Automatic Data Processing - Q3 2023

Transcript

Operator (participant)

Good morning. My name is Michelle, and I'll be your conference operator. At this time, I would like to welcome everyone to ADP's Q3 fiscal 2023 earnings call. I would like to inform you that this conference is being recorded. After the prepared remarks, we will conduct a question-and-answer session. Instructions will be given at that time. I will now turn the conference over to Mr. Danny Hussain, Vice President, Investor Relations. Please go ahead.

Danny Hussain (VP of Investor Relations)

Thank you, Michelle, and welcome everyone to ADP's Q3 fiscal 2023 earnings call. Participating today are Maria Black, our President and CEO, and Don McGuire, our CFO. Earlier this morning, we released our results for the quarter. Our earnings materials are available on the SEC's website and our investor relations website at investors.adp.com, where you will also find the investor presentation that accompanies today's call. During our call, we will reference non-GAAP financial measures, which we believe to be useful to investors and that exclude the impact of certain items. A description of these items, along with a reconciliation of non-GAAP measures to their most comparable GAAP measures, can be found in our earnings release. Today's call will also contain forward-looking statements that refer to future events and involve some risks.

We encourage you to review our filings with the SEC for additional information on factors that could cause actual results to differ materially from our current expectations. I'll now turn it over to Maria.

Maria Black (President and CEO)

Thank you, Danny, and thank you, everyone, for joining us. For our Q3, we delivered strong results, including 10% organic constant currency revenue growth, 110 basis points of adjusted EBIT margin expansion, and 14% adjusted EPS growth. Our continued solid financial performance underscores the power of our innovative and mission-critical HCM solutions that serve over 1 million diverse clients around the world, as well as our highly recurring revenue business model. As usual, I'll start with some highlights from the quarter. The demand environment was healthy overall. In Q3, we drove another quarter of solid Employer Services, new business bookings growth, representing a record Q3 bookings amount. Bookings performance continues to be particularly strong in our downmarket portfolio.

In Q3, we sold and started over 60,000 new RUN clients, where our new user experience has helped us reach record level new client satisfaction rates these past few quarters. We also had strong bookings results in our insurance and retirement services offerings, supported not only by legislative tailwinds, but also by the competitive positioning of our downmarket HCM ecosystem. Demand for our Employer Services HR outsourcing solutions remained high, and we recently reached the 10,000-client mark. We also saw continued booking strength in our compliance-oriented solutions, including tax remittance and wage payments, which have always been key differentiators for us. On a year-to-date basis, we are within our bookings guidance range and are trending in line with our expectations from the outset of the year. We look forward to finishing the year with a strong growth.

Our Employer Services retention rate came in better than expected once again. While we continued to experience normalization in our downmarket out-of-business rates, this was offset by the strong retention rates in our U.S. mid-market and international businesses, both of which continue to benefit from years of improving client satisfaction. We're pleased to be raising our full-year retention guidance. Our Employer Services pays per control grew 4% for the quarter and continues to decelerate at a very gradual pace. For several quarters now, layoffs at many larger companies have been offset by the labor demand elsewhere, which in total has resulted in year-over-year employment growth. We're pleased to expect the higher end of our previous pays per control guidance range.

Last, on our PEO, while growth in revenue and average worksite employees continued to decelerate this quarter, we were pleased to see PEO bookings growth re-accelerate nicely in Q3, especially in March. This represented much better performance than we experienced in Q2 and resulted in our largest quarter for PEO bookings ever. Despite the current inflationary environment and broad-based macroeconomic uncertainty, we are focused on our PEO sales execution and on delivering continued strong client satisfaction, and we remain confident in the long-term secular growth opportunity. Stepping back, while we are pleased to be on track to deliver very strong full-year financial results, we are even more excited about how we are leveraging our unmatched scale and decades of innovation experience to drive continued progress on our important modernization journey.

We are making our solutions more powerful and easier to use, and we are making our unparalleled insight and expertise more accessible than ever. In doing all this, we're delivering an experience that's better for our clients, better for their employees, and better for ADP. I mentioned the tens of thousands of new clients we onboarded in our down market. Over a third of those clients utilized our digital onboarding experience, yielding a faster time to start, happier clients, and greater productivity for our implementation team. We just completed our busy year-end period, during which we helped our clients with over 75 million U.S. tax forms. To further enhance the client experience, we proactively surfaced critical year-end data to our clients before they had to search for it. This not only reduced friction for them, but also reduced the number of calls and interactions with our service teams.

For years, we have directly engaged and served our clients' employees through channels like Wisely. As we focus on the overall employee experience we can offer, we continue to add valuable functionality like a savings envelope that employees have used to move more than $1 billion into savings over the last 12 months in a new financial wellness hub with tips, tools, and education to drive better financial outcomes. With our new Intelligent Self-Service solution, we are already interacting with over 3 million client employees per month through our Action Cards feature. Our Voice of the Employee solution is helping thousands of clients obtain better insights from their employee populations, which can drive higher engagement and satisfaction for those employees.

The opportunity to continue creating value and efficiency in the world of work is meaningful, and we believe these modern approaches that reduce friction and exceed client expectations will help us deliver on that in the coming years. With that in mind, I want to provide some perspective on how we are strategically positioning ourselves to invest over the near term given the economic backdrop. As we shared earlier this year, in fiscal 2023, we were impacted by higher wage inflation. We also added to our service and implementation capacity to meet the expectations of our growing client base, and we invested throughout the year in sales and product. As we position for potential economic slowdown beyond this fiscal year, we are being thoughtful about how we prioritize our investments.

At the same time, we are very much committed to our ongoing modernization journey, which is critical to our sustainable growth, and that will require continued steady reinvestment into the business. In the coming quarters, I look forward to updating you on near-term growth priorities for ADP. Before turning it over to Don, I want to take a moment to recognize our associates for their continued focus on helping our clients through the many challenges they face each day, especially amid these uncertain times. Resiliency and partnership represent core components of the ADP brand promise and are among the many reasons businesses around the world choose to partner with the leader in the industry.

