沛齊 (PAYX) 2017 Q4 法說會逐字稿

Welcome, and thank you for standing by.

(Operator Instructions) This call is being recorded.

If you have any objections, you may disconnect at this point.

Now I will turn the meeting over to your host, Mr. Martin Mucci, President and Chief Executive Officer.

Sir, you may begin.

Thank you, and thank you for joining us for our discussion of the Paychex fourth quarter fiscal 2017 earnings release.

Joining me is Efrain Rivera, our Chief Financial Officer.

This morning, before the market opened, we released our financial results for the fourth quarter and fiscal year ended May 31, 2017.

You can access our earnings release on our Investor Relations web page, and our Form 10-K will be filed with the SEC before the end of July.

This teleconference is being broadcast over the Internet and will be archived and available on our website for approximately 1 month.

On today's call, I will update you on the results of our business in the fourth quarter and fiscal year, and Efrain will review our financial results and discuss our fiscal 2018 guidance.

After that, we'll open it up for your questions.

Fiscal 2017 ended with solid revenue and earnings growth and progress on our key initiatives.

Over the past 3 years, our service revenues and operating income have experienced strong compound annual growth rate of approximately 8%, finishing fiscal 2017 with over $3 billion in service revenue for the first time.

We continue to enhance our position as a leading provider of human capital management or HCM solutions.

Attachment of our various HCM service modules continues to grow, driving 12% growth in our HRS revenues for fiscal 2017.

Our comprehensive HR outsourcing solutions, which are our ASO and PEO offerings, have continued to experience strong demand in the marketplace with nearly 500 Paychex HR specialists providing service to over 1 million worksite employees, a milestone we reached in fiscal 2017.

In addition, we have experienced strong demand for our time and attendance solutions, among other offerings.

As of May 31, 2017, we served approximately 605,000 total payroll clients, consistent with a year ago.

Client growth was impacted by a challenging demand environment compared to last year and a modest decline in retention.

Our business model is resilient, and we believe we will resume client growth in fiscal '18.

The past few months have been a time of political uncertainty, and we believe this has impacted outsourcing decision-making in the mid-market in particular.

We are constantly evolving to enhance our competitive position and are focused on showcasing the value proposition of our full suite of HCM solutions.

Last year in fiscal '16, we had a particularly strong sales year across many divisions, driven in part by an increased demand for the outsourcing of HR and payroll solutions and our Affordable Care Act product in the mid-market as a result of the ACA requirements.

This created tough comparisons for fiscal '17 sales.

Our fiscal 2017 mid-market payroll sales declined from the high level of activity experienced a year ago, and this impacted the number and size of clients sold.

Our client retention within our total payroll client base was approximately 81%.

And we have been engaged in a realignment of our service organization to allow greater flexibility and customization of our service the clients receive, and we completed this effort in the fourth quarter of this past fiscal year.

We project -- this project included the creation of our multiproduct service centers, our 24/7 dedicated service centers as well.

And as part of this initiative, there has been a reallocation of client service specialists and clients among different service organizations.

We believe this movement contributed to the modest decline in client retention this fiscal year, just off our near-record high levels of the last year.

We anticipate that retention will return to prior levels as this change has been completed and we transition back into higher tenure.

In addition, this was the first year in the past few years that we've seen a slight uptick in losses due to clients going out of business.

Small business sentiment has remained positive.

However, the pace of employment growth seen in the first quarter of the calendar year has reversed in this past quarter.

While the level of job growth has declined, there has been a steady increase in wages.

A recent survey of our small business clients shows that changes that would most benefit their future success and growth are job creation, tax reform and health care reform.

These are all priorities of the current administration's agenda, and policy changes in these areas will likely lead to more HCM outsourcing demand.

We have also seen an increase in the level of state regulations, including specific minimum wage changes and overtime rules even as the federal government has taken steps to reduce similar regulations.

Many multi-state small and midsize businesses should expect to experience an increased demand for outsourcing of their HR requirements given these changes, and we are well positioned to support them through our technology and dedicated service.

Throughout this last fiscal year, we have continued to offer new innovations to our technology platforms and value-added service offerings.

A differentiator for us is our approach to user interface design.

Our mobile-first design delivers the same client experience across any device: tablet, phone or desktop.

It provides our clients immediate access to payroll, HR and reporting data from a single application.

In addition to the technology innovation, we are continually making investments to respond to changes in client service needs, never losing that focus on delivering dedicated, personalized service anywhere clients want to receive it.

In December, we were honored with the Brandon Hall Group bronze medal for the second year in a row.

This award recognized Paychex Flex for the best advance in HR or workforce management technology for small and midsized businesses.

In May, we were honored to earn 2 Stevie Awards: one was a silver award in the Company of the Year, Large category, and we also received recognition for Customer Service Department of the Year.

The Stevie Awards are presented annually by the American Business Awards and are considered to be top honors for sales and customer service.

We recently also received Ethisphere's honor as one of the World's Most Ethical Companies.

This is the ninth time Paychex has been honored with this prestigious recognition, and we appreciate the importance that our clients and employees place on this key value as a company.

Paychex earned placement on Forbes' annual list of America's best employers on the list of large employers.

This recognition is a result of Forbes polling employees on everything from company culture and trends to benefits and human resources.

Paychex jumped up more than 50 spots from its 2016 ranking.

And just yesterday, we announced that for the seventh consecutive year, we ranked as the largest 401(k) record keeper by total number of defined contribution plans according to PLANSPONSOR magazine.

In addition, we earned the ranking of largest record keeper by total plans with less than $10 million in assets.

These honors are owed to the thousands of Paychex employees, who deliver on our service promise each and every day.

I'd also like to note our PEO is one of the first to be certified to provide PEO services under the Small Business Efficiency Act.

To be certified, we had to meet strict auditing and reporting standards.

We have over 20 years in the PEO industry, and achieving this certification reaffirms our position as a leading provider of PEO services in the U.S. We are proud of our market-leading positions and drive innovations in product and service to remain so.

We continue to focus on being shareholder-friendly company as well.

For fiscal 2017, we returned over $800 million to our stockholders.

Dividends paid were in excess of $660 million or 81% of our net income, and we continue to repurchase our common stock opportunistically to offset dilution and utilized $166 million for that purpose last year.

