Paychex Q3 2024 Earnings Call Transcript

Quartr
Provided by Quartr
April 2, 2024

There are 13 speakers on the call.

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 an opportunity to ask questions during the question and answer session. Please note this call is being recorded.

Operator

And it is now my pleasure to turn today's call over to President and Chief Executive Officer, John Gibson. Please go ahead.

Speaker 1

Thank you, Mike. Thank you everyone for joining our discussion today on the Paychex Q3 fiscal year 2024 earnings release. Joining me today is Bob Schroeder, our Chief Financial Officer. This morning before the market opened, we released our financial results for the Q3. You can access our earnings release on our Investor Relations website.

Speaker 1

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 Q3 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 Q3 and the 1st 9 months of the current fiscal year. Total revenue growth of 4% in the Q3 reflected a lower contribution for our employee retention tax credit or ERTC service as compared with the prior year period.

Speaker 1

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.

Speaker 1

We put nearly $90,000,000,000 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 era 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 4 years ago.

Speaker 1

We are winning in the marketplace and our long proven recurring revenue growth formula still holds true in 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 midsized business owners. Despite the headwinds in the quarter, we delivered 7% growth in diluted earnings per share and expanded operating margins due to our long standing 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.

Speaker 1

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 and midsized businesses. A tight job market for qualified workers, reduced 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 2nd quarter continued in the 3rd quarter.

Speaker 1

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 3rd quarter was also in line with pre pandemic levels and both revenue and HR outsourcing worksite employee retention remains at record levels as we continue to focus our resources on acquiring and retaining high value clients.

Speaker 1

Our sustained high revenue retention demonstrates that our value proposition and our market leadership remain intact. The fundamentals of Paychex are sound. I'd like to highlight the success in our PO business specifically, which has continued to gain momentum with strong results during the 1st 9 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 PO offering, both outside and inside our client base.

Speaker 1

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 in 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.

Speaker 1

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 say, 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.

Speaker 1

Paychex was also recently recognized by Fortune Magazine as one of the most innovative companies for the 2nd 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 this period in Paychex history more focused we serve. I'll now turn it over to Bob to give you a brief update on our financial results for

Speaker 2

the quarter. 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.

Speaker 2

I'll start with a summary of our Q3 year to date financial results and then provide an update on our fiscal 2024 outlook. And as promised to many of you on the phone, I will share some preliminary thoughts around fiscal 2025. Total revenue for the quarter increased 4% to $1,400,000,000 which reflects a lower contribution from our ERTC as compared to the prior year quarter. Management Solutions revenue increased 2% to $1,000,000,000 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 was impacted impacted the growth by about 300 basis points.

Speaker 2

PO and Insurance Solutions revenue increased 8% to $346,000,000 That was driven by higher average worksite employees and an increase in our PEO insurance revenues. Our PEO saw continued momentum in worksite employee growth and medical plan participant volumes during the Q3. Interest on funds held for clients increased 25% to 44,000,000 dollars primarily due to higher average interest rates. Total expenses increased 3% to $790,000,000 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 $650,000,000 with an operating margin for the quarter of 45.1 percent.

Speaker 2

That represents about 80 basis points of margin expansion over the prior year period. I would like to highlight that is just 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.

Speaker 2

Both diluted earnings per share and adjusted diluted earnings per share increased 7% to 1 point $3.8 I'll quickly summarize our results for the year to date period. Total revenue grew 5% to $4,000,000,000 Management Solutions revenue increased 4 percent to $2,900,000,000 PO and Insurance Solutions increased 7% to $939,000,000 and interest on funds held for clients increased 44 percent to $108,000,000 Total expenses for the 1st 9 months grew 4% to $2,300,000,000 dollars and our operating margins for the 1st 9 months of the year were 42.5 percent, net to 70 basis points 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.

Speaker 2

Our balance for cash, restricted cash and total corporate investments was $1,800,000,000 and our total borrowings were approximately $817,000,000 as of the end of the quarter. Cash flow from operations for the 1st 9 months was $1,700,000,000 that's up 30% compared to the same period last year. That was driven primarily by higher net income in fluctuations in working capital and returned a total of $1,100,000,000 to shareholders through the 1st 9 months of the year that includes $963,000,000 in dividends and $169,000,000 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.

Speaker 2

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 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 this year. I think it's passed the House, it hasn't yet passed the Senate, but that does create a level of uncertainty around ERTC.

Speaker 2

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 of the quarter and also impacts the guidance that 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 percent range.

