Earnings Call Transcript
PAYCHEX INC (PAYX)
Earnings Call Transcript - PAYX Q3 2023
Operator, Operator
Good day, everyone, and welcome to today's Paychex Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, you will have the opportunity to ask questions during the question-and-answer session. Please note, this call will be recorded, and I will be standing by if you should need any assistance. It is now my pleasure to turn the conference over to Mr. John Gibson. Please go ahead, sir.
John Gibson, CEO
Thank you, Todd. Thank you, everyone, for joining us for our discussion of the Paychex third quarter fiscal year '23 earnings release. Joining me today is Efrain Rivera, our Chief Financial Officer. This morning, before the market opened, we released our financial results for the third quarter ending February 28. You can access our earnings release on our Investor Relations website. Our Form 10-Q will be filed with the SEC within the next day. This teleconference is being broadcast over the Internet and will be archived and available on our website for approximately 90 days. I'm going to start the call today with an update on the business highlights and then Efrain will review our financial results and outlook for fiscal year '23. We'll then open it up for any of your questions. As you saw in our press release, we delivered solid financial results for the third quarter with total revenue growth of 8% and adjusted diluted earnings per share growth of 12%. Thanks to the outstanding efforts of our employees, we completed a successful selling and calendar year-end season with strong sales volumes and revenue retention for the quarter. We continue to see a stable macro environment and demand for our solutions. Our unique value proposition is clearly resonating in the market. Small and midsized businesses continue to show remarkable resilience, as seen in our job index over the last two months, as they contend with a constantly changing labor market, inflation, increasing regulations, and rising interest rates. Before we get into the third quarter results, I want to address the recent volatility in the U.S. banking market due to two highly publicized bank closings. We have no cash, restricted cash, or investments deposited within Silicon Valley Bank or Signature Bank, and we've met all client fund obligations related to employee payment services and remittances to applicable tax or regulatory agencies. We continue to monitor this situation and believe that our existing client funds held in cash, cash equivalents, and investment balances are more than sufficient to meet all client fund obligations. We remain ready, as we were when the crisis was unfolding, to help businesses and their employees whose payroll processing or direct deposits may have been impacted by these bank closures. Paychex has a long-standing track record of being a stable place for customers, employees, and investors during all macroeconomic situations and crises, and we demonstrated that once again. The selling season was positive in terms of both revenue and volumes in a highly competitive environment. Demand has remained strong for our HR outsourcing solutions, though, as we reported in prior quarters, we continue to see a trend of clients shifting preferences for our ASO model over the PEO model. In the third quarter, we saw revenue retention remain near record levels and normalization of uncontrollable losses at the very low end of the market. The focus and investment we continue to put in our high-value clients are making a difference in the customer experience. The advisory assistance we provide our clients is critical in these challenging times. Our retention for our HR outsourcing businesses, both ASO and PEO, stands at an all-time record high year-to-date. PEO and Insurance Solutions continue to show lower health insurance attachment and enrollment inside those clients that are attaching. This is specifically impacting our PEO in the Florida market, and the softer rates for workers' compensation insurance continue to impact the property and casualty part of our insurance agency. We expect these trends to continue early into the next fiscal year and normalize as the year progresses. Paychex is uniquely positioned with a continuum of solutions designed to help businesses in any macro environment. We help them recruit and train employees, gain access to capital, and provide valuable benefit packages such as insurance and retirement. Through our innovative technology, compliance, and HR expertise, we are here to help businesses drive efficiency within their HR processes, freeing up valuable time for them to focus on growing the business. Competing for and retaining employees remains a challenge for today's workforce. I want to commend Congress and the President for signing the recent SECURE Act 2.0, which will introduce a range of new opportunities for businesses looking to introduce a retirement benefit and make their employee value proposition more competitive. We have begun to launch campaigns to educate the market on the SECURE Act 2.0 and continue to position Paychex as the industry leader in retirement plans that we are. We are working on strategies to leverage our strength in this market and capitalize on this opportunity in the years ahead. As higher interest rates and disruptions in the banking system have impacted the cost and access of capital for many small and midsized businesses, we have fully embraced this challenge to help them by proactively assisting our clients with obtaining financial assistance available through non-traditional financial partnerships and government programs such as PPP and the ERTC program. We continue to see strong demand for our full-service ERTC solution. Many of the businesses we've helped are leveraging their new financial flexibility to reinvest in new solutions, such as a retirement plan or one of our integrated HCM technologies. Recently, our ERTC service was recognized with a Stevie Award for helping businesses obtain critical financial support. In uncertain times, people look for stable, trusted advisers to help them succeed. I am proud that we have been recognized as one of the most admired, one of the most ethical, and one of the most innovative companies by several prominent and respected brands. We remain one of Fortune's most admired companies in 2023, and for the 15th time, we were named among the most ethical companies in the world by Ethisphere. This select group of companies shows exceptional commitment to ethical operations, compliance performance, governance, and risk practices, including strong commitments to ESG, and diversity, equity, and inclusion. Today, we are announcing that we have been named to Fortune's list of America's most innovative companies for 2023 due to the innovation we've shown in our products, processes, and culture. These awards are the result of the dedication of our 16,000-plus employees who support our clients and help them succeed every day. I am very proud of the team and of Paychex. There's no question that we are a well-managed and stable market leader that people can depend on. We have a long-standing track record of being there for our customers when they need us most, and we continue to be well positioned to help them through the HR challenges they are facing and whatever comes their way in the future. Now, I'll turn it over to Efrain, who will take you through our financial results for the third quarter.