Our unrelenting support through years of growth, years of challenge, and the years in between is something they've grown to count on, and we are honored to support them. With that, I'll turn it over to Don.

Don McGuire (CFO)

Thank you, Maria. Good morning, everyone. I'll provide some more details on our Q3 results and update you on our fiscal 2023 outlook before briefly touching on fiscal 2024. Let me jump straight into the segments, starting with Employer Services. ES segment revenue increased 11% on a reported basis and 12% on an organic constant currency basis, which is the strongest ES revenue growth we've experienced in quite some time. As Maria shared, ES new business bookings were solid and kept us on track with our full-year outlook. We're not making any change to our guidance, but we do believe the middle of our guidance range feels most likely at this point.

On ES retention, following another quarter of better-than-expected results, we're again revising our outlook, and we now expect retention to be down only 10 to 20 basis points for the full year compared to our prior outlook of down 20 basis points-30 basis points. This again will be driven by retention decline in our down market from normalized out-of-business losses and is mostly offset by improved overall retention elsewhere. Pays per control remains strong in Q3, and we are raising our outlook to now assume about 4% pays per control growth for the year compared to our prior outlook for 3%-4% growth. Client funds interest revenue increased in Q3 in line with our expectations, and we're updating our full-year outlook utilizing the latest forward yield curve, which in this case resulted in no major change.

On FX, we had about 1 percentage point of ES revenue headwind in Q3, and there is no change to our outlook for a full-year headwind of between 1% and 2%. Following our strong Q3 ES revenue growth, we're pleased to be raising our outlook once again to now expect about 9% growth, up from 8%-9% before. Our ES margin increased 80 basis points in Q3, which was in line with our expectations. We are narrowing our full-year outlook to now expect about 200 basis points of margin expansion, and we still see significant opportunity to invest in sales, product, and elsewhere throughout the organization to capitalize on the growth opportunity in front of us, which we are choosing to do at this juncture.

Moving on to the PEO, we had 5% revenue growth, driven by 3% growth in average worksite employees. As a reminder, this deceleration is driven by a few factors, including slow pays per control growth, difficult comparisons versus record retention levels, and softer recent bookings growth than we experienced the last two years. For this fiscal year, we now expect PEO revenue growth of about 8%, with growth in average worksite employees of about 6%, both at the lower end of our prior ranges. Maria mentioned the bookings reacceleration in Q3, we are feeling upbeat about reaccelerating the revenue growth in the coming several quarters. This guidance update is mainly due to a tweak to our pays per control assumption within the PEO as it decelerated a bit more than we previously assumed, somewhat different from what we experienced in the ES segment.

We are separately lowering our outlook for revenue, excluding zero margin pass-throughs, to a range of 7%-8%, due mainly to lower SUI rates in Q3 than we previously anticipated. PEO margin increased 140 basis points in Q3, which was better than expected, due primarily to continued favorable workers' compensation reserve adjustments, which we had not assumed, as well as the lower SUI costs I just mentioned. We are raising our outlook for PEO margin to now expect it to be up 50 basis points-75 basis points for fiscal 2023. Putting it all together, we still expect consolidated revenue growth of 8%-9% in fiscal 2023, but now believe it will be towards the higher end of that range.

We are maintaining our outlook for adjusted EBIT margin expansion of 125 basis points-150 basis points and for a fiscal 2023 effective tax rate of about 23%. We now expect adjusted EPS growth of 16%-17% compared to our prior outlook of 15%-17%. I also want to provide some early high-level color on what to expect for next year. We are still going through our annual planning process, but there are a few things to consider at this point. First, assuming a slowing economic backdrop, pays per control could be at a below-normal growth rate next year, among other potential macro considerations. I would also point out that while client funds interest appears positioned to give us some contribution to growth, based on the latest forward yield curve, it will likely be very modest.

At the same time, we have good momentum in our ES bookings performance and ES retention, and we are feeling upbeat about the continued opportunity to build on our decades of success. Thank you, and I'll now turn it back to Michelle for Q&A.

Operator (participant)

Thank you. If you'd like to ask a question, please press star one one. If your question has been answered and you'd like to remove yourself from the queue, please press star one one again. In order to keep within our allotted time, please ask one question with a brief follow-up. We will take our first question from Bryan Bergin with Cowen. Your line is open.

Bryan Bergin (Equity Research Analyst)

Hi, all. Good morning. Thank you. Don, maybe just building on those last comments you had there, I'm curious, just any indications or call-outs worth mentioning as it relates to fiscal 2024, really in the context of the medium-term outlook that you've given in the past, just how should the street consider the magnitude of potential impacts across some of these KPIs from a potentially slower macro environment?

Don McGuire (CFO)

Yeah, Bryan, good morning, and thank you for the question. It's still early. We're still in the middle of our planning process. I think we have a lot of things going in our favor still. We still have relatively high client fund interest. Pays per control have been good and strong. Bookings continue to be strong, as we said earlier. As we get into 2024, I think we're gonna be in a pretty healthy spot with what we know today. I guess the challenge we all have is trying to guess what's coming in terms of the broader macro situation. You know, we continue to see strong demand. Retention continues to be pretty good, although it's normalizing a little bit in the down market as we did expect. I think things feel pretty good at this juncture.

I'm gonna have to ask you to bear with us a little bit as we make our way through our plan, and we stay tuned to what's going on in the macro environment, even closer as we get forward or closer to our July 1st beginning of the year.

Bryan Bergin (Equity Research Analyst)

Okay, that's fair. Just on the PEO. Worksite employee view down ticks, and I think you were down sequentially in average worksite employees. Can you just talk about what you're seeing in kind of the pays per control versus the retention aspect in the PEO? With bookings reaccelerating, how long does the reconnection to improved growth take?

Don McGuire (CFO)

We did have, as you mentioned, we had a particularly strong PEO bookings month in March, which we're optimistic is going to continue and help us as we go forward. Certainly, we're gonna have to see how those bookings continue through the balance of the year, trying to anticipate how those are gonna actually result in revenue. Things do start relatively quickly in the PEO business, but it's gonna take some time, once again, to see how that stuff rolls from bookings into revenue. We're pretty optimistic about how things went in the Q3, especially with the finish, and we do expect to see that reacceleration as quickly as we want to.

