Paychex, Inc. (NASDAQ:PAYX) Q3 2024 Earnings Call Transcript April 2, 2024

Paychex, Inc. beats earnings expectations. Reported EPS is $1.38, expectations were $1.36. Paychex, Inc. 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 Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, you'll have an opportunity to ask questions during the question-and-answer session. [Operator Instructions] Please note this call is being recorded. And it is now my pleasure to turn today's call over to President and Chief Executive Officer, John Gibson. Please go ahead.

John Gibson: Thank you, Mike. Thank you, everyone for joining our discussion today on the Paychex third quarter fiscal year 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 third 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. 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 for the third quarter and then turn it over to Bob for a financial update and then of course, we'll be happy to take your questions.

We delivered solid results in the third quarter and the first nine months of the current fiscal year. Total revenue growth of 4% in the third quarter reflected a lower contribution for our employee retention tax credit or ERTC service as compared with the prior year period. This is consistent with our previously communicated expectations that ERTC revenue would become a headwind in the second half of the current fiscal year. Excluding this impact, our total revenue growth accelerated to 7% in the quarter, while our new client volumes remained solid and in line, and both client and revenue retentions were in line with our expectations. Several factors including our decision to wind down the ERTC program based upon the recent legislative developments on Capitol Hill, continued moderation of employment growth within our client bases and slightly lower realized rates all combined to create headwind, a larger headwind than what we had anticipated in the quarter.

With the end of the ERTC program, we are now officially in the post pandemic era at Paychex, and I will tell you I am very pleased with how our teams have performed during these past several years. We put nearly $90 billion of financial aid into the hands of our clients, and based upon an analysis by MIT, we estimate that we save over 300,000 small business jobs. While these pandemic error programs are not part of our normal reoccurring revenue product strategy or our business model at Paychex, they were certainly consistent with our purpose. And that's simply to help businesses succeed. And I believe that we are a better company today than when we entered the pandemic four years ago. We are winning in the marketplace, and our long proven a recurring revenue growth formula still holds true.

And this post pandemic and digitally driven era for the company, focused client growth, value-based price realization, increased product penetration, and opportunistic acquisitions are still the key pillars of the Paychex growth strategy. We are exiting the pandemic era with an even greater focus on our purpose, more opportunities to impact our clients and their employees, and with an even stronger reputation as a trusted advisor to small and mid-sized business owners. Despite the headwinds in the quarter, we delivered 7% growth in diluted earnings per share, and expanded operating margins, due to our longstanding tradition of expense discipline. As one of the best operators in the business, we continue to demonstrate our ability to deliver on earnings in uncertain times, and still make the necessary strategic investments to drive long-term profitable growth.

Our culture of expense management along with investments we've made the past several years in digitization and enhanced sales and operational excellence capabilities have positioned us well for future profitable growth as well. The macroeconomic and labor market remains challenging for small mid-size businesses, a tight job market for qualified workers reduce access to affordable growth capital and inflationary pressures continue to be headwinds for small businesses. Our small business employment watch continues to show moderation in both job growth and wage inflation. But however, a relatively stable macro environment, the softening in hiring we started to see in the second quarter continued in the third quarter. There is more choppiness in hiring across all customer segments and industries now.

Our clients tell us they still can't find qualified employees and are not willing to hire just anyone at higher wage rates, especially in areas with recent minimum wage increases and aggressive legislative changes. The demand for our HR technology and advisory solutions remains robust and the volumes of new clients added in the quarter were strong. We continue to deliver value for our customers as seen on our revenue retention results, which remain above pre-pandemic levels. Client retention for the third quarter was also in line with pre-pandemic levels and both revenue and HR outsourcing work site employee retention remains at record levels. As we continue to focus our resources on acquiring and retaining high value clients. Our sustained high revenue retention demonstrates that our value proposition and our market leadership remain intact.