Efrain Rivera, CFO
Thanks, John. Good morning to everyone on the call. I'd like to remind you of the customary items I usually mention that during these conversations, we're going to talk about forward-looking statements. Items like EBITDA, non-GAAP measures, please refer to our press release for more information on these topics. I'll start by providing some of the key points for the quarter and finish up with a review of our fiscal 2023 outlook. Total revenue for the quarter, as you saw, grew 8% to $1.4 billion. Total service revenue increased 7% to $1.3 billion. Obviously, we're benefiting from the increase in interest rates. Management Solutions revenue increased 7% to $1 billion, driven by additional product attachment and HR ancillary services. It's largely what we've discussed previously, our ERTC product and price realization. We continue to see strong attachment of our HR solutions, retirement, and time and attendance products. Demand for our ERTC service remains strong and contributed approximately 1% to revenue growth in the quarter. Demand for this product, along with our internal execution, has continued to exceed our expectations, while ERTC has been a tailwind, we expect demand to continue into fiscal year '24. It will eventually moderate and become a headwind as we progress through next year. Beyond Insurance Solutions revenue increased 6% to $321 million, driven by higher revenue per client and growth in average worksite employees. The rate of growth was impacted by factors previously discussed, including lower medical plan sales and participant volumes, along with the mix shift to ASO as John called out. We expect these trends to normalize as we progress through fiscal 2024, meaning a little more of a balance between PEO and ASO. Interest on funds held for clients increased significantly to $35 million in the quarter, primarily due, as you know, to higher average interest rates. Total expenses were up 8% to $769 million. Expense growth was largely attributable to higher headcount and wage rates in general, to support growth in our business. Operating income increased 9% to $612 million, with an operating margin of 44.3%, a slight expansion over the prior year period. Our effective tax rate for the quarter was 24.3%, compared to 22.3% in the prior year period. The prior year period included a higher volume of stock-based compensation payments and the recognition of a tax credit related to our development of client-facing software that generated the difference in rates. Net income increased 9% to $467 million, and diluted earnings per share increased 8% to $1.29 per share. Adjusted diluted earnings per share increased 12% for the quarter to $1.29 per share. Let me quickly summarize the results for the first nine months of the fiscal year. Performance has been strong. Total service revenue increased 8% to $3.7 billion, and total revenue was up 9% to $3.8 billion. Management Solutions was up 9% to $2.8 billion. PEO and Insurance Solutions up 6% to $877 million. Operating income increased 9% with a margin of 41.8%. Adjusted net income and adjusted diluted earnings per share both increased 12% to $1.2 billion and $3.31 per share. Our financial position remains strong, as you can see, with cash, restricted cash, and total corporate investments of more than $1.6 billion. Total borrowings of approximately $808 million as of February 28, 2023, cash flow from operations, again, solid for the first nine months was at $1.3 billion and with an increase from priority driven by higher net income and changes in working capital. We've declared our quarterly dividends at $0.79 per share for a total of $854 million during the nine months of fiscal 2023. Our 12-month rolling return on equity was stellar at 47%. Now, let me turn to our guidance. For the current fiscal year ending May 31, 2023, our current outlook incorporates our results for the first nine months and our view of the evolving macroeconomic environment. We have raised guidance on certain measures based on performance this past quarter; updated guidance is as follows: Management Solutions revenue is now expected to grow slightly above 8%. We previously guided to a range of 7% to 8%. PEO and Insurance Solutions outlook is unchanged, with growth expected in the range of 5% to 7%, although we anticipate it to be towards the lower end of the range. We expect Q4 PEO and Insurance Solutions growth to be below 5% due to the factors that we've discussed throughout much of the year. Interest on funds held for clients is expected to be in the range of $100 million to $105 million. Total revenue is expected to grow approximately 8%. Other income and expense net is now expected to be income of $10 million to $15 million, obviously due to higher interest rates. Adjusted diluted earnings per share is now expected to grow in the range of 13% to 14%. We previously guided to growth of 12% to 14%. So we tightened the range, obviously, with one quarter left. Guidance for margins and effective tax rates are unchanged, but we do anticipate being on the higher end of the range for operating margin and the lower end of the range for the effective tax rate. We currently are in the middle of our annual budget process and are working on expectations for next fiscal year. As you know, this is challenging for a number of different reasons, not the least of which are expected outcomes in terms of interest rates and the economic environment. We'll provide final guidance for fiscal 2023 during fiscal 2023's fourth quarter earnings call in June. However, let me share some preliminary thoughts regarding fiscal 2024. On a preliminary basis, we believe that the exit rate in the fourth quarter is a decent approximation for total revenue growth for 2024. This should result somewhere in the range of 6% to 7%. Again, we have more to do there, but this is our thought process at the moment, and it's heavily dependent on what we think will happen with interest rates during the year. At this point, our assumptions are conservative. Management Solutions is expected to be lower as a result of moderating ERTC revenues. We called that out last year, but it didn't happen; it actually went the other way. We do think it's going to happen next year. PEO and Insurance revenue growth is expected to trend higher as we progress through the year with moderation in some of the headwinds we have experienced this year, primarily around insurance attachment and also, as we called out, mix shift to ASO. We remain committed to improving margins and we anticipate that operating margin will expand at this stage in the range of 25 to 50 basis points for fiscal 2024. Of course, all of this is subject to our current assumptions, which can change, especially if there are significant changes to the macro environment, which at this stage we are not seeing. I'll refer you to our investor slides on our website for more information. Now, let me turn the call back over to John.
John Gibson, CEO
Thank you, Efrain. With that now being complete, Todd, we'll open up the call for any questions people have.