The strong cash generation in our business model allows us to reward our shareholders with a high dividend yield without constraining our ability to invest in our business.

In summary, our fourth quarter closed out another successful year for the company.

In these uncertain times for our clients in terms of HR and regulatory requirements and their need to efficiently grow their businesses through recruiting, engaging and supporting their employees, we are poised as an essential partner for their success.

We believe we have sustainable growth within our market ecosystem with the combination of our state-of-the-art technology, full suite of HCM product offerings and world-class service that meets clients' needs as they grow.

I appreciate the great work and efforts of our Paychex employees and management team.

And I will now turn the call over to Efrain Rivera, who will review our financial results in more detail.

Efrain?

Thanks, Marty, and good morning to everyone.

I'd like to remind everyone that today's conference call will contain forward-looking statements that refer to future events.

Refer to the customary disclosures.

Fourth quarter financial results for fiscal 2017 marked continued progress.

I'm going to touch on some of the key highlights for the fourth quarter and fiscal year.

I'll provide greater detail in certain areas, and then I'm going to wrap with a review of the outlook for the upcoming fiscal year in 2018.

Total service revenue, as you saw, grew 6% for the fourth quarter to $785 million and 7% for the fiscal year to $3.1 billion.

Interest on funds held for clients increased 14% for the fourth quarter to $14 million and 10% for the fiscal year to $51 million.

These increases were primarily driven by slightly higher average interest rates earned.

Expenses increased 5% for the fourth quarter and 6% for the fiscal year.

The expense growth in both periods was impacted by higher wages and related expenses due to growth in headcount, primarily in our operations areas.

Expense growth was moderated by lower variable selling costs.

Our operating margin was 37.4% for the fourth quarter, an 80 basis point improvement over the prior year quarter.

For fiscal 2017, our operating margin was 39.3%, a year-over-year improvement of 50 basis points.

We continue to maintain industry-leading margins while investing in our operations and in technology.

Our effective income tax was 35% for the fourth quarter compared to 35.5% in the prior year.

For both the full year 2017 and 2016, the effective tax rate was 34.3%.

The effective income tax rates for both fiscal '17 and '16 were impacted by discrete items recognized.

In fiscal '17, discrete tax benefits recognized included the impact of adoption of new accounting guidance related to employee stock-based compensation payments.

This new guidance has resulted in discrete tax benefits recognized upon exercise or lapse of stock-based awards.

In fiscal 2016, we recognized a net tax benefit on income from prior tax years related to customer-facing software that we provide.

Net income increased 10% to $195 million for the fourth quarter and 8% to $817 million for the fiscal year.

Diluted earnings per share also increased 10% to $0.54 per share for the fourth quarter and 8% to $2.25 per share for the year.

On a non-GAAP basis, adjusted net income increased 9% for both the fourth quarter and fiscal year to $194 million and $799 million, respectively.

Adjusted diluted earnings per share grew 10% to $0.54 for the quarter and grew 8% to $2.20 for the year.

Note that these 2 non-GAAP measures exclude the certain discrete tax items that we previously discussed.

Please refer to our press release for a discussion of the non-GAAP measures and reconciliation to the related measures under GAAP.

So basically, what we're doing and as we talk going forward here, we're going to exclude the benefit of those tax benefits when we talk about adjusted net income.

So if you look at the slides that are on our Investor page, you'll see on Page 16 a very clear and detailed example of what we're talking about.

So any confusion, just look there.

Payroll revenue increased 2% for the fourth quarter to $441 million and 3% to $1.8 billion for fiscal 2017, the growth in payroll revenue largely due to better revenue per client as a result of price increases net of discounting.

Year-to-date payroll service revenue growth of 3% included approximately a little bit less than 1% from the impact of Advance Partners.

Similar to the emphasis I made last quarter, with the evolving nature of our business to an HCM service provider, our offerings of bundled products to our customers have increased.

Revenue from those bundles is allocated and apportioned between payroll and HRS.

Payroll growth remained steady in the low single digits, and HRS revenue growth reflects the sale of more services to clients and greater revenue per client.

Average client size, as we've discussed previously, has been trending down slightly this year, and this had an impact on revenue growth during the year.

HRS revenue increased 10% to $344 million for the fourth quarter, and 12% to $1.3 billion for the fiscal year.

It was actually 44% of service revenue in the fourth quarter, and it shows that within a short period of time, we'll be about half and half payroll and HRS.

The increase in HRS reflected continued growth in the client base across all major HCM services, including comprehensive HR outsourcing services, retirement services, time and attendance and HR administration.

Retirement services also reflected an increase in asset fee revenue earned on the value of participant funds.

Insurance services benefited from continued growth in revenue from our ACA compliance service as well as growth in the number of health and benefit applicants, along with higher average premiums and an increase in our workers' comp product.

For the fiscal year, the impact of Advance Partners was also approximately 1% of the growth of HRS revenue.

Turning to our investment portfolio.

Our goal is the same as it's always been: protect principal and optimize liquidity.

On the short-term side, primary short-term investment vehicles are bank demand deposit accounts, variable rate demand notes.

In the longer-term portfolio, we invest primarily in high-credit-quality municipal bonds, corporate bonds and U.S. government securities.

Our long-term portfolio has a current average yield of 1.7% and an average duration of 3.2 years.

Our combined portfolios earned an average rate of return of 1.3% for the fourth quarter and 1.2% for the fiscal year, up from 1.1% in the respective prior year periods.

During fiscal 2017, the Fed increased the federal funds rate twice: 25 basis points in December and 25 basis points in March 2017.

We've seen a modest impact from these rate increases on our fiscal 2017 results but anticipate a greater impact in the upcoming year.

The Fed again increased the market interest rate by another 25 basis points earlier this month.

The impact to net earnings of a 25 basis point increase in short-term rates is estimated to be in the range of $3 million to $4 million after taxes for the next 12-month period.

It's incorporated in the guidance.

We don't make any assumptions in the guidance at this stage as to future Fed rate increases, although we believe that there will be some.

Average investment balances for funds held for clients were down modestly in the fourth quarter and about 1% for the year.

I'll walk you through highlights of our financial position.

It remains strong with cash and total corporate investments of $777 million as of May 2017.

