Paylocity Holding Corporation (PCTY) Q2 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Paylocity Second Quarter 2015 Fiscal Year Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] And as a reminder, this conference is being recorded. I would now like to turn the conference over to Mr. Peter McGrail. Sir, you may begin.

Good afternoon, and welcome to Paylocity's earnings results call for the second fiscal quarter of 2015, which ended on December 31, 2014. I’m Peter McGrail, CFO, and joining me on the call today is Steve Beauchamp, Chief Executive Officer of Paylocity. Today, we will be discussing the results announced in our press release issued after the market closed. A webcast replay of this call will be available on our website under the Investor Relations tab. Before beginning, we must caution you that today's remarks in this discussion including statements made during the question-and-answer session contain forward-looking statements. These statements are subject to numerous important factors, risks and uncertainties, which could cause actual results to differ from the results implied by these or other forward-looking statements. Also, these statements are based solely on the present information and are subject to risks and uncertainties that can cause actual results to differ materially from those projected in the forward-looking statements. For additional information, please refer to our filings with the Securities and Exchange Commission for the risk factors contained therein and other disclosures. We do not undertake any duty to update any forward-looking statements. Also, during the course of today’s call, we will refer to both GAAP and certain non-GAAP financial measures. We believe that non-GAAP measures are more representative of how we internally measure the business and there is a reconciliation schedule detailing these results currently available in our press release, which is located on our website at www.paylocity.com under the Investor Relations tab and filed with the Securities and Exchange Commission. The non-revenue financial measures we will discuss today are non-GAAP unless we state the measures as GAAP. With that, let me turn the call over to Steve.

Thank you, Peter, and thanks to all of you for joining us on our second quarter earnings call. Peter will review our financial results in detail, but let me share a few highlights from the second quarter. Our second quarter was very strong across all our key metrics. Total revenue along with recurring revenue was up 44% year-over-year approximately 2% of this quarters revenue growth is due to a shift in recurring revenue that would normally occur in our third fiscal quarter. The revenue shift was due to some of our clients running an extra payroll in December based on the calendar year-end holiday schedule. Adjusted recurring gross margin increased to 67% for the quarter, up from 63% the same period last fiscal year. The improvement in adjusted gross margin expansion was largely driven from the purchase of one our resellers at the end of last fiscal year. Adjusted EBITDA which was slightly negative reflected these improvements in margins as well as additional benefit of higher margin recurring revenue shifting from our third fiscal quarter to the current quarter. During the second quarter, we completed a secondary offering consisting of 4.6 million shares including 750,000 primary shares further strengthening our balance sheet as we ended the quarter with nearly $90 million in cash. During the quarter we’re once again ranked under Lloyd’s list of 500 fastest growing technology companies in North America. We increased our sales and marketing spend by 58% year-over-year this quarter as we continue to see demand growing for our unified SaaS payroll and HCM solutions. The fall selling season is a very important time of year as many medium sized businesses evaluate their payroll in HCM platform targeting a change in January. We were pleased with the activity level driven by our sales force as many of our first-year sales reps begin ramping up to our expected first-year productivity levels. The competitive landscape remains very similar to last years selling season with most of our sales activity targeting businesses using one of the traditional payroll providers. We did however notice a slight increase in activity with prospects who are currently using an in-house software, which we believe is largely due to the increased complexity driven by healthcare reform regulations taking effect in 2015. We continue to build momentum in our referral network of 401k advisors, insurance brokers and third-party administrators that recommend our solution and provide our sales force with high quality referrals. Our investment in ACA marketing tools, educational content and our proprietary ACA module has provided momentum with health insurance brokers. We have developed a number of new broker partnerships as they are searching for a platform to help their clients comply with 2015 healthcare legislative changes. The combination of a strong quarter in new business sales along with our continued investment in the referral channel, increased sales and marketing expense in the second quarter to 25% of total revenue up from 23% for the same period last fiscal year. Not only is this a very busy quarter for our sales team, but also for all of our employees who focused on delivering a seamless year end experience to our clients. Our cross functional year end committee coordinates with all of our internal operational teams to ensure we can answer all the various year end payroll questions, complete annual bonus and adjustment payrolls and file year end tax forms to various federal, state and local agencies. We filed in excess of a 100,000 tax returns and produced more than 1.5 million W-2s. I am very proud of the effort and collaboration from all employees during this very busy time of year. As we continue to focus on delivering innovative technology backed by high touch service for our clients. We believe strongly that our unified HCM platform purpose-built for midsized clients is a key differentiator versus traditional payroll providers and therefore, we will continue to aggressively invest in our cloud-based software. These investments are paying off as we continue to drive increase utilization of our platform by our clients and their employees. The greater level of access to employee information across the organization unable administrators to automate previously manual processes. As an example Paylocity’s Apple and Android mobile applications continue to gain momentum as we recently passed 100,000 lifetime downloads and are currently averaging more than 10,000 unique users per day. Continue to invest in our platform resulted in research and development costs of 14.8% of our revenue for the quarter when you combine what we capitalized and what we expect. This was up from 13.3% for the same period last year. In summary, we are very pleased with the results from our second quarter and the momentum we built going into the second half of our fiscal year. With that let me turn it back over to Peter.

