Paycom Software Inc (PAYC) — Q2 2015 Earnings Call Transcript

Thank you, and good afternoon. Before we get started, I would like to note that certain statements made during this conference call that are not historical facts, including those regarding our future plans, objectives, and expected performance are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements represent our outlook only as of the date of this conference call. While we believe any forward-looking statements we have made are reasonable, actual results could differ materially, because the statements are based on our current expectations and are subject to risks and uncertainties. These risks and uncertainties are discussed in our Annual Report on Form 10-K that was filed with the Securities and Exchange Commission on February 26, 2015, and as maybe supplemented by subsequent Form 10-Q filings. You should refer to and consider these factors when relying on such forward-looking information. We do not undertake and expressly disclaim any obligation to update or alter our forward-looking statements, whether as a result of new information, future events, or otherwise except as required by applicable law. Also, during the course of today's call, we will refer to certain non-GAAP financial measures. A reconciliation schedule showing GAAP versus non-GAAP results is included in the press release that we issued after the close of the market today, which is available on our website at investors.paycom.com. I will now turn the call over to Chad Richison, Paycom's President and Chief Executive Officer.

Thanks, Craig, and thank you to everyone joining us on today's call. In the second quarter of 2015, our sales momentum continued with revenue of $49 million. This represents growth of 47% compared to the second quarter of 2014. Revenue for the first six months of 2015 grew 48% compared to the comparable prior-year period. Annualized new recurring revenue or ANRR was $16.5 million, representing growth of 43% over the second quarter of 2014. Our cloud-based offering continues to gain traction in the marketplace, as both managers and employees recognize the advantages they can enjoy with our intuitive single-database system. The foundation of our ongoing sales success is our industry-leading solution. To maintain this leadership, we are relentlessly focused on software development. In addition to rolling out new applications, we also continue to deepen the functionality within each of our existing offerings. As a result, we once again more than doubled our research and development expenditures, growing our investment 103% year-over-year on a non-GAAP basis. In the second quarter, we augmented two of our existing solutions with the release of Enhanced ACA and GL Concierge. I will spend a few minutes describing each of these offerings and how they will provide businesses with the premier solution in their respective categories. We were excited to deliver a new Affordable Care Act compliance offering to the market in our Enhanced ACA application. While we already provided an intuitive and convenient ACA dashboard that has been very well received, our Enhanced ACA application offers even greater functionality to our clients. Based on feedback from our well-attended monthly ACA webinars, we believe businesses are more concerned than ever about the employer mandate reporting requirements. With this in mind, we set out to aid businesses in their pursuit to better monitor, report, and evaluate the organizational needs in order to comply with this significant piece of healthcare reform. Before Enhanced ACA, we provided clients with the ability to run reports and track and set required ACA periods, all through our ACA dashboard. With Enhanced ACA, users are able to get up-to-date information and proactive alerts when approaching applicable large employer status and when part-time or hourly workers are nearing full-time status. This new solution also offers easily accessible historical data for audit purposes, advanced reporting including action items, as well as updates on legislation and compliance requirements. Additionally, with Enhanced ACA, we remit Forms 1094 and 1095 on the client's behalf. As employers gear up to report for the first time in 2016, we have had numerous clients sign up for the enhanced ACA service. We expect this momentum to continue as we near the end of the year, for which the required data and reports will be filed with the IRS and furnished to individual employees. Our second major development for this quarter was General Ledger Concierge. GL Concierge gives accounting professionals expansive General Ledger mapping, transparent auditing, customizable file layouts, and intuitive reporting capabilities, as well as real-time alerts on items impacting that reporting. Our General Ledger application is completely customizable allowing companies to automate the import feed to various accounting software solutions. Through our push reporting application introduced last summer, on-demand GL reports can be automatically generated and sent to all necessary recipients within an organization. We are seeing strong demand for this payroll GL application, and we expect this demand to continue. These new applications underscore the power of our substantial and growing solution. While we are seeing a strong reception for these new offerings, they are still in initial rollout and we anticipate their respective financial contributions will be modest this year. I'd like to take a moment to provide a quick update on Paycom Learning, our recently launched learning management system or LMS. We are proud that our software is streamlining and formalizing companies' training processes and helping them enhance and maximize the value of their human capital. Since launching the application in February, we have seen a strong reception from the marketplace. Through Paycom Learning, businesses are engaging with their employees and taking advantage of our ability to pull courses into the onboarding process, consolidating what were once multiple tasks into one. Here is a quick real-world example of how our LMS application helps our clients. A large auto dealership group added Paycom Learning and is enjoying the functionality that derives from our single-database solution. With our system, they are able to store certifications for dealership compliance, audits in one system, and can easily pull courses into employees' career paths to help those workers achieve individual career goals and fill mission-critical roles. This is just one example of a trend that we are seeing across many clients in the industries. Our expanding solution and the growing awareness of our single-database human capital management or HCM offering continue to allow us to reach up-market to larger organizations. I'm happy to share that we continue to bring on larger clients in the second quarter, and we would like to take a minute to highlight three new clients we won this second quarter. First, we added a large disability and senior support services organization that operates across several states. Prior to joining Paycom, the 5,000-plus employee company was using numerous tools that resulted in an incomplete HCM process. This client now uses multiple applications within our software to streamline their HCM practices and is extremely pleased with the benefits they receive by deploying our solution. Next, we won a facilities management company with nearly 2,500 employees. They had also been utilizing multiple methods to meet their payroll and HCM needs. They are now using several Paycom applications to enjoy a full HCM deployment that should greatly enhance their business practices. In addition to the anticipated $70,000 in annual cost savings, this client looks forward to a potential $200,000 in Work Opportunity Tax Credit that our solution will help them realize through strategic candidate sourcing and hiring. Finally, we brought on a restaurant group that was utilizing a professional employer organization or PEO service prior to Paycom. The group, which has over 3,200 employees, added numerous Paycom applications, including time and attendance, benefits administration, E-Verify, applicant tracking, and Paycom surveys. These are just five of the multiple Paycom products that the group added. Businesses like this restaurant group enjoy the flexibility and convenience of having an HCM provider that builds and develops its offerings in-house and delivers it within a single application. As I've stated on previous calls, we are continuing our trend of bringing on clients at or above the top end of our target range, as evidenced by these new client examples. These highlighted wins are indicative of our success in the marketplace that demonstrates the power and scalability of our software. In conclusion, we had a very productive second quarter. Our sales success continued, while our development engine fired on all cylinders. We are optimistic that our momentum will continue through the second half of the year and beyond. I will now turn the call over to Craig for an update on our financials and our guidance.