Speaker 2

PO and insurance is still expected to grow in the range of 7% to 9%, although we now expect 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 $140,000,000 to 150,000,000 Total revenue is now expected to grow in the range of 5% to 6%. Our prior guidance was 6% to 7%. Percent. Other income net is expected to be income in the range of $40,000,000 to $45,000,000 and this is raised from the previous guidance of $35,000,000 to 40,000,000 dollars 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%.

Speaker 2

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 Q4. We are currently anticipating total revenue growth to be approximately 5 percent in Q4. We expect the ERTC headwind to Management Solutions growth in the 4th quarter to be similar to what it was in the 3rd quarter, and we would also expect 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.

Speaker 2

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 2025. On a preliminary basis, we would expect total revenue growth to be consistent with the 4th 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%.

Speaker 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 2025 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 2025. We are still going through the annual budget process, working through the details.

Speaker 2

Will 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 Q4. I'll refer you to our investor slides on our website for additional information. And with that, I'll turn

Speaker 1

it back over to John. Okay. Thank you, Bob. Mike, we'll now open it up for questions.

Operator

Absolutely. And we do have our first question from Mark Marcon with Baird.

Speaker 3

Good morning and thanks for taking my questions. So ERTC, just one thing just to clarify, Bob, when you talked about that you sold it in February, but because of the legislation, you're going to end basically bipartisan and is basically going to end retroactively in January 1. So you then stopped recognizing the revenue. Did you is any ERTC revenue from that you sold from January 1 through February actually included in the Q3 number that you just reported?

Speaker 2

Yes. Everything that we sold and filed in the month of January, Mark, is included in the quarter, but nothing beyond January 31. So we continue to sell it in the month of February. I would say the faucet was still running steady in February on ERTC and we made the decision not to recognize revenue around that just because there's so much uncertainty and we're telling our clients that because of that level of uncertainty if that bill does pass, we would not we would refund their monies for the service that we sold in the month of February. So we think it's the right decision from an accounting standpoint to stop recognizing revenue on it.

Speaker 2

And then I would just say as we move forward in the month of February, that faucet has slowed to a drip. On ERTC, obviously, we're not focused on it and it's there's probably a little bit that came in, in March, but that was probably stuff that we already had kind of in the queue that we were still processing. It's pretty much that program is over.

Speaker 4

And just Yes, go ahead.

Speaker 3

I mean, just related to the guide that you were providing, I was obviously for the Q3 within Management Solutions because of the ERTC headwind, things were tougher. And it seems like you actually did see some acceleration ex ERTC on total revenue. So I was just wondering like is there any way to quantify the impact in terms of not recognizing that revenue in February just because obviously you're anticipating that coming in. So any thoughts there?

Speaker 2

Yes. I mean, high level, Mark, I mean, we provided guidance for the quarter. I think you guys know what the guidance was that we provided for the quarter. The Q3 actually came in maybe about 100 basis points in that range lower than what we had said. And I would say probably a third or a little bit more of that was related to the decision that we took on ERTC.

Speaker 2

So you could probably do the math on that and back in to get to a number that's close to the impact in February.

Speaker 3

Okay, great. And then with regards to the margin expansion, obviously, that's very encouraging, especially when you're not getting that benefit from ERTC. What are the key drivers in terms of that? Is it the AI initiatives? Is it efficiency on the sales side?

Speaker 3

What's driving the margin expansion? And to how do you think to what extent do you think you're going to be able to continue that strong progress?

Speaker 1

Yes, Mark. This is John here. Again, as you know, we pride ourselves in being the best operators in the industry and have the DNA of and we know the leverage to pull as we see the type of trends that we see. So we've certainly done those, what I would say typical things, but the deeper question you're asking is the right one. The fact of the matter is over the past 3 years, we've done a lot of investments as we've had the opportunity with the ERTC benefit to make a lot of investments in the business.

Speaker 1

We really focus around our digitalization and digital adoption capabilities. We've built global capabilities in our operations footprint. And we started to really roll that out and really test and pilot that over the course of this fiscal year. And particularly during selling season, a lot of the enhancements both on the client service and retention side as well as the digital onboarding across each of our platforms, we launched a series of products that demonstrated to us at scale that we can drive a stronger operational and sales efficiency in our model. And so we're going to continue to double down on that and continue to look for opportunities that we can drive digital transformation in our back office, drive digital adoption by our prospects and channel partners, clients and their employees.

Speaker 1

And we believe that's going to continue to drive margin expansion. That's what we've seen in these tests and pilots. And now we're really starting to push and roll that out at scale.

Speaker 3

Perfect. Thank you very much.

Operator

And we have our next question from Kevin McVeigh with UBS.

