Paychex, Inc. (PAYX) Q4 2017 Earnings Call Transcript
Published at 2017-06-28 16:34:05
Martin Mucci - President, Chief Executive Officer, Non-Independent Director Efrain Rivera - Chief Financial Officer, Senior Vice President, Treasurer
Rayna Kumar - Evercore Danyal Hussain - Morgan Stanley Jim Schneider - Goldman Sachs James Berkley - Barclays Ashwin Shirvaikar - Citi Gary Bisbee - RBC Capital Markets Bryan Keane - Deutsche Bank Tim McHugh - William Blair Jeff Silber - BMO Capital Markets Mark Marcon - R. W. Baird Lisa Ellis - Bernstein
Welcome and thank you for standing by. At this time, all participants are in a listen-only mode until the Q&A session of today's conference. [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 webpage 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 one 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 will open it up for your questions. Fiscal 2017 ended with solid revenue and earnings growth and progress on our key initiatives. Over the past three 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 specialist providing service to over one 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 2018. 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 2016, 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 2017 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. This project included the creation of our multi-product service centers, our 24x7 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 is being completed and we transition back into the higher tenure. In addition, this was the first year in the past few years that we have 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 the changes that would most benefit their future success and growth are job creation, tax reform and healthcare 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 over time rules even as the federal government has taken steps to reduce similar regulations. Many multi-state small and mid-size 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 any way our 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 mid-sized businesses. In May, we, we were honored to earn two 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 are in 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 premise each and every day. I would also like to note our PEO was 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 to 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 the 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 would 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 am going to touch on some of the key highlights for the fourth quarter and fiscal year. I will provide greater detail in certain areas and then I am going to wrap up 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. 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 2017 and 2016 were impacted by discrete items recognized. In fiscal 2017, 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 $779 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 two 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 are doing and as we talk going forward here, we are 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 will see on page 16 a very clear and detailed example of what we are talking about. So if 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 is largely due to better revenue per client as a result of price increases, net of discounting. Year-to-date payroll cable service revenue growth of 3% included approximately a little bit less than 1% from the impact of the 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 bundle product products to our customers have increased. Revenue from those bundles is allocated in a portion between payroll and HRS. Payroll growth remains steady in the low single digits and HRS revenue growth reflects the sale of more services declines and greater revenue per client. Average client size, as we have discussed previously, have 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 will 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 participants' 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 the 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 principle and optimize liquidity. On the short-term side, primarily 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 have earned an average rate of return of 1.3% for the fourth quarter and 1.2% for the fiscal year, up form 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 have 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 will 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 have 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 average $4.3 billion for the fourth quarter and $4.1 billion for the fiscal year. Our total available 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 $40 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 non-cash adjustments contributing to the working capital growth where 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 onboard testament to their success and winning business in that part of the market and that impacted balances as of the end of the year. We will see the benefits of the 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 continue 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 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 will 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 I am going to repeat that again, growth in payroll service revenue anticipated 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, of the ranges 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 recognized 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, but we anticipate we may realize a modest benefit during the year. So to just 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 will understand what's going on there. So that concludes my discussion. And I will turn it back over to Marty.
Great. Thanks Efrain. Operator, we will now open up the call to any questions please.
Thank you. We will now begin the question-and-answer session. [Operator Instructions]. Our first question will come from the line of Mr. David Togut from Evercore. Sir, your line is now open.
Good morning. It's Rayna Kumar for David.
Can you please call out what the 4Q 2017 bookings growth was? And if you can just discuss your expectations for FY 2018 bookings?
Yes. This is Marty. So 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 look at the year before and the couple of years before. We were more on that level. Last year we peaked, in fiscal 2016 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 2017 we had a lower overall PAR sale than that level, but more on a normalized basis. And when we look at this year, we certainly expect the growth 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 are making, some things we are adjusting to. We are increasing the spend in digital marketing because we are seeing a larger number of leads coming in, obviously on the web and we feel good about the marketing that we are doing and we are increasing that investment. And we are 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 have positioned ourselves to be able to do that frankly and 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 will bounce back.