During the fourth quarter, we ended the year with no debt.

We paid down a small amount of debt that we had outstanding during the year.

Funds held for clients were $4.3 billion compared to $4 billion as of May 31, 2016.

Funds held for clients vary widely on a day-to-day basis and averaged $4.3 billion for the fourth quarter and $4.1 billion for the fiscal year.

Our total available sale -- for sale investments, including corporate investments and funds held for clients, reflected net unrealized gains of $32 million as of the end of the year compared with an unrealized gain of $48 million as of May 31, 2016.

Total stockholders' equity was $2 billion as of the end of the year, reflecting $662 million in dividends and, as Marty mentioned, $166 million of repurchases of Paychex common stock.

Our return on equity for the past 12 months was not only sterling but a very sterling 42%.

Our cash flows from operations were $960 million for the fiscal year, a modest decrease from prior year.

This was the result of fluctuations in working capital offset by higher net income and noncash adjustments contributing to the working capital growth -- or growth in accounts receivable balances as of the end of the year from our Paychex Advance business.

And we had a very large client that we brought on board, testament to their success in winning business in that part of the market, and that impacted balances as of the end of the year.

We'll see the benefits of that client as we go through next year.

We remind you, talking about guidance, that this outlook is based on our current view of economic and interest rate conditions continuing with no significant changes.

Our guidance for the full fiscal year is as follows: payroll service revenue anticipated to be in the range of 1% to 2%; HRS revenue growth anticipated to be in the range of 8% to 10%; interest on funds held for clients anticipated to grow in the mid- to upper teens, so that means 15% to 20%, reflecting the benefit of recent increases in short-term rates.

Total revenue including interest on funds held for clients is anticipated to grow approximately 5%; operating income, expressed as a percentage of total revenue, anticipated to be approximately 40%.

Investment income net is anticipated to be in the range of $9 million to $11 million.

Our effective tax rate is expected to be in the range of 35.5% to 36%.

Adjusted net income is expected to increase approximately 7%.

Adjusted net income excludes the impact of the discrete tax benefit recognized in fiscal 2017 relating to employee stock-based comp payments.

We made no assumptions as to future benefits to be recognized in our fiscal 2018 projections due to the uncertainty of measurement involved.

Please refer to our non-GAAP financial measures disclosure in our press release and our investor presentation, Page 16, for a reconciliation of this non-GAAP measure to GAAP-basis net income for fiscal 2017 as well as further discussion regarding our use of this measure.

GAAP-basis net income is anticipated to grow approximately 5%.

GAAP includes the impact of $18.3 million in discrete tax benefits recognized this year, related again to that same issue, employee stock-based comp payments.

Adjusted diluted earnings per share -- so now we turn to EPS again, non-GAAP, is anticipated to grow in the range of 7% to 8%.

This measure, again, excludes the impact of the tax benefit recognized in fiscal 2017 related to employee stock-based comp payments.

As previously mentioned, you can find it in the press release, and you can find it in the investor presentation.

Now what many of you are waiting to hear, further detail on the annual guidance.

So I'll provide this detail on the gating for fiscal 2018.

First, growth in payroll services revenue is anticipated to be within the full year range for the first half of the year and toward the high end of the range for the second half of the year.

So let me repeat that again, growth in payroll service revenue anticipated to be within the full year range for the first half of the year and toward the high end of the range in the second half of the year.

Growth in HRS revenue is anticipated to be within or above the full year range for each quarter with one exception, which is the first quarter, which will fall below the low end of the range.

So if the range is 8%, we anticipate at this point that it's going to fall below that range.

Total revenue growth as a consequence in the first quarter will fall below the full year guidance range, modestly below, but below.

Growth in net income on a GAAP basis is anticipated to be, essentially, flat for the first quarter.

In the first quarter of fiscal 2017, that's when we recognize a large tax benefit from the adoption of new accounting guidance related to employee stock-based comp payments.

As previously noted, our guidance for fiscal 2018 does not include any assumptions around this benefit, although we anticipate we may realize a modest benefit during the year.

So just to reiterate there on first quarter, we anticipate at this point that it will be flat with prior year on a GAAP basis.

If you look at what we did in Q1, you'll understand what's going on there.

So that concludes my discussion.

And I'll turn it back over to Marty.

Great.

Thanks, Efrain.

Operator, we will now open up to -- the call to any questions, please.

(Operator Instructions) Our first question will come from the line of Mr. David Togut from Evercore.

This is Rayna Kumar for David.

Can you please call out what the 4Q '17 bookings growth was?

And if you can just discuss your expectations for FY '18 bookings?

Yes.

Rayna, this is Marty.

So in the -- we don't talk so much about the exact growth.

I think what we saw was overall PAR sold was down from last year.

It was more on a normalized basis.

If you looked at the year before and a couple of years before, we were more on that level.

Last year, we peaked -- fiscal '16, we peaked.

I think with ACA, we saw a lot of not only the ACA product sales but we saw a number of opportunities for payroll and time and attendance and other products.

People made decisions because of ACA to outsource, and so we had a bump up.

And then this last year, fiscal '17, we had a lower overall PAR sale than that level, but more on a normalized basis.

So -- and when we look at this year, we certainly expect the growth to go -- to be back up.

We don't really talk about exactly where we are on that but we feel good about the changes in go-to-market strategy that we're making.

Some things we're adjusting to.

We're increasing the spend in digital marketing because we're seeing a larger number of leads coming in obviously, on the web.

And we feel good about the marketing that we're doing, and we're increasing that investment.

And we're also increasing the number of virtual sales reps because the leads that are coming in, we need to sell even faster.

And clients are looking to sell them over the phone through chat, et cetera.

And we're -- we positioned ourselves to be able to do that, frankly, had already set up that positioning in the fourth quarter.

So down a bit from last year.

However, we feel good about, going into this year, the growth in PAR sales that'll bounce back.

Rayna, our acronym internally for bookings is PAR.

It's Paychex annualized revenue, if anyone's sort of wondering what PAR is.

That's very helpful.

And just lastly, could you discuss the pricing trends you saw in the fourth quarter for both payroll and HR services, and how we should think about pricing for FY '18?

Yes, I think -- I don't think we saw any big change.

I do think overall pricing competition picked up a little bit in the year, not so much in the quarter, but in the year.