Thanks, Steve. Let me walk through the results and provide a bit of color as well as review some of the key aspects of our financial model. Total revenue was $34.3 million, which represents a 44% increase from the same period in the prior year. As Steve noted, second quarter revenues benefited by an estimated 2% from the subset of our clients processing in extra payroll in December due to the year-end holiday schedule. Our revenues have two major components; recurring and non-recurring. Our recurring revenue has historically represented about 94% of our overall revenues and is separated into two categories; recurring fees attributable to our cloud-based payroll and HCM software solutions and interest income on funds held for clients. For the quarter, our total recurring revenue of $32.4 million was up 44% from the year ago quarter and represented 95% of our total revenue. Recurring fees were up 45% in the quarter. Interest revenue was up modestly 3% year-over-year as declining rates were offset by balance increases. Our nonrecurring revenues are comprised of implementation services and other and primarily consist of implementation fees charged to new clients for professional services provided to implement and configure our payroll and HCM solutions. Implementation services and other revenue was $1.9 million for the quarter, up 35% from the year ago quarter. The combination of high recurring revenue percentages and high retention rates provide significant visibility into our future operating results. Like our revenues we separate our cost of revenues into two different categories, recurring revenue and implementation services and other. These two numbers are combined to form our overall costs and meant to produce our overall gross profit margins. We refine our gross margins further by providing adjusted numbers, we adjusted two items. First, we exclude cost related to stock-based compensation and second we exclude amortization expense associated with capitalized research and development costs. A reconciliation of GAAP to non-GAAP adjusted gross margins is provided in the press release we issued after the close today. We believe these adjusted numbers provide the best and most reliable comparison to other SaaS companies. Adjusted gross profit in the first quarter was $17.8 million representing a gross margin of 51.9%, as compared to $11.2 million or 46.9% in the year ago quarter. This improvement was primarily the result of the acquisition of one of our two resellers in May, the aforementioned revenue shift into the second quarter as a result of the year end calendar and natural leverage. We expect the year-over-year margin improvement to narrow as we move forward in the fiscal year, as we have reached our targeted staffing levels in many areas. We view our adjusted recurring revenue gross margins as the best barometer for our overall long-term margin opportunity, as we generate these margins on the vast majority of our revenues. Our adjusted gross profit on recurring revenues was $21.6 million or 66.7% in the quarter, up from $14.1 million or 62% in the year ago quarter. Again, this improvement was primarily the result of the acquisition of one of our two resellers the aforementioned revenue shift and natural leverage. As we’ve discussed in the past, our adjusted gross margins on nonrecurring revenue specifically on implementation services are negative. We view the negative margins on our implementation services as a great short-term investment, they only last three to six weeks, which then become a long-term, high-margined annuity. In regards to implementations, we charge what we believe are market rates and we’ll continue this practice as we continue to gain market share. As noted in our last earnings call, we are incrementally increasing our investments in two key areas. First, we are focusing investment in research and development to maintain and extend our technological leadership. Second, we are engaging in sales and marketing activities that have the potential for longer term impacts, including taking a higher profile industry event and cultivating our relationships with our unique broker referral channel, both of which we’ve highlighted earlier. In order to understand