Hi Rayna. Our acronym internally for bookings, it's PAR, Paychex annualized revenue, if anyone is 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 2018?
Yes. 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 so we didn't feel like competition change 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 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 that fiscal 2018, 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.
Thank you. Next question is from the line of Danyal Hussain from Morgan Stanley. Sir, your line is now open.
Hi. Good morning everyone. Thanks for taking the question. I guess I just wanted to ask, maybe first on retention. You called out that you have worked on the service initiative in part to address this. I just want to know if there's been any change so far and what have you observed, I guess at the end of the fourth quarter and so far has there been 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 have been moving and I talked about this a little bit, we have been shifting to different client service segments. So while we have sold a lot more of our HR administration online, our time and attendance offerings, et cetera. We started moving clients to multi-product 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 are more inbound calls, then 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 service centers where we are open 7x24 and we have much better technology, enhanced technology that we put in place that we invested in as well as chat, et cetera, our 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 multi-product centers or other areas. We then, during the course of the year, hired a number of new client service specialist 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 have seen in the fourth quarter already, client satisfaction numbers coming back up, client service specialist tenure, so then the experience, the certification, the months of experience are coming back up as well. We are back even above where we were at the beginning of the fiscal year. So we think now we are 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. Thank you. 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 underlying client behavior? Or is this more a function of just easier comps and the fact that you are investing in maybe some of these higher growth digital channels?
No. 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 2016 with ACA coming on very heavy in the requirements, we saw a number of new opportunities and 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 2017, those number of opportunities were decreased. There wasn't as much of a push on that. So there was a little bit of a macro change there. I do think that, as I mentioned in my comments, what we are 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. Over time 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 are making with the virtual sales increase and the additional investment in marketing spend, we really think is going to drive the growth back up to where we would like to see it.
Thank you. And maybe just a clarification on the earlier point on pricing. Was that elevated pricing competition 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 was 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 HCA.
Sure. Thank you very much.
Thank you. The next question will come from the line of Jim Schneider of Goldman Sachs. Sir, your line is now open
Hello. Good morning guys. Thanks for taking my question. I was wondering if you could maybe just give an update and touch on the federal regulatory environment? Clearly we have had inaction on ACA Repeal-and-Replace for some time now. What are your clients in the mid-market telling you about or what's 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 are 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 that as a headwind incorporated in your fiscal 2018 guidance?
I think there's a couple of points I would 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 are not seeing much drop-off in the number of clients in the Affordable Care Act. I think what we are seeing in the behavior is, hey, I am 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 am going to stick with the product. In addition to that, what we are also seeing the behavior is, hey once I put insurance as a benefit offering to my employees, I can't just say I am 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 are going to see a big drop-off of those that are necessarily providing insurance now just because the mandate is not there. I do think though, as I mentioned that we are seeing in our jobs index that's more small businesses under 50, that there has been a drop-off of the employment growth rate. And so they are not hiring as many and I do think there is probably some of that macro out there where, hey I am 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. Thanks. And maybe just as a follow-up, on the HR growth, clearly the 8% to 10% growth you are calling out below this fiscal 2017 level, but I think you are indicating that that's largely due to difficult comps and ACA. So I guess maybe it's still a deceleration over the trends you have 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 2018, 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 over how many states is that?
Hi Jim. I will 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 years. So I would say that's part A. Part B, remember that we had about little bit over 1% contribution from Advance Partners. They are doing very well, but we obviously don't have that going into next year. So if you stripped out those factors, we are growing double digit in HRS. And I think you are absolutely right. I called out in the first quarter that HRS is below the range of total guidance for the year for revenues, just 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 that, I will just turn that over to Marty to talk.
Yes. I think from a state perspective, we are probably seeing almost half the states look for ways to put in their own regulations to make up for the federal reductions. So they are looking for minimum wage increases. They are looking to put in new overtime rules for the state. They are looking for all kinds of things and I don't think that will even, now you are even hearing about, depending on what happens with Affordable Care Act, various taxes, new taxes, payroll taxes, possibly to make up for some of the reduction and what the feds are subsidizing at the state level. The other thing on the HRS revenues, every product, every client base or proper set we have all increased in this fiscal year. So we continue to feel really good about 401(k). We are still the leading provider of the most plans of anybody. We have over a 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 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.
