Paylocity Holding Corporation (PCTY) Q3 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Paylocity Third Quarter Fiscal 2015 Earnings 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] As a reminder, this conference is being recorded. I would now like to hand the conference over to Peter McGrail, Chief Financial Officer. Please go ahead.

Good afternoon and welcome to Paylocity's earnings results call for the third fiscal quarter of 2015, which ended on March 31, 2015. 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 third quarter earnings call. Let me start by sharing a few highlights from the third quarter. Our third fiscal quarter was very strong across all of our key metrics. Total revenue was up 40% year-over-year with recurring revenue up 41%. Adjusted recurring gross margin increased 4.4% to 73.8% for the quarter up from 69.4% for the same period last year. The improvement in adjusted gross margin expansion was driven from a combination of the reseller purchase completed at the end of last fiscal year along with driving leverage in our business model as we scale. Adjusted EBITDA of $7.5 million was up 45% from the same period last year to reflecting the margin improvements. Our fiscal third quarter is our largest revenue quarter as it includes high margin calendar year-end revenue associated with annual tax filing and W-2s. We completed the acquisition of our New Jersey reseller during the month of April. With this purchase of our last reseller, the Paylocity sales force now provides national sales coverage. The third fiscal quarter is not only our largest revenue quarter, but the largest quarter for on-boarding new clients as many clients choose to switch platforms in January. We were very pleased with our performance this quarter as we sold and implemented a record number of new Paylocity clients. The demand environment remains strong as mid-market clients search for a unified platform that combines robust payroll in human capital management functionality with a modern interface that is easy to use for every employee in the company. We believe we are in the early innings of this long-term transition to SaaS, and our modern architecture and consumer-oriented user interference provides significant advantages versus the traditional payroll providers. The majority of our new business revenue in the quarter and fiscal year to date was generated from clients moving from traditional payroll service providers to Paylocity. The referral network of 401K advisors insurance brokers and third-party administrators remains a very important part of our go-to-market strategy. The referral network continues to provide more than 25% of our new business revenue in the quarter. We are gaining additional momentum with help and benefits brokers. They are increasingly seeking a technology partnership that allow them to effectively manage the complexity of healthcare reform legislation for their clients while at the same time protecting them from traditional payroll providers, PEOs, and newer technology entrants, all competing for insurance commission revenue. Our combination of an industry-leading software platform, including a comprehensive Affordable Care Act module, experienced feet on the street sales force, and extensive data integration capabilities makes Paylocity a natural partner. The success in the broker channel combined with our expanding platform has allowed us to continue to drive increased productivity in our sales force. The combination of a very strong year-end selling season, along with marketing spend to support our broker channel, resulted in a 38% increase in non-GAAP sales and marketing expense this quarter compared to the same period last year. Not only is this quarter important for new business sales, but it is also a very important quarter for all of our operational teams. I am very proud of the effort from all of our teams as we continue to deliver revenue retention that exceeds 92%. We expect to increase our pace of hiring for our client service teams in the fourth quarter based on the strong year-end sales results. We will also be hiring service staff earlier than prior years to make sure our new team members are fully trained and ready to support our clients as they navigate their ACA responsibilities. We expect that the majority of clients' employees will be required to file annual 1095C forms this calendar year end, and we are excited about the opportunity to help our client and channel partners navigate the complexities of ACA. I would also like to take this opportunity to welcome Mark Kinsey, our new Senior Vice President of Operations. Mark's leadership experience running large complex client facing teams will allow us to scale the organization with a continued focus on delivering the highest quality service to our clients. One of the key drivers behind our IPO was to provide the ability for continued investment in our industry-leading platform. We continue to drive innovation in our platform, releasing new features and enhancements to the user experience every quarter. We assign small 13-person agile teams to specific product categories, allowing us to add additional teams as we grow, while maintaining a creativity and entrepreneurial culture. We have increased R&D investment by 55% for the first nine months of the year when you combine what we capitalize and what we expense versus the same period last year. Hiring talented R&D team members is a challenge for all software companies, and we are pleased with our pace of hiring, which increased toward the end of the quarter and into April. This hiring momentum in R&D will allow us to continue delivering innovative solutions for midmarket clients as we execute on our long-term product roadmap. The talent management category is a great example of where we are realizing some of the benefits from this increased investment. We are beginning to see more demand for our onboarding product and newly refreshed performance management application. We believe this is a combination of Paylocity's differentiated offerings in this category along with an increase in overall demand for talent management software in the midmarket. Based on the strength of these new products, we have been able to revise our talent management pricing strategy resulting in a $10 increase per employee per year. This change increases our total maximum revenue opportunity to $230 per employee per year. In summary, I'd like to thank our more than 1,000 dedicated employees for making the busiest quarter of the year a success. I would now like to turn it over to Peter to review our financial results in more detail.