And not -- so we didn't feel like competition changed all that much from a technology and product offering.

We feel very good about that.

I think pricing got a little more aggressive during the year because -- probably because everyone faced the same issue, which was kind of a decrease in opportunities as a result of ACA the previous year.

Now fewer people were outsourcing.

There were fewer opportunities.

Everyone got a little bit more aggressive on price, nothing significant.

And we still feel that, as you look at fiscal '18, this new fiscal year, we should still be able to have a price increase in our normal range.

And we didn't have any major drop off because of that.

Next question from the line of Danyal Hussain from Morgan Stanley.

I guess, I just wanted to ask maybe first on retention.

You called out that you've worked on the service initiative in part to address this.

Just want to know if there's any change so far.

And whether you've observed, I guess, at the end of the fourth quarter and so far in June, any improvement?

Yes, in the fourth quarter, what we saw was a trend of bringing tenure back up.

What basically happened is -- and we knew there would be some client disruption because of this, over the last 18, even 24 months, we've been moving -- and I've talked about this a little bit.

We've been shifting to different client service segments.

So while we've sold a lot more of our HR administration online, our time and attendance offerings, et cetera, we started moving clients to multiproduct centers, where we have teams of people.

Where you just don't have payroll, but you have payroll and time and attendance and HR expertise in a team setting that is still dedicated to the client, but now you have that full team setting.

We also saw an increase in number of online clients, clients doing payroll themselves, over the last few years.

And we shifted them to what we call a dedicated service center because they're more inbound calls than they are our normal service model of calling out to the client at a specified time.

We had more inbound, kind of as the client needed the service.

So we shifted them to dedicated to service centers, where we're open 24/7, and we have much better technology, enhanced technology that we put in place, that we invested in as well as chat, et cetera, web chat, et cetera.

So we finished that in the fourth quarter, all of that move.

That disrupted some clients, meaning that a dedicated payroll specialist that I had prior, I may have lost because I moved more tenured people into multiproduct centers or other areas.

We then over -- during the course of the year, hired a number of new client service specialists who had less experience, and that caused some disruption in the clients and in the level of service.

And so our near-record high client retention of 82% fell to about 81%.

We expect that to come back.

What we've seen in the fourth quarter already, client satisfaction numbers coming back up.

Client tenure -- or I'm sorry, client service specialist tenure, so then the experience, the certification, the months of experience are coming back up as well.

We're back even above where we were at the beginning of the fiscal year.

So we think now we're obviously coming out of that and expect to get ourselves back up near record highs by the end of the year.

Just to add to that.

The fact that retention went down was not a complete surprise to us.

We had planned it to be down about 50 basis points.

Obviously, it was higher than we anticipated by the time the year concluded.

Okay.

And then just a clarification on sales bookings.

Marty, you said that you feel good about growth for the year.

Has there been any change in the underlying client behavior?

Or is this more a function of just easier comps and the fact that you're investing in maybe some of these higher-growth digital channels?

No, I -- well, I think it's a combination of both.

I do think there was some customer behavior that changed last year, which as I described was that the year before, in fiscal '16, with ACA coming on very heavy in the requirements, we saw a number of new opportunities.

And we didn't -- I don't think at the time we realized as much that they were a big jump in the number of opportunities that were out there where people said, "Hey, it's time for me to outsource everything, payroll, HR, et cetera." Then in this last fiscal year '17, those number of opportunities were decreased.

There wasn't as much of a push on that.

So -- and then the number of -- so there was a little bit of a macro change there.

I do think that, as I mentioned in my comments, what we're seeing is the level of regulations, while they may be reducing on the federal level with the current administration, state regulations are increasing.

Minimum wage specific to cities and states are changing.

Overtime rules are being put in place in states as opposed to federal.

Everything is getting more complicated, and we think this will produce even more opportunities.

And then internally, the changes we're making with the virtual sales increase in the additional investment in marketing spend, we really think is going to drive the growth back up to where we'd like to see it.

Maybe just a clarification on the earlier point on pricing.

Was that elevated pricing competition in -- up in the mid-market or throughout?

Mostly in the mid-market.

We actually felt pretty good about the small market this year when you look at the total clients.

And so it was a little bit more -- I mean, there's more competition, I think, in all markets, but I think the mid-market was a little more aggressive.

And I think that was folks coming -- I think that was competitors also coming off of the higher year with ACA.

The next question will come from the line of Jim Schneider of Goldman Sachs.

I was wondering if you can maybe just give an update, touch on the federal regulatory environment?

Clearly, we've had inaction on ACA repeal and replace for some time now.

What are your clients in the mid-market telling you about -- or what is their behavior telling you about their intention to kind of put on new bookings or generate new sales in the face of that?

Or we're going to have to wait until that is kind of fully resolved and baked before that part of the market gets unstuck?

Are you seeing some parts of the market get unstuck now?

And I guess, just kind of broadly speaking, do you still see it as a headwind incorporated in your fiscal '18 guidance?

I think there's a couple of points there to make.

One is, the good news is the retention of the ACA product with our clients is very good.

So even though there's all this talk about repealing the Affordable Care Act and the mandatory requirement, we're not seeing much drop off in the number of clients in Affordable Care Act.

They -- I think what we're seeing in the behavior is, "Hey, I'm still going to have to do something.

I may not have a mandatory requirement to hold insurance, but I need to report something, and I'm going to stick with the product." In addition to that, what we're also seeing the behavior is, "Hey, once I put insurance into my -- as a benefit offering to my employees, I can't just say I'm not going to offer it anymore because it's not required." It's been used to -- recruit and keep, retain employees of our clients, and I don't think you're going to see a big drop off of those that are necessarily providing insurance now just because the mandate's not there.

I do think, though, as I mentioned, that we're seeing in our jobs index, and that's small businesses under 50, that there has been a drop off of the employment growth rate.

And so they're not hiring as many.

And I do think there's probably some of that macro out there where, "Hey, I'm a little confused as to what's going to happen on tax reform, what's going to happen with the Affordable Care Act and those kind of things."

That's helpful.

And maybe just as a follow-up, on the HRS growth, clearly, the -- kind of the 8% to 10% growth you're calling out, below this fiscal '17 level but I think you're indicating that that's largely due to difficult comps on ACA.

