Paychex, Inc.

Ladies and gentlemen, thank you for standing by, and welcome to the Paychex, Inc. Report's third quarter fiscal 2019 results conference call. At this time, all participants have been placed in a listen-only mode, and the floor will be open for your questions following the presentation. If you would like to ask a question at that time, please press star 1 on your touch-tone phone. If at any point your question has been answered, you may remove yourself from the queue by pressing the pound key. We ask that while posing your question that you please pick up your handset to allow optimal sound quality. Lastly, if you should require operator assistance, please press star zero. It is now my pleasure to turn the floor over to Martin Mucey, President and Chief Executive Officer, to begin.

Great. Thank you, Laurie. Thank you for joining us for the discussion of the Paycheck's third quarter fiscal 2019 earnings release. Joining me today is Efren Rivera, our Chief Financial Officer. This morning before the market opened, we released our financial results for the third quarter ended February 28, 2019. You can access our earnings release on our Investor Relations webpage and our Form 10-Q will be filed with the SEC within the next few days. This teleconference is being broadcast over the internet and will be archived and available on our website for approximately one month. On today's call, I will review business highlights for the third quarter. Efren will review the third quarter financial results and discuss our guidance for fiscal 2019, and then we'll open it up for your questions. Financial results for the third quarter of fiscal 2019 reflected solid progress against our objectives and growth across our major product lines. Our total revenue growth was 14% for the third quarter, management solutions revenue grew 4%, and PEO and insurance services revenues grew a strong 65%, of course, reflecting the inclusion of the OASIS outsourcing group acquisition. On December 20th, 2018, we acquired OASIS, the largest privately held PEO in the U.S., and an industry leader in providing HR outsourcing services for approximately $1.2 billion in We finance this acquisition with $800 million of new long-term debt, along with cash on hand. Oasis is a great fit for our PEO growth strategy, adding to our scale, expanding relationships with new insurance partners, creating upsell opportunities into the existing Oasis customer base, and augmenting our talent with an addition of an experienced leadership team. Integration of Oasis is in process, with a combination of the Paychex and Oasis PEO leadership teams already complete. We're excited with the experience and talent that comprise this new team, and we're confident in their ability to continue to expand our leadership position in the HR outsourcing industry. In fact, Paychex and Oasis now will, combined, serve more than 1.4 million worksite employees through our various HR outsourcing services. Execution and operations has been strong, as reflected in our client satisfaction scores and client retention. We continue to be pleased with current retention results and are on track to end the fiscal year with retention in line with our historic all-time high. Our excellence in customer service was recently recognized as we earned a Stevie Award for Customer Service Department of the Year for the third straight year. One of the reasons for this recognition was our use of technology to evolve and improve the clients' and their employees' service experiences. Our strength and focus on technology, including self-service options for our clients, allows us to proactively respond to the changing preferences of our clients' needs. And thank you to the thousands of paycheck service givers who remain committed to responsiveness, reliability, and serving as a trusted business partner to our clients. We made significant investments in our sales force this year, particularly in our inside sales and mid-market sales teams and in lead or demand generation. We completed our selling season with improved performance led by our Sure Payroll, HR Solutions, PEO, and our inside payroll and insurance sales teams. Our internal sales teams continue to gain ground reflecting improved sales execution and productivity. Our Paychex IHS Market Small Business Employment Watch has recently showed that small business jobs growth remains pretty flat in this low unemployment economy. and hiring and retaining employees is a major challenge of businesses in this current environment. These factors, along with growth in wages, are evidence certainly of a tight labor market. Paychex is positioned to help small and mid-sized businesses recruit, hire, and retain talent with a broad portfolio of service offerings that allows clients to provide an attractive compensation and benefits package, along with opportunities for growth and development of their employees. We continue to enhance Paychex Flex, making significant investments designed to simplify the complexity of HR administration. The latest enhancements bring more performance management, workflow approvals, real-time analytics, and a configurable events calendar functionality to the platform. These features are all backed by self-service capabilities that empower employees and administrators to complete tasks from any location on any device. These significant technology product enhancements support our clients in recruiting, onboarding, training, and developing their employees in a market where I mentioned it gets increasingly difficult to find and retain employees. In addition to our HR center offering, our broad product set allows our clients to provide competitive benefits, including retirement and insurance options. Finally, our clients are supported by a team of over 500 paychecks HR specialists around the country who serve their growing HR needs as states have increasingly made it more challenging to run and grow their businesses without this expertise. We continue