The fundamentals of Paychex are same. I'd like to highlight the success in our PEO business specifically, which has continued to gain momentum with strong results during the first nine months of the fiscal year. We finished the quarter with strong results in sales, retention and insurance enrollment. We have continued to see a shift back towards the PEO offerings both outside and inside our client base. This shift mix has a long-term positive impact on the customer lifetime value in our model, particularly as clients attach insurance benefits. AI and related technology investments are also key areas of focus in our industry and something that, as many of you know, we've been focused on for many years. We are proud to announce that we successfully implemented in the quarter several additional innovative AI models that significantly improved results for Paychex and our clients.

Leveraging innovative technology and advanced analytics has allowed us to gain deeper insights into prospects and client behavior, their preferences, and their growing needs. Last month, we announced that Beaumont Vance has joined the company as our Senior Vice President of Data Analytics and AI. In this newly created role, he will be responsible for refining and executing the company's data strategy, including the use of business intelligence, advanced analytics, and AI driven automation to drive both improved business performance and enhanced customer value. We are excited to have Beaumont on Board to help us capture the full value of our vast data assets. I want to thanks to the hard work of our more than 16,000 employees and their focus on our company's values.

Paychex continues to be recognized for both what we do and more importantly in my opinion, how we do it? We are proud to be recognized for the 16th time by Ethisphere, as one of the world's Most Ethical Companies in their recent annual list. Paychex was also recently recognized by Fortune Magazine as one of the Most Innovative Companies for the second consecutive year. These recognitions and the many product and service awards that we have received in the past year and over the decades is a testament to the strength of our business model, culture and the commitment to invest in our business and our employees to deliver long-term value for our customers and investors. I'm very proud of how our employees have delivered for our customers, for each other, for our communities, and for our shareholders throughout the pandemic area.

We exit at this period in Paychex history, more focused and determined to be the digitally driven HR leader in our industry, and we are even better positioned to capture the opportunities in the markets we serve. I'll now turn it over to Bob to give you a brief update on our financial results for the quarter.

Bob Schrader: Thanks, John, and good morning, everyone. I'd like to start by reminding everyone that today's commentary will contain certain forward-looking statements that refer to future events, and therefore, involve some risks. In addition, I will periodically refer to some non-GAAP measures, like adjusted diluted earnings per share. I'd refer you to our press release for our customary disclosures around those metrics. I'll start with a summary of our third quarter and year-to-date financial results and then provide an update on our fiscal '24 outlook, and as promised too many of you on the phone, I will share some preliminary thoughts around fiscal '25. Total revenue for the quarter increased 4% to $1.4 billion, which reflects a lower contribution from our ERTC as compared to the prior year quarter.

Management Solutions revenue increased 2% to $1 billion. This was primarily driven by growth in the number of clients served across our suite of HCM solutions and increased product penetration, and that was offset by the decline in our ERTC revenue. And as we disclosed in the press release, that has impacted the growth by about 300 basis points. PEO and Insurance Solutions revenue increased 8% to $346 million, that was driven by higher average worksite employees and an increase in our PEO and Insurance revenues. Our PEO saw continued momentum in worksite employee growth and medical plan participant volumes during the third quarter. Interest on funds held for clients increased 25% to $44 million, primarily due to higher average interest rates.

Total expenses increased 3% to $790 million. Expense growth was attributable to higher compensation costs and PEO direct insurance costs related to the higher average worksite employees as well as the higher Insurance revenues during the quarter. Operating income increased 6% to $650 million with an operating margin for the quarter of 45.1%. That represents about 80 basis points of margin expansion over the prior year period. I would like to highlight that margin expansion is despite the ERTC headwind that we just called out, we were still able to deliver really strong margin expansion in the quarter. And I think as many of you know, ERTC is pretty much like interest rates, it's pretty much all margin. Both diluted earnings per share and adjusted diluted earnings per share increased 7% to $1.38.