That's helpful. Thanks. you.
Thank you. The next question will come from the line of James Berkley from Barclays. Your line is now open.
Good morning guys. Thanks for the time. Marty, if you just could provide some more color on 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 uncertainty related and ACA driven versus competition related, if at all? Just especially given strong growth rates you have seen from some smaller players that focus on that space, Paylocity, for example. Those other guys offer ACA solutions as well. Maybe part of that disconnect has to do with the fact that the smaller players have less robust ACA offerings and easier comps? I am just trying to get a better feel for what's going on there.
Yes. I think that certainly can be part of it, but I think we feel good. We do feel good about the technology and the offering that we have as well as the service. I think we have talked about that some of the mid-market, we are 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 has had some impact on mid-market. 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 down a little bit more aggressive, but we feel very good about the offerings that are out there. We are very competitive and we are 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 on a B2B from all of the administration and they are probably a little bit slower.
Okay. Thanks. And then just could you talk a little more about the large client you alluded to? How large? What impact you see it having to growth next year? What drove the client decision to us Paychex?
That was specifically related to the advance funding portion of the business. So if you notice there was a bump in receivables. The way that business works is, if you find a large client, you get the receivable impact upfront and then you start realizing the benefit as you collect fee. 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 it's very bullish on what's going on there.
Thanks for that clarification. Last one here, just to build out Jim's prior question around HR revenue just being a little slower than we have seen in the past. Could you break out what's going on there and touch on how confident you are in top line guidance with margin expansion is a lot higher in the guidance there than we typically see? So just kind of like what's going with few things? And then you may have previously set the bar low, it seems, just because last year you had probably tried to avoid lowering guidance like you saw last year. It looks like maybe you set the bar low.
Great question. I would say, if you look at us over the last six years, we have never missed earnings. So I would say that we have generally beaten on the upside. So there is always an element of conservatism in our guidance and I hope that that continues into next year. But though what's going on is that we have a grow-over comparison. And by the way, we are the first to report and I am certain that others will say exactly the same thing. There is a grow-over comparison on ACA modules that everyone's 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 and HRS 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 2016. So basically that's what's going on there. On the margin guidance, just remember that when I said margin guidance, sometimes I talk 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 are getting the benefit of investment income. But we are 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 have said it appeared to be flat, I got a lot of questions and I said, even in a year where we were investing in operations, for the reasons that Marty mentioned before, pivoting to a much more dedicated service options for clients and we still, despite those investments delivered 50 basis points. Part of that was lower variable selling costs. 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.
Thank you. Next question is from the line of Ashwin Shirvaikar from Citi. Sir, your line is now open.
Hi. How are you guys. Good morning.
I read your policy questions, by the way. I read then all. We talked about them, just so you know, okay.
Yes. Thank you. I wanted to sort of go back to this notion of payroll and HRS becoming equal sized. 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 a little bit more permanent 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, 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 t make it higher? 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 two 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 the complexity in the requirements and compliance, they do. So we think there is a growing need for the HR outsourcing at smaller levels of a client which is good for us. I think we have gotten better and better at providing a full-service sales opportunity right upfront. One of the things you are 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 are 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 have made and we think that that will drive that that as well. And I also think that you are 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 are doing some allocations now. But it's going to get more and more difficult to do that.
Got it. And then the lower permanent hiring growth that you alluded to, should that translate to higher temp hiring growth that helps Advance Partners? And is there 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 have done very well and I think that the temp environment is definitely picking up. We have even seen in our own numbers that 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, three or four years ago. So you are definitely seeing more businesses take part-time and temps and we are continuing to look at rollup strategy as part of getting a great company like Advance was that there are number of these funding companies out there that are small and that could benefit by a rollup strategy and the technology and innovation that advances those. So we definitely think there is 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 were looking for. And I just wanted to clarify, is there a breakage assumed in there where you are taking gains? Or is it fairly straightforward?
