Earnings Call Transcript - PAYX Q3 2021

Operator, Operator

Good day and thank you for standing by. Welcome to the Paychex Third Quarter Fiscal Year 2021 Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Martin Mucci. Please go ahead.

Martin Mucci, CEO

Thank you. And thank you for joining us for our discussion of the Paychex third quarter fiscal '21 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 ended February 28, 2021. 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 few days. This teleconference is being broadcast over the Internet, will be archived and available on our website for about 90 days. I will start today's call with an update on the business highlights for the third quarter and then Efrain will review our third quarter financial results and provide an update on our outlook for fiscal 2021. It is hard to believe that it's been over a year since the beginning of the mass shutdowns in response to COVID-19. This past year has been different from any other that we've experienced before. New challenges have forced us to find innovative ways to connect with our clients, prospects, and our own employees. I'm very proud of how the Paychex team embraced these challenges and took a leadership role throughout this pandemic, as evidenced by the newly released Sapient Insights Group Annual HR Survey just coming out this week that ranked Paychex Flex, our SaaS-based cloud application, number one among all solution providers as rated by their Voice of the Customer report in both user experience and client satisfaction scores. Our results for the third quarter reflect strong retention and client-based growth across all of our lines of business, most notably in our ASO HR outsourcing business. We completed the selling season with strength in our virtual, digital, and HR outsourcing sales driven by new business starts and the increasing need for HR support. Our traditional sales channels have been impacted by headwinds arising from restrictions on face-to-face meetings and delayed decision-making by the prospects. However, we've seen growth in key sales metrics, including sales presentations and close rates, which have continued in March as well as increases in win rates versus our competitors. We are well positioned to take advantage of the opportunities as we transition back to a normal market condition. As Efrain will discuss in more detail, with less than a quarter remaining in our fiscal year, we are proud of the fact that our total service revenue for the year will be roughly flat to last fiscal year after the major impact of businesses during the pandemic. Our initiatives to reduce expenses while accelerating our investment in the innovation of our products and service delivery have not only maintained our industry-leading profit margins but have positioned us well for growth as the pandemic situation improves. We have delivered solid client growth and demonstrated our unique value to our clients and partners through some of the most difficult times. Throughout every stage of the pandemic, we have demonstrated our commitment to helping clients with our multifaceted approach response, which includes a comprehensive COVID Online Help Center, state-specific resources, educational webinars, product innovations, in-app Paycheck Protection Program tools, specialized employee training, and more. Our efforts were recognized not only by our clients in the form of strong client satisfaction scores and retention, but we were also recently honored as the 2021 Silver Winner of a Stevie Award for the most valuable COVID-19 response. We continue to listen to and work with small and mid-sized businesses to provide the information, resources, and support they need. A recent Paychex survey to these businesses revealed that three of the biggest obstacles facing small and mid-sized business owners are financial instability, planning the return to office, and employer vaccination policies. While financial instability is the biggest concern, the government stimulus pay plans have been very effective in helping small and mid-sized businesses stay afloat. Paychex has continued to build on its portfolio of PPP solutions in real-time as new government relations are passed. To date, we have assisted our clients in quickly applying for and obtaining over $60 billion in PPP loans. We have also helped them claim approximately $1.5 billion in paid leave and employee retention tax credits. Paychex Flex is the first HR software solution to introduce integrated tools to help businesses maximize tax credits while not impacting PPP loan forgiveness. Our experienced HR professionals help our clients by delivering effective recommendations based on our clients' unique circumstances and business needs. These new challenges include assisting in navigating the complex stimulus legislation, developing return-to-office plans, creating vaccination policies, and the data analytics and tools to support employee recruitment and retention in this difficult time. The complexity of these issues has resulted in higher demand for HR outsourcing as more clients recognize the advantage of putting our expertise to work for them. In recent months, this increased demand has contributed to strong growth in our ASO business, as businesses are looking for more immediate HR support, but some reluctance to make changes to the employee benefits by selecting the PEO model. We do expect that as businesses begin to evaluate their options and implement benefit decisions, there will be a more normalized mix of ASO and PEO product selection. We announced on the last call that we were introducing our new pooled employer plan or PEP. This new product is a cost-effective retirement plan designed to expand retirement plan access with reduced administration for employers. We have been very pleased with the reception of this new offering in the market, and after just a few short months have approximately 2000 new clients on PEP. We believe that recent mandates in California requiring retirement benefits for employees will lead to even more interest in our PEP product and other retirement solutions. Paychex remains the top record keeper for retirement plans, originating the most new plans annually. We also announced our integration with Fiserv's Clover point-of-sale systems. We offer integrated payroll and time and attendance for small business retailers via a new app in the Clover App Market. Integration is now complete and existing Paychex customers can download the app to allow time and attendance to be handled within the Clover system, with seamless integration with Paychex Flex. This integration increases cross-selling opportunities for both companies and significantly enhances the client experience for shared customers. In addition, we launched several enhancements to our data analytics in Paychex Flex, including a Diversity and Equal Pay live report that builds upon our recently released EEO-1 compliance solution to give administrators the ability to analyze their pay and diversity data, allowing businesses to uncover opportunities to create a more diverse and equitable workforce. Our innovative solutions continue to receive industry recognition. We were recognized by the Business Intelligence Group, earning a 2021 Big Innovation Award for being a leader in real-time payments. Last May, we were the first HR solutions provider to offer real-time payments, giving businesses more freedom and flexibility. I'm very proud of the two awards that Paychex has been honored with recently. For the 13th time, Ethisphere named us one of the 2021 World's Most Ethical Companies and we are also on Fortune's list of World's Most Admired Companies. These awards acknowledge our commitment to ethical business practices, values-based culture, innovation, social responsibility and leadership, as well as our support for the business community and its employees throughout the COVID-19 pandemic. I give credit to the innovation, integrity, and hard work of our employees who have continued to show up for our clients, even while navigating the challenges of the pandemic in their own lives. As we enter our second year with COVID, we remain diligent in helping businesses continue to navigate the pandemic and remain hopeful that the worst is behind us. We are confident that our resilient business model, strong financial position, and dedicated employees will help Paychex to finish fiscal year 2021 even stronger than we started it. I will now turn the call over to Efrain to review our financial results for the third quarter. Efrain?