By the way, just back to your earlier question a little bit, you know, we talked about high single-digit growth in our midterm view, and we won't be happy if we don't get something like that.

Maria Black (President and CEO)

I think, Bryan, if I can just comment on the quarter-over-quarter real quick, as I think you mentioned the sequential growth Q2 to Q3 in worksite employees. That is something that obviously we noticed as well, and as Don mentioned, you know, from a medium-term perspective, we are definitely still committed, you know, from the medium term to the worksite employee growth that we have guided to for that. However, as it relates to kind of the quarter-over-quarter, we noticed the same thing that you noticed, and obviously that's not the ideal situation, and we're hopeful that won't be the case as you look sequentially on the quarter-to-quarter, Q3 to Q4, but also year-on-year.

I think that's really a byproduct of timing, and that timing is really about retention, right? It's really about, call it Q3 retention results, which we've cited before were a bit softer than we expected, as a result of that, you see the sequential piece to the quarter-on-quarter.

Bryan Bergin (Equity Research Analyst)

Okay. Is that just a function of the type of client within PEO?

Maria Black (President and CEO)

In terms of the type being?

Bryan Bergin (Equity Research Analyst)

White, more white-collar.

Maria Black (President and CEO)

I don't know that it's a function of more white-collar. I think it's really a function of some of the feelings that we have post-pandemic as the renewals have really been kind of rippling through the business of the PEO. It's really a by-product of some of the post-pandemic impact that we saw in the PEO. It's really a by-product of the retention softness that we saw in the Q1 and the Q2, and then quarter on quarter this past quarter. I don't think it's necessarily a by-product of- because retention, you know, continues, albeit it's normalizing a bit in the down market. We do have very strong retention in the mid-market. We also have strong retention, albeit, you know, tiny bit less than last year in the down market.

I don't really think it's a by-product of the client base or white collar. I think it's really a by-product of kind of a post-pandemic environment in the PEO.

Bryan Bergin (Equity Research Analyst)

Okay. Thank you.

Operator (participant)

Thank you. Our next question comes from Bryan Keane with Deutsche Bank. Your line is open.

Bryan Keane (Managing Director and Senior Equity Analyst)

Hi. Good morning. Thanks for taking my questions. I guess just trying to look at Employer Services, really strong growth in the quarter, 12% organic. If you back into the guidance for Q4, it looks like a little bit of a deceleration. I think you get to something around 8% growth. Just trying to understand the puts and takes there for the Q4 guide versus the strong results in the Q3.

Don McGuire (CFO)

No, thanks for the question. You know, the biggest impact, I guess, in terms of growth would be we are going to continue to see strong growth from client fund interest in the Q4, but certainly Q3 is by far the strongest quarter, just given the seasonality of tax receipts, et cetera, for us. I think that would be one of the key drivers. Of course, we did mention as well that we expect to see pays per control growth coming down and softening a little bit, even though a bit higher than we expected to see last quarter. It's, it is coming down. It's certainly starting to moderate.

Bryan Keane (Managing Director and Senior Equity Analyst)

Got it. Then on the booking side, although bookings were strong, I think you commented maybe towards the lower end of the range of 6 and 9. Just, can you help us maybe think about how bookings will translate into future revenue growth for the Employer Services? If you can remind us as we get our model set or start thinking about fiscal year 2024.

Maria Black (President and CEO)

Yeah. I'll let Don comment on how the bookings kind of relate to the models on the revenue side. From an overall bookings perspective, what we cited in the prepared remarks is that we do anticipate the middle of the range, so we did keep the range constant. It's constant with the outset of the year. It's also constant with last quarter's guidance. We are keeping that 6-9 range. We do anticipate, at this point, the middle of that range, and we feel pretty confident heading into the Q4 when we take a look at how we exited March, but also taking a look at the number of sellers we have, the investments we've made into the ecosystem.

As those sellers ultimately gain tenure, because we're actually lasting a lot of new hires that we had, if you will, a year ago. Pretty excited as we step in. The other part of that confidence is really about what we're seeing as it relates to the overall pipeline. Pipelines are strong. That's more of a, call it, enterprise and international or large deal type of comment. We're seeing tremendous activity in the top of the funnel, still upmarket. The downmarket continues to shine for us, and that's really supported by what we're seeing in continued increases in new business formations. We're also seeing those new business formations generate inbound leads. We're seeing good activity on the digital side.

Feel confident as we step into the Q4, and then I'll let Don comment on how ultimately, where we land in the Q4 and how that translates into revenue for us next year.

Don McGuire (CFO)

On the modeling side, roughly a 1% change in ES bookings growth impacts us in the $17 million-$20 million annually on revenue growth. That's kind of how to think about your models. I think that's been pretty consistent.

Danny Hussain (VP of Investor Relations)

Yeah. Bryan, the timing is-depends on the business. Obviously, strong performance in the downmarket will impact revenue much more quickly. If you have strong global view sales at the other end of the extreme, that can take several months to even more than a year in some cases to roll in. Typical rule of thumb for us is a couple quarters to see the full impact. Of course, the bookings throughout the year have been pretty consistent for us, and so wouldn't expect any real call-outs from the revenue timing standpoint.

Bryan Keane (Managing Director and Senior Equity Analyst)

Great. All right. Thanks for the color.

Operator (participant)

Thank you. Our next question comes from Eugene Simuni with MoffettNathanson. Your line is open.

Eugene Simuni (Managing Director and Lead Fintech Analyst)

Hi, guys. Good morning. Maria, I wanted to pick back up on your comments about the strength downmarket. Maybe elaborate on that a little bit. What are the macro factors, your competitive positioning that's still supporting that? If you could contrast that for us a little bit with what's going on in the mid-market. I know, you know, it's, it's still doing well, but the question is: Is there a path for mid-market to get to as strong of a point as downmarket, and what are the levers that maybe you're able to pull to get you there?