So I guess, can you -- but it's still a deceleration over the trends you've seen in the past couple of years.

So how much of that is cyclical?

And then as we head into the back half of fiscal '18 and in -- what's your visibility on that growth rate kind of improving?

And I guess, to the point you made earlier about increasing state regulations, what opportunity do you still see remaining on HRS from a state level?

And how -- over how many states is that?

Hey, Jim, I'll take the first part of that question.

So the answer is the 8% to 10% range versus double digit really has a lot to do, as you said, with the fact that our assumption is that Affordable Care Act revenue and modules are likely to be flat to down slightly with this year.

Given the amount of uncertainty going on and the fact that we anticipate sort of the normal amount of attrition that we see with those clients, we have not been aggressive in our assumption around what happens with ACA.

And obviously, we had a nice benefit from that over the last couple of years.

So I'd say that's part a. Part b, remember that we had a little about a 1 -- little bit over 1% contribution from Advance Partners.

They're doing very well but we obviously don't have that going into next year.

So if you strip out those factors, we're growing double-digit in HRS.

And I think you're absolutely right.

I called out in the first quarter that HRS is below the range of total guidance for the year for revenues.

It's because of the comp primarily, with the Affordable Care Act.

As you get through first quarter, the comps get easier and then we resume more normalized patterns of growth.

So in the second half, HRS growth is certainly stronger than the first half.

That's at least at this point what we anticipate.

Now with respect to state regulations and all of that, I'll just turn that over to Marty to talk through.

Yes, I think from a state perspective, we're probably seeing almost half the states look for ways to put in their own regulations to make up for the federal reduction.

So they're looking for minimum wage increases.

They're looking to put in new overtime rules for the state.

They're looking for all kinds of things.

And I don't think that'll even -- and now you're even hearing about, depending on what happens with the Affordable Care Act, various taxes, new taxes, payroll taxes possibly, to make up for some of the reduction in what the Feds are subsidizing at the state level.

The other thing on the HRS revenues, every product, every client base for -- or every product set we have, all increased in this fiscal year.

So we continue to feel really good about 401(k).

We're still the leading provider of the most plans of anybody.

We have over 1 million worksite employees more than anyone on our HR outsourcing.

And we were one of the first to be, as I mentioned, on the PEO certification.

So we feel very good about HR outsourcing in particular being -- coming back pretty strong.

So once we get past some of the comparables that Efrain mentioned, I think we continue to feel really good about HR outsourcing, PEO and ASO.

The next question will come from the line of James Berkley of Barclays.

Could you just try to provide some more color in the mid-market versus down market.

You called out the mid-market as a challenging area last quarter, obviously.

Just getting a lot of questions from investors around how much of the challenging environment, particularly in that mid-market, is uncertainly-related and ACA-driven versus competition-related, if at all?

Just especially given strong growth rates you've seen some other -- from some smaller players that focus on that space, like a [Pay Lassi] for example.

While those other guys offer ACA solutions as well, maybe part of that disconnect has to do with the fact that those smaller players have less robust ACA offerings and easier comps?

Just trying to get a better feel for what's going on there.

Yes, I think that's certainly -- can be part of it.

But I think we feel good -- we do feel good about the technology and the offering we have as well as the service.

I think we have talked about that some of the mid-market is we're working through a migration from an old platform.

Now 96% of our Flex clients are on Flex, so it's not like it's a large number that we still have to work through.

But I think all of that is -- has had some impact on mid-market.

I wouldn't say -- I think we feel very good about -- from a technology.

Pricing a little bit tougher.

Again, I think, people, all of us, all competitors were challenged a little bit coming off the ACA year and so pricing got a little bit more aggressive, but we feel very good about the offerings that are out there.

We're very competitive, and we're not really necessarily losing that much more to anybody in particular.

I think it was just a tougher compare year.

Macro wise, I think there is, as I mentioned, some impact of -- for those larger clients over 50 employees, okay, what is exactly the impact going to be to me from all of the administration and they are probably a little bit slower.

And then could you just talk a little bit more about the large client you alluded to?

How large, what impact do you see it having to growth next year?

What drove the client's decision to use Paychex?

That was specifically related to the advanced funding portion of the business.

So if you've noticed, there was a bump in receivables.

The way that business works is if you fund a large client, you get the receivable impact upfront and then you start realizing the benefit as you collect fees.

So I was just calling out specifically, what was happening with Advance Partners.

And by the way, that business grew strongly and has been a tremendous contributor during the year and we think going forward.

So we're very bullish on what's going on there.

Last one here.

Just to build out Jim's prior question around HRS, what -- revenue just being a little bit slower than we've seen in the past.

Could you break out what's going on there and touch on how confident you are on top line guidance with -- margin expansion's a lot higher, the guidance there, than we typically see.

So just kind of what's going on with those 2 things?

You may have purposely set the bar low it seems just because last year, yes, probably trying to avoid lowering guidance like we saw last year.

It looks like maybe you set the bar low, so...

Great question.

I would say if you look at us over the last 6 years, we have never missed earnings.

So I'd say that we've generally beaten on the upside.

So there's always an element of conservatism in our guidance and I hope that continues into next year.

But no, what's going on is that we have a grow over comparison.

And by the way, we're the first to report, and I am certain that others will say exactly the same thing.

There's a grow over comparison on ACA modules that everyone is going to face.

For us, the impact is more significant in the first quarter and it abates as we go through the year.

And the second part, as I mentioned, Advance Partners was a contributor to revenue for the year, in HRS of a little bit over 1%.

But most of that benefit occurred in the first half of the year because we acquired them in the second half of '16.

So basically, that's what's going on there.

On the margin guidance, just remember that when I said margin guidance, sometimes I talk -- I, in the past, talk about operating margin excluding float.

It's up.

And then operating margin in general, it's up, of course, because now we're getting the benefit of investment income.

But we're very proud of operating at 40% margins.

That always is a number that we think we want to beat.

So last year, if you remember what the guidance was, we said it appeared to be flat.

I got a lot of questions and I said even in a year where we're investing in operations for the reasons that Marty mentioned before, pivoting to much more dedicated service options for clients.

And we still, despite those investments, delivered 50 basis points.

