Paychex Benefits From Resilient Labor Market in Fiscal Q3 2023, but Conditions Likely to Soften

Wide-moat Paychex PAYX posted a solid third-quarter fiscal 2023 result that was in line with our expectations. Despite a moderation in hiring activity, the firm enjoyed year-on-year revenue growth of 8% during the quarter underpinned by new client wins, healthy product attachment and like-for-like price increases, partly offset by ongoing weakness in insurance adoption. The firm continues to benefit from increased uptake of nonrecurring employee retention tax credit services, and an uplift in ultra-high margin interest income.

While Paychex continues to benefit from a resilient labor market in late fiscal 2023, we trim our full-year adjusted operating margin forecast toward the midpoint of guidance to 40.7% from 40.9%. Operating margins in the third quarter and year to date have remained flat compared with the prior year period, and we expect this trend to persist as the firm continues its investment in product development and sales. For the full year, we forecast adjusted earnings per share growth of 13%, in line with guidance. However, while our near-term operating margin forecast decreases slightly, our longer-term revenue growth and operating margin expansion estimates are unchanged. As a result, we maintain our $120 fair value estimate, and shares currently trade in line with our unchanged valuation.

Paychex’s core small business market has remained remarkably resilient, with high-profile layoffs in the technology sector being largely isolated to larger corporates so far. While microbusiness natural attrition has normalized toward prepandemic levels, overall revenue retention remains strong reflecting the stickiness of the firm’s offering, and benefits from a strategic shift to a larger, more diversified client base. However, we expect contractionary monetary policy aimed at curbing economic activity to eventually weigh on employment within the base by calendar year-end, before a bounceback in 2024 as interest rate hikes are unwound.