Efrain Rivera, CFO

Thanks, Marty. Hello, everyone, on the call. Good morning. I'd like to remind you that today's conference call will contain forward-looking statements. You know where to look for those disclosures. Please refer to them. In addition, I'll periodically refer to non-GAAP measures such as adjusted operating income, adjusted EBITDA, et cetera. Please refer to our press release again and our investor presentation for more information on these measures. I will start by providing some of the key points for the quarter. Then I'll follow up with some greater detail in certain areas and then I'll wrap with a review of our fiscal 2021 outlook and some initial thoughts on fiscal 2022. Our third quarter results reflect the impact of economic conditions resulting from COVID. For the third quarter, service revenue of $1.1 billion decreased 2% compared to the prior year, largely due to a lower volume of client employees paid across our HCM solutions. As a reminder, our third quarter includes certain annual revenue streams that declined due to lower employment. Total revenue declined 3% to $1.1 billion, impacted by a decline in interest on funds held for clients. Within service revenue, Management Solutions revenue was even at $847 million and PEO and Insurance Solutions revenue declined 8% to $250 million. Interest on funds held for clients decreased 29% for the quarter to $15 million due to lower average interest rates and realized gains. Average balances for interest on funds held for clients were consistent with the prior year. Expenses were down 4% to $643 million. The decline in expenses was driven by lower discretionary spending, reduced facilities costs, and lower amortization of intangible assets. Operating income was flat at $469 million and reflected an operating margin of 42.2%, a 100 basis point improvement from the prior year quarter. Our effective income tax was 24.2% for the third quarter compared to 23.6% for the same period last year. Both periods reflect net discrete tax benefits related to stock-based compensation payments that occur with the exercise of stock option awards. Adjusted net income decreased 1% to $349 million for the quarter. Adjusted diluted earnings per share also decreased 1% during the quarter to $0.96 per share. Year-to-date, service revenue declined 3% to $3 billion, with Management Solutions revenue declining 1% and PEO and Insurance declining 6%. Interest on funds held for clients declined 27% to $45 million. Total revenue declined 3% to $3 billion. Operating income decreased 5% to $1.1 billion and adjusted operating income decreased 2% to $1.1 billion reflecting a margin of 37.6%, an improvement of 50 basis points compared to the prior-year period. Adjusted operating margin excludes one-time costs of $32 million related to the acceleration of cost savings initiatives, including the long-term strategy to reduce our geographic footprint and headcount optimization, the majority of which was recognized during the first quarter. Adjusted diluted earnings per share decreased 3% to $2.32. Turning to our investment portfolio, our primary goal is to protect principle and optimize liquidity, as we've mentioned frequently. We continue to invest in high credit quality securities. Our long-term portfolio has an average yield currently of 1.9% and an average duration of 3.4 years. Our combined portfolios have earned an average rate of return of 1.1% for the quarter, down from 1.8% last year. I will now walk through the highlights of our financial position. It remains strong. Cash, restricted cash, and total corporate investments are $1.1 billion and total borrowings were $804 million as of February 28, 2021. Funds held for clients as of the same date, February 28, 2021, were $4.2 billion and increased from $3.4 billion as of May 31, 2020. Funds held for clients, as you know, vary widely on a day-to-day basis and average $4.5 billion for the third quarter. Our total available-for-sale investments, including corporate investments and funds held for clients reflected net unrealized gains of $82 million as of February 28, 2021. That compares to $100 million as of May 