The Market Is Overreacting to Paychex's (PAYX) Earnings

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Over the years, there have been a few occasions when I felt it necessary to warn investors about overreacting to stand-alone earnings reports. When a company releases their quarterly results outside of the normal earnings season, they garner a lot more attention than reports that come out when the earnings are flowing thick and fast. That often leads to a market overreaction.

It can be a positive or negative move, but when traders are focused on just one piece of news, everyone feels they have to get involved and trade that news, so those moves tend to get overdone, often quite drastically. There is an example in this morning’s premarket, and it is one where the overreaction applies not just to the individual stock, but also what the company’s performance says about the economy and therefore the broader market.

Paychex (PAYX), the HR and payroll outsourcing company, reported their financial year Q3 results this morning, and the stock dropped to around $112 from yesterday’s close of $121.62, a loss of around 8%. It has since bounced back a little but looks set to open around 5% lower on the news.

PAYX chart

But was the report that bad? Not really.

The obvious problem was a miss on revenue, but that wasn’t as bad as the initial market reaction suggests. Sales of $1.44 billion fell short of analysts’ estimates by $20 million, a not insignificant sum to any of us, for sure, but a tiny percentage of the overall amount. By the way, that still represented a year over year increase of 4.2%. Then there was the “weak” guidance on the same front. Paychex is now forecasting for the full year revenue growth of between five and six percent, which would result in a slight miss of current expectations.

Both of those misses, however, can be attributed to one thing: In a press release accompanying the report, CEO John Gibson said that “total revenue growth in the third fiscal quarter reflected a lower contribution from our Employee Retention Tax Credit (ERTC) Service as compared with the prior year period."

It is reasonable to assume that adjusted expectations for that service going forward also explain, at least in part, the lower-than-hoped-for revenue guidance.

To be honest, my reaction to a revenue miss based on reduced ERTC related revenue was, “No s---, Sherlock!” The ERTC is a government subsidy offered to companies who retained employees during covid, and a drop off in revenue from those seeking to take advantage of that should hardly come as a surprise. Even if the impact of lower ERTC service revenue is a bit exaggerated here, if it explains some of what was already a tiny miss, what is all the fuss about?

When it comes to the implications for the economy, some traders are worried that any hints of softness in Paychex’ earnings suggest weakness in the small and mid-sized businesses that form the core of the company’s clientele. Small businesses are usually the driver of growth in America, so that is a concern, but if even some of the miss and outlook adjustment is down to the ERTC situation, that also looks like an exaggerated worry.

For starters, economic strength right now is largely a function of AI-led improvements in productivity. That is a good thing but could be somewhat disruptive for smaller businesses in the early days of change. Some hesitation in that part of the economy is therefore understandable, but small businesses will, if their history of adaptation is to be believed, emerge from the temporary disruption stronger than ever.

What has been overlooked by the market in all of this is the fact that despite missing on revenue, PAYX beat on EPS in their Q3. It was only a penny beat, but on lower than expected revenue it still suggests more efficient operations and higher margins, something that will outlast a temporary downturn due to reduced revenue from a sunsetting government program. That is good news, but the market is focused on the bad.

What we are left with is a big drop in a stock on an understandable, temporary reduction in revenue and an admirable beat of profit expectations despite it. If that news had come alongside earnings releases by a dozen or so other companies, it would probably have had little impact, but as the only earnings release on a quiet news day, it has got everyone’s attention.

Traders trade: it’s what they do, and when they are focused on something, they will trade it, sometimes even when a calmer look at the “news” indicates that it isn’t really that significant. That is what we are seeing here, and a strong bounce back in PAYX is therefore likely over the next few days.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

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