No. We wouldn't give guidance assuming a breakage. I think if you are 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 this year was a little bit artificially depressed and next year we are not assuming we are going to do that. Very modest immaterial number. So no, there is no gains. That what's going on.
Okay. Got it. Thank you guys.
Thank you. Next question is from the line of Gary Bisbee from RBC Capital Markets. Sir, your line is now open.
Hi guys. Good morning. I think I ask you this every year in the fourth quarter. So I will 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 are getting closer to that? Just any color to help us think about the long-term potential of HRS. Thank you.
Yes. Gary, I don't think we are 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 company may need more support on HR and that we have tailored our products and the service teams to support that bodes very well for us. I think the most penetrated would obviously be workers' comp. 401(k) is pretty strong as well. And HR outsourcing. All of these leave a lot of opportunity, insurance being the smallest penetration and the newest that we have offered, meaning H&B, health and benefit insurance. So lots of opportunity there. We don't disclose it exactly, but there is 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 on 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, you know -- ?
A little bit on competition, but I think that the vast majority frankly was kind of self-driven, unfortunately that we knew, as Efrain said, we projected some because 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 brought into the mix. We didn't shutdown 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 are doing it virtually in a lot of places. So we moved a lot of experienced people into multi-product centers to handle other kinds of businesses and that disrupted the clients. So I would say, 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 are past that and we already see it starting to bounce back at the end the Q4. So we are feeling good that we will 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 or so? And what's the outlook within the guidance you have provided for the trend in that? Thank you.
Yes. So let me start. I 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 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 is skewed smaller during the year, so slightly smaller. It depends on what assumptions you make about wage growth but we expect we will be flat to up slightly going in the next year as opposed to being down slightly this year. So those are the things impacting balances.
Thank you. The next question will come from the line of Bryan Keane from Deutsche Bank. Your line is now open.
Hi guys. Most of my questions have been asked and answered. Just wanted to ask on client growth. It was flat and I guess you usually that's up a couple 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 2018, what might cause that?
I think as we have 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 have talked about, I think all of the changes now being done in the fourth quarter from moving clients around into better service segments and service models, I think we are going to see that bounce back, because I think everything's in place where we are seeing the tenure of our specialist 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 are an online client and you are mostly calling in, we needed better technology tools that are 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 are really well positioned in multi-product 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 combined those teams. So we have the best expertise and a combined team to handle multi-product clients. We think that is going to help, particularly in the mid market where we have sold multiple products and we have 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 here as well.
Yes, we did. We saw, that was a little surprising to us because given all the things you are seeing in the economy, we are little surprised, but we have seen a few more losses as a result of that. Don't really know why. We have seen new business starts. We are not expecting a big change in that. They have kind of come back up to where they were pre-recession and they have held there. And so I think that will work in our favor. And there was something else you mentioned that I was going to say. But 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 are seeing is, more clients coming to us from the web as opposed to from a call and client referral, that type of thing. They are coming in. They are searching, as you would expect. They are going on the web and they are contacting our team that way. We would then give that to a rep in the field, even if they were a small one, two, three employee client startup. And what we are finding today is, many clients don't want to wait two days to have a rep come and visit them. They are ready to buy on the phone. So we have increased our digital spend pretty significantly and we have increased our virtual sales reps who are selling 7 days a week and almost 24 hours. They are ready to handle the sale right over the phone and the client is 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 2018 as I understand in HRS and payroll services, I think it's kind of in the range and then it goes to the high-end during 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? Thanks so much.
No. I mercifully do not have to talk about days in 2018. So that has 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 are a little tougher and then they ease in the back half on the assumption that the way that we think the sales year 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 would withhold that until we go through the year. I would anticipate, I think that implicit in that guidance is that we are 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 would think that coming out of 2018 we should see a little bit higher growth than 2%. But let's get to Q4 and we will have another conversation.
Okay. Helpful. Thanks so much guys.
Thank you. Your next question will come from the line of Tim McHugh of William Blair. Sir, your line is now open.