Maria Black (President and CEO)

Absolutely. I'll start with the downmarket, just to kind of reiterate the strength we're seeing there, top of funnel. We are very pleased with what we saw in the performance of the downmarket. That's also inclusive of the downmarket ecosystem. Think this is our RUN platform. I talked about the Q3 onboarding 60,000 clients. It's pretty incredible. Those clients also, many of them have attach rates of our retirement services offering, our insurance services offering. The entire downmarket portfolio is definitely performing well for us and has for quite some time. It is driven by what we're, what we're seeing macro. You know, just to kind of reiterate what we've seen is new business formations are up year-over-year, 8%.

By the way, they're still up year on pandemic, as I call it. They're actually, if you look at current new business formations, versus the year of 2019, right? Pre-pandemic, it's actually 8,000 or so a week, and this is all from the U.S. Census Bureau. From the standpoint of what we're seeing, that kind of emanate into the pipelines and into the top of funnel, we do have double-digit growth in our digital inbound leads, right? I think these are SEO, SEM ads, where ultimately clients are coming to us, and we're meeting those clients with our inside sellers, and the demand is there, and the demand is strong. The mid-market was a bit softer this quarter than it was last quarter.

That said, we also are very excited about the pipelines that we're seeing in the mid-market that specifically call it the tech only. We do have strength in our Employer Services HR outsourcing offering, which also touches the mid-market. Combined, you know, your question around is there a path to see tremendous growth there between those businesses, we are seeing growth, and we are excited about our overall mid-market position from a competitive landscape. We do have our Next Generation Payroll engine that's attached to about 30%-40% of our mid-market new business sales. What I will tell you is it's resonating incredibly well in the market. It's resonating with the sellers. That's always a good sign when they like to talk about it and they like to demo it.

It's also resonating in terms of the competitive landscape and more wins. We feel that there's definitely path. That's what we're investing in, both in product and the ecosystem to have the mid-market be as an exciting of a story as the down market is for us.

Eugene Simuni (Managing Director and Lead Fintech Analyst)

Got it. Very helpful, color. Thank you. For my follow-up, I want to quickly come back to the PEO. Can you talk a little bit about the kind of the macro headwinds for the PEO that I think we discussed last time, specifically the insurance attach rates, insurance premiums kind of blocking PEO growth? Is that still a factor, or not any longer?

Maria Black (President and CEO)

Yeah. What I would say is that the PEO demand remains strong, and so we're bullish about the secular tailwinds of the PEO. We're bullish about the value proposition. As it relates to benefits and benefits attach, I know there's a lot of discussions. There are a lot of surveys out there from the likes of Kaiser, et cetera, as it relates to our clients making different choices. I think what we see within our base is perhaps some asks of that. On the peripheral, kind of on the margin, you know, perhaps there's price sensitivity as it relates to benefits. What that really allows for is for our sellers just need to be, call it, more surgical as they go to market.

In terms of the value proposition of the PEO and benefits still being a big component of that is the case. We skew definitely a bit more white collar in our PEO. In addition to that, our model with a for-fully insured model is a little bit different. You know, the companies that we attract to our PEO are still companies that want to be employers of choice. Employers of choice, especially in a macro environment such as this one, where talent is still the name of the game, they want to offer benefits, and benefits are a piece of that. What I would say is, you know, we're not seeing huge signs. I think even if you take a look at the revenue ex the ZMPT, you'd be able to see kind of what's happening with benefit revenue.

There's not huge signs that there's a shift in benefits attractiveness. I think the shift that we see is just the sharpness that our sellers need to have as they position the value proposition and call it the right plans and the right rates to the right clients.

Eugene Simuni (Managing Director and Lead Fintech Analyst)

Got it. Thank you very much.

Operator (participant)

Thank you. Our next question comes from Kevin McVeigh with Credit Suisse. Your line is open.

Kevin McVeigh (Managing Director)

Great. Thanks so much. Maria Black, I think you talked about 60,000 new RUN clients in the quarter. Can you help us dimensionalize that? Where would that typically be? You know, how should we kind of expect that to evolve going forward?

Maria Black (President and CEO)

The 60,000 clients that I mentioned are specific to our downmarket, specifically the RUN platform. That's actually 60,000 clients that we started. Where would they be? They would be all over the United States, if you will. And I'm not trying to be funny about it, but it's really, you know, a pretty amazing effort if you think about the volume of clients, the throughput, if you will. They come to us through, you know, some of the things that we talked about today, new business formations. They also come to us through our channel ecosystem. We've made a lot of investments into the relationships we have with our CPAs, with our banks.

for us is obviously the highest volume quarter. That's why it's kind of fun to give that shout-out this quarter because, you know, arguably, I would say, that's not a typical quarter for ADP as it relates to number of units and the throughput because many of the starts do happen in January in that business. They're kind of all over the place, and they come to us through the strength of our distribution model and the strength of our overall ecosystem. Did that answer the question, Kevin?

Kevin McVeigh (Managing Director)

It did. I guess I was just, you know. I know Q3 is the high watermark. How should we think about 60,000 maybe relative to Q3 of last year? Was it 40? I mean, just trying to understand, like, how the momentum's accelerating there, and then just what's the profitability, 'cause it sounds like a third were digital onboarded. The ones that are digitally onboarded, how much more profitable are those than a traditional client that's onboarded? Just trying to get a sense of if we're at an inflection point in terms of the growth there.

Maria Black (President and CEO)

Yeah. Listen, I, fair enough. I don't know that I meant to trip myself into giving a quarter-on-quarter number. What I would tell you is it's higher than last quarter. It's higher, both in revenue obviously and the performance. It's also higher in share unit volume. I suppose I'll kind of leave it at that. In terms of the third that comes through the digital onboarding, what that yields is a few things, Kevin, one of which is a better experience for the client, right? Our digital onboarded clients have very high, what we call new business client NPS results, right? And when a client starts with us happier, it yields to a happier client long term, which yields to a happier and more retentive client.