Operator, Operator
Our first question comes from Kevin McVeigh with Credit Suisse.
Kevin McVeigh, Analyst
Congratulations on the strong results. John or Efrain, I know it's early, but the outlook for 2024 appears similar to 2023, despite some macro challenges. You tend to be cautious, so could you clarify the key factors influencing this? Is there potentially more pricing involved, and what are the underlying assumptions regarding unemployment? I'm trying to gain a clearer understanding of this situation.
Efrain Rivera, CFO
Yes, let me allow John to discuss our macro perspective further. Kevin, to address some of the higher-level assumptions in our plan, ERTC will not be the positive influence it was this year, as we mentioned last year. We believe there’s a strong likelihood we won’t see it impact next year, but this effect will be more noticeable in the second half of the year than in the first half. Additionally, looking back at the beginning of this year, we saw a nice macro uplift from employment, which appears to have peaked. While it isn't declining, we have observed a significant moderation in employee additions as the year has progressed. These factors will act as headwinds moving forward. Regarding interest rates, we have a better sense of the situation in the first half of the year, but it’s challenging to predict what will happen in the second half and whether rates will decline. We are preparing our portfolio to navigate these changes. That covers the headwinds; on a positive note, we believe HR remains strong, retirement is performing well, and HCM continues to advance. PEO, which has contributed positively to growth this year, is expected to perform even better next year. A significant part of the slowdown in PEO insurance growth can be attributed to the insurance sector, but we anticipate improvements as we move into next year. Additionally, we maintain a disciplined approach to costs, which will drive the results we project for 2024. That’s an overview of the numbers we’ve compiled, and I will let John address the macro factors and any other relevant aspects of the business.
John Gibson, CEO
Yes, Kevin, keep in mind that we've certainly seen a reference and really expected to see some moderation. I mean, we don't expect another 4.5 basis points increase in interest rates; we don't expect the type of hiring that we saw from the HCM. It's hard to believe that the great resignation was just last year, a year away. So certainly, we've had the benefit of staffing up. But we're not seeing any contraction moderation. In fact, if you look at our job index, which has been a great indicator of small business health and the increases in both January and February that we've reported, it's actually an increase in the index. We have not seen that through all of this fiscal year. So these are the first two months where we've seen an increase in the index and saw some moderation in wage inflation as well. So, we're certainly not seeing it. The demand for our products, the HR products, the online products that we're offering, the HCM products of the 401(k) effort is really strong. I mean, we had a strong sales quarter in the second quarter and the third quarter was actually better than that even on a relative basis, quarter-to-quarter compared to prior periods. So, we're seeing good demand in what I would say is moderation stabilization. We are closely watching all the indicators, but we're not seeing anything negative. We've got a very diverse client base. Paychex represents Main Street small and midsized businesses; we're not heavily weighted here or there. So we tend to represent what's going on in Main Street. I don't think Main Street small business owners have been reckless in hiring or requisite spending or able to spend more than they make. Again, they struggle through this and we've been helping them get through it. Our retention has been strong, particularly where accounts in our HR advisory products, both PEO and ASO are again at record levels. We have a good degree of confidence that our value proposition is resonating with our current clients. We still think there are a ton of opportunities inside our client base to provide them further assistance. And while we've seen a shift towards ASO versus PEO this year, those ASO clients are Paychex clients. We will be talking to them again next year about whether or not it's the right time and whether or not they've got the right benefits offering that now meets their needs, and we're doing a lot of work to ensure we have the right continuum of insurance products to meet the market conditions for small businesses today. This labor challenge that we have is not going to go away, and I don't think the complexities of hiring people is going to go away. I think that bodes well for how we've positioned ourselves; from an HCM perspective, our technology is driving efficiencies and it's helping people manage remote workers. It's helping them attract workers, and quite frankly, our HR advisory services are paying big dividends. So I hope that gives you some color on what we're seeing.
Operator, Operator
Thank you. Our next question comes from David Togut with Evercore ISI.
David Togut, Analyst
Just to dig into fiscal '24 guidance a bit more. Could you walk through some of the underlying drivers of Management Solutions revenue growth for next year and in a little greater depth? In particular, if you could, let's say, start with the critical year-end selling season, which you've just gone through, you've indicated it was strong. If you could kind of walk through what parts of the bookings were particularly strong within your client base, small end like sure payroll versus kind of more of the core payroll processing business, and then in addition to that, if you could comment on your expectations for client revenue retention next year and also for pricing?
Efrain Rivera, CFO
Let me break it into two parts and then I'll let John comment on the selling season. To develop the revenue plan for Management Solutions, several dimensions need to be considered. First, we need to understand our client growth expectations, and John can address what we observed during the selling season in terms of unit sales growth. The second aspect is our expectations regarding pricing, which we can't precisely outline yet. Both client growth and pricing are essential assumptions as we look towards next year. We aim for continued growth in our bundled suite's ancillary products, including time and attendance and HR administration. Furthermore, within Management Solutions, retirement and HR are significant growth drivers, and we expect strong performance from both areas, partly based on what John mentioned. Combining all these factors forms the basis of our approach towards Management Solutions. We also anticipate that PEO and Insurance will grow faster than this year, primarily due to expected improvements in headwinds as we enter next year, although some challenges may still be apparent in Q1. You accurately framed the question; if we come out of the selling season and feel that we haven't met some objectives, it becomes more challenging to plan for '24. However, John noted that we believe we had solid performance during the selling season. While we are not providing percentages at this stage, we shared detailed information about our client base after Q4, and we will discuss that further. I'll let John elaborate on what we experienced during the selling season.