Thanks, Chad. Before I review our second quarter results and also our outlook for the third quarter and fiscal year 2015, I would like to remind everyone that my comments related to certain financial measures will be on a non-GAAP basis. Adjusted EBITDA and non-GAAP net income are non-GAAP financial measures that exclude stock-based compensation and other non-recurring charges including transaction expenses related to our initial public offering and our follow-on public offering. A reconciliation of our GAAP to non-GAAP results is included in our press release. Our sales momentum continued in the second quarter with total revenues of $49 million, representing year-over-year growth of 47% from the comparable prior-year period. Within total revenues, recurring revenue was $47.8 million for the second quarter of 2015, representing 97.6% of the total revenues for the quarter and growing 46% from the comparable prior-year period. ANRR was $16.5 million for the second quarter of 2015 compared to $11.5 million in the same period last year and representing 43% growth from the comparable prior-year period. As a reminder, ANRR is an estimate based on the annualized amount of the first full month of already onboarded new recurring revenue. Total adjusted gross profit for the second quarter was $41 million representing an adjusted gross margin of 83.6%. This compares to 80.9% in the second quarter of 2014. Our gross margin strength was driven by revenue outperformance as well as ongoing cost discipline. Turning to operating expenses, as a reminder we pay commissions to our sales reps based solely on new sales at the time of their first monthly billing cycle. This is a one-time commission that we recoup over the life of the client relationship. When we experience strong sales performance in a quarter, there's a potential for us to see increased expenses in that quarter depending on the timing of the client's onboarding process. For the second quarter, total adjusted administrative expenses were $30.1 million. This compares to $23.2 million in the second quarter of 2014. Administrative expenses declined as a percentage of revenue as compared to the first quarter of 2015, as we are beginning to see some leverage in our model. R&D expense increased to 103% from the comparable prior-year period. As Chad detailed, we're continuing to make investments to broaden our suite of offerings. Adjusted EBITDA was $13.1 million or 26.8% of revenue in the second quarter of 2015 compared to $6.1 million or 18.2% of revenue in the second quarter of 2014. Non-GAAP net income for the second quarter of 2015 was $6 million or $0.10 per diluted share based on approximately 58 million shares versus $2.1 million or $0.04 per diluted share based on approximately 52 million shares a year ago. You should note for modeling purposes that our stock-based compensation expense reached approximately $1.1 million per quarter, as we issued restricted stock under our long-term incentive plan in July. Turning to the balance sheet, we ended the quarter with cash and cash equivalents of $42.7 million and debt of $26.3 million. As a reminder, this debt represents the financing on our corporate headquarters. With that, let me turn to guidance for the third quarter and for fiscal 2015. For the third quarter of 2015, we expect total revenues in the range of $51 million to $52 million representing a growth rate over the comparable prior-year period of approximately 40.7% at the midpoint. We expect adjusted EBITDA for the third quarter in the range of $9 million to $10 million representing an adjusted EBITDA margin of nearly 18.4% at the midpoint. For fiscal 2015, we are raising our revenue guidance from $203 million or $205 million up to a range of $210 million to $212 million or 39.8% year-over-year growth at the midpoint. We expect adjusted EBITDA for fiscal 2015 in the range of $44 million to $46 million, representing an adjusted EBITDA margin of nearly 21.3% at the midpoint. In summary, we had an excellent second quarter and look forward to continued momentum through 2015. With that, we will open the line up for questions.