31, 2020. The decrease in that gain position resulted from increases in longer-term yields during the nine-month period. Total stockholders' equity was $3 billion as of February 28, reflecting $671 million in dividends paid and $78 million of shares repurchased during the first nine months. Our return on equity for the past 12 months was 37%. Cash flows from operations were $871 million for the first nine months. That was a decrease from the same period last year, driven by lower net income and fluctuations in working capital, including an increase in purchased accounts receivables due to continued recovery from the COVID-19 pandemic and growth in the business, offset by an increase in worksite employees' payroll-related liabilities. Now, I'm going to turn to guidance for the current fiscal year ending May 31, 2021. The outlook reflects our current thinking regarding the speed and timing of the economic recovery. It does not assume any acceleration due to government stimulus. After seeing the third quarter results, Management Solutions revenue growth year-over-year is expected to be in the range of flat to growth of 2%. PEO and Insurance Solutions is expected to decline in the range of 2% to 5%. We're now providing guidance on total service revenues. Total service revenue, not total revenue, which is now expected to be in the range of a decline of 1% to growth of 1%. Interest on funds held for clients is expected to be between $55 million to $65 million, unchanged from prior guidance. Total revenue is expected to be in the range of a decline of 2% to flat. Adjusted operating income as a percent of total revenue is now anticipated to be in the range of 36% to 37%, up from previous guidance of approximately 36%. Adjusted EBITDA margin for the full year fiscal 2021 is expected to be in the range of 41% to 42%, up from approximately 41%. Other expense net is anticipated to be in the range of $25 million to $30 million, unchanged from previous guidance. Our effective income tax rate is expected to be in the range of 23% to 24%. Adjusted diluted earnings per share is expected to be in the range of a decline of 2% to flat, whereas we previously guided to a decline in the range of 1% to 4%. We're really pleased with our ability to manage through the P&L impacts of the pandemic, especially loss of variable revenue, which as you all know carries a high margin. Now, turning to the fourth quarter and fiscal year, we currently anticipated total service revenue growth in the range of 7% to 9%. Remember, to get total service revenue growth, you need to understand that in the fourth quarter, interest on funds held for clients is expected to be approximately $15 million, consistent with previous quarters. Obviously, we expect to see a sharp rebound from what we've experienced in the first three quarters and a return to growth. Adjusted operating margin is expected to be in the range of 33% to 34%. We're also currently in the process of preparing our annual plan for fiscal year 2022. We'll provide more complete guidance for fiscal 2022 during our fiscal 2021 fourth quarter call in June, but I want to provide some very preliminary color on our initial thoughts around fiscal 2022 in this call. We believe that total service revenue growth will be in the range of 6% to 7%. Interest on funds held for clients is expected to be in the range of $55 million to $65 million and does not assume any significant change in interest rates. Obviously, we've got a lot of work to do to position the portfolio, but this is where we're at right now. We also anticipate that adjusted operating margin will be approximately 37% and that the effective tax rate will be in the range of 24% to 25%. Let me just say one thing. We typically will exclude our benefits from stock compensation exercised at this point. We're not baking any here. We probably will get some benefit, but too early to call. If as if that wasn't enough of a caveat, all of this is subject to our current assumptions, which are subject to change. I will refer you to our investor slides on our website for additional information. With that, I'll turn the call back to Marty.