Part of that was lower variable selling cost.

So we feel very comfortable on the expense guidance because we have specific plans against that.

And our job is to figure out how we can do even better than what we put out there in terms of our guidance.

So that's a little bit of color on what our thought process was.

Next question from the line of Ashwin Shirvaikar from Citi.

I read your (inaudible) questions, by the way.

I read them all.

We talked about them, just so you know, okay.

I wanted to sort of go back to this notion of payroll and HRS becoming equal size.

There are a couple of things, I think, going on there.

One is sort of, from a headline perspective, the takeaway can be that there is a slowdown coming that's a little bit more prominent in nature for HRS.

But then you also look at the penetration metrics that you guys have provided.

And you guys are, what, 15%, 20% penetrated with regards to your payroll base.

So I guess, the question becomes, why isn't the -- with that level of penetration, why isn't the pace of growth and rate of penetration higher?

Is there something you can be doing there to make it higher?

I mean, is that opportunity real, in other words?

There is definitely opportunity for improvement, and we feel it's a great opportunity.

I think one of the things that's probably challenged us in the past is the size of the client.

So when the clients are smaller, obviously, they don't need as many of the HR outsourcing-type products.

However, 2 things: one, from a macro environment, we are seeing more and more of those regulations and those needs come down in size.

So a client a few years ago that was 15 employees didn't need HR outsourcing.

But today, due to the complexity in the requirements and compliance, they do.

So we think there's a growing need for the HR outsourcing at smaller levels of a client, which is good for us.

I also think that there is -- I think we've gotten better and better at providing a full-service sales opportunity right up front.

One of the things you're seeing in our go-to-market strategy for sales is to offer the clients the full value of our products in the first conversation with them as a prospect.

Which in the past, we sold payroll and then we came back later and sold them other products.

And I think we're seeing that the clients are needing more things up first, and frankly, we weren't servicing the full value of what they were looking for.

And that change we've made, and we think that that'll drive that as well.

And I also think that you're seeing, as more clients are taking a bundled product, it's becoming more difficult to separate payroll and HRS as a revenue source because these products are bundled.

And we're doing some allocations now, but it's going to get more and more difficult to do that.

Got it.

Got it.

And then the lower permanent hiring growth that you alluded to, should that translate to a higher temp hiring growth that helps Advance Partners?

And is it a further -- is there a further M&A opportunity then in that direction?

Yes.

I think, as Efrain said, Advance Partners had a great year, better than we expected, and great leadership there in the team.

And they've done very well.

And I think that the temp environment is definitely picking up.

We've even seen in our own numbers that in clients with less than 50 employees, the part-time workforce by itself has gone up to become more than 10% of the workforce from about 6% just a few years ago, 3 or 4 years ago.

So you're definitely seeing more businesses take part-time and temps, and we are continuing to look at roll-up strategies.

Part of getting a great company like Advance was that there are a number of these funding companies out there that are small and that could benefit by a roll-up strategy and the technology and innovation that Advance does.

So we definitely think there's more opportunity there, and definitely think there will be more temp and gig economy-type part-time employment, where people are working multiple places part time instead of full time.

Got it.

One last clarification question.

The investment income outlook was a touch higher than what we're looking for.

And I just want to clarify, is there any breakage assumed in there where you're taking gains?

Or is it fairly straightforward there that...

No, no, no.

We wouldn't give guidance assuming a breakage.

I think if you're looking at year-over-year, Ashwin, there are a number of items that run through that.

So this year, we wrote off a small investment, several small investments that we had made, or wrote down the value of those investments.

So they -- so this year was a little bit artificially depressed.

And next year, we're not assuming we're going to do that, very modest, immaterial number.

So no, there's no gains.

That's what's going on.

Next question from the line of Gary Bisbee from RBC Capital Markets.

I think I ask you this every year, the fourth quarter, so I'll keep the trend going.

Can you give us an update of just penetration within the payroll client base of some of the key HRS offerings?

And how do you think about the opportunity remaining, the ceiling, where you're getting closer to that?

Just any color to help us think about the long-term potential of HRS.

Yes.

Gary, I don't think we're getting near any ceilings.

I think we have lots of opportunity.

And in fact, as I mentioned on the last question, I think the opportunity is growing because the needs are coming down in size.

So I think the opportunity is very strong there.

I think the fact that a 10- or 15-employee company may need more support on HR and that we've tailored our products and the service teams to support that bodes very well for us.

I think the most penetrated would obviously be worker's comp.

401(k) is pretty strong as well.

And HR outsourcing is -- all of these leave a lot of opportunity, insurance being the smallest penetration and the newest that we've offered, meaning H&B, health and benefit insurance.

So lots of opportunity there.

We're very -- we don't disclose it exactly but there's a lot of opportunity there for us.

And in fact, I think the opportunity is increasing, particularly for HR support.

Okay, great.

And then you talked about the internal stuff impacting the retention.

Was there any change in competitive intensity in terms of the number of losses and where the losses were going?

Or was it -- you mentioned some increase in out of business and then your service changes.

Is that it?

Or was there also...?

A little bit on competition, but I think the vast majority was, frankly, was kind of self-driven, unfortunately.

That we knew, as Efrain said, we projected some because we wanted -- we knew that we would have to disrupt some clients and their payroll specialist or their client service specialist that's dedicated to them.

The good news is that provides us great retention.

The bad news is when we have to change it on a client and move them around a little bit.

At first, that causes disruption, and there was a lot of newer people bought into the mix.

We didn't shut down an area necessarily, and close a business or close a location and move it.

But we did move a lot of people around and are doing that kind of still across the country, but we're doing it virtually in a lot of places.

So we moved a lot of experienced people into multiproduct centers to handle other kinds of businesses and that disrupted the client.

So I would say, most -- we really feel, based on all of the stats we have, most of the change in retention from our near-high best to down about a percentage point was really caused by the service disruption, the changes we made.

And now we're past that, and we already see it starting to bounce back at the end of Q4.

So we're feeling good that that'll -- we'll get back there through this next year.

Okay, great.

And then just on the client funds balances, can you give a little more color on why that's been moving slightly lower over the past year?

So what's the outlook within the guidance you provided for the trend in that?

Yes.

So let me start.

I'd mentioned this a couple of times.

