of a tailwind to growth this year. It does do better next year. The Insurance business that we call out PEO, a lot of the moderation on the growth rate in PEO insurance coming from insurance, we think that starts to improve as we go into next year. And then we have the normal level of cost discipline in the business that drives the results that we’re anticipating in 2024. So that’s a broad overview of, Kevin, numbers we’ve put together. I’ll let John talk to macro and any other parts of the business we need to call out.

John Gibson: Yes. Yes. Kevin, keep in mind that we’ve certainly seen a reference and really expected to see some moderation. I mean, we don’t expect another 4.5 basis points increase in interest rates that we don’t expect the type of hiring that we saw from the HCM. It’s hard to believe that the great resignation was just last year, a year away. So certainly, we’ve had the benefit of staffing up. But we’re not seeing any contraction moderation. And in fact, if you look at our job index, which has been a great indicator of kind of small business health and what we’ve seen in both January and February that we’ve reported, it’s actually an increase in the index. And we have not seen that through all of this fiscal year. So these are the really first two months where we’ve seen an increase in the index and also saw some moderation in wage inflation as well.