our overall investment in research and development, it is important to combine both what we expense and what we capitalize. On a combined non-GAAP basis, research and development investments were $5.1 million or 14.8% of revenue in the first quarter compared to $3.2 million or 13.3% of revenue in the year ago quarter. On a non-GAAP basis, sales and marketing expense increased to $8.5 million or 24.7% of revenue in the quarter compared to $5.4 million or 22.7% in the year ago quarter, as we continue to expand our marketing efforts in fiscal year 2015. On a non-GAAP basis, general and administrative costs were $6.8 million or 19.7% of revenue in the first quarter compared to $5.1 million or 21.2% of revenue in the year ago quarter. Our adjusted EBITDA, which is adjusted for cost related to stock-based compensation in the amortization of intangibles related to our reseller acquisition, was negative $0.2 million for the quarter versus negative $0.7 million for the year ago quarter, compared to $5.1 million or 21.2% of revenue in the year ago quarter. Our adjusted EBITDA, which is adjusted for costs related to stock-based compensation in the amortization of intangibles related to our reseller acquisition, was negative $0.2 million for the quarter versus negative $0.7 million for the year ago quarter. Non-GAAP net loss per share was negative $0.05 for the quarter based on 49.8 million basic and diluted weighted average common shares outstanding. Briefly covering our GAAP results, for the quarter, gross profit was $16.3 million, operating loss was negative $6.5 million and net loss was negative $6.4 million. Like others in our industry, we do collect funds from our clients in advance of making payments to employees and taxing authorities. Our cash flows from investing and financing activities are influenced by the timing and amount of funds held for clients, which vary significantly from quarter-to-quarter. Funds held for clients are restricted solely for the repayment of client fund obligations. In regard to the balance sheet, we ended the quarter with cash and cash equivalents of $89.5 million. As Steve mentioned we completed with the secondary offering in the quarter, which added $18.4 million to our cash position. From a cash flow perspective, we generated $0.1 million in cash from operating activities in the quarter ended December 31, 2014 and spent $1.7 million on property, plant and equipment. Finally, as we’ve noted in the past, we experienced fluctuations in revenues and related costs on a seasonal basis. For example, our revenues in our upcoming third fiscal quarter are positively impacted by a preparation of W-2 documents for our clients’ employees and our costs traditionally increased during the same period because it has historically represented are most significant for new client acquisition. I’d now like to provide our financial guidance for the third quarter and updated guidance for the full-year of fiscal 2015. Total revenue for the third quarter is expected to be in the range of $44 million to $45 million. Adjusted EBITDA is expected to be in the range of $4 million to $5 million. Non-GAAP net income is expected to be in the range of $2 million to $3 million or $0.04 to $0.06 per share based on approximately 52.1 million diluted weighted average common shares outstanding. Total revenue for the year is expected to be in the range of $146 million to $148 million. Adjusted EBITDA is expected to be in the range of $3.5 million to $4.5 million. Non-GAAP net loss is expected to be in the range of negative $5 million to negative $4 million or negative $0.10 to negative $0.08 per share based on approximately 50.1 million basic and diluted weighted average common shares outstanding. In summary, we are very pleased with our operational performance during the second quarter of fiscal year 2015. Before turning the call back to the operator, during the upcoming quarters these will be at the Raymond James Institutional Investors Conference on March 3, in Orlando and I will be at the JMP Tech Conference on March 3, in San Francisco, and the Northland Capital Markets Growth Conference on March 18 in New York. Operator, we are now ready to begin the question-and-answer session.