So I think -- the first thing is we made a change in terms of the timing on when we remit payments to taxing authorities in certain states.

I won't bore you with the details, but suffice it to say that, that brought balances down a bit, and that's been a headwind through the year.

We think that, that starts to abate next year.

Client mix has had some impact.

Our client mix has skewed smaller during the year, so slightly smaller.

It depends on what assumptions you make about wage growth, but we expect we'll be flat to up slightly going into next year as opposed to being down slightly this year.

So that's -- those are the things impacting balances.

The next question will come from the line of Bryan Keane from Deutsche Bank.

Most of my questions have been asked and answered.

Just want to ask on client growth.

It was flat and, I guess, usually that's up a couple of points.

I think it was up 2% last year.

I know attrition played a role here, but just thinking about other factors that maybe caused that to be more flattish this year.

And then when you think about a potential rebound for fiscal year '18, what might cause that?

I think, as we've talked about, Bryan, I think most of the impact of that has been the increase in losses.

So the drop in retention rate was probably a bigger piece of that.

And I think as I've talked about, I think all the changes now being done in the fourth quarter from moving clients around into better service segments and service models, I think we're going to see that bounce back.

Because I think everything's in place.

We're already seeing the tenure of our specialists move up.

I also think that being now in the right place, the reason we did it was to drive client retention even higher, which was, hey, when you're an online client and you're mostly calling in, we needed better technology tools, better web chat, et cetera, to handle the client the way they wanted to be serviced.

And all of that now is in place.

And so we feel that we're really well positioned in multiproduct centers.

Before where, if you had payroll and time and attendance, we had a specific team on time and attendance that we move you to.

We now combine those teams, so we have the best expertise and a combined team to handle multiproduct clients.

We think that is going to help particularly in the mid-market and where we've sold multiple products, and we've increased, of course, that penetration.

So we really feel like that will bring us back into that kind of growth rate.

Okay.

What about changes in new business starts?

It sounded like also you maybe mentioned that bankruptcies picked up a little bit faster as well.

Yes, we did.

We saw -- that was a little surprising to us because given the other things you see in the economy, we're a little surprised.

But we've seen a few more losses as a result of that.

Don't really know why.

We've seen new business starts.

We're not expecting a big change in that.

They've kind of come back up to where they were prerecession, and they've kind of held there.

And so I think that'll work in our favor.

And there was something else you mentioned that I was going to say.

But I think we've -- oh, and I guess the other thing I was going to say is, our go-to-market strategy that I mentioned earlier on sales I think will also drive more sales, particularly on the low end for these new business start-ups.

What we're seeing is more clients coming to us from the web as opposed to from a call-in client referral, that type of thing.

They're coming in.

They're searching, as you'd expect.

They're going on the web, and they're contacting our team that way.

We would then give that to a rep in the field, even if they were a small, 1-, 2-, 3-employee client start-up.

And what we're finding today is many clients don't want to wait 2 days to have a rep come and visit them.

They want to -- they're ready to buy on the phone, so we've increased our digital spend pretty significantly.

And we've increased our virtual sales reps, who are selling 7 days a week and almost 24 hours.

They're ready to handle the sale right over the phone, and the client's ready to buy that way.

So we think that's going to really help us.

All that's set up and already running.

Okay.

And then last question for me.

Efrain, you talked about the seasonality for fiscal year '18, as -- I understand, in HRS.

In payroll services, I think it's kind of in the range, and then it goes to the high end in the back half.

Is that seasonality as well?

And I know last year, we talked about some difference in processing days.

So is that not a factor this year?

No, no.

I mercifully do not have to talk about days in 2018, so that had no impact, Bryan.

No, I think that the way -- if you look at where our growth was last year, the compares in the first half were a little tougher.

And then they ease in the back half on the assumption that the way that we think the sales year will unfold -- unfolds that way.

So that's basically what's going on.

And does that make 2% a more normalized growth rate then going forward as we think about the model?

I think, Bryan, I'd withhold that until we go through the year.

I would anticipate -- I think that implicit in that guidance is that we're still assuming a little bit of client mix occurring during the year.

So I would say, just given the amount of change that's happened already, I think that coming out of 2018, we should be -- we should see a little bit higher growth than 2%.

But let's get to Q4, and we'll have another conversation.

Your next question will come from the line of Tim McHugh of William Blair.

Just one question.

I guess maybe, I don't know if it was just my impression, but I think the prior call or 2, you had obviously talked about this weakness in the mid-market that you've been seeing.

This call, I don't know if it's just because of the year-end, but seems to be a little bit more talk of small business market in terms of retention and kind of choppiness in that market.

Is that -- did it change late in the year in the small business market?

Or is it just you talking about full year trends?

I guess I'm trying to understand if you saw some incremental weakness, and whether it's retention or new sales more in the small business side of the spectrum late in the fiscal year?

Yes, I would say, the impact -- the small business actually was, we felt pretty good from a -- I think overall, when you look at small business, the sales were pretty good.

Nothing major changed there.

The retention is where we took some of the hit in small business.

And again, self-inflected with some of our changes when you think about moving some clients that were on dedicated service specialists to multiproduct centers, because they bought more.

Remember, small being under 50, so they have multiple products, also moving them to the online center.

So I think the impact on small was really more from retention, which we think is -- we'll recover out of that now that things are kind of done.

The mid-market was more of an impact on sales from less opportunities coming out of the ACA year and a little bit more aggressive competition because I think everybody felt lower opportunities.

I feel very good about where we are from a technology standpoint and a product offering, but the pricing got a little bit stronger.

The pricing competition probably got a little bit stronger.

We still held our own pretty well there.

But I think again, if you look at sales growth, we were down from last year in total amount sold and -- but it was more even on a normalized basis to where we were the year before that.

And so I think -- hopefully, that clarified it a little bit.

And when did you -- the service alignment, was that in the fall you started rolling that out?

Yes, it was really -- this last year is where most of it happened, this last fiscal year.

We kind of finished up at the beginning of fourth quarter.

A little of it went into the previous year, too.

But I think we saw the biggest impact during the middle of this year as we got around to selling season.

I think we had -- we paid a little bit for more drop-offs in clients during that third to beginning -- kind of the third to beginning of fourth quarter type of thing because of just issues with the disruption and so forth.