to enhance our technology for efficiency through the use of artificial intelligence and machine learning. The Flex Assistant, our AI chatbot, conducts conversations with our clients and their employees in response to a number of service inquiries. We have seen an increasing adoption of our chat bot because of the immediate response and quick and easy to understand solutions to customer inquiries as well as their employees' inquiries. This allows for efficiencies for us in internal processes by reallocating resources to more complex tasks. Our Paychex Flex Assistant can cover topics across the Human Capital Management Suite and guides users on how to self-serve if they prefer. The best AI chatbots function through natural language processing to interpret a user's language to understand and meet their needs. Combining NLP with machine learning enables a bot to quickly learn and adapt. And with the millions of monthly flex users, our chatbot is uniquely positioned to mature rapidly. Earlier this year, we launched client self-onboarding e-commerce functionality within our Sure Payroll product. We are the first of public competitors public company competitors to utilize a true e-commerce technology. Paychex Accountant HQ, our latest technology and service offering designed exclusively for accountants, was recognized as a winner in the 2019 Big Innovation Awards presented by the Business Intelligence Group. Accountant HQ provides a unique combination of technology and service, allowing accountants the full access to their authorized client data, extensive reporting capabilities, real-time data integration, key account contacts, and an accountant resource library, all backed by our industry-leading service model. Accountant HQ's dashboard and robust reporting capabilities allow for efficiencies, but also data insights to help accountants deliver greater value as a trusted business partner. We are especially proud to have been recently recognized for the 11th time by Ethisphere Institute as one of the 2019 World's Most Ethical Companies. This honor recognizes a fundamental value at Paychex, which is to have the very highest ethical business practices for our clients, employees, shareholders, and our communities. Thank you to all of our employees for consistently living this Paychex value and earning this recognition. We were also named one of the top 125 training organizations by Training Magazine for the 18th consecutive year, this year climbing up two spots to number 12. Paychex is dedicated to world-class employee learning, and development and takes great pride in our training programs. Our training and development team empowers our employees to embrace a career-long approach to learning and development. I'll conclude by emphasizing that our state-of-the-art technology, full suite of integrated HCM product offerings, and personalized service is a powerful combination that positions us for sustainable growth within our markets. Our employees make this combination successful with their hard work and commitment to our clients each and every day. I will now turn the call over to Efren Rivera to review our financial results for the third quarter.

Efren? Thanks, Marty, and good morning. I'd like to remind everyone that today's conference call will contain forward-looking statements that refer to future events that involve risk. Please refer to our earnings release that provides disclosure and forward-looking statements and related risk factors. In addition, I'll periodically refer to some non-GAAP measures such as adjusted operating income, adjusted net income, and adjusted diluted earnings per share. These measures include certain discrete tax items and one-time charges. Please refer to our press release and the investor presentation for a discussion of these measures and a reconciliation for the third quarter to their related GAAP measures. I will start by providing some of the key highlights for the quarter, then follow with some greater detail in certain areas. I'll touch briefly on year-to-date results and wrap with a review of our fiscal 2019 outlook and a 20 framework. So look also at the investor presentation. We've got more detail there. Total revenue and total service revenue both grew 14% for the third quarter to $1.1 billion and $1 billion, respectively. our first $1 billion quarter and hopefully the first many to come. The acquisition of OASIS in December 2018 accounted for approximately one-half of the growth in service revenue. Expenses increased 13% for the third quarter to $641 million. The acquisition of OASIS contributed approximately 12% to this growth. Total expenses for the prior year three months ended February 28, 2018 included, as you recall, a one-time bonus paid to non-management employees and a one-time charge following the termination of certain licensing agreements. Total expenses, excluding OASIS and these one-time costs in their respective prior year periods, increased approximately 9% compared to last year. This 9% growth was primarily driven by increased headcount due to investment in the Salesforce technology resources and operations to support the growth in the business. In addition, an increase in PEO insurance pass-through costs impacted the quarter. Operating income increased 16% to $429 million. Operating margin was 40.1% for the third quarter, comparing to 39.4% for the same period last year. Adjusted operating income, which excludes the previously mentioned one-time charge in the prior year quarter, increased 7%. I just keep referring you back to both the presentations we posted on the investor presentation we posted on the website. It goes through in extensive detail all of the call-outs. Our effective income tax rate was 23.7% for the third quarter compared to 1.1% for the same quarter. period last year. The enactment of the Tax Cuts and Jobs Act or tax reform in December 2017 resulted in a significant decline in the federal corporate statutory tax rate. In the third quarter last