Thank you, sir. [Operator Instructions] And our first question comes from Nandan Amladi from Deutsche Bank. Your line is open. Please go ahead.

Good afternoon, thanks for taking my questions. So I assume the first question on the broker channel, clearly it’s been an important source of new business for you. But it appears to be fairly fragmented market with lots of these individuals. Are there sort of midsize firms much likely are owned, that’s actually are more - that organize that perhaps could expand your reach.

Yes, I think from an overall brokers strategy, we really focused on our local sales force across the country driving these relationships and if you look at a typical profile of a broker who is referring as business it could be a one or two broker firm that have 50 to 100 clients each or it might be a more regional player with stronger reach that might have 50 employees across the firm and 25 different producers. So those are typically the profile from the smallest to these regional firms that we work with them most, and it’s really the individual relationships that are formed between our sales organization and that individual broker that drive us business. So we think there is opportunity to expand within the exciting footprint and broker referral relationship we had today. We also think there is significant opportunity to add broker referral relationships across the country, because it is highly fragmented and there is thousands and thousands of these brokers across the country.

Right. So how much of your sales and marketing effort is on this broker channel versus creating awareness with the brand and so on.

Yes, it’s a good question. So obviously it’s a direct sales model with our feet on the street sales force across the country and they are spending most of their time with prospects, but they still spend a portion of the time actually reaching out to the brokers, meeting with them, we provide them marketing content, we provide them education and tools. And so most of our marketing effort is really driven towards broker content as well as marketing seminars and we deliver that marketing tools through the actual sales force. So I think it’s a fair statement to say a lot of our marketing efforts are in the broker channel versus overall brand awareness, but it’s an important point to understand that is driven through the sales force.

Thank you. Our next question comes from Justin Furby from William Blair. Your line is open. Please go ahead.

Hey, guys, thanks. And great quarter, I want to stick on the channel say real quick. I’m curious I think you last said it was north of 25% of your business, what is that look like in Q2 specifically and Steve what do you think that goes in the next sort of three years. And do you see any of the competitors out there targeting the middle market that are trying to build up a similar type of a channel strategy that you guys have already built up?

Yes, so first of all in terms of our goals and objective we would love to be able to maintain that at greater than 25% of our new business revenue as we continue to grow the business. So we’re obviously growing the business fairly aggressively being able to maintain that we think is a great goal if it increases a little bit from our perspective that’s our potential upside. So I think that’s probably the way we think about the expansion, do we see other providers in a space kind of the second part of your question. We do at time see other providers when we go into brokerage other people might have gone in and we think one of the unique things that we offer besides the fact that we are not competitors to these brokers, is the fact that we have got significant data integration capability. And we do this with hundreds of providers across the country and really it’s the combination of our sales organization focused on the broker the fact that we don’t compete with them. And then most importantly that we have the data integration capabilities that we are looking for and we don’t see that very much in the market place and the brokers don’t see that available from very many players. So that’s really the combination has been unique value proposition to the broker.

Okay, and then you mentioned some pull forward in the quarter, but even when you met that out I mean I think this is the best outperformance you had since the public, so what drove that I guess is the bigger deal size is it more a velocity, lower churn, what are the different components of that. And then can you remind us when you look at sort of isolates from new deals, how much bigger are those in terms of ASPs versus your sort of average customer across the entire bay?

Yes, so I think there are several questions to built into that, it is mostly driven by performance from our sales organization, we are pretty methodical in the planning around our retention rates what’s happening with our customers, it’s new revenue that’s being driven to the organization that driven that outperformance for the quarter. We are very pleased with the performance from our sales perspective. From a average revenue per customer that’s something that we will provide more color at the end of the year, we do actually like to really focused on measuring that at the end of the year, because there is a lot of volume coming on in this third quarter as well. So from our perspective we are seeing good trends around new business acquisition, we focused on revenue first. And at the end of the year we’ll give guys a sense in terms of what that average revenue per customer looks like, but we have seen some good progress with some of the new module we released as we’ve talked about before something like on boarding got some very good traction for us in the marketplace.

Okay, and what is churn doing, Steve that it’s staying I think similar to 92, but if you even pass it further as it improving as it getting more staying pretty consistent?

I think we are very happy with where our overall retention rates have been historically and we talk about that being 92% plus, they continue to be 92% plus and we think that’s absolutely best in class. So we're focused on maintaining a very similar retention rate as we continue to grow at these aggressive rates.