Speaker 5

Thanks so much.

Speaker 1

Hey, Kevin.

Speaker 5

On the execution. I guess, Bob, this would be for you. The 25% guidance preliminary, pretty helpful. Any sense of what type of macro environment you're factoring into that, I guess, from an employment perspective more broadly?

Speaker 2

Yes, Kevin. I mean, we're still going through and finalizing all of our assumptions. But I would say at this point in time, we would assume a fairly stable, steady macro environment. Obviously, there's an expectation that the Fed is going to start cutting rates later this year. We do have some of that factored in at this point in time.

Speaker 2

But I would say overall, the assumption is a fairly steady state macro environment with some expectation that there'll be rate cuts as we move into the fiscal year.

Speaker 1

Yes. I think Kevin, I would just add on that on the macro side. We are adjusting our view and have adjusted our view even more as we looked at the Q3 based upon some of the hiring dynamics that we're seeing in the client base, because there is somewhat of a disconnect when you look at an economy that's growing at 3% to 3.5%, high 2s even if you go back, what you're seeing from a hiring perspective. And I would say the state of hiring in small businesses continues to be a challenge. I think it's a labor issue, it's not a demand issue.

Speaker 1

What we continue to see is clients telling us they're having trouble filling open positions and quite frankly with qualified candidates. I think one of the things that our HR professionals that are engaged, as you know, we have about 2,200,000 of our clients' worksite employees under management by our HR team. So as we saw some of the trends we saw that were disconnected from our models in a 3% GDP economy, why weren't we seeing hiring that we would have anticipated happening in the base. We had active structured dialogues with those clients. And what we're hearing is that they have open positions, they want to hire, they can't find qualified people and I think they had been burnt through the course of the pandemic in hiring just anyone.

Speaker 1

And so they're not willing to do that at the current labor rate. So the macro environment that we see, you look at our job index, continued moderation in hiring, continued moderation in wage inflation. We saw that January February, I'd say this December, January February, if you look at our releases, continued to show moderation. And actually January February were the 1st 2 months in our index, still over 100 still showing growth, but those were the 1st 2 months that we actually saw growth under pre pandemic levels. And so stay tuned.

Speaker 1

Tomorrow, we'll release the March one. But what I would tell you is that what we see is a moderating economy. We see a stable economy. We don't see signs of a recession. We don't see all the other demand was strong.

Speaker 1

Our pipeline was strong. The other things that you would typically see that would be more recessionary, we're not seeing mass layoffs. We're not seeing layoffs across point. What we're seeing is openings, vacancies, trouble hiring and businesses being cautious in who they're bringing into their workforce.

Speaker 5

A lot of sense. And then John, just to follow-up on that point, is that is kind of that tight labor what driving kind of the reenrollment on the insurance side of the PEO or just anything to call out in terms of what's been driving

Speaker 1

that? I think on the PEO enrollment, I want to really give credit to the team there. I think as you recall, a year ago, a little over a year ago, this was a challenging area for us. We were seeing things, participation rates went as high, attachment wasn't as high. We really looked at all aspects of both our product, our insurance product offerings, our enrollment processes and how we engage employees around that top to bottom and we made some changes in both the product offerings we have as well as we approach clients and the employees in our insurance offerings in the PO.

Speaker 1

And I think the team has done a good job there. And what we've seen is, now we're back to at to slightly above attachment rates and our participation rates are back to our historical norm. So I think that was a little bit more of an execution issue than any macro item.

Speaker 6

Thank you.

Operator

And we have our next question from Tien Tsin Huang with JPMorgan.

Speaker 7

Hi, thanks. Good morning. I wanted to ask on PE, I know the commentary around sales retention and attach was quite strong and then you move into the low end. I'm just curious if maybe you can elaborate on that and maybe your initial thinking around PEO momentum going into next year as well? Because I know that was something that we were tracking.

Speaker 7

Thank you.

Speaker 1

Yes. Do you want me to Yes. Go ahead. So I'll just start listening to fight you over.

Speaker 2

No, no, no. So I'd say that the big driver of maybe guiding more towards the lower end of the range was the employment headwinds that John called out in the script. We continue to see moderation in employment and that really was across the board. For the most part, the PEO has been able to outrun it with strong execution both in sales, retention. And we mentioned we continue to see record levels of worksite employee retention, really strong worksite employee growth in that business and then really getting our medical insurance attachment and volumes back to where we see it.