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 $47.3 million, which represents a 40% increase from the same period in the prior year. As Steve noted, third quarter revenues are impacted by new clients changing payroll providers at the beginning of the calendar year as well as annual tax filings including W-2 processing. Our revenues have two major components, recurring and non-recurring. Our recurring revenue has historically represented about 92% to 93% of our overall quarter three revenues in a 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 third quarter, our total recurring revenues of $43.9 million was up 41% from the year ago quarter and represented 93% of our total revenue. Recurring fees were up 41% in the quarter. Interest revenue was up 22% year-over-year as a result of our growing average balances. Our nonrecurring revenues are compromised 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 $3.3 million for the third quarter up 31% from the year-ago quarter. The combination of high-recurring revenue percentages and high retention rates, provides 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 others. These two numbers are combined to form our overall costs and then to produce our overall gross profit margins. We refine our gross margins further by providing adjusted numbers. We adjust for two items. First, we exclude costs related to stock-based compensation, and second, we exclude amortization expenses 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 the adjusted numbers provide the best and most reliable comparison to other SaaS companies. Adjusted gross profit in the quarter was $29.4 million, representing a gross margin of 62.3% as compared to $19.6 million or 58.1% in the year-ago quarter. This improvement was primarily the result of the acquisition of one of our two resellers in May of 2014 and natural leverage. As Steve mentioned, we just completed the purchase of our remaining reseller during late April of this year. So as we anniversary the margin improvement from the first reseller, we will begin to see margin improvement associated with the second reseller. 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 $32.4 million or 73.8% in the quarter up from $21.7 million or 69.4% in the year-ago quarter. Again, this improvement was primarily the result of the acquisition of one of our two resellers in May of 2014 and natural leverage. We are pleased with the improvement we've seen in fiscal year 2015 in our adjusted recurring and adjusted total gross margins as compared to the prior year as we ultimately work toward our long-term margin targets in each of these areas. As noted in our last few earnings calls, 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 at industry events and cultivating our relationships with our unique broker referral channel. 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 $5.3 million or 11.1% of revenue in the quarter compared to $3.4 million or 10% of revenue in the year-ago quarter. On a year-to-date basis, research and development investments were $14.8 million or 13.1% of revenue compared to $9.5 million or 11.9% of revenue in the prior year-to-date. On a non-GAAP basis, sales and marketing expense increased to $11.8 million or 24.9% of revenue in the quarter compared to $8.5 million or 25.2% in the year-ago quarter. On a non-GAAP basis, general and administrative costs were $7.4 million or 15.6% of revenue in the quarter compared to $4.7 million or 14.1% of revenue in the year-ago quarter. Fiscal year 2015 represents our first full year as a public company. Our adjusted EBITDA was $7.5 million for the quarter versus $5.2 million for the year-ago quarter. Non-GAAP net income per share was $0.11 for the quarter based on $52.2 million diluted weighted average common shares outstanding. Briefly, covering our GAAP results. For the quarter, gross profit was$28 million, operating income was $1.7 million and net income was $1.8 million. Like others in our industry, we collect funds from our clients in advance of making payments to employees and taxing authorities. Our cash flow through investing in financing activities are influenced by the timing and amount of funds held for clients, which varies 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 $93.2 million. From a cash flow perspective, we generated $9.4 million in cash from operating activities in the quarter ended March 31, 2015 and spent $2.2 million on property, plant, and equipment. Finally, as we’ve stated in the past, we experienced fluctuations in revenues and related costs on a seasonal basis. Revenue in the third fiscal quarter is always our largest due to our annual recurring billings attributable to the preparation of W-2s and other annual tax filings. January has also historically been the month where we generate the most new client’s docs during the year, and this year was no exception. I'd now like to provide our financial guidance for the fourth quarter and update guidance for the full-year of fiscal 2015. Total revenue for the fourth quarter is expected to be in the range of $37.5 million to $38.5 million. Adjusted EBITDA is expected to be in the range of negative $1.2 million to negative $0.2 million. Non-GAAP net loss is expected to be in the range of negative $3.7 million to negative $2.7 million or negative $0.07 to negative $0.05 per share based on approximately $50.7 million basic and diluted weighted average common shares outstanding. We are raising our full-year guidance as follows. Total revenue for the year is expected to be in the range of $150.2 million to $151.2 million. Adjusted EBITDA is expected to be in the range of $6.5 million to $7.5 million. Non-GAAP net loss is expected to be in the range of negative $1.8 million to negative $0.8 million or negative $0.04 to negative $0.02 per share based on approximately $50.2 million basic and diluted weighted average common shares outstanding. In summary, we are very pleased with our operational performance during the third fiscal quarter of fiscal year 2015. Before turning the call back to the operator during the upcoming quarter Steve will be at the William Blair technology conference on June 10 in Chicago. Operator we are now ready to begin the Q&A session.