John Gibson, CEO
Yes. No, I think, David, the key point was that we had both strong revenue production and good volume production across the core business and continued to see an accelerated level of growth. We were growing our HR businesses at a good healthy clip before the pandemic and when it hit, we started to come out and they accelerated. We're really seeing strong growth there, strong growth in retirement services, our online services, time and attendance, and the other bundles that we're offering retention insights. We're just seeing a lot of traction in our products and services, and we saw it in the third quarter. As I said, the third quarter was a step-up from the second quarter; we felt pretty good about the second quarter. It was a highly competitive environment. I would say there's a lot of aggressive competitors out there, and I think our products and our sales team did a great job executing. Also, I feel good about in that quarter is that we sell a lot of our business; only about 50% of our new clients come to us from strategic partnerships, and we had a good year-over-year increase there. Again, I think what's going on is not only are our products and services resonating, but people that are advising clients are beginning to prefer, hey, if I'm going to advise my clients where to go, maybe they need to be in a nice safe place where I don't have to have worries about whether or not their employees are going to get paid. So, I think that's also helped us in the third quarter as well.
David Togut, Analyst
Just pivoting to the float, Efrain. How are you positioning the float if the Fed is almost done raising short-term interest rates?
Efrain Rivera, CFO
That's an interesting point, David. I wonder whether they're almost done raising short interest rates. I tend to agree with you, but I'm not so certain about it. But the levers you have there are what percentage you have long-term versus what percentage you have short-term? And where do you lock long-term rates over a period of time, so you can manage what happens on the downside of the cycle? So, we're starting to extend duration now because we're of the conviction that interest rates seem to be getting close to some sort of peak. Having said that, my prognostication skills on this are not anything anyone should take to the bank, but I do think from a portfolio management perspective, it's probably better to start going longer now for us. We were shorter earlier in the year.
Operator, Operator
Thank you. Our next question comes from Ramsey El-Assal with Barclays.
Ramsey El-Assal, Analyst
Efrain, can I ask you to drill down a little bit in terms of the factors that are giving you confidence that the insurance side of PEO will improve next year? Just curious about the drivers or sort of reasoning behind that expectation.
Efrain Rivera, CFO
Yes. So, two things, Ramsey. It's interesting. It's been an unusual year in the sense that we've seen softness in insurance inside the PEO, and we've seen softness in insurance, particularly health care insurance, in our agency. I'd start with the obvious point that at some point, people do need health insurance, and at some point, as clients grow within the PEO, we add more clients. We're going to get more health care attachment. What's happened this year is that in the PEO in particular, you have renewals that occur in the fall, and then you have renewals that occur at the beginning of the year. If, in that cycle, you don't get what you expected, you basically have to wait for some period of time if we start all of that process over again. As we went through the year in the first half of the year, we thought we would come out of the year with robust insurance as we get to the end of the year. It was better, but it wasn't what we expected. On the agency side, it's been moderating as we've gone through the year, and we've gone through cycles like this over the years where we see attachment lower and then it picks up. So part of it is almost a new reversion phenomenon that we think will occur. The second part is, we have put several different initiatives that don't bear immediate fruit, but we think will bear fruit as we go into next year. One thing that's really interesting is, as John highlighted, this preference for ASO versus PEO is a permanent preference for many clients who want a PEO solution because they want the benefit of it, and we're expecting that we're going to see more of that as we head into next year. So while PEO performance has been lower than what we anticipated during the year, it's still been growing at a decent clip. It's being somewhat attenuated by the insurance business, which has been very sluggish through the year.
John Gibson, CEO
Yes. I would add to that. I think it's important to understand that particularly on the insurance attachment side in the PEO, remember, that's a lot of pass-through revenue, not a lot of margin, but it's a big dollar number. So a small percentage change in any direction has an overweighted impact on the revenue in the PEO, right? An extra 1 or 2% participation within the base I think is critical. And to Efrain's point, you have this opportunity to reset your insurance portfolio every open enrollment. You're hoping that you have the right portfolio of costs and the plans that people can afford, and they want to gravitate to what they're going to do. That cycle comes up every fall and into the winter. So certainly, we're taking a lot of data. We're doing a review of every market for the PEO and looking at our health insurance lineup, making sure it's competitive. We're taking an affordable approach for clients. We're talking to our clients, and we're already in the process of beginning to reset that and talk about that reset. So we're confident that we'll have the right lineup and opportunity. As Efrain said, historically, most of Paychex's PEO sales, prior to our acquisition of Oasis, came from upgrading ASO clients into the PEO business, a lot from within the base. Now it's far more outside the base, but we still have the capability inside the base. We think there's additional opportunity to upgrade them to PEO to increase revenue, increasing the lifetime value of the customer to us, it's the right thing to do for the business, and we'll be looking at plans to do that as we go into next year as well.
Ramsey El-Assal, Analyst
Let me sneak one follow-up; you called out higher revenue per client as a driver in the quarter. I'm just curious, over time, have you seen the overall growth algorithm of the business shift such that that higher revenue per client metric is sort of more important? I guess the underlying question is, do you expect ongoing gains there to persist, or was there something a little more lumpy about it that we should be aware of?
Efrain Rivera, CFO
No. For sure. I mean, if you look at, if you parse all the data, I'm not sure you get it from all of the public fiscal, but you get pretty close. You've seen persistent growth in revenue per client. I think we've been very skillful at finding new opportunities, both with product attachment and the ability to create new products and services within our client base to drive that revenue higher. So yes, we can talk about an algorithm that's about units and pricing or an algorithm that's really around revenue per client, and revenue per client has become more important, certainly in the last five years.