Speaker 2

So it's really a little bit of the macro headwind. And the other thing I'll call out on the PEO, I think the print is strong at 8%, but as you guys know that that category is PEO and insurance and insurance is typically dilutive to the growth of that overall category. So I would say that the PEO standalone growth is north of that number obviously that we gave you. So really strong performance in the PDO business. And we're building momentum and we see that carrying into next year.

Speaker 2

I'm not ready to give splits on next year between management solutions in the PO, but we certainly would expect the PO and insurance to grow at a faster overall rate than the total revenue growth that I gave you.

Speaker 7

Got it. Okay. Very clear. So it's just really the employment side that's out of your control. Perfect.

Speaker 7

So my quick follow-up just on the pricing front among the three factors you mentioned pricing last. Any more color on the pricing? Is it more discounting that you're seeing? And I'm curious if that informs your typical price action that you would take in the May or the spring timeframe, and if that's baked into your look ahead or preliminary 2025 outlook? Thank you.

Speaker 1

That is a broad question. So if I missed something, you'll come back. But here's what I would say. We're still able to go into the market and command our traditional value based pricing for the value we provide. I think you could see that in the retention.

Speaker 1

And what I would tell you is, again, and I'll be so glad when I don't have to use this word again, which I think will probably be 12 months from now. Ex ERTC, when I look at our actual revenue per client because ERTC was in a lot of the pricing bundles that we would sell when you're looking at the data is we're actually seeing that the pricing that we're getting across the various product groups being on part of what we have seen historically. I would remind you that over the last 3 years, we have guided and have said what's been at the high end of our traditional range. And I think that our assumption is as we go into the post pandemic era that we're going to like everything else seems to be going back to the mean, to slightly higher. So when I look at retention, again, retention back to kind of pre pandemic levels, but slightly better.

Speaker 1

I think that's where you'll see pricing and we still feel good about where we can go in terms of pricing. I think the competitive environment, it's always been a competitive environment. I think there were 2 dynamics going on that were interesting. To me, when I looked at the data and again, when I'm looking across when I'm looking across our 401 business, our PO business, our HCM mid market business, our small business HCM business, our SurePayroll business. I just when I go across our insurance business, the broad set of businesses and look at the 3rd quarter, which is one of our largest volume quarters and I see the volume hold up to what I expected.

Speaker 1

But what was interesting, the average client size was down in almost all of those slightly, which impacts our realized price, right? You just have less employees, you have less checks. And what I sense is that they're in the if you think of our business boulders, rocks and pebbles, right? I think boulders have been harder to move, less decisions, slower as you've heard some others competitors that are more targeted in the upper end of the market talk about extended decision timeframes, etcetera. So while we got the volume we expected, we got a little more rocks and pebbles than we expected, which drove a little bit of the rate.

Speaker 1

And then it was a more competitive environment in terms of both clients from a retention perspective and from a purchase perspective, demanding more and I would say being a little more negotiative in their approach, which is kind of what you sense in the economy with high inflation.

Speaker 7

Yes. Thank you for the complete answers.

Operator

And we have our next question from Bryan Bergin with TD Cowen.

Speaker 8

Hi, guys. Good morning. Thank you. I wanted to just dig in a bit more on bookings. Can you just talk about how the Q3 bookings came in relative to your expectations?

Speaker 8

How 4Q is trending so far? And if you can give us some added color on the across client size PEO versus ASO as well?

Speaker 1

Yes, Brian, I would just probably reiterate what I kind of already said. We had solid demand for our solutions really across the board. Volumes were in line with our expectations. What I said before is across each one of those sectors, I would say that the average size of the deal that we landed was smaller than what we anticipated than typical. So and I'm talking small, small, small amounts of differences.

Speaker 1

But as you all know in a business of our scale, a small change going from average 1 or 2 employees or 3 or 4 employees or worksite employees per deal, it can have an impact on the revenue you expect.

Speaker 8

Okay, understood. And then just on the sales front and sales investment, I guess, can you give us a sense on how sales headcount has trended relative to the start of the year? And as you go forward and plan for 2025, how are you thinking about adding absolute sales headcount versus trying to lean on more tech investments to drive more productivity?

Speaker 1

Yes, Brian, I would say this, our sales headcount has been at our expectations through the year. When we went into the selling season, we were at headcount, that's what we reported. I think to your point, what was interesting in the Q3, when I look holistically across the business, the amount of business we drove digitally across each of the platforms was impressive. And that's approaching some of our other channels that have historically been Paychex's bedrock of where we've gotten business. And so what we're seeing is and what we're doing with digital, I think will continue to be something and we're looking at a lot of different go to market strategies that we think will drive more productivity in our sales reps.