Thank you. [Operator Instructions] Our first question comes the line of Justin Furby from William Blair.

Hello, guys. Thanks for taking my questions, and congrats on another stunning quarter. I wanted to hit on gross margin, particularly given the recent reseller buyout. You guys saw a really solid result here. It looks like you're tracking to 70% plus for the full fiscal year. And I guess I'm just wondering as you look up the next two to three years, where do you think that goes in terms of overall recurring gross margins and then just overall gross margins in general? And then I've got a couple of follow-ups.

Sure. So I think we've obviously outlined the impact of the resellers in terms of the impact on the overall gross margin. As Peter mentioned in his comments, just completing the last acquisition of the reseller, we'll get some benefit over 12 months from the second reseller. I guess the way we think about gross margin is this natural a scale business and we are committed to gradually driving margin it expansion over time we certainly had a big quarter from a margin expansion perspective largely driven from fantastic performance in sales revenue that dropped to the bottom line. So we certainly had more margin expansion and we had expected. And so we’ve tried look at this over the long-term and we are focused on driving approximately 80 basis points to 100 basis points in natural levels outside of the resellers that may not happen in a perfectly straight line there is time to we get a little bit more margin and there might be times where we invest a little bit more about I think the important point is philosophically, we understand that gross margin expansion is important and it something that we are committed to driving over the long-term.

Okay, and what about overall gross margins, Steve? Do you expect the mix of recurring versus services to stay consistent and should we think about services gross margins as being roughly consistent with where they have been?

Yes, good question we do think about being roughly consistent in terms of what they have been so assuming a similar growth rate then we would roughly they would have a similar impact to us if our growth rate obviously was reduced it would be a smaller portion. So although the margin would still be negative, it would count for a much lesser than impact so it can actually increase overall gross margin. But we have been very consistent in terms of our growth rate as you look at our first year is a public company and so that as not necessarily had been a benefit for us been roughly consistent.

Okay. Great. And then you guys obviously keep stepping on the gas on the R&D line in terms of your investments. And we're now a little over a year out post-IPO. And I guess I'm wondering is if you're able now to go into deal cycles and show to prospective customers these investments and whether that's a big differentiator in deals where you're going up let's say against some of the other mid-market SaaS competitors.

Sure, I think that we absolutely believe that our product differentiation is the number one reason why companies are choosing the Paylocity platform, and the investments in R&D are fuelling that. And I think probably the easiest point of evidence towards that is if you look at our average revenue per customer increase over time, that is largely coming from us selling more product to these new customers. So not only are they seeing the differentiation, but they're buying more product from us on an ongoing basis. On an annual basis, we'll give you our client count, you'll be able to calculate kind of that increase in average revenue per customer but as you look over the last few years, we've been consistently in the low to mid-teens in terms of that average revenue per customer increase. And I believe that that's really being driven by adding capability and functionality to our platform and then seeing those adoption rates increase.

Okay, great. And then last question, in terms of sales hiring, I think you're kind of going through that process right now ahead of fiscal year end. I'm wondering could you give an update in terms how you feel about the recruiting process, and should we be expecting a similar level of growth in overall sales headcount as we've seen the last few years? Thanks.

I would tell you that we are in the throes of the planning process for next fiscal year, as you would expect this time of year. As we have mentioned on prior calls, our sales recruiting process happens once we finish the calendar year end. It does kick up kind of in March, and this will continue all the way through into the first quarter of next fiscal year. And the way we look at this is, although we haven't finalized our targets, and we'll certainly give you a headcount on our annual call when we complete that. We feel really good about our progress so far. So we've started recruiting pretty heavily in March. We've had new hire classes in March, into April, and into May. And so we look at our performance relative to where we were last year at this same time, and we feel very good about where we're at with our headcount as we start increasing towards our target. We haven't finalized that target but we're pretty close and we've got really good momentum from a hiring perspective. Things are going well.