Hi. Just one question. I guess maybe I don't know if it was just my impression, but I think the prior call or two, you had obviously about this weakness in the mid-market that you have been seeing. This call, I don't know, if it's just because of the year-end, but it seems to be a little bit more talk of small business market in terms of retention and kind of choppiness in that market? Did it change late in the year on the small business market? Or is it just talking about full-year? I guess I am 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 of the small business actually was, we felt pretty good from, I think overall when you look at small business, the sales were pretty good, nothing major change there. The retention is where we took some of the hit in small business and again self-inflicted with some of our changes when you think about moving some clients that were on dedicated service specialist to multi-products because they bought more. Remember, small being under 50, so they have multiple products also moving them to the online centers. So I think the impact on small was really more from retention, which we think is we will recover out of that now the 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 strong. 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, 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 that went into the previous year too. But I think we saw the biggest impact during the middle of this year as we got around the selling season. I think we paid a little bit for more drop-offs in clients during that third to beginning of fourth quarter type of thing because of just issues with disruption and so forth. But that's done now and everybody's kind of in the right place and we have hired back up and we have got the tenure back up and the training and certification levels back up.
When you say it's done now, have you seen, is that just 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 your past issues with that?
What I would say is, the changes are done and the numbers as far as having the client service specialists in place, the tenure, the certification, that's done. And some of the satisfaction numbers, net promoter scores, have begun to increase back kind of towards 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 are aiming to get ourselves back to all-time highs or near all-time highs by the end of the fiscal year.
Thank you. The next question will come from the line of Jeff Silber from BMO Capital Markets. Sir, your line is now open.
Thanks so much. I know it's late. Efrain, just a couple of numbers related questions.
As far as 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 is going to be essentially flat year-over-year. So I think that's the other. And then 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, half a million to a million shares could be as low as that for the year.
Okay. Fantastic. Thanks so much.
Compared to this year, I should say. So okay, thanks.
Thank you. Next question is from the line of Mark Marcon from R. W. Baird. Sir, your line is now open
Good morning, Marty and Efrain. 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 are still to a dedicated payroll specialist that we have always been known for. They are still with the dedicated. What's happening is, as more clients have moved to online, our model was a call-out model. So we called you at 10 o'clock, 10:00 AM every Monday morning to get your information. Or you could do it other ways, of course. But that was normal. And as more clients move to online, they were doing it themselves, calling in. The answer performance wasn't as strong as we would like. We started moving more online clients to a ded, what we called a dedicated service center. You are still assigned a dedicated person but you can reach anyone in that case. But the normal client who is not online gets a dedicated payroll specialist who still calls out for them.
Great. And then was the attrition any different between, I am not talking about the micro-part of the market, but between say companies with 10 to 20 relative to 50 and above?
I would say it was roughly the same. The impacts were kind of across the board, maybe for different reasons. But all the clients, 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 there to a dedicated to a multi-product service center and so they were serviced, not only with a 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 size clients.
But 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 one to 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 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 are 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 a tenure person to go to a multi-product 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 that did have some impact, unfortunately. But we think this is the right setup for the future. We are done and we are building expertise now in those areas.
Okay. And the net promoter scores, how are they indexing relative to your norms?
They are 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 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 are feeling like it's early from the fourth quarter results, kind of, the end of the fourth quarter, but we are 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 am not asking about specific penetration, but just overall like how many would have multiple modules?
Hi Mark. I think we will disclose that in the K. So we have got a pretty extensive disclosure as to who takes what there. And I think you will be able to see that revenue kind of, I can't recall it off the top of our head.
Okay. Thank you very much.
Thank you. The last question will come from the line of Lisa Ellis from Bernstein. Ma'am your line is now open
Hi. Good morning guys. Efrain, a couple quick ones for you. Can you remind us of how you think about your dividend policy when you go through the sort of periods of ups and downs?
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. So the growth rate and the dividend gets impacted when the business kind of go through elevated periods of faster growth and then slower growth?
Right. So if it slows down and we try to just target, 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, 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 will conform to more customary patterns, but it's pretty identified what exactly happened there.
Okay. Terrific. That's it from me. Thanks guys.
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 are interested in replaying the web cast of this conference call, it will be archived for about 30 days. Thank you 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.