John Gibson, CEO
I think it's important, Ramsey, to keep in mind that we're driving more value to the customer through our technology as well as our advisory services, and that value is driving retention. It's driving pricing power, and it's driving an openness to add additional products and services over time. The old traditional model we've always had has been able to drive price increases over time to cover our cost increases. We've been able to go into the base and drive attachment. I would layer on top of that because we focus so much on the HR value proposition and driving customers up our kind of value continuum that the other benefit we're seeing here is revenue retention. Now they're looking at us as their trusted adviser, saying they want their 401(k), time and attendance, and other digital offerings from Paychex.
Operator, Operator
Thank you. Our next question comes from Andrew Nicholas with William Blair.
Daniel Maxwell, Analyst
This is Daniel Maxwell on for Andrew today. Sort of similar to the last question, but specifically on WSE growth in the PEO and ASO client base, if you can break apart, how much of that is coming from existing clients versus new clients and attrition? Any color on why there has been a preference for ASO over PEO and the reasons you expect that balance to normalize? Is that just coming from increased confidence in upselling to PEO, or is there anything else in there?
Efrain Rivera, CFO
Yes, Daniel. So, we've seen healthy growth in WSEs across ASO and PEO. We don't separately break them out, but both have been growing. So, we're seeing positive results on that side of the equation. Splitting it out between new adds versus existing base. The reality is that because the existing base is so large, it dwarfs the impact of new adds from a WFE perspective, especially when you consider attrition. We've seen good growth on WSE that makes us, as John said, more positive about the general value of our HR advisory services across ASO and PEO. I'll let John talk through shifting preferences in a given year between ASO and PEO.
John Gibson, CEO
Yes, Daniel. What we're noticing is that some clients who previously offered our insurance and had 25 employees enrolled now have 22, or we see clients in our PEO who have decided to stop offering insurance altogether. Given the uncertainty, there's a caution around adding new benefits. It's notable that businesses recognize the need for benefits to attract and retain employees. The 401(k) program is performing well since it is a lower-cost benefit that requires less commitment. With the SECURE Act 2.0, companies with 20 to 50 employees can set up a 401(k) and have all startup and annual costs covered through tax credits. In contrast, health insurance requires a long-term commitment once it's offered, which creates some hesitance. There’s potential for us to explore more innovative products that provide affordable access to healthcare for our employees, and our teams are actively working on this. As we approach new enrollment, which will occur this fall and into the second quarter of our fiscal year, I hope this information is helpful.
Efrain Rivera, CFO
Yes. With respect to buybacks, I think we've talked about what our philosophy is in general. At this stage, we're evaluating a range of opportunities from an M&A perspective, and if the right opportunity comes along, I'll let John talk to that, what we're looking at. But the right opportunity comes along. We obviously have the dry powder to be able to make something happen.
John Gibson, CEO
Yes. I think our position has changed on this. The market conditions have changed, and I think we're going to continually be on the lookout for opportunities that accelerate our position from an HR leader and technology leader and continue to position us as the leading digital HR human capital management provider. We've seen some valuations starting to come down. The recent disruptions in the financial markets may create additional opportunities. As Efrain said, we stand ready if the right opportunity comes around to pull the trigger. It's not that we haven't wanted to do something, but we're not going to overpay for anything. You'll see the same financial discipline from Paychex. What we believe is that the market conditions are more conducive to us moving forward on the M&A front, but we will see if that actually transpires.
Operator, Operator
Thank you. Our next question comes from Samad Samana with Jeffries.
Samad Samana, Analyst
Maybe one, just as I think about that comment about the number of new customers coming through strategic partnerships, how should we think about how that impacts kind of customer acquisition costs? Those tend to be slightly larger, smaller, more profitable, less profitable? How should we think about where you're acquiring the customers from and what the impact of that is to the financials?
John Gibson, CEO
I wouldn't think anything about it. I'd really be more commenting that's been Paychex for 50 years. Over 50% of our new clients have always come from strategic alliances we have. We're a respected partner with the associations, especially the CPAs. They've always been a big source. It doesn't do anything to our cost of acquisition. I think they tilted certainly during the selling season. We saw a good uptick in how they were referring Paychex over other options that they have. That was my comment.
Samad Samana, Analyst
Okay, great. As we think about the bookings in the quarter, anything to call out between the different customer sizes? So think about it as very down market and maybe more micro customers versus your average customer size. Just any trends or pockets of strength or weakness?
John Gibson, CEO
Actually, I would say we had good strength across the board. What I would tell you is that we saw a little more strength up market, not just the small start-up ones and twos. During the pandemic, that's where we saw a lot of growth. We know business starts, they were at crazy levels that have subsided, but they’re still at high levels compared to pre-pandemic. So when all these startups were happening, we also do a lot of managed payroll, insure payrolls. As you can imagine, a lot of people were hiring household staff during the pandemic. We saw a lot of escalation on that micro end. I'd say that's balanced out and it’s returned to a more normal state; what we saw in the third quarter was strong in the more traditional segments for Paychex.
Operator, Operator
Thank you. Our next question comes from Bryan Bergin with TD Cowen.
Jared Levine, Analyst
It's actually Jared Levine for Bryan today. How does the 3Q PEO revenue and worksite employees come in relative to your expectations? And then what is the expectation for 4Q in terms of how worksite employees and at-risk health insurance revenue will compare to 3Q?