Okay, great. Thanks very much, guys and congrats.

Thank you.

Thank you. And our next question comes from the line of Terry Tillman from Raymond James.

Hey, Steve and Peter, can you all hear me okay?

We can Terry.

Yes.

Okay, well I'll use a different adjective. I'll say spectacular. Spectacular quarter. I guess I had a series of questions, too. The first question, Steve, relates to bookings activity. It sounds like you're indicating there was strength in the bookings activity. But what about the typical size of new customer deal? Was that remaining in that kind of sweet spot of about 110 employees? And then what could you articulate about the booking strength? Was there much benefit from your last round of sales hiring? Or is that still more productivity gains to be had in the future?

Yes, good question, Terry. So first of all, the overperformance that we had in the quarter was certainly driven by a strong sales performance. So, you are correct. We were very pleased with that in the quarter. It is the quarter where we start seeing some of our newer reps hit full stride and start to perform. So as you think about it, we hire in the spring all the way through the end of the summer. They're selling to a lot of customers who like to start in the January timeframe. That's were we start to see them have an impact. So the combination of overperformance was driven from both our experienced reps having success, but also the new hires from our last new hire class last year, really starting to hit the stride. So we had good productivity from both camps.

And following on Justin's questions about product innovation, and you emphasized it a lot in the prepared remarks and when we've spoken to you in the past. Clearly, it's a competitive weapon, but I'm sure it's when you're facing off against the traditional incumbents, the service-oriented companies, the service bureaus, if you will, what are the competitive responses like? Is it the same type of competitive responses or are you seeing any change or any shift or pivot to focus more on product innovation from some of your peers?

Yes, so I certainly think that the industry as a whole is moving towards much more of a technology evaluation when they're looking at alternatives. So the fact that we've got a newer technology and that we believe we've got leading application for midmarket companies as the primary point of differentiation, but I would tell you that the traditional payroll service providers understand this as well, and they certainly have every intention of investing in technology and trying to be competitive. We still believe we've got a lead in the marketplace and that's also why you'll hear a lot of passion and energy around continued investment in R&D so that we can maintain and maybe even extend that lead over time from a differentiation perspective. So we see them responding by adding capabilities and functionality to their platform, but we're also doing the same. And I would tell you that certainly in the quarter, the number one reason customers are coming to us is absolutely our product differentiation. So we feel confident we can continue to invest properly in R&D and get a return on that.

Okay. And then my last question just relates to, you give us a good update on the per employee per year now that you're able to garner I think $230 and you released a couple new modules, onboarding and a benefits module in the recent past. How do we think going forward? Are there major gaps still in your suite that you need to fill? Or is it more of just incremental enhancements and going deep with what you've already got, and then we could see a steady increase in that per year economics you get? I'm just trying to understand kind of product vision and if there are major holes to be filled how we could see a steady increase potentially in per employee per year? Thanks.

Yes, so we like to divide our product into five categories, so payroll, human resources, time and labor, benefits, and talent management. And so I think it's a little bit of a mix. There's an opportunity potentially for us to add new modules and capabilities that will increase that per employee per year number from $230. We have a long-term goal to be able to drive that to $300 per employee per year. We've got a roadmap that we feel we will execute towards those objectives. But a lot of it is also going to be enhancing the application, adding capabilities, tweaking it so that we can get more dollars out of each of those categories over time. So I think you're going to see a mix of additional modules and capabilities and then enhancements to those categories that allow us to get a little bit more per employee per year dollars out of each of those categories. Payroll is probably the hardest one to do because it's the most established, but certainly we see room in all four of those other categories over time.

Okay, it sounds good, thank you.

Thank you. And our next question comes from the line of Pat Walravens from JMP Securities.

Great, thanks. It's actually Pete Lowry in for Pat. I'd like to echo the congratulations on a great quarter. I guess first, as you think about the land and expand strategy, I know typically you've been in the expand phase. Where do you think you fall on the spectrum of land bursts expand currently?

Yes, so I would tell you that I think we are still focused primarily on the land part of a land and expand strategy. Most of the average revenue per customer increase that we've gotten historically has been from selling more to new customers, and I don't think that that trend has changed in our most recent past. That will continue to be a focus. We will continue to evaluate the expand opportunity. And we're kind of in our planning process for next fiscal year, and I would think that over time, we'll start to expand a little bit more. The way I think about this is land is the first and most important priority. That's where we're spending most of our time and energy, and you'll start to see a little bit of expand grow into our strategy over time gradually.