Speaker 1

And I think what we're trying to do right now is make sure we're doing the proper territory management, so that we can have even more reps more productive. So I'm not prepared. We're still working through our final budget planning process. What I can tell you is that we're driving a lot of productivity on a per rep basis and we're going to make sure that we're covering every nook and cranny of the market. So making sure how many sales people do we actually need to go after the market opportunity we have in each of the segments.

Speaker 1

And I think getting more specific about segment sizes and product type is what we're focused on as part of our new go to market strategy going into this post pandemic era.

Speaker 8

Okay. It's clear. Thank you.

Operator

And we have our next question from Samad Samana with Jefferies.

Speaker 4

Hi, good morning. Thanks for taking my question. So maybe first, we'd heard about maybe pricing increases going into effect, let's call it, either toward the end of the year or earlier this year. I was just curious if there is a change in the timing of when you push through price increases for customers this year? And then I have a follow-up question as well.

Speaker 2

Yes. I'll take the first question. Yes. No change, Samad. I mean, I think your timing, I mean, it's not always the exact time every year, but it's in that range typically towards the end of the fiscal year, beginning of the next fiscal year is typically when we have our annual price increases.

Speaker 2

So really no change to timing there.

Speaker 4

Okay, great. And then I guess just as you think about with segmenting size, I know what you just said about the average deal size comparing it being smaller. But are you seeing any trends within if you stratified it by your smallest customers versus maybe slightly more like mid market? And then same question between management solutions and PEO, if you're seeing anything that's different by the type of customer that you're seeing in terms of behavior or deal size or deal closing times?

Speaker 1

No, I Smedes, I don't really see much change overall. What I would say is, in part of this, I'm reading what I hear others have said that that play in markets and when I look at our by deal size. So we've got a mid market team, we've got a PO team, they're out in the market outside the base and they're going after deals and they're getting an average deal size and we'll get a mix, we'll get this number of clients over 1,000 employees, this many 500 to 999, you get the drill, right? And on average, you just you get a mix and that's the mix that kind of holds in the marketplace kind of historically. What I think you see when I look across it and Bob can comment as well is that on the larger side, the larger end, the enterprise end of that market, there was less of those deals that came in, in the PO, came in, in the ASO and came in, in the traditional HCM.

Speaker 1

And we made up the volume in more average slightly average sized deals that we get. But then when you add that all together because you have less boulders to the mix, you have a little less either worksite employees or less checks than you planned on. Does that make sense? I'm going

Speaker 4

to it does. I'm going to squeeze one more and I know 2 are normally delivered. But is there any I know you're not guiding by segment for next year, but is there any reason, Bob, to assume that the trend line that you've guided for next quarter for management solutions ex ERTC and PEO, like what's implied in the guide that, that wouldn't be the trend line heading into next year? Like is there anything that would materially get you off of those trend lines?

Speaker 2

Yes. I mean, I wouldn't say significantly, Samad. I mean, I don't want to get into providing specifics on the 2 categories yet as we're still going through our annual budget process. But we certainly would expect the PO insurance category growth next year to be similar to what we've seen this year. And Management Solutions is where the big headwind is with ERTC.

Speaker 2

But I would say similar trend lines to where we're exiting the year.

Speaker 4

Great. Thank you so much. Have a great day.

Speaker 1

Thanks, Samad. And Samad, I appreciate that you recognizing the three Eric. Although he's gone, we Thanks for indulging me. Take care.

Operator

And we have our next question from Jason Kupferberg with Bank of America.

Speaker 9

Hi, this is Carol and I'm on for Jason. So in terms of capital deployment heading into 4Q and also 2025, can you give an update on the relative attractiveness of buybacks versus M and A? And then also could you give an update on like the general health of your M and A pipeline?

Speaker 2

You want to start with that?

Speaker 1

Yes. Look, I would say that we continue to be open to acquisitions that meet the strategic objectives that we've laid out and that make financially sense. I would say that I feel like, in several areas and industries that we have interest that the multiples that I've seen, are getting into line that are more reasonable and trying to be active. And the key thing is just the timing of that, when is the right time of that. So we're certainly open for business, active engaging in both tuck ins, where we can add capability.

Speaker 1

We're doing a lot of things and looking at what we can do from an AI and digital HR perspective, constantly looking for adjacencies that are driving really the needs of our customers in terms of what they need to succeed and what we've talked about the access to capital, being able to retain and then hire employees, and really getting access to affordable benefits that allow them to attract clients. So all of those things are open. We've got an active engaged team that is talking to a lot of different prospects, but more to come. We certainly have the capital capability and the ability to do acquisitions and we're prepared to pull the trigger if we can come across something that makes financial sense.