This is Harry on for Raimo. Thanks for taking the question and congrats on a great quarter. I was just hoping you could give a little bit of color on progress around new office openings. And now that we're heading into the second half of the year, if you haven't had any clarity or just initial thoughts on office openings in the New Year, I'd really appreciate any color around either of those.

We opened up five offices in the first quarter of this year, which was our largest year of office openings to date. Those offices are doing very well. All of our offices typically progress at very close to the same rate, especially in aggregate when you look at all of them. And so they are continuing to progress as well as the ones in 2014. We are always reviewing new opportunities. We will, in the future, have additional office openings, but we haven't announced any plans for that right now.

Maybe if I can just ask Harry's question a different way. You're growing really fast. You opened up five new offices this year and I understand how long it takes for the new offices to generate revenue and come up to speed. How many offices do you think you'd need to open in 2016 to keep the growth rate somewhat close to the same growth rate that you're performing in 2015?

Well, I think the growth rate that we'll have in 2016 is substantially dependent on the offices we've opened to date. I mean, as you know, and we've discussed prior in calls and in meetings, the offices that we opened this year are going to have a great impact in a couple of years. So they're not going to have a significant impact this year. And they're going to have a little bit of an impact next year, but not significant when you look at the overall number of offices that we have impacting our revenue. So to answer your question, the number of offices we would need to open in 2016 to impact 2016 growth number is minimal. But the number of offices we would need to open in 2016 to continue to work on our overall growth plans into the future, we're going to have to open some offices. We know that. We continue to identify areas, and we continue to be underpenetrated in the areas we're in today. And so we look at both current geographies for additional offices and/or leadership teams. And then we also look at new geographies. And so we're still going through that process. We do have a bunch of candidates that continue to build, and we do have mature sales managers who are also willing to help us expand in that area. And so that's really the way we view it.

And then the ANRR this quarter, obviously it couldn't have matched the 61% last quarter, but still just incredibly strong again. What is driving that? Was there any pull forward again like you said last quarter into Q1 or anything anomalous? So you mentioned ACA as a very strong uptick with customers. If you can maybe give us a sense of how much ACA impacted the ANRR this quarter and maybe thoughts on what the trajectory of ANRR might look like for the rest of the year, that'd be helpful.