Okay, thanks. And then as you continue to sustain growth rates at north of 40%, what are the most challenging aspects of managing that growth?

Well, we've been very consistent as you can see in our first full year as a public company in terms of gradual margin expansion, consistent revenue growth. I think from my perspective, the consistency and we've obviously done that even in prior years, so we’ve been very consistent in operating at a fast-growth pace that's around 40 growth historically. And I think we've become pretty adapt at being able to manage that in all facets, whether it's the go-to-market strategy, training a sales rep, hiring the sales rep, implementing the new customers, driving a high quality service level experience. It's hard to pick out any of those. Frankly, it's obviously hard in a fast-paced environment to be able to execute. But I think we've proven historically we've been able to do that. At the same time, we've got to stay focused on investing in R&D for the future. And so that's something that even though we're having great success in the market today, we're not losing sight of the fact that we've got to continue to advance our solution going forward, and in many cases sometimes it's hard to keep focused on both of those things, executing for the present and investing for the future. But I think we've got a nice balance going on right now.

Great, thank you.

Thank you. [Operator Instructions] Our next question comes from the line of Jim MacDonald from First Analysis>

Good afternoon, guys, I hope you can hear me.

Yes, we can hear you Jim.

Great. Question on the New Jersey reseller, do you expect a similar impact as the California reseller? Is it bigger or smaller?

That’s a good question Jim, this is Peter. Just to provide some color for those who are listening who don't quite understand what our resellers were. We had two resellers we signed up back in 2007 and we purchased one in May of 2014 we’re anniversarying that now. That one was in the Southern California area; this one is in New Jersey, that geography. To understand the mechanics, we pay them back through – we pay a revenue share back to them through cost of revenue. This reseller was just a little smaller than the first reseller, and we’re little bigger than - or 40% bigger than when we bought the initial reseller. So the impact will be a little bit less that this reseller from the first reseller. We're still in the planning stages for next year, but to give you some sort of benchmark, we’re thinking around the 150 basis point improvement in margin over the next four quarters or so. So slightly less than the first reseller, given the dynamics I just talked about.

Thank you. And our next question comes from the line of Kash Rangan from Merrill Lynch.

Hey, guys, thanks for taking my questions. Could you talk about the comparable environment, the run rates, and who you're running into? Has there been any change in that trajectory?

Yes. Thanks for the question, Kash. I would tell you that as we look at the competitive environment, and we stay very close to this every quarter. It's a big selling quarter for us, the first calendar quarter of the year and our third fiscal quarter, we see really similar trends. So we get the majority of our customers moving from traditional payroll service provides. We have this entire fiscal year seen a little bit more activity from customers who are in-house. We believe that the reason that is the case is because of the healthcare reform and the ACA laws that are going to be taking in effect the balance of this year, and customers are searching for a way to be compliant with the annual filings that will be required. So I would tell you that's probably really the only thing that stands out as we're seeing a little bit more volume. That's not a huge category for us, but it has spiked a little bit. Other than that, it's mostly the traditional payroll service providers. We rarely see someone like an Ultimate Software because they're a little bit larger into the space. So it's all the usual suspects.

Got it. And final follow-up question is, when you look at your installed base, Steve, what do you think is the opportunity for - I know that you're not yet focusing on the expand side of the equation, but when and if you choose to do so, what is the realistic addressable market within your installed base as to what percentage of folks might be using other solutions that may be hard to displace versus folks that are more likely to go with your additional modules? Thank you. That's it for me. Congrats.

All right. Thanks. So we do think that the expand opportunity is one that will be material to us, without question. As we continue to invest in R&D and we continue to increase the product portfolio and we continue to drive that average per employee per year up on an ongoing basis, then that increases that opportunity. And so we’ve had great success with onboarding in the marketplace, primarily selling that to new customers. We have done so a little bit to existing customers, more because they've asked than anything. And so I will tell you that you're going to see this as we kind of come to the end of the year. You'll look at our kind of unit growth and average revenue per customer growth, and that's going to give you directionally a better idea of what that opportunity might look like. But I think over time you'll just start to see that expand opportunity maybe a little as we move into next fiscal year, but more so even beyond.

Thanks so much. Keep it up. End of Q&A

Thank you. And that concludes our question-and-answer session for today. I would like to turn the conference back over to management for any closing comments.

I'd like to take the opportunity to thank everybody for dialing in today, and also thank you for your interest in Paylocity. Thank you very much and have a great evening.

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, and you may now disconnect. Everyone have a good day.