year, we recognized a net discrete tax benefit of $79 million from the revaluation of our net deferred tax liabilities at this lower rate or at the new lower rate. In addition, during the third quarter last year, we recognized a fiscal year-to-date catch-up for the lower blended effective tax rate applicable for the fiscal year. These two items resulted in the low 1.1% effective rate for the prior year quarter. We anticipate that the effective tax rate before any discrete tax items will be approximately 24% for the full year fiscal 2019. Again, I refer back to the investor presentation. Net income decreased 12% to 325% for the third quarter, primarily due to significant tax impacts I just discussed, partially offset by the one-time charge following termination of certain licensing agreements, also recognized in last year's third quarter. Adjusted net income increased 3%. Adjusted net income is a non-GAAP measure that excludes the one-time charge-related termination of the licensing agreements, tax benefit revaluation, deferred tax liabilities, and excess tax benefits related to employee stock-based comp, which we call out. However, this measure still incorporates the impact of the year-to-date catch-up for the lower blended federal corporate statutory rate recognized in the third quarter last year, which is monitoring the growth for the current period. Diluted earnings per share decreased 11% to $0.90 for the third quarter, but adjusted diluted earnings per share increased 3%. These growth trends reflect the same factors as discussed for net income. And again, I'd refer you back to the investor presentation, which details it. I will now provide some additional color in selected areas. Management solutions revenue, which includes payroll service revenue together with our HCM products included in many of our product bundles increased 4% to $802 million for the third quarter. Lessor contributed less than 1% to the growth. The remaining increase was driven primarily by growth in client bases across our HCM services and growth in revenue per check, which improved as a result of price increases and net of discounts. PEO and insurance. It increased 65% to $248 $6 million for the third quarter. Excluding OASIS, PEO and insurance service revenue would have increased 17% for the third quarter. This growth was primarily driven by the continued strong demand for our combined PEO services, which along with WSC growth or worksite employee growth in our existing client bases resulted in solid growth in client worksite employees served. Our insurance service revenue benefit from growth in the number of health and benefits applicants, the rate of growth for insurance services, was moderated by softness in the workers' comp market. As state insurance funds declined, we expect this trend in workers' comp revenue to persist, and we expect it to persist into next year, more to follow on that. It'll have a modest impact. Interest on funds held for clients. It increased 27% for the third quarter, $23 million, primarily as a result of higher average interest rates earned. Average balances for interest on funds held for clients were down for the third quarter, primarily driven by the impacts of lower client-employee tax withholdings, resulting from tax reform and client-based mix, partially offset by wage inflation. Investments in income. Our goal, as you know, is to protect principal and optimize liquidity. We continue to invest in high credit quality securities. The long-term portfolio currently has an average yield of 2.1% and an average duration of 3.1 years. Our combined portfolios have earned an average rate of return of 2% for the third quarter, up from 1.5% last year. Year-to-year year-to-date results. Let me briefly summarize where we've been for this nine-month period. Management solutions revenues up 4%. PEO and insurance revenue increased 40%. 23% without OASIS and 17% organic. Interest on funds held for clients increased 28% driven by interest rate increases partially offset by the impact of a 2% decline in average invested balances. Total revenue, this includes obviously OASIS, up 10%. Operating margins were 37.8% tempered by accelerated investments in the business and growth in PEO direct insurance costs. Net income increased 4%, and adjusted net income increased 12%. Diluted earnings per share increased 3%, but adjusted diluted earnings per share increased 12%. Let's go through the highlights of our financial position. It remains strong with cash, restricted cash, and total corporate investments of $886 million as of February 28, 2019. We had a strong cash flow quarter, even though we utilized part of our cash to pay for the OASIS acquisition. Funds held for clients as of February 28, 2019 were 5.4%. compared to $4.7 billion as of May 31, 2018. Funds held for clients, as you know, vary widely on a day-to-day basis, averaging $4.4 billion for the third quarter and $3.9 billion for the nine months. Total available for sale investments, including corporate investments in funds held for clients, reflected net unrealized losses of $10 million, compared with $38 million as of May 31, 2018. Total stockholders' equity was $2.6 billion as of February 28, 2019, reflecting $604 million in dividends paid and $33 million of shares were purchased during the first nine months of fiscal 2019. Our return on equity for the past 12 months was a formidable 42%. Cash flows from operations were $1 billion for the nine months, an increase of 3% from the same period last year. The increase was driven by higher net income and non-cash adjustments, partially offset by working capital fluctuations. Working capital fluctuations related to timing around collections and related tax payments for the combined PEO business, a decrease in accrued liability balances in connection with the termination of certain licensing agreements in fiscal 2018. Now, turning to 2019 guidance, I will discuss the guidance for full year fiscal 2019. I remind you that our