Efrain Rivera, CFO
Yes. Jared, I won't get into that level of granularity at this point. We will report as we get through the quarter and year-end, but I'm not ready to dive into specific operational metrics for the PEO at this point. We called out that revenue was going to be lower in Q4. That's a function of the topics that we've talked about relative to insurance; but yes, I won't go any further than that. We'll have more to say as we get to Q4.
Jared Levine, Analyst
Okay. The 25 to 50 basis points of potential margin expansion for FY24, can you discuss what the primary drivers of that expansion would be?
Efrain Rivera, CFO
Yes. It's an emphasis that the Company has had. We're going through the budget process, frankly, after this call, and we started the process of putting our budget together. We just have a mantra to get more efficient where we can get more efficient. Some of it comes from operations, some of it comes from sales, some of it comes from G&A. It's really across the business, and where we see an opportunity to become more efficient, not simply massively cut costs, obviously that's important, but also deploying technology where appropriate to become better at doing what we're doing. Many of the technologies that you read about and hear about, we don't trump it, but we use. We think that advances in things like AI can be of tremendous help to tech angle services businesses. We're excited about the potential to understand the risk and are actively looking at how we can deploy those technologies to become more efficient, get better at serving the clients.
Operator, Operator
Thank you. Our next question comes from Jason Kupferberg with Bank of America.
Jason Kupferberg, Analyst
I guess there's a school of thought out there that just one of the byproducts of the banking crisis could be some tightening of credit; small businesses find it harder to get loans. They tend to bank with a lot of the regionals, etc. I'm just wondering what your take is as we start to look into fiscal '24. It doesn't sound like you guys are really assuming a recession per se in that preliminary outlook for next year. I just want to get a reaction to that to start.
John Gibson, CEO
Yes, Jason, I think I mentioned it in my remarks and some other questions. I don't think there's any doubt. I mean, prime at 8% for small and midsized business centers, and you talk to regional banks; I hear there's going to be some tightening of credit. That's part of the reason we've seen a lot of our customers engaging us on our ERTC product. Interesting, I would say as we approached some of our clients, a few were like, I really don't need that. A lot of our clients are main street small business owners. They aren't seeking a handout; they are sometimes a little gun-shy about getting out. There's been a lot of talk about auditing this stuff. We've had several clients come back and say, I can use this money; on average, it's about $180,000 per client. So we've been doing that. We created partnerships with fintechs during the PPP during the pandemic, and we're also helping our clients from that perspective because we've become a trusted source for our clients to help them figure out how to take advantage of tax programs and government programs. When you look at the PPP loans, 9% of all the PPP loans in the U.S. were placed by Paychex; that was more than JPMorgan and Bank of America combined. So, we're continuing to support them and help them, and we'll continue to look for ways that we can help them access non-traditional funding sources. I think that's another part of our value proposition that our customers and CPA partners are appreciating.
Jason Kupferberg, Analyst
Okay, understood. As a follow-up, I just wanted to ask on the float side of things; maybe a two-parter there. The first part just being, obviously, the unrealized losses have increased with rates going up, but just wanted to confirm you guys can comfortably meet all the float obligations just short-term component? I know you said so far to date, obviously, that's been the case. But I just wanted to make sure we shouldn't expect any material amount of realized losses? And then just any thoughts on Fed, now coming this summer, do you see any potential impacts on float if it's adopted by enough banks? And maybe just talk about how your float income breaks down between payroll and tax pieces.
Efrain Rivera, CFO
Yes. Let me take the first part. Yes, Jason, obviously, as John mentioned earlier in the call, when you have interest rates rising by 450 basis points at that pace, and you're holding very high-quality securities, but our interest rates at 1.5%, you're going to see some unrealized losses in the portfolio. We hold our securities to maturity, so that really doesn't represent an issue. We've had swings from plus $100 million to minus, obviously, at this point, and this has nothing to do with credit, so there's no issues there. Understand why you ask and understand all of the concerns that others had. Those securities will roll in the portfolio as they mature; our average duration is around 3.5 years, so this is relatively quick. So, no issues there. High quality; we only typically invest in A or above, and no concerns there. The second part of your question, I didn't catch. I was focusing too much on the first part, Jason.
Jason Kupferberg, Analyst
Yes, sorry, I was just asking about Fed now, with those real-time rails coming out this summer. Just any thoughts on how that could, if at all, impact float balances and float income? Obviously, we'll see how many banks adopt it, right? And then just any thoughts on your float income, how it breaks down between the payroll and the tax pieces, because I know obviously some of the float you hold a lot longer.
Efrain Rivera, CFO
Yes. Yes. Good question. We've been anticipating that at some point, the current landscape of payments, certainly ACH windows, will narrow. But, as you know this very well, a lot of our float income is not coming necessarily from overnight payroll; it's coming from taxes and that should not be impacted significantly under the Fed rules. The other part I’d mention is that we stopped asking questions lately about real-time payments. We do think there will be opportunities in the future, which may be an opportunity to monetize even if you lose some element of float income. Final point, just to advertise since this is my 12th year now, as you know Jason, there was a point when our business was heavily dependent on float; it was 27% or so of net income. We're in a different world right now. We'll manage through it, even if it doesn't materialize quite the way we expect it to. That's the breakdown of the three pieces that I think will impact us going into the future.
Operator, Operator
Thank you. Our next question comes from Kartik Mehta with Northcoast Research.
Kartik Mehta, Analyst
Efrain, I wanted to go back to your comment on Management Solutions, payroll, and pricing. Do you think it's fair to assume that considering the inflationary environment we're in and obviously that's impacting your costs as well, that the pricing on the payroll side will be higher than normal, maybe not as high as it was last year, but higher than normal?