Martin Mucci, CEO

Thank you, Efrain. Operator, at this point, we will open it up for questions.

Operator, Operator

Our first question comes from David Togut of Evercore ISI.

David Togut, Analyst

Two questions, please. First, if you could quantify some of the key performance indicators a little bit more, for example, client retention. Marty, you referred to some delays in sales cycles. Can you walk us through the booking trends you saw in the quarter? My follow-up is really around the receivables balance, which was up 81% versus the May balance sheet. Perhaps, Efrain, you can talk a little bit more about the purchased accounts receivables, what are the terms around that?

Efrain Rivera, CFO

Let me talk to that, David. As many of you know, we have a business that provides funding for staffing firms. In the last quarter of the year, staffing was flat on its back. We weren't providing any lending because there was no lending to be provided to staffing firms, and as a consequence, the receivables balance was very low. Our cash flow was very high in the last quarter. What's happened is that trend persisted through the first half of the year, and then staffing came roaring back, starting in January. At the end of the quarter, we had purchased significantly more receivables than we anticipated when the year started. On an average basis, we're only about 4%-5% above where we were last year. So, it's a little bit of an artifact of the decline in staffing followed by a sharp rebound. That number will come down significantly in the fourth quarter. So, that's what's happening on receivables. So, you had three questions there. I think the other ones were retention and bookings growth.

Martin Mucci, CEO

David, on the sales side, what we've seen is an improvement, particularly toward the end of the quarter, which has continued now into March on sales opportunities. We're getting in front of clients for presentations. What we've seen throughout the first half of the year and into the selling season was a lot of no decisions. We get in front of clients, but they're just not ready to make a move. We're starting to see that open up in the last month or so, and we're getting good opportunities in front of clients. Our win rates, where they make a decision, we're doing better against competitors than we have in the past, and sales results year-to-date are on track with what we expected. However, one of the tough things that played against that was just not getting enough face-to-face meetings with clients. Certainly, that always put a bit of a dampening effect on the selling season where we have so many units that come in that way. The positives have been on digital. We've increased our marketing and have a lot more digital sales, coming through the web, selling telephonically. So, we've seen improvement there. Strong double-digit growth in ASO sales. But on the PEO side, as I mentioned, it's a bit slower because they haven't wanted to change. The positive is that we have very strong client retention, on track for the best retention in our history.

Operator, Operator

Our next question comes from the line of Ramsey El-Assal of Barclays.

Ramsey El-Assal, Analyst

Thanks for the early view on fiscal 2022. That’s super appreciated. Can you help us think through the key drivers of PEO performance next year? What are the sort of pressure points in that business that need to lift to see it return to a more normalized growth profile?

Martin Mucci, CEO

I think one is the hospitality side, particularly on the Oasis acquisition that we did, concentrated in the southern states. As you see hospitality come back, the stimulus picking up, the new grants for restaurants, bars, hotels, et cetera, will drive more of the PEO clients. The more comfort in getting employees back into the business place is going to be very important to them. With the workforce expected to return, benefits will become a focal point.