I think in terms of what the call it margin profile or lifetime value of those clients look like over time, we're still learning a bit about that, but it's very optimistic for us as we're seeing the results. I think the other is it also yields efficiency for our implementation organization, right? If you think about having the ability to have these clients digitally onboarded allows the more complex onboardings, if you will, perhaps clients that are coming to us with more complications around their taxes or maybe from a competitor or something, you know, that actually demands an implementation person to be involved at a much higher level. It allows their focus to remain there, which also should yield a better experience for those clients. We're also seeing that.

Overall, we are seeing, and I cited it in the prepared remarks, we're seeing new clients come on board happier. The digital ones are happier than the non-digital, but they're all happier than they were last year, which is a good thing for us as it relates to the retentive nature of those clients over time and what they will bring to us in terms of lifetime value.

Kevin McVeigh (Managing Director)

Helpful. Thank you.

Operator (participant)

Thank you. Our next question comes from James Faucette with Morgan Stanley. Your line is open.

James Faucette (Managing Director)

Great. Thank you very much. Wanted to quickly, Maria, ask a clarifying question. On the mid-market, you kind of talked about some of the things that you're doing there, but just to be clear, it sounds like from your perspective that it's more issues or things that ADP can do to address versus macro. I just wanna make sure I'm understanding kinda your list of objectives and things to do in that segment.

Maria Black (President and CEO)

Absolutely. The, you know, the mid-market for us still has, and we're still experiencing solid mid-market sales, right? I don't, you know, from my vantage point, I don't think it's necessarily the softness that we saw in Q3 versus Q2 was a byproduct of a macro type of environment. We're paying close attention to demand cycles. We're paying close attention to pipelines. You know, in terms of it, are there some cycles that are perhaps a tiny bit elongated? Maybe. There might be some more approval layers involved, and there may be, you know, a little bit of cycle elongation.

I would tell you, we're not seeing that much of that in the mid-market. It really looks more like 19, it looks more like pre-pandemic than it does, necessarily something that would give us a belief that there's a macro concern in the mid-market. What I would say is on the macro side, it's not getting any easier in the mid-market to be a client, right? If you think about the complex environment for the mid-market customers and clients, it does continue to increase. They're solving for hybrid work, they're solving for talent, they're solving for compliance, regulation, and they're turning to HCM providers such as us to help with all of that.

I think the macro supports a very strong environment for the mid-market, and we do continue to expect to have mid-market growth, including our HRO.

James Faucette (Managing Director)

Got it. Got it. Then I guess maybe dovetailing with that, can you speak a little bit about the competitive environment and, you know, any changes you're seeing there, or what are you seeing from customers? Is there a flight to quality versus maybe some of the regional players? What is the impact of newer entrants? Just can you give us kind of a state of the competitive landscape?

Maria Black (President and CEO)

Sure. I would say the competitive landscape, one way to think about it actually hasn't changed that much. Is there a flight to quality? Sure. We've seen some of that, but it's not material at this time as it relates to clients calling us and, you know, asking about the macro and what's happening in the world. We've had a few of those calls just recently based on some things that have happened in the environment. What I would say, you know, when I think about the competitive environment, we look at this very closely. We just completed our strategic plan process, and we've been looking at our competitive position against all the major players, mid-market and others, over the last, you know, handful of years in a surgical way.

What I would offer is a few items, one of which is we have strong retention, specifically in the mid-market. We also have very strong retention in international. We have near record highs in NPS. I would say that our value proposition and our competitive positioning, you know, is proof, if you will, if you look at the retention. From a balance of trade, we are also winning more away from our competitors than we have in years past. Again, I think our position is about the same when I look at it year-over-year, but it's getting, you know, perhaps a little bit better on the win side, and I think that a lot of that does have to do with the quality that we're providing.

I cited kind of NPS results. Certainly the investments we've made, the investments into our organization to serve our clients better. Some of the things I talked about, new products that we're leveraging, you know, the likes of AI to actually drive self-service, to drive a better experience for our clients, their employees, and drive friction out. I would say investments into products. Then lastly, again, investments into new products that is creating better wins for us.

James Faucette (Managing Director)

That's great. Thank you so much for that color, Maria.

Maria Black (President and CEO)

You bet.

Operator (participant)

Thank you. Our next question comes from Kartik Mehta with Northcoast Research. Your line is open.

Kartik Mehta (Executive Managing Director and Director of Research)

John, I know you gave preliminary FY 2024 guidance, and one of the things you talked about is obviously pays per control moderating. Could there be an offset because inflation is still running high, and there is a pricing opportunity for the company, especially on the payroll side?

Don McGuire (CFO)

Yeah, Kartik, it's a good question. Certainly talked about pays per control growth decelerating. We've called that out. We've also, and I mentioned earlier for 2024, I think there's a risk that it decelerates further. We'll have to watch and see what happens there. On the inflation side and pricing, we're still in the early days of our FY 2024 plan, you know, we're watching it carefully. I think we can say that we are happy with the impact and results of the pricing decisions we took in 2023. We had those readily accepted, I guess, with, you know, reflected by our higher NPS scores, by our continued strong retention. We have an ability to take price. As we always come back to, we're in this for the long haul with our clients.

Their long-term retention is the most important thing to us, so we need to make sure that we continue to have that good value proposition between what the absolute price is, how much price we can take, et cetera. Once again, Kartik, it's definitely something we're looking at and trying to evaluate as we get closer to, you know, putting the plan to bed.

Kartik Mehta (Executive Managing Director and Director of Research)

Maria, just on the PEO side, Is any of the attrition related to maybe customers deciding that they had a PEO and it just got too expensive for them, so they've decided to move out of the PEO for a while until they can get a better understanding of what's happening in the economy? Any changes like that?

Maria Black (President and CEO)

I would say that's always the case. I think every year as we go through renewals, as we go through the year-end cycle, you have clients that are choosing to buy into the PEO, and you have clients that are choosing to exit the PEO. When I look at where we get our clients from, obviously I think we've cited multiple times that about 50% of the new business that comes into the PEO comes from our existing ADP base. That would suggest that at least 50% come from a non-PEO environment, and we somewhat tend to return them the same way. That's not to say that clients don't at times. You know, we don't trade customers between us and the other PEOs. Generally speaking, I think that's always the case.