Speaker 2

And Carolyn, I mean, the only thing I would add to that just overall as it relates to capital allocation, really no change in our approach there. We're going continue to invest in the business. Dividends are we're going to continue to grow the dividend and that will continue to be our primary use of cash. You mentioned share repurchases, really no change in our philosophy there. We do that to offset dilution from executive comp.

Speaker 2

You saw recently a month or so ago, we did do a new share reauthorization, so we can continue to do that. The old authorization had expired. And then to John's point, we certainly are interested in M and A opportunistically and we'll continue to use M and A to drive growth in the business. So our strategy and philosophy around capital allocation is very consistent with what you are all used to in the past.

Speaker 9

Okay, awesome. Thanks. That's great color. I appreciate you guys taking my question.

Operator

And we have our next question from James Faucette with Morgan Stanley.

Speaker 10

Thank you so much. I wanted to go back on just a quick couple macro points that you were making. If I rewind to back in potential for increases in out of business rates, etcetera. And just wondering like how that's evolved and what's your current outlook is there? And it seems like you feel better about it, but I just want to make sure I'm interpreting your comments

Speaker 1

correctly. Yes, Jim, I would say that out of business rates are not out of the norm that you would expect given the accelerated new business starts that we saw 2 to 3 years ago. Small business starts are down a little bit from those peaks and high, but still above pre pandemic levels. But again, it goes back to what I said before. We're not seeing signs of what would typically be seen in a recessionary period where there was accelerated out of businesses.

Speaker 1

Right now, what I would say out of business is elevated, and particularly in the low end. But when you look at that in context of how many new businesses were started over the last 3 years, that's not atypical because within 2 years, 50% are gone, within 5 years, 75% of them are gone. So that's it's not being driven by what I would say economic hardship or broad based. Businesses that you would not expect to go out of business don't seem to be going out of business, if that makes sense.

Speaker 10

Yes, it does make sense. I appreciate that. And then we've talked about kind of labor scarcity pretty consistently for the last few years. And I think your incremental comments in terms of the quality of labor and specifically, employers being more discerning now. It's interesting.

Speaker 10

Any specific areas or whether it be industries or geographic regions that that's important to? And I'm asking the question because I'm trying to think about

Speaker 1

what the path to resolution

Speaker 10

there is or if this is just something we're perpetually going to be grappling with?

Speaker 1

Well, what we keep trying to focus ourselves on is what more can we do to help our clients retain and attract quality employees. It's in their interest, it's certainly in our interest given the way we get paid. I think as you know, you know, we launched 2 years ago the AI based retention insights product that gives them insights of where they may have retention risk. We've got this the partnership with Indeed that's a fully integrated and we're actually elevating their job postings up in the listings for them as part of that partnership.

Speaker 11

We just did the Vizier

Speaker 1

product, which is on the way to be launched. We'll give them compensation information to be done. We're going to be doing some things in the next fiscal year around creating benefit bundles for our non insurance HCM clients that allow their employees to feel like being part of that employees relationship gives them access to catastrophic care. We're trying to do a lot of things to solve this problem for our clients. And obviously, there's more we need to do because the simple fact is we have a generational change happening in the labor force.

Speaker 1

Participation rates remain below pre pandemic levels and it's going to be very difficult given the rate of retirement that we're seeing in baby boomers to really see that change. And what you see in the prime age workers, we're actually at record highs. The problem is there's not enough prime age people to fill all the opportunities. And then when you look at the productivity gap that you have generationally, and that's just in terms of experience. I don't want to disparage any generations in any way, but just the fact you're replacing someone with years of experience with someone that's newer in experience.

Speaker 1

I really think this is going to be an ongoing public policy issue that's going to have to be addressed. There's a lot of retraining with AI and digital jobs. I think more needs to be done. I mean, we got this we got the R and D tax credit thing that's sitting out there, not to get on political bandwagon here, but we need to do more to allow businesses to invest in productivity and drive productivity enhancements. And that's not going to replace workers, that's going to enable them to get the work done with less workers that are going to exist in the marketplace.

Speaker 1

So I think this is a systemic problem. I think it's a great opportunity for us because it really goes to the products and services that we offer for a small and medium sized business owner. That's kind of my personal view on it and it continues to show up in the data that we look at.

Speaker 10

Get. That's great. I really appreciate that.

Operator

And we have our next question from Ramsey El Assal with Barclays.

Speaker 6

Hi, thanks for taking my question. How much did M and A contribute in the quarter? And if you could help us think through whether there's an inorganic contribution when it comes to your preliminary F-twenty five guidance, what that might be as well?