Efrain Rivera, CFO
I'll hand it over to John to discuss pricing, as it’s important to differentiate between actual pricing and the value we provide to customers. To address your question, we generally see pricing in the range of 2% to 4% on a realized basis, and while it could be slightly higher for some clients, it’s often discounted. I'm hesitant to go into specifics about pricing for next year, but I anticipate the pricing environment will differ from this year, which was quite atypical due to inflation. I want to focus only on pricing and not get into value. There’s always potential to enhance the value we deliver to customers, and they are typically open to paying for that added value. Now, I'll let John share some insights on that topic.
John Gibson, CEO
Yes. We certainly don't want to talk about future pricing on this call. But I think it's fair to say that we have gotten far more scientific and precise about the ability and willingness of our customer base to pay based on a series of attributes about the way that they consume our services, how they want to be served, and what products that we attach. We see better stickiness and price elasticity. All of that is driven by a lot of AI, data science, and modeling for us to be very precise in that regard. As Efrain said, we try to talk a lot about value and about how we engage them in the utilization of our products and services. We approached over 100 million mobile interactive uses with our Paychex Flex product for the first time in the third quarter. The majority of those are employees engaging the product. We've been doing a lot to introduce that to our clients, their employees. They're getting accustomed to the notifications and changes in real time that they can make with Paychex. People we can do that with see a higher value from us. It enhances customer experience, and it also contributes to service and margin benefits at the same time. We will continue to understand what things we can engage the customer around, which, if we engage them, will increase the value they get from Paychex. Because of our competitive position, we can generate more value to the bottom line simultaneously.
Kartik Mehta, Analyst
Fair. We've discussed PEO and ASO extensively. Can you provide some context regarding revenue per client for PEO compared to ASO?
Efrain Rivera, CFO
Yes. I'd say, Kartik, the way to think about it is ASO does not, in general, include insurances. So, what you end up getting in a little bit of price on PEO on the base product is the added revenue that comes from benefit attachment, typically, for example, workers’ comp and also healthcare. Not all clients take health care, but when they do, then the revenue can be significantly higher.
Operator, Operator
Thank you. Our next question comes from Bryan Keane with Deutsche Bank.
Bryan Keane, Analyst
Just a clarification on the preliminary outlook for fiscal year '24, it doesn't sound like you expect the U.S. recession in that guidance. Is that correct? I guess if we do see a U.S. recession, how would it show up in the numbers, Efrain, because there's definitely a lag impact to where it shows up in the actual financials?
Efrain Rivera, CFO
Yes. Bryan, that's a good point, and obviously, we all hear the same chatter everyone is hearing. At this point, I can only tell you what we see right now. I can say, as we've said, we see signs of moderation that we've been seeing since the fall after Q1, but we don't see any significant signs of slowing. We just got through the last three months. John gave an overview of what was happening in the selling season. That would have been a signal that, hey, maybe something is going on here that we needed to pay attention to and incorporate. At this point, through the selling season, we haven't seen signs of a slowdown. I have seen signs of moderation, and we've incorporated that in our thinking. To the extent that we see a slowdown, obviously, we'd see it by July, and we've incorporated that in our thinking; we come back and say, guess what, things are slowing down. I don't think that things will occur that way, but it could. The way we think about the year is really – I have said this probably for the last three or four years; it's in two halves. We're confident about what we expect to see in the first half, as we believe we have good trending. The Fed is tight, and our clients are going to be much more impacted by rate increases in prime than anything else. At this point, they seem to be absorbing the rate environment, which we've recently gotten very close to peak short-term rates.
John Gibson, CEO
Yes, Bryan. I'd just point you to our Paychex IHS job index reports on our website and look at January and February; both months, the job index improved. We didn't see it in any other consecutive months in the prior fiscal year. So, certainly, we don't see as Efrain already said, and I can reiterate it, but even the benchmarks we would see leading into a recession and where we're seeing demand from our clients regarding employment, again, moderation, stabilization.
Operator, Operator
Thank you. Our next question comes from Peter Christiansen with Citi.
Peter Christiansen, Analyst
Just wondering if we can get a sense for the health of the top of the funnel, if we were to exclude the ERP side of things. What are you seeing from new business formation, and also perhaps some share shifts from regional cell filers? That kind of stuff would be helpful color there.
John Gibson, CEO
Yes, Peter, again, I'll go back; business applications and business starts, again, are back to pre-pandemic levels. I'm always trying to explain that when I look at our data; for our budget points, I'm looking back almost five fiscal years now, and fiscal year '19 stands out because it’s where both all this entity is happening and the other fiscal years. Business starts are down from where they were historically, so when I even look at some of our retention in the small end, it doesn't surprise me because in good times or bad, a small business that starts two years later, most aren't in business. There's good new business starts. When I look at our sales from the third quarter, they were strong across the board, not just in ERTC but across the board. I'm not seeing anything on a macro level that would indicate to me that there are macro issues or demand issues relative to the products and services we offer.
Operator, Operator
Thank you. Our next question comes from Mark Marcon with Baird.
Mark Marcon, Analyst
A couple of questions. One is basically in terms of the margin guide or the preliminary thoughts with regards to margins for next year. To what extent would you expect to see any sort of improvement in terms of the margins excluding the impact of float income? How are you thinking about that?
Efrain Rivera, CFO
Yes, I don't think float will play as big an impact on margin expansion as it did this year. I will hold the answer to that question until I've gone through the budget process because it depends on where I end up regarding float income for next year. We anticipate that it will grow, so that will exert a positive impact on margin next year. But remember, Mark, one other thing: We called out ERTC as moderating; that's going to exert a countervailing force. So when I pull those two together, I'll figure it out and will answer on Q4. I think there will be, at the end of the day, likely real improvement in operating margin when all is said and done.