ACA in itself or Enhanced ACA itself has very little impact on this quarter's ANRR. I think our position as a thought leader in being able to provide an Enhanced ACA software as well as corresponding service helps us win some deals because of the importance of the legislation and the impact of the filing if you don't file things correctly. And so I think that's helping us. What's happening is that we have both mature cities and new cities maturing, but within each of those cities, we have reps that are maturing all the time and these reps are selling deals and continue to bring in not only businesses that are at the top range of what our typical target has been, but we're bringing in more of them. And so it gets harder and harder to grow a grown number, but with proper product and a good sales staff and support group, we're able to do that.

I actually have a follow-up to Mike's question there on ANRR. We're seeing growth at elevated rates, 43% this quarter, down a little bit from the very strong quarter, as you pointed out last quarter, but still greater than the revenue growth rate last year, which obviously bodes well for growth this year net revenue. I guess, when I look back, and I look at the numbers it looks like there is an inflection point. Obviously, business is good, but over the last four quarters, we've sort of seen it, and I'm just curious if there is something that you can comment on around that timing? Was it partially due, Chad, do you think maybe to increased brand awareness from the IPO? Was that helpful? Is it just the timing of new modules coming out? And then just help us to understand, I mean it's a good thing, but just help us to understand what's happened over the last four quarters. I mean it was nice growth before that too, but we certainly have seen an inflection point in the business?

I mean, I can't say. I definitely do think having an IPO definitely didn't hurt brand awareness. I think there was also some significant motivation on our end, going through the IPO process, coming out the other end, standing where we stood at the time and just having this feeling of we can do a lot more than we're doing. And we really started down that track last year. But it was just one additional gear that we went through. I mean, we've had this type of growth or similar growth in the past as well. And so for us, it's just continuing to work to plan that we started working a while back. I do believe that as our product has matured and we've gotten better at each module, we become a much stronger prospect for other clients that are wanting to utilize this technology. And so we're having a greater number of wins and more of them, which you're going to have to have to grow a grown number.

Chad, I wanted to ask you, you referenced that you're bringing in businesses at or above the top of your targeted range in terms of size, and that definitely got my attention. So I was wondering if you can share any more color. Were there any unusually large clients you signed this quarter or are you seeing a change in that trend or the segmentation in the forward pipeline at all?

The answer to that is no. I mean, the size of clients, the difference between one client size and the other were very similar. There wasn't any client that stood out that made up the difference there. Well, the same as last quarter. There wasn't any client last quarter, when we had the growth last quarter that stood out. But what's happening is we're receiving more clients at that level. I mean, we were bringing on 4,000 and 5,000 employee companies five years ago, we just weren't bringing on as many of them as we do this year. I think it's also important for everyone to note that our focus hasn't changed in the size of clients we go at. We have a very strong value proposition. It's just that our products continue to mature, and as the value proposition resonates with people at the large end of our focus, more and more want to use it. But we're still very focused on the 50 employee to 2,000-market as well.

As a follow-up, I'd say the single biggest question that we hear from investors at an industry level is that there, frankly, is a pretty impressive breadth of HR software companies that are delivering profitable growth and seemingly living off the natural churn from ADP and Paychex and Ceridian and others, and combined with some ERP replacements and of course some greenfield opportunity or new business formation. But even the companies that are providing the churn seem to be doing fine, as I think you referenced in answering John's question. So there is question of just when will be the music end kind of at an industry level? And yet, we look at the combination of growth and margin that you're delivering here and it is in absolutely elite territory, no question about it. So I am curious, is there any change in the sourcing of the new deals that you're booking? For example, more or less success against the service bureaus or the ERP? Is there anything else? And is there anything you're seeing in the pipeline that would make you more or less confident in the ultimate size of the opportunity here for Paycom.