I don't believe there's a larger trend toward that this time than there has been in the past. I think really in the end, you know, it's really a byproduct again of kind of what we saw with the renewal post-pandemic and what's the impact of that as we headed into this selling cycle, if you will.

Kartik Mehta (Executive Managing Director and Director of Research)

Thank you very much. Appreciate it.

Operator (participant)

Thank you. Our next question comes from Ramsey El-Assal with Barclays. Your line is open.

Ramsey El-Assal (Managing Director)

Hi. Thanks for taking my question. I also wanted to follow up on the PEO and particularly on the bookings re-acceleration. I'm just curious how much of that re-acceleration is sort of from a better, you know, kind of external demand environment versus changes in your sales strategy. I'm just trying to figure out how much is sort of push versus pull when it comes to that recovery. I guess the underlying question is, you know, your confidence level that this re-acceleration is a sustainable trend.

Maria Black (President and CEO)

Fair. Thank you, Ramsey. We are excited about the PEO re-acceleration, specifically what we saw in March, and obviously how we feel stepping into this final stretch. I think it'd be too early to comment on the finish, but the pipelines are strong. What I would tell you is that I'm bullish about the demand in the market for the PEO, and the overall value proposition. All things being equal, I think, we're positioned well, as well as anybody else as it relates to the overall PEO, I guess, demand, if you will, right? The re-acceleration was really, in my mind, more a byproduct of top of funnel, you know, filling the pipelines. We made a lot of investments into our seller ecosystem in the PEO.

We have incentives that we can pull. In addition to that, we've invested into, and I think I've talked about it a couple times on these calls, we've invested into artificial intelligence that actually looks across our base to a project where we're actually looking at the ADP base to try to serve up the right, call it PEO seller at the right time to the right ADP client. We're getting smarter. I'm not doing a good job saying it outside of we're getting smarter in terms of who we are actually targeting on the PEO using technology today that didn't exist.

I think all of that has kind of yielded to, you know, what I would say is a strong execution by the PEO sales team to drive the re-acceleration that we would expect and that we are excited to see and optimistic that it will continue.

Ramsey El-Assal (Managing Director)

Okay, great. A quick follow-up. When you look across the business, are you seeing any vertical specific areas of softness, maybe tech or commercial real estate or financial services? Are there any worrisome kind of verticals that you're keeping an eye on?

Maria Black (President and CEO)

Are you referring to the PEO specifically or the overall macro?

Ramsey El-Assal (Managing Director)

No, I'm sorry. No, I should have been more clear. Just more broadly across the business, are there any- You know, you guys have a pretty broad macro view, I'm just curious if there's any specific areas that are causing any concern in terms of, you know, recent trends.

Don McGuire (CFO)

Yeah, maybe I'll jump in. I think in terms of verticals, certainly seeing all the reports and reading all the things about commercial real estate that everyone else is. You know, if we look at the breadth and the distribution of our client base, it's pretty broad, so I'm not so sure that we're seeing any particular verticals that are causing us any undue concern at this time. I would say, as been reported, Maria mentioned it in the prepared remarks, certainly the enterprise space, the upmarket space is where there's been a lot more layoffs announced, et cetera, particularly in tech. We're looking at that. You said in the past, though, that's not the biggest part of our business.

Even though there's some more softness in that end of the market, it's being more than offset by the success we're having in the down and the mid-market. From a particular vertical, nothing in particular.

Ramsey El-Assal (Managing Director)

Okay. Thanks. I appreciate it.

Operator (participant)

Thank you. Our next question comes from Samad Samana with Jefferies. Your line is open.

Samad Samana (Managing Director)

Greg, good morning. Thanks for taking my questions. Maybe first one, Maria, just I wanted to maybe get a better understanding when you're talking about a change in maybe the investing philosophy of the company, just as you're adjusting to the macro environment evolving as well. Is that more around maybe pulling back on hiring? Is that more about maybe redirecting where resources are? Can you maybe just help us better understand what that translates into and maybe how we should think about that impacting both the top and bottom line?

Maria Black (President and CEO)

Yeah. Thanks, Samad Samana, and good morning. I'm happy to talk about modernization. It's one of my favorite topics, as all of you are probably learning from my prepared remarks. I think it's important to think about the modernization journey we've been on, and how it really can set us up for kind of future growth and future margin, if you will, as a company. That's really what it's all about for us. I think we've been undergoing transformation. We've been undergoing modernization for years. I would actually suggest that ADP has been modernizing for the last 73 years as we've invested in technology to make things better for us as a business to become more efficient. We've been investing in our clients and in product to make it easier for them.

I think that's not a new cycle. The way I think about modernization is really a client first lens, right? It's really about all the things that I cited. It's about taking out friction. The way I think about the investment, which is your question, Samad, is it's an imperative for us to continue to invest in modernization because it's the modernization that over time has really allowed us to reinvest in growth and reinvest in the business. And we are committed to a continued journey of growth and margin, and as a result of, you know, really the way we've been able to do this. For us, it's really about both. It's really about the and, right? It's about growth and margin expansion.

I think this virtuous cycle that we've been on really as a company for a very long time, which is we make things easier, we make them better, we become more efficient, we make things better for our clients, and that allows us to invest in growth, and it allows us to invest in back into our shareholders, if you will, in margins. It's really an and story, and it's key to who ADP is, and it will be a key for us as we go forward. In terms of the commentary that I made around how we're thinking about it in the macroeconomic backdrop, it is important time to make sure we're making the right choices and the right trade-off. I mentioned earlier, we've been in the middle of our strategic planning process the last quarter.

As we've gone through the business, if you will, end to end, rest assured that we are trying as a company to make the very best decisions to have the very best outcomes as it relates to growth and margin.

Samad Samana (Managing Director)

Great. I appreciate that. Then just one quick follow-up for Don. I was just looking at the guidance by segment and the margin for ES, looks like you settled that at the, within the range at the lower end. I'm just curious maybe what drove that. Is that Is it purely float contribution driven, or is that more the result of just bookings being better, so expenses being pulled forward? Just help me understand why that was narrowed to the, to the lower end of the range, please?