Mark Marcon, Analyst
Do you think there will or will not be?
Efrain Rivera, CFO
Will, that's my expectation. But I haven't confirmed it.
Mark Marcon, Analyst
We should expect some improvement in margins. I know you're currently working on the budget, but are you expecting an increase in the size of the sales force and overall headcount, or do you believe that the technological advancements you are implementing will be enough to support the business with the current staff?
Efrain Rivera, CFO
Yes, good question. I'll answer in two ways and then let John give his commentary because I'm sure he scrutinizes every headcount in the sales budget. The short answer is that we're where it makes sense to add headcount to drive greater sales; we are likely to do that, and I'll let John talk to that. I think you rightly identify something that has been a feature of the Company, which is increasingly if you look at not only in the U.S. but also in Europe, where we also have a growing business, a lot of our sales are done digitally and do not require, at least at a minimum, the level of sales involvement that our field sales force provides. You're going to have a mix. I don't think we know quite yet whether there are adds, but I would be careful. I know our competitors tout their headcount adds as a precursor or driver of growth; that is not necessarily where we are. We can grow without adding headcount, although there are places where we may do that. I'll let John talk to that.
John Gibson, CEO
Yes, I don’t tell adding expense to the business very frequently. We constantly look to ensure we have the right go-to-market strategies and coverage. We're focused on using our vast data sets, analytics, and digital engagement as much as we can. Five years ago, our digital, including international paychex.com and surepayroll.com, has probably improved by 20%. We're driving analytics to make our sales force more productive rather than just cold calling across the market or inside the client base. We're using data analytics and models and triggers of behaviors of people engaging in our systems to give them active risk. I think there's opportunity for productivity and we’re doing a lot more digital engagement inside our applications; we're creating digital experiences to drive more attachment of ancillary products and services.
Mark Marcon, Analyst
Fantastic. One last one. Did you say what your pace per control ended up increasing over the course of this quarter or this year on a year-over-year basis? I've got some investors that are under the impression that your pace per control might be up by 300 bps, and then they're factoring in the ERTC and looking at the underlying growth; I'm not sure that the numbers are right. So just what did you see in terms of pace per control for this last quarter?
Efrain Rivera, CFO
We didn't talk about it, but I will say that through the year, we have seen increases in pay per control or we would say checks, and it's moderated as we've gone through the year. So, it's been a tale of two cities; the first half was different than the second half of the year.
Operator, Operator
Thank you. Our next question comes from Eugene Simuni with Masset Makinson.
Eugene Simuni, Analyst
I just have one quick question to follow up on the comment that you made on SECURE 2.0. It’s always interesting to hear how regulatory developments can help you guys. So can you elaborate a bit specifically on what the opportunities for Paychex might be from that act? What is the time frame for when we might see that flow into your financial results?
John Gibson, CEO
Yes, we’re in our planning stages to figure out how we want to approach the SECURE Act 2.0. We started some education, certainly within our base, and we're trying to scope the size of the opportunity across the market and determine what investment we're going to make. That's something I think we'll talk about more in the next call. We're doing a lot of surveys trying to get a handle on where people are in their understanding of what it means. There’s a huge education effort, and I think it's a powerful value proposition. Small and midsized businesses need to compete against larger employers who typically have richer benefit plans. There’s going to be a secular trend, and I think we’re well positioned for that opportunity. The SECURE Act 2.0 will allow companies with between 20 and 50 employees to basically set up a 401(k) plan, and you would pay Paychex literally nothing because you can get all the setup costs and annual costs covered through tax credits. It’s important for us to help small and midsized businesses understand these programs and facilitate them. We're doing a lot to scope that and certainly believe it's important and could have a strong impact moving forward.
Operator, Operator
Thank you. Our last question comes from James Faucette with Morgan Stanley.
James Faucette, Analyst
Just a couple of questions from me. First, and I know we've talked a little bit about this both in previous quarters and now, but can you recap for us why you think ERTC outperformed what you thought it would do during the course of this fiscal year? And how that contributes to you thinking that it could slow a little bit next?
Efrain Rivera, CFO
I think that when we entered the year, we thought there was widespread understanding and knowledge of the program such that as we went further into the base, the clients would have already availed themselves of the service. What we found was that they were anxious to hear and to be educated about the program and the way it works and our ability to facilitate their access to the program made them constructive about wanting to participate. The level of understanding was a little lower than we anticipated. This year, as we get into next year, more time has elapsed; the ability to access the programs is running out. So, as we get into the beginning of calendar '24, we believe the opportunity both within our base and in general will have moderated.
John Gibson, CEO
Again, I would just reiterate this shows how we’re trying to help our clients. Many of them thought they didn’t qualify or were unsure, or were concerned about the hassles and challenges participating. We learned early on that we needed to be more precise in terms of what clients we reached out to and inform them personally that they qualify and what that meant financially. Our data science team was able to pinpoint accuracy and tell clients we know from our data that you qualify and this is how much we're talking about. That information now resulted in more demand; paired with macro pressures, created that tailwind we experienced exceeding expectations.
Efrain Rivera, CFO
That's a good point. At this point, I only have the understanding of what we have seen but all indications point to observing some moderation. We're actively integrating this information.
John Gibson, CEO
At this point, we do not have anything in our data that would suggest a slowdown is imminent, but it’s something that we’re monitoring closely.