Okay great and then one more if I may on the in-house opportunity where you talked about seeing more of those replacements. Is that - if you look at the overall market what's your guess of in the middle market what that looks like in terms of percentage using something in-house versus ADP or HX or something else?

Yes, I think it’s difficult to get your arm specifically around that. There is a not a lot of third-party studies around sizing in-house versus kind of an outsource traditional service provider, think the traditional service providers plus the local and regionals would be the majority of the market, but it wouldn’t surprise if in-house was 30% or 40% based of my experience versus some third-party study.

Okay great. Thanks very much guys, great quarter.

Thank you.

Thank you. Our next comes from Kash Rangan from Merrill Lynch. Your line is open, please go ahead.

Hi, thank you very much. Steve, I’m curious if I can get your comments on number one, any change in the competitors from whom you are getting business and number two any change with respect to the new modules on top of the core that you are getting increasing attach and thirdly any views on sales capacity expansion going forward. Thank you very much.

Yes, let me start with the last one first. Our cycle from a sales capacity perceptive, we are just in the middle here of our third fiscal quarter of the year, we do most of our hiring in the spring timeframe and so we're just going to start that planning process here as we come into the March timeframe. So I don’t really have any color for you yet in terms of what we are looking for new heads, we’ll obviously give you that as we wrap up the fiscal year. So trends from a competitive perspective another part of the question, I think as I mentioned in my prepared remarks we have seen most of our activity in the sales force as well as new customers coming on board from the traditional payroll providers, so ADP and pay checks make up the majority of new business and that trend continues to be the case. The one unique element is due to some of the changing laws in 2015, due to healthcare reform we have seen more in-house clients evaluating their existing systems and seeing if they can handle some of these legislative changes in a more automated fashion and we did see that percentage increase a little bit in the quarter.

And if I could…

Go ahead.

And if I could… Yes go ahead. Yes go ahead.

You want to ask what the tax rate, I think it was the third piece of the question.

Yes.

Overall we're seeing, I would say its fair to say that we are seeing customers continue to buy the entire HCM platform that has really become the differentiation point, its not just about payroll anymore, its about the broader HR capabilities, we are seeing great attach rates in employee self services and human resources, we're seeing growing rates and benefits in onboard and so overall we’ve been pretty happy with how the investment in R&D is really allowing us to differentiate in the marketplace.

And finally if I could Steve, ADP, Paychex have been talking about cross-platform, what in your opinion has still allow velocity to continue to how to execute against legacy companies that are putting on a new story to their approach?

Yes, I think that you’ve seen Paychex and ADP talk about their investments in technology over the last several years. I think we’ve advantage that we built this application organically from the ground up using our most recent technology, delivering a very unified experience to the customers. And when we get in there with prospects and we are able to demonstrate them how easy it is to use, how simple it is, and how can automate a lot of their processes, but they are seeing the value and I think the evidence is the fact that we continue to see the same percentage of business from ADP and Paychex regardless of the platform change.

Thank you.

Thank you. Our next question comes from Brian Peterson with Raymond James. Your line is open. Please go ahead.

Hi, guys, congrats on the quarter and thanks for taking the question. So I wanted to hit on the in-house replacement that you guys referenced. When you look at the size of your pipeline maybe a few quarter ago, do you actually see this as an incremental opportunity versus what you’ve may have hoped for then? And you referenced potentially 30% of the market out there with in-house. Do you see in-house is potentially anywhere close to that size of our current pipeline?

Yes, that’s a good question. We have traditionally gotten less of our business from in-house than what is generally available in the marketplace. So this is not been our focus. And frankly I won’t see that changing in the immediate future. Lot’s of time these in-house leads are coming from brokers or reaching out directly to us. We spend most our time prospecting versus the traditional payroll service providers. So although I think it’s an incremental opportunity I wouldn’t want to give you a sense that that’s going to really kind of change our trajectory or whoever getting our business from.