Don McGuire (CFO)

Yeah. I think there's a couple of things going on. One, certainly we're continuing to benefit from bookings growth, retention, pricing space for controllers, all a little bit stronger. We certainly are getting lots of tailwinds, or we have lots of tailwinds in Q3, in particular from client fund interest. That's been very helpful for us. The things slow a little bit from a client fund interest perspective in Q4, that certainly is not as helpful as it was. We are, of course, as Maria just mentioned, we are taking advantage of some of those extra float funds that we have to reinvest in the business or continue to invest in the business on modernization.

It's all about, I think, trying to find the right balance and still delivering the, as we mentioned, the higher end of the earnings per share prediction or guidance. It's all about finding the right balance, and we will continue to invest in modernization and deliver improvements as we, as we go forward.

Samad Samana (Managing Director)

Great. Appreciate you taking my questions. Thank you.

Operator (participant)

Thank you. Our next question comes from David Togut with Evercore ISI. Your line is open.

David Togut (Senior Managing Director)

Thank you. Good morning. Could you walk through the 140 basis points of PEO margin expansion in Q3? It seems pretty notable given the deceleration in PEO revenue growth. In particular, could you unpack the size of the workers' compensation reserve release in Q3?

Danny Hussain (VP of Investor Relations)

David, it was, $17 million. You'll see it in the Q compared to $7 million last year. It wasn't a huge amount.

David Togut (Senior Managing Director)

Right.

Don McGuire (CFO)

Those are the two impacts. The biggest impact was the reserve adjustment on workers' comp. The other big item there is the lower SUI costs. There's virtually no margins on SUI. SUI comes down on the top, it certainly improves the margins. Those would be the two major impacts-On the margin improvement in PEO.

David Togut (Senior Managing Director)

Got it. Just as a follow-up, Don, could you walk through your strategy on managing the tax filing float going forward? We've got a pretty steeply inverted yield curve right now, which means it's actually more expensive for you to borrow in the commercial paper market and invest float medium-term duration bonds. Are you thinking of shifting the investment portfolio at all in the year ahead?

Don McGuire (CFO)

You know, we've had that strategy in place for some 20 years or so, and we've realized about $2.8 billion of incremental benefit from that strategy. We have the strategy in place. We always revisit these strategies and look at them. It's true that the yield curve is inverted for the 7th time in 50 years. How long that continues, I'm not sure. We'll continue to look at that strategy and see what we need to do, if anything, to change it as we go forward. It is something we've been committed to, and we follow closely. Near term, certainly we've benefited this quarter because of the inflow of funds in what's calendar Q1. There's a big balance. There are big benefit there to us.

As we go forward, we'll continue to look at the opportunities and decide if we need to make any material changes to the investment strategy.

Danny Hussain (VP of Investor Relations)

David Togut, one point worth clarifying because this has come up before. If you look at the last slide of our earnings presentation, you'll see a disaggregation of client short, extended, and long. One thing I think is worth emphasizing is that we are net long exposed to the client short. In other words, if short-term interest rates went up and up and up, that would actually be beneficial to our earnings and our margins. It just shows us in two different places, which can often cause confusion. It's actually not hurtful to us to have these higher borrowing costs because we have more dollars invested long in the client short portfolio.

David Togut (Senior Managing Director)

Understood. Thank you.

Operator (participant)

Thank you. Our next question comes from Mark Marcon with Baird. Your line is open.

Mark Marcon (Senior Research Analyst)

Hey, good morning, everybody. Maria, you talked about modernization. Can you talk about the areas of emphasis? One area that I'm particularly interested in is international and what you're seeing there in terms of opportunities. Thank you.

Maria Black (President and CEO)

Sure. Overall, I think modernization is really about end to end. Think of it as product, and continuing to make investments in ensuring our products are next generation, if you will. That's certainly the case across many pieces of our portfolio, and you're well aware of the investments we're making in next-generation technology. I think product is a big piece of it. I think other is the internal modernization. That would be everything from go-to-market to, call it, the seller ecosystem modernization. I think I've spoken to that quite a bit in the past, as well as how we actually serve our clients. Again, we referenced that today.

Kind of going back to modernization, specifically in our opportunity in international, we're very excited about our position in international, very excited about the opportunity that we have, and this is definitely an area that we have been modernizing. If you think about each and every country that we serve, over 140 countries today, that we have offers over time, we have been modernizing the platforms, and we've been consolidating platforms. To your point, Mark, that work is not done. We still have, that journey that we've been on is the journey that we're going to continue.

As we do that, we're also focused on ensuring that we continue to make the investments to the platforms, and we continue to make the investments into the overall ecosystem of how we serve our clients international to really drive further, call it opportunity. There's still places in international, and I'll probably leave it with, you know, we'll be back next quarter to talk more about things such as our growth strategy. I think as it relates to international, all of that modernization should also yield a growth opportunity for us because it's still a big world, and there are places that we, even though we're in more countries than anybody else, there are countries that we don't exist.

There are segments within certain countries where our offer still has opportunity. we're incredibly excited about the overall international space, where we are, the work that we're doing and where we're going.

Mark Marcon (Senior Research Analyst)

That's great. Maria, can you talk a little bit about just what the appetite is? You know, obviously it's diverse across the globe. Broadly speaking, are you seeing a greater level of interest in terms of modernization of HR and HCM systems across the globe? Certainly it's been an ongoing trend in the U.S. for quite some time, but just I'm hearing from others that, you know, there is a pickup in terms of RFPs that are occurring, things of that nature, and that we could be at the early stages of higher levels of growth, international macro notwithstanding.

Maria Black (President and CEO)

What I would suggest, Mark, is that over the last few years, the conversation in the international space has definitely shifted a bit. I could suggest the same thing, which is that it's picked up. That conversation today tends to lead with more of a global offer, global system of record, kind of conversation. We walk in today, and we have a conversation with a client more often than not about how many countries are you in, and where can we help serve you, and how can we tie it all together to make an ability for that client to really see across multiple countries and have more of a unified experience, versus, I would say, perhaps 5, 10 years ago, it was more of a country-by-country conversation.