Ramsey El-Assal, Analyst

A follow-up for me is, I wonder if you could kind of update us on the relative importance in the business now of cross-selling to existing customers versus signing up new ones.

Martin Mucci, CEO

Over the last few years, we talked about the power of 3,000 sales reps across all divisions. We've shifted from selling payroll first and then coming back in to sell HR complete benefit packages upfront. While it's been harder to get interest, leading with HR has been very important during the pandemic. This has resulted in double-digit growth in our sales of ASO, and we continue to see strong performance.

Operator, Operator

Our next question comes from the line of Kevin McVeigh of Credit Suisse.

Kevin McVeigh, Analyst

Marty, you talked about an increase in win rates against competitors. Maybe can you help us understand that a little bit, maybe how much of that is just better service through the pandemic versus more competitive product?

Martin Mucci, CEO

We've seen that the innovation in the product has really positioned us very well. Our document management has been very popular, and we've seen a big increase in the mobile app, which continues to be five-star and increases in utilization. Our recent successes, such as helping clients secure $60 billion in PPP loans, have significantly enhanced our brand strength. That's resulted in capturing a greater market share against our competitors.

Efrain Rivera, CFO

Yes, it does contemplate that some of the variable costs that came out of the business will go back in. We're looking to optimize our cost structure. But this year, we exceeded expectations on margins and have seen good news in terms of revenues.

Martin Mucci, CEO

We're strategically focused on controlling costs while investing in our product development. Improvements in self-service capabilities have yielded significant benefits in client satisfaction and operational efficiencies.

Operator, Operator

Our next question comes from the line of Bryan Bergin of Cowen.

Bryan Bergin, Analyst

Curious how you are thinking about the PPP impact on potential future switching behavior due to the regulations and reporting requirements.

Martin Mucci, CEO

Many clients have seen a great value in the support we've provided during the pandemic, such as filing for loan forgiveness. This increases retention while providing further benefits for our clients.

Efrain Rivera, CFO

Looking ahead, we're seeing operational efficiencies that will be beneficial in managing costs and expenses; however, we're also positioned to leverage improvements in the macroeconomic landscape.

Martin Mucci, CEO

We have not yet seen an impact from competitors introducing micro solutions. Our value lies in the personalized support we offer to our clients, which helps differentiate us in the market.

Operator, Operator

Our next question comes from the line of Pete Christiansen of Citi.

Pete Christiansen, Analyst

Marty, could you talk about the decision delay discussion? Has it been a regional issue given that some southern states have opened up? How has that impacted face-to-face meetings?

Martin Mucci, CEO

As more businesses open up, they're becoming more comfortable with face-to-face meetings. The shift to digital sales has benefited us as well, allowing us to hone our skills quickly. We're ready to resume face-to-face meetings but want all parties to feel comfortable.

Efrain Rivera, CFO

Going into next year, we will continue to spend against the opportunities we see without reducing our marketing expenditure significantly.

Martin Mucci, CEO

The impressive retention numbers reflect our commitment to providing value to clients throughout the challenges posed by COVID. The retention is strong, and we expect that to continue.

Operator, Operator

Our last question comes from the line of James Faucette of Morgan Stanley.

James Faucette, Analyst

How are you feeling now about the pace of innovation in the industry? Are you comfortable with how Paychex needs to innovate to match or exceed the competitive environment?

Martin Mucci, CEO

Most of our innovation can be served through internal development, although we're also exploring partnerships that enhance our offerings, like our integration with Clover. Our technological strength is significant in the marketplace. At this point, we will close the call. If you're interested in replaying the webcast of this conference call, it will be archived for about 90 days. Thank you for taking the time to participate in our third quarter press release conference call and your interest in Paychex. We greatly appreciate it. I hope you all continue to remain safe and healthy. Thank you very much.

Operator, Operator

Thank you. This does conclude today's conference call. You may now disconnect.