Speaker 2

Yes. Ramsey, I mean, M and A, we didn't do any new M and A. The only M and A that we've done this year was the small Alterna acquisition that we did at the end of Q1. Obviously, it contributes something. It's a small number.

Speaker 2

It doesn't even round to 1%. So it's really not a big contributor at all. In the guide, we typically don't, although we're always active in looking for opportunities, we're not going to put anything into a forecast until the deal is closed. So that does not assume any the preliminary guide does not assume any level of M and A next year.

Speaker 6

Got it. Got it. One quick follow-up from me. SecureAct 2.0, what are you seeing there? Does that have the potential to emerge as kind of a tailwind that might help offset some of the ERTC headwind?

Speaker 6

Or is it too early to tell? Maybe give us an update on what you're seeing on SecureAct 2.0?

Speaker 1

Yes. I think, Ramsey, replacing ERTC is a very difficult thing to do both in terms of the revenue nature of it and the profitability of it. And I would say that helping and basically we're doing filing as you know. We were doing tax filings, which is something this quarter our business And there was a lot of hype around ERTC. So there was a lot of education going on by others that was helping that.

Speaker 1

What I see in the SECURE Act is I think it's a great thing. I mean our retirement business had a solid quarter and it's had solid year to date and that continues to be a strong growth driver. I think you still got to talk to business owners and educate them on it. It's still a sales process. We've had states that have made it mandatory.

Speaker 1

Those come and go in the area. The other thing on the SECURE Act 2.0, which we've been pushing on is there is a little bit of a loophole that kind of disadvantages businesses with under 10 employees. I won't get into the nuances of it. And there's pretty bipartisan support in both the House and Senate to try to close that loophole. And we keep pushing for that.

Speaker 1

I do think that would particularly help in our micro segment, really accelerate, some adoption there. But right now that loophole is still there.

Speaker 6

Got it. All right. Thank you so much.

Operator

And we have our next question from Ashish Sabadra with RBC Capital Markets.

Speaker 1

Hi, this is David Page on for Ashish. Thanks for taking my question. I just had a question on your AI initiatives. Maybe can you provide some of the customer feedback? Like what I guess what parts of your tools or your AI models that they're liking and maybe some of the benefits you're seeing internally in terms of greater sales teams productivity, etcetera?

Speaker 1

Thank you. Yes. So David, what I would tell you at this point in time, a lot of our AI initiatives and investments have really been focused internally, both in terms of how we drive efficiency, how we drive better sales productivity, how we do better marketing and targeting, how we do better customer service and identify clients that are risk, how we do better pricing and discounting, so that we're not giving too much away, but we're giving enough to get the right type of lifetime value that we want. Really on the client side, the retention insights has been a very popular product with our larger customers in terms of getting insights of what they're doing. And we're just in the stages of really rolling out our Vizier product, which will give them basically 750,000,000 data compensation data points that will allow our customers in real time to understand how competitive they are if they're making a job offer, what they could potentially do and that's just in the early stages.

Speaker 1

What I believe is, because of our vast data set, we're going to be able to provide a degree of insights and information when coupled with our HR advisors, that I truly think is going to set us apart from any of the smaller regional players or local CPA, because we're just going to be able to give them the vast data set insights that we have. And so, as I mentioned, we just hired a new SVP, whose full time job is to do nothing but pull all of the capabilities we have across the company and develop a robust strategy of how we can drive the most out of AI to drive more value for our customers and drive more operational efficiency into the company.

Operator

And we have our next question from Bryan Keane with Deutsche Bank.

Speaker 11

Hi, guys. Good morning. I just had a couple of clarifications. The miss on revenue in Q3 versus your guided expectations, it sounded like a third of that was the ERT decision to stop recognizing the revenues. Then I'm just trying to fill in the gap and the other 2 thirds of kind of versus your expectations on the mess, if I heard that correctly.

Speaker 2

Yes, that's right. Hey, Brian, so it's roughly there's 3 big drivers that or 3 drivers that we've talked about. They're all small, but there's 3 drivers that we've talked about. Certainly, the continued moderation of employment, we definitely saw lower checks per client, lower change in base relative to what our assumptions were. That started in Q2.

Speaker 2

We updated our forecast in Q2 for some of the trends that we are seeing. But I would say employment came in a little bit softer than even our revised assumptions in the forecast. And then John mentioned a little bit on the rate. We saw smaller client sizes, maybe a little bit higher discounting than what we assumed. I mean, we're still getting really good price realization overall and strong growth in revenue per client.