I'll quickly summarize our results for the year-to-date period. Total revenue grew 5% to $4 billion. Management Solutions revenue increased 4% to $2.9 billion. PEO and Insurance Solutions increased 7% to $939 million. And interest on funds held for clients increased 44% to $108 million. Total expenses for the first 9 months grew 4% to $2.3 billion. And our operating margins for the first 9 months of the year were 42.5%, and that's a 70 basis point expansion over the prior year period. Diluted earnings per share and adjusted diluted earnings per share both increased 9% year-over-year to $3.62 and $3.60, respectively. I'll now give you a quick overview of our financial position. As many of you know, we maintain a strong financial position with high-quality cash flows and earnings generation.

Our balance for cash, restricted cash and total corporate investments was $1.8 billion. And our total borrowings were approximately $817 million as of the end of the quarter. Cash flow from operations for the first 9 months was $1.7 billion, that's up 30% compared to the same period last year. That was driven primarily by higher net income and fluctuations in working capital. And we returned a total of $1.1 billion to shareholders through the first 9 months of the year. That includes $963 million in dividends and $169 million of share repurchases. And our 12-month rolling return on equity remains robust at 47%. I'll now turn to our updated guidance for the current fiscal year. This outlook assumes the current macro environment, which obviously had some level of uncertainty.

We have revised our guidance on certain measures based on performance this quarter and this also reflects the impact of our decision to wind down our ERTC service based on recently proposed legislation. I just want to pause there from my prepared remarks to provide a little bit more color on ERTC. I think many of you guys are aware that there is bipartisan legislation out there that would end the ERTC program retro to January 31 of this year. I think it's past the House. It hasn't yet passed the Senate, but that does create a level of uncertainty around ERTC. We continue to sell it in the month of February. We made a decision based on that level of uncertainty to stop recognizing the revenue on ERTC subject to -- or subsequent to January 31 and we've essentially removed it from the forecast in Q4.

And so that's part of what you see as it relates to the impact to the quarter and also impacts the guidance the updated guidance that I'm about to give you for the year. Management Solutions is now expected to grow in the range of 3.5% to 4%. We previously had guided to the lower end of the 5% to 6% range. PEO and Insurance is still expected to grow in the range of 7% to 9%, although we now expect that it will be more towards the lower end of that range. Interest on funds held for clients is still expected to be in the range of $140 million to $150 million. Total revenue is now expected to grow in the range of 5% to 6%. Our prior guidance was 6% to 7%. Other income net is expected to be income in the range of $40 million to $45 million, and this is raised from the previous guidance of $35 million to $40 million.

Our guidance for operating margins and effective tax rate are unchanged, although we still do anticipate being at the high end of the operating margin guidance range, which was 41% to 42%. And adjusted diluted earnings per share is still expected to grow in the range of 10% to 11%. Now let me just provide a little bit of color on the fourth quarter. We are currently anticipating total revenue growth to be approximately 5% in Q4. We expect the ERTC headwind to Management Solutions growth in the fourth quarter to be similar to what it was in the third quarter. And we would also expect the operating margins to be around 40% in the quarter. We are currently in the middle of our annual budget process and working on our expectations for the next fiscal year.

We obviously will provide formal guidance like we normally do at the end of the Q4 when we get to that call. However, I will share some preliminary thoughts and I will emphasize the word preliminary around what we're expecting for fiscal '25. On a preliminary basis, we would expect total revenue growth to be consistent with the fourth quarter growth rate. And as a reminder, as I just told you, that would be in the 5% range. And this does include a headwind from ERTC of approximately 2%. I mean, ERTC, for all intents and purposes, is 0 going forward. I know what that headwind is going to be. I know what the dollar amount was this year, and it will be approximately a 2% headwind to revenue growth for FY '25 and that is assumed in the 5% range number that I gave you.

And then despite this headwind, we are committed to delivering operating margin expansion in fiscal '25. We are still going through the annual budget process, working through the details. We'll provide more color as we get to the end of the year. Obviously, this is based on our current assumptions, which we are still working through. Those may change, but we'll update you again when we get to the fourth quarter. I will refer you to our investor slides on our website for additional information. And with that, I'll turn it back over to John.

John Gibson: Okay. Thank you, Bob. Mike, we'll now open it up for questions.

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