It's a very large TAM. I believe that the TAM continues to grow. I believe we're just entering the HCM technology phase. If you really go out and visit with the client, many of them are still using new technology the old way. And so I still believe we're at the beginning of where HCM is heading. Even with the deals that we've brought on from LMS, these are large companies and many of them were still doing it themselves through email and other ways. I believe it's still a developing industry. I think that probably accounts for some of the growth of others that are so large, the ones you've mentioned. The other, I would mention is there are very few of us that do full-service payroll. I know we talk about it, there are a lot of HCM companies out there, and there may be. But as far as when you're talking about the ones that are doing full-service payroll, tax, depositing, filing, and reciprocity law and everything else, I mean six or seven of us, and you name three of them. I do believe that's a special expertise that a few of us have that we do that we're good at. So I think the industry is growing. I don't see -- and the other part of your question was, are we seeing any difference in in-house versus those deals that are using another vendor, and it's still true today that the overwhelming majority, or greater than 80% of the business that we do receive comes from companies that had another vendor at the time of decision. We don't really see that changing. We don't expect competitors to stop innovating or trying to keep their client base. We expect them to do that, and we have our own strategy here for imposing our will and what we want for this company.

Craig, I might have missed this. But did you share with us customer retention rates for Q2?

No. We typically report customer retention rates on an annual basis, and we reported that at the end of 2014. And it was very consistent from prior years.

Any color on it in terms of change or anything along those lines?

No.

Chad, on the Learning Management Systems, I was wondering who you were seeing competitively? You mentioned in the prior question you're largely replacing going in situations where nobody had anything. But are you seeing competitors when you go in to bid for that business?

Yes. I mean, we do see competitors and it's all over the board. I mean it's a mixed bag of what I call point solution providers, which are providing just LMS and maybe mixing with a little bit of something else, and even maybe our premier competitors that we've kind of mentioned some on this call. So it's a mixed bag. I was more trying to illustrate the fact that there are still very large companies out there that are really not even in an automated system for LMS. I was just trying to set the stage for how I do believe we're still at the beginning of overall HCM usage. Not necessarily being sold, but how it's being used.

I know you talked about it on prior calls. But can you just remind us about your economic sensitivity and what you guys have seen in prior economic slowdowns?

We've been through. I mean we started our company in 1998. I can't really speak for everybody else's, but this business I do believe it takes a while to build it and then it's also fairly strong, once you're there. You do have base fees. You do have price proceeds. But we haven't really experienced -- well, we haven't experienced any type of hiccup through this economic downturn, if you want to call that, which definitely, when you look at some industries it qualifies. Nor did we in 2008, when we had the mortgage companies and the financial institution as well as energy going through something very similar. We're very diversified across all industries and many geographies. Our Florida office didn't go down in 2008 or Arizona office didn't go down in 2008, when you had the housing market and everything else. We typically -- definitely, I mean we're industry agnostic when it comes to that.

Chad, maybe a couple of questions around pricing to help us get a feel for no attach rates and penetration of the customer base. I guess, I'm curious on a per employee per month basis. What's a customer paying, if they sign up for just base payroll? And then what's kind of the average new customer onboarding at? And then if they bought everything, what would they be paying you? So it will help us get a sense for how successful you are attaching adjacent modules and then penetration of the base.

We don't disclose individual pricing or what each module costs publicly. We have discussed in the past, our annualized opportunity for any one employee is around $400 annualized. So we have discussed that in prior calls.

And then any sense as kind of where the average employee is now to get us a feel for how much growth there could be within the installed base?

It's not something that I could disclose. But it's definitely something that we monitor.

And then, Craig, maybe help us a little bit on the seasonality of the sales and marketing spend. I mean, you obviously talked a little bit about the variable comp. What other factors go into that line item as we kind of think about our models going forward?

On the sales and marketing, typically the first quarter is going to be fairly high. Our sales season ends at the end of January. So typically the sales reps will be at one of the highest rates in that first quarter. Throughout the year, that will hit certain targets, and their rates will continue to increase in terms of commission. So the second quarter is typically a little lower and it builds throughout the year through the first quarter.

I'd like to go into the ACA a little more. How big an opportunity do you think that is? And can you tell us whether you plan to price at monthly or if you're going to price the form separately like a W-2?