So -- but that's done now, and everybody's kind of in the right place.

And we've hired back up, and we've got the tenure back up and the training and certification levels back up.

So...

When you say it's done now, have you seen -- is that just that, I guess, the change on your end is done?

Or have you seen enough data points in terms of retention metrics?

Has it been long enough that you look at kind of the client behavior to say you're past the issue with that?

No.

What I'd say is the changes are done, and the numbers, as far as having the payrolls, the client service specialists in place, the tenure, the certification, that's done.

And some of the satisfaction numbers, Net Promoter Scores, have -- began to increase and back kind of toward where we were.

I wouldn't say the retention has changed yet.

That's going to take a little longer over, I think, the next few quarters to get back.

But we feel like we're aiming to get ourselves back to all-time highs or near all-time highs by the end of the fiscal year.

The next question will come from the line of Jeff Silber from BMO Capital Markets.

I know it's late.

Efrain, just a couple of numbers-related questions, [grateful for] giving the seasonal guidance on the revenue line.

Anything to point out on the margin or expense side?

No, Jeff, other than what I said in first quarter that that's the anomalous quarter just because we booked the stock comp expense benefit in that quarter.

And so on a GAAP basis, I called out that first quarter's going to be essentially flat year-over-year, so I think that's the other.

And then obviously, we show a decent improvement in margin.

And that, I think, should get you where you need to be in terms of your modeling for the year.

Okay, great.

And then in terms of annual numbers for share count and capital spending, what should we be looking for?

Good question.

So CapEx will be in the range of about 3.5% of sales, and the share count at the same level or slightly below, Jeff.

When I say slightly below, 0.5 million to 1 million shares, could be as low as that for the year -- compared to this year, I should say.

So...

Next question from the line of Mark Marcon from R.W. Baird.

I was wondering if you could drill down a little bit more with regards to just the client service.

With regards to the small-market clients, so those with 10 to 50 employees, are they still primarily serviced by one single client service associate?

Or is it going into a team?

No.

They're still to the dedicated -- they're still to a dedicated payroll specialist that we've always been known for.

Yes, they're still with the dedicated.

What's happening is, as you move more clients to -- as more clients have moved to online, our model was a call-out model.

So we called you at 10:00, 10:00 a.m.

every Monday morning to get your information or you could do it other ways, of course, but that was normal.

And as more clients moved to online, they were doing it themselves, calling in.

They -- the answer performance wasn't as strong as we liked.

We started moving more online clients to a -- what we called a dedicated service center.

You're still assigned a dedicated person, but you can reach anyone in that case.

But the normal client who's not online gets a dedicated payroll specialist, who still calls out to them.

Great.

And then was the attrition any different between -- I'm not talking about the micro part of the market but between, say, companies with 10 to 20 relative to 50 and above?

I'd say it was roughly the same.

The impacts were kind of across the board maybe for different reasons.

But all the -- because most of the clients did see some -- many of the clients did see some change even as you talk a little bit larger.

Many of them went from the local person, who was just their -- to a dedicated -- to a multiproduct service center.

And so they were serviced not only with their dedicated person, but more of a team.

They may have reached someone different.

So I would say it was kind of split across the different-sized clients.

I mean, they should be reaching the same person.

I mean, on a go-forward-basis, your primary contact should still be your primary person, right?

Correct.

Now on a go-forward basis but I may have moved you -- but I did move many of them to a new person during the year to get them in the right kind of service model.

And -- but now they have a dedicated person.

No matter where they are, they still have a dedicated person.

And so now that's why we feel, hey, I think we're in good shape now.

But it certainly caused some disruption.

And you might have had a new person who was brand new in some of these cases.

Because we pulled the tenured person to go to a multiproduct service team, and then they got a new person, who wasn't as trained, was not the same person they knew for the last couple of years.

And it did have some impact, unfortunately.

But we think this is the right setup for the future.

We're done and we're building expertise now in those areas.

Okay.

And the Net Promoter Scores, how were they indexing relative to your norms?

They're coming up.

So our onboarding, we also moved to a new way of onboarding our clients that we think is more efficient and better service value to them.

That onboarding -- and the Net Promoter Score has gone up from the beginning of the year nicely, and our overall service number has gone up as well.

So we're feeling like it's early in the -- from the fourth quarter results, kind of the end of the fourth quarter, but we're feeling like things are turning very positive.

Okay.

And then of the 605,000 clients that you have, how many have solutions that would typically be within HRS?

I'm not asking about specific penetration but just overall, like how many would be -- would have multiple modules?

Hey, Mark, I think we'll disclose that in the K. So we've got a pretty extensive disclosure as to who takes what there.

And I think you'll be able to see that rather kind of recall it off the top of our head.

The last question will come from the line of Lisa Ellis from Bernstein.

Efrain, a couple of quick ones for you on -- can you remind us of how you think about your dividend policy when you go through these sort of periods of ups and downs?

Yes.

Yes, Lisa, we peg it at about 80 to low 80s in terms of percentage of net income.

And that's kind of what we target as a payout rate.

Okay, okay.

So the growth rate in the dividend gets impacted when the business kind of goes through elevated periods of faster growth and then slower growth.

Right, right.

So if it slows down, then we try to just target -- to titrate it down a bit so that it stays in that range.

Okay.

And then the second one, somewhat related, I guess, is you did call out that cash flow from operations was down 6% year-on-year but highlighted just fluctuations in working capital.

So is your expectation that, that would revert year-to-year?

Or is it more also driven by underlying performance?

No, no, no, not at all.

That was anomalous.

So what ended up happening, Lisa, is if you break down what happened this year, we had about $60 million more in tax payments.

Some of those are temporary differences that will reverse in the following year.

We had additional funding requirements for Advance Partners that were unusual because right at the end of the year, we brought on a very large client.

Those situations should not be present next year.

So it'll conform to more customary patterns.

But it's pretty identified what exactly happened there.

Thank you, everyone.

At this time, we don't have questions on queue.

Speakers, you may proceed.

Okay, 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 30 days.

Thank you for your -- for taking the time to participate in our fourth quarter press release conference call and for your interest in Paychex.

Have a great day.

Thank you.

That concludes today's conference.

Thank you all for joining.

You may now disconnect.