Speaker 2

But I would say it was a little bit softer relative to what our forecast assumptions were. And then the bigger piece there was the ERTC that I mentioned. So when you look at those three things, they're roughly a third a piece is how I would characterize it.

Speaker 11

And then when I jump from the 3rd quarter revenue growth of 4% to the guided 5%, what accounts for the extra the strength of 100 basis points when I go into the Q4?

Speaker 2

Yes. So I'd say there's a few things to call out there, Brian. One, I mentioned the ERTC headwind being similar to Q3. It's a little bit less than it was in Q3. So that has a little bit of an impact.

Speaker 2

You have less of a headwind from ERTC in Q4. We're still getting strong client base, price realization, product penetration that carries into Q4. And then I would say on the PEO side, we came out of selling season in a stronger position from a worksite employee standpoint in medical enrollment. And so we're going to get the full quarter benefit of that in Q4 relative to where we were in Q3. So we got positive momentum, I would say, heading into Q4 in both businesses.

Speaker 2

And then we are getting a little bit of a lift in interest on funds in Q4. You're seeing a little bit stronger growth there versus Q3. Some of that is the compare. We did some repositioning of the portfolio. I think we had some unrealized losses that we took in Q4 to better position the portfolio going forward.

Speaker 2

And so you get a little bit of a tailwind in growth from that as well. And I'd say when you put those together, that's what accounts for a little bit stronger growth in Q4 relative to Q3.

Speaker 11

Got it. Thanks for taking the questions.

Speaker 4

Yes.

Operator

And we have our last question from Scott with Wolfe

Speaker 12

Research. Hey, good morning guys. Thanks for taking my question. Just one for me. Wanted to go back to the expense and margin side.

Speaker 12

I mean, the outperformance, I think, was notable despite the ERTC revenue going away. And I just wanted to outperformance, I think, was notable despite the ERTC revenue going away. And I just wanted to clarify, I mean, I know you talked about some of the efficiencies off of the investments over the last few years. But were there any specific actions on the expense side that you took during the quarter as the ERTC revenue sort of wound down?

Speaker 1

Yes. I wouldn't say anything specific to call out, Scott.

Speaker 2

I mean, obviously, we're always trying to look at expenses and making sure that we're not letting new costs into the business and really focusing. We saw the headwind come in. So I wouldn't say there's anything specific to call out other than good expense management. And there are some of that margin expansion that you saw in the quarter is being driven by interest rates. But even when you exclude that, we saw good margin expansion during the quarter.

Speaker 1

Yes. I don't want to I don't want to shortchange the tremendous job that each and every employee does in the company in terms of managing expenses and we have this built into our DNA when we say, hey, we're seeing signs, it's time to go. People know what to do and they do it. Because again, as Bob pointed out, some of that PO insurance revenue is direct revenue pass through. So when you look at our margins, you think some of that revenue, and you'll lose in the ERTC.

Speaker 1

I just want to commend how good a job we've done. And I think I've done historically, as part of our just DNA as being the best operators. And so, it's every little bit, every little thing matters and so there's no one big thing. I would say that the insights that we're gaining and the opportunity for digitalization, the investment we've made in enabling our clients and their employees to engage our systems and the rate in which they're adopting that opportunity is tremendous. And we've invested over the last several years into building out both our AI robotics capabilities and our global footprint.

Speaker 1

And I think all of those investments we've made over the last 3 years during the pandemic era when we had the ERTC are going to serve us well as we move forward. So I just look at it and say, as we exit this era of the pandemic from a Paychex perspective, I think we're entering the new era of just fundamentally a better positioned company. I think we're a more positioned trusted advisor to small businesses. We're delivering more value to our customers. They're rewarding that with retention and with better pricing in a market where there's a lot of cheaper alternatives out there.

Speaker 1

We're more digitally enabled in all aspects of our business than we've ever been. And I think we're more agile and focused and also more profitable, quite honestly. So hats off to the team for all the things we've done to get ourselves in this position that when the tide turned, we had leverage we could pull to make sure that we're delivering for our shareholders.

Speaker 12

Great. Thanks guys.

Speaker 2

Thanks.

Speaker 1

Is that it, Mike?

Operator

And that does conclude our Q and A session for today.

Speaker 1

Okay. Well, listen everyone, at this point, we'll close the call. If you're interested in a replay of the webcast of the conference call, it will be archived for approximately 90 days. And I want to thank you for your interest in Paychex and hope all of you have a great day. Thank you.

Operator

This does conclude today's program. Thank you for your participation. You may now disconnect.

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Earnings Conference Call
Paychex Q3 2024
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