outlook is based upon our current view of economic conditions, continuing with no significant changes. We've maintained our guidance as provided last quarter, including the overlay on OASIS, which I'll talk about in a second. I will reiterate these guidance ranges and provide some color where applicable. And then just finally to remind everyone, I give the guidance first excluding any anticipated impact from the OASIS acquisition, then followed with the anticipated impact of OASIS on our results. And I would say this. Some of you have updated your models for the inclusion of OASIS, some have not, and so thought that it made more sense and was better to be very clear to say, here's what our base guidance is and then the overlay of OASIS. So just remember that as I walk through this. So excluding OASIS, management solutions expected to grow approximately 4%. PEO and insurance anticipated to grow in the range of 18% to 20%. Interest on funds held for clients anticipated to grow 20% to 25%. Total revenue anticipated to grow in the range of six to seven. Operating income as a percent of total revenue anticipated to be approximately 37%. Interest income net anticipated to be in the range of 10 to 15 million. The effective income tax rate for fiscal 2019 expected to be approximately 24%. Net income and diluted earnings per share anticipated to grow approximately 4%. Adjusted net income and adjusted diluted earnings per share are both expected increase in the range of 11 to 12%. We give the guidance this way so there can be no confusion as the fact that we're tracking exactly to the plan that we set at the beginning of the year and don't blend or confuse the info on OASIS. So now let's talk about it when we include OASIS. It's anticipated, as we said previously, to have an incremental impact on total revenue in the range of $155 to $175 million in fiscal 2019. As we refine these numbers, we think that that number is going to be on the lower end of that range in the low 160s. Excluding one-time costs related to the acquisition, OASIS is anticipated to have minimal impact on earnings per share in Now, when we include one-time acquisition and integrated integration costs, we anticipate the impact on diluted earnings per share to be approximately three cents per share for fiscal 2019. That's consistent with what we've said previously, a little more color on where we fall within that 155 to 175, and that really has everything to do with the way we are looking at pass-through costs in that business. I'll provide you with a little additional color for the last quarter of the year. Consistent with how we guided on last quarter's call, we anticipate that management solutions revenue growth in Q4 will be below the full year rate due to the anniversary, primarily, among other things, of the lessor acquisition. We still think that management solutions will fall between 3% and 4%. Last quarter, we indicated that for Q3, we anticipated PEO and insurance services revenue increase in the range of 15% to 17%, and for Q4 to be in the range of 10% to 13%. Growth in Q3 came in at the high end of the guidance range we provided last quarter, and we now expect growth for Q4 to be approximately 9%, so below that range. There's two reasons for that. There was some timing of revenue that shifted between quarters on the insurance side, and despite this, we anticipate achieving our full-year guidance range. We'll talk a little bit more about what we're seeing as we talk about the 20 guidance, but there's also a little bit of softness on the workers' comp portion of our insurance revenue that pulls that revenue down a bit. Now, let me talk about the 2020, and I would just caveat everything I'm saying by saying that we haven't completed our planning process, but we thought, given the OASIS acquisition and the fact that you'll need to update models, we thought we'd give you some preview of what we're looking at for the year, including OASIS. We'll provide the detailed guidance during our fiscal 2019 fourth quarter call as we always do, but let me give you some high level commentary based on a preliminary look into next fiscal year. Management solutions, revenue growth, we anticipate it to be comparable to the growth in 2019. PEO and insurance revenue, excluding OASIS, anticipated to reflect low double-digit growth, so that means about in the range of around 10%. Including OASIS, PEO and insurance services revenue growth will be in the range of 30% to 35%, with growth higher in the first half of the year until the anniversary of the OASIS acquisition. Operating margins at this stage we think will be in the range of 37% to 38%. We'll see where we end this year, but that anticipates some improvement, some leverage on the base business. We anticipate OASIS will contribute revenue in the range of $355 to $375 million next year, and it's going to be largely neutral to earnings per share. With the significance of the interest expense and amortization expense associated with the OASIS acquisition, we introduced a discussion of EBITDA margins. Please refer to the investor presentation on our IR webpage for the calculation of EBITDA for the first nine months of fiscal 2019. We anticipate EBITDA for the full year fiscal 2019 will be approximately 41%. And we expect EBITDA as a percent of total revenue for fiscal 2020 to be consistent with fiscal 2019. And if you look at the way we calculate EBITDA, it's pretty simple and should be pretty easy to follow. I reiterate that these comments are very preliminary and subject to revision as we finalize our plans for next year. I will refer you to our investor slides on our website for more information for more information. By the way, I just wanted to clarify one thing, that 37% to 38%, it's clear on the webpage, would exclude, that operating margin I cited would exclude OASIS. So, look at the slide. It, I think, lays it out pretty clearly. So, with that, I'll end my comments and turn it back to Marty. Okay, thank you, Efren.