Okay, got it, thanks. And just on the guidance, so even if I adjust for the 200 basis point impact benefit this quarter and I strip that out for the fiscal 3Q outlook I’m getting the kind of mid 30% sequential growth. I think the last few fiscal 3Q quarters, it’s been closer to 40%, is there anything to suggest that seasonality may have slowed down there or you just embedding some conservatives on that? Thanks.

Well, I think you got to go back to our business model and it’s a pretty big quarter for us and third quarter we do a lot of new business, it’s a big quarter from a retention perspective and so we got to factor in all those when we look at our guidance. And the reality is we got to sell and we got to implement pretty much in the quarter that we are talking about and so we try to really factor that into the guidance and that’s what we did this quarter.

Our next question comes from Pat Walravens from JMP Securities. Your line is open. Please go ahead.

Hey, guys this is actually Matt in for Pat. I want to congratulate on a great quarter. I was curious if you could actually some of the main reasons that customers are staying with Paylocity, I know you touched on few of those, but if you could drive in, maybe the number one thing I would really appreciate it?

Sure, I think as I mentioned earlier we definitely see a lot of differentiation in the sales process. And then as we get the customers on the platform and the more they get their managers using it and their employees using it. The platform itself can be very sticky as evidenced by our retention rates. And I think that certainly one of the key factors. But I would say equally important is the fact that we are there for our customers when they need to reach out to us, when they need help, when they call us. If you think of mid market customers 100 employee plus average, they only have a few users and those users do need help if they go into a new state or try to implement new part of our system. So I think it’s a combination of having a differentiated platform and kind of backing that up with service, so that we are there for the customers and from my perspective that’s the winning formula and why they stay with us.

Okay, great. And then also did you guys see any benefit from the improving employment trends across small businesses?

From our perspective we take a look at that each quarter, we see what’s happening with our customer base, we are also adding a lot of customers, so there is no question in an improving employment trend market, we get a little bit of benefit from that, but when you are talking kind of 40% plus growth rate that we posted it’s still a relatively small percentage. So yes, a little bit half of that, but not that big in terms of order of magnitude.

Got it. Thanks, guys.

Thank you. Our next question comes from Jim Macdonald from First Analysis. Your line is open. Please go ahead.

Yes, good quarter guys. Just scrolling up on one of the previous question. So it seems like your guidance implies a pretty good year end selling season in your March guidance, could you give us some color about how the year end went?

Yes, I think the way we look at year-end activity, its very much an activity driven model, we task our sales force with revenue targets and then as we go through selling season we look at the amount of activity they have got in front of prospects, the number of prospects they are seeing and you know for us to have a really great year-end we need these first year reps so we hired a number of them to really ramp up in productivity. So we saw pretty strong activity level going into the selling season, January just closed, so we're still wrapping up the details with January as we speak, but we feel very good about the sales performance overall through the year-end selling season.

And you may not give this at this point, but could you talk a little bit about your increase in number of brokers you have kind of signed up as partnership.

Yes, I actually – I mean we look at this more on an annual basis, so I don’t actually have the numbers in front of me Jim, but I would tell you that we are absolutely adding brokers to our broker network and we're also getting more leads from current brokers. So its both of those things are happening and that’s driving the fact that we’ve still been able to get more than 25% of our business and we need both of those things to happen from a long-term perspective to be able to build that channel.

Just one more question I’ll try here. Although I may not get any answer. What's the latest on buying the second distributor?

Yes, so just as a reminder we purchased one reseller at the end of last fiscal year, we now have the option as of this fall to purchase a second reseller in the New Jersey market, we certainly have made no final decisions, otherwise we would have made announcements on that. So there is a variety of factors we have to look at in terms of customer transition, time of year, so as soon as we make that decision we would communicate it, it certainly makes economic sense for it, we just got to make sure that the timing is right and we’ve got the right transition plan in place.

Great. Thanks a lot. End of Q&A

I’m showing no further questions at this time. I would like to hand it back over to management for closing remarks.

Well thank you very much for everyone dialing in today, I hope everyone has a great evening.

Ladies and gentlemen, thank you for participating in today's conference. This concludes our program. You may all disconnect and have a wonderful day.