Today it starts with a multi-country conversation. I think all of that suggests what, you know, it appears you've heard from others, which is the narrative in the international is shifting. I think there is greater demand for HCM offerings in international as it relates to companies now that are more global than they've ever been. Certainly, the hybrid environment has accelerated that a bit, and the ability for companies to be able to see their workforces and make talent decisions, headcount decisions across multiple countries, that's a very different conversation today than it was just, you know, a few years ago. We see that when we just recently, actually this quarter, we had all of our international clients together at an event. You know, the topic is about their transformation.

It's about their HCM transformation and the partnership that we have with them to solve for that. I think the beauty of ADP is that we have the ability to solve the MMC, the multi-country piece, and we also have the ability to solve the in-country. A lot of times for clients, it's a mix of both. It's really about the flexibility we have in our partnership options to serve these clients in a very unique way.

Mark Marcon (Senior Research Analyst)

Perfect. Thank you.

Operator (participant)

Thank you. We have time for one more question. That question comes from Tien-Tsin Huang with JPMorgan. Your line is open.

Tien-Tsin Huang (Managing Director and Senior Equity Research Analyst)

Hey, thank you so much. I know you covered a lot already. I just wondered on the down market side, given the success in the bookings here, just curious if that's changing your thinking in investing more or even less, maybe in ASO versus PEO than the digital sales versus the seller ecosystem. I'm curious as you're going into fiscal 2024 here, if there's any maybe change in thinking and prioritization there.

Maria Black (President and CEO)

We have leaned into the down market in terms of the investments we've made. When I think I referenced earlier the seller headcount as we head into the final stretch here and how pleased we are with the investments we've made in headcount and the ecosystem around them, investments into the channels, things of that nature. As all of that turns into more productivity because the headcount is actually gaining tenure, it is primarily sitting. Those investments have been in the down market. Again, think our SBS platform, the retirement services, the insurance services, most of that also comes into our digital sales organization, also known as inside sales. We are making investments into inside sales to really serve the down market.

What I would suggest is that from our viewpoint at this point, the demand is there. We've leaned into that demand, and we will continue to lean into the demand, to drive the growth, that we're driving out of the down market, you know, as long as it exists, if you will.

Tien-Tsin Huang (Managing Director and Senior Equity Research Analyst)

Yeah. No, glad to hear it. If you don't mind, one more question. Just have to ask you since you mentioned it, Maria Black, with AI, you know, we've been getting a lot of questions on Generative AI and ChatGPT. You, you mentioned being smarter around serving up PEO when necessary at the right time. Just broadly speaking, how are you thinking about generative AI and how that might help you run your business better, both from a sales perspective, but also from a, from a delivery perspective support standpoint?

Maria Black (President and CEO)

Thank you, Tien-Tsin Huang. I'm thrilled you asked this question because I was counting on it during this call because it definitely seems like it's the topic du jour. The real answer is just like everybody else, we're incredibly excited about Generative AI. We have been very excited about AI for quite some time. You mentioned what we've been doing for our sellers in the PEO. That's broad-based work that we've been doing for a long time and continue to invest in AI into making us more efficient. That example is about our sellers. We are making similar investments, even with the new technologies that are out there, to really look at how we can make our service associates as well as our sellers more productive.

You think about all the things that an agent, if you will, does today to support a client and some of the Generative AI tools that can drive, you know, a different level of efficiency, and we're very excited. We have, I think it's something around like 44 different work streams that are underway currently, to take a look at different ways that we can leverage these tools internally. That's also notwithstanding the opportunity that it creates for our industry, right? If you think about the HCM industry, there are still very many things inside of HCM that are administrative in nature in terms of whether it's job descriptions, performance reviews, you know, things that are, maybe handbooks, things that are very tactical that really at times hold back the practitioner from doing what they wanna do, which is be a strategic partner.

We're really excited to put these tools also into our product for our clients and our practitioners to be able to lean into. All that said, we're very excited about the opportunity. One thing I would point out, because it's important and it's also very topical right now, which is that the good news is we've been doing a lot of this work, and as such, you know, we have standards. We have a way to think about the ethical nature and that, you know, kind of comes at parity with who we are, given that we have the big data, if you will, behind ADP and the 40 million wage earners that we pay.

When we think about all of this, you know, with also with the lens of doing it the right way and making sure that it's ethical, it's secure, it's compliant, all the things that you would expect from ADP. No doubt, Tingen, that we are excited about the opportunity it creates for us internally and the opportunity that it creates for us in our product to really serve the industry, right? Make this entire industry that much more strategic and that much more exciting. Great question.

Tien-Tsin Huang (Managing Director and Senior Equity Research Analyst)

Yeah. No, it's fun stuff. Hope to learn more soon. Talk soon. Thank you.

Operator (participant)

Thank you. This concludes our question and answer portion for today. I am pleased to hand the program over to Maria Black for closing remarks.

Maria Black (President and CEO)

Yeah. First and foremost, thank you everybody for joining today. Really appreciate the questions and the interest. As you can imagine, I sit here one quarter into my new role as CEO, and I get a lot of questions. Just last night I got another text that said, How were the first 100 days? How was the Q1? What have you been up to? Here's what I would offer. The Q3 for ADP, you heard it in my tone today, you heard it in my excitement about, you know, some of the volumes and the throughput, that the Q3 is really where you see ADP shine. It is our finest quarter. You have year-end, you have busy season, you have selling season that all kind of come together.

In this quarter, what I would say is add in some economic strangeness and questions about, you know, what's happening in the world. I would say that sitting here 1 quarter in, I couldn't be more excited, I couldn't be more pleased, I couldn't be more grateful for the sheer execution of our associates. I felt the breadth and depth of ADP this quarter at its finest. With that, I just want to take another minute to thank our associates for everything that they do to power this great company. I'd also like to thank all of our partners and stakeholders and everyone on the call listening today. I couldn't be more proud and more excited about this company. With that, we will wrap up the call.

Operator (participant)

This concludes the program. You may now disconnect. Everyone, have a great day.