With ACA, we came out initially with the ACA dashboard, because we were still kind of waiting on the regulations. Now, we've implemented Enhanced ACA. There is a fee for Enhanced ACA, and that fee also rolls over into an annualized fee for forms filing. It's really hard for us to sit here today and say, okay, what exactly is the revenue opportunity for that. But what I will say is, I believe every client or prospect out there -- well, first of all, I believe every prospect out there should be using us. But then from that standpoint when someone becomes a client, I believe every client that has 30 employees or more really needs to pay attention and get on some type of ACA program. With the new bill that was signed after the Supreme Court ruling, if you try to do ACA correctly and you don't, it’s $250 a form with a $3 million minimum. If you don't even try to do it right, it's $500 a form and there is no cap on what you can be penalized in the year. So I mean, it's a serious filing. It's something that's new, obviously to our industry. It's something we are looked at to perform on behalf of a client. I think companies that use a company like ours or some of our competitors depend on this, so they don't have to have that expertise in-house. I do believe, on an ongoing -- and this is just the beginning. We don't know where ACA filing and reporting requirements are going to end. Usually, you start up one way and then it will change over time. I do believe ACA represents an opportunity, as much for Paycom, but also for our industry as a whole. I think ACA definitely represents a revenue opportunity.

And my follow-up on the ACA. When do you think this revenue will -- I mean, will it start to hit in the September quarter? Will it sort of get to a level it's going to get to by first quarter next year? Any thoughts on how this revenue will layer in?

I mean, I would expect first quarter of next year there to be some ACA revenue. How measurable it is and what impact it makes, I don't know. I mean, the same question could be asked for rising interest rates: what did that do to us, as they rise as well? But I do believe there will be something there. Well, I know there will be something there. It's just to what extent it's substantial or how measurable it is, I don't know yet.

Just one quick housekeeping question and then a couple of others. How much R&D was capitalized in the quarter, Craig, if you wouldn't mind? And then, less housekeeping, I know we were just talking about ACA. Is the treasury going to be issuing any updates on Form 1095 before the end of the year or do you think everything is still on track there for fiscal year '16 reporting? And then finally, just one more question. How should we be thinking about your normalized ANRR going forward? Should we still be thinking of it on an annualized basis in the mid-30% growth range or should we be thinking about it trending higher?

So I'll answer the last. And I'll let Craig finish up with how much of R&D we capitalized for this particular quarter. On the ANRR, we're not going to give any future guidance on that. ANRR is somewhat guidance itself into future quarters. So moving forward, we're going to report ANRR. It has been strong. I did say that last quarter just to kind of let people know that we really jumped out there, but you never know what happens with us. So moving forward, ANRR isn't something we're going to forecast. As far as what the IRS is going to do with the ACA, I mean we expect them to continue to address Forms 1094 as well as Form 1095. And then you have both Forms B and C for both of those, depending on if you're an insurance company or an actual business that's issuing these. With anything, anytime something new comes out, there's always afterthoughts on how can it be better, what other information do we need, how do we make others compliant? So I would find it very hard to believe that there is not more coming down the pipe from the reporting agencies. I would also be surprised if we're not full steam ahead, Katy bar the door, on this right now. I don't see it changing. It's here. Those people that aren't compliant are going to be in some trouble. I do believe that.

In terms of the capitalized R&D, it's around 30%, so slightly above 30%.

Quick question, I'm sorry if I missed this. How is the productivity from the new offices you've layered on in the last 12 going?

So I did talk about that earlier, Brad, yes it's going well. It does take an office 24 months to mature, and these offices that we've opened at the first of the quarter are each maturing as they should be.

And given how strong your growth has been, have you given thought to going even faster with new office openings?

We definitely look at those opportunities. I mean it's important for us to have assured success each time we do open up an office, and we're very happy with the way they're progressing now. And then as opportunities present themselves through both backfill opportunities and new manager relocation opportunities and prospect revenue opportunities, then we'll look to move into additional markets in the future.

And geographically, have you seen any unevenness in growth around the country?

We have not. Not geographically. I mean, you're going to have some offices that do better than others, but you could have an Orange County doing better than an L.A. or San Fran doing better than a San Jose. So I wouldn't really be able to point geographically if there's a difference there.

And so I want to thank everybody for joining. We did sustain our momentum through the first half of 2015 and are extremely proud of the progress we achieved in broadening our industry-leading solution. We're going to be presenting at the Pacific Crest Global Technology Leadership Forum in Vail, on August 11 and then again at the Canaccord Growth Conference in Boston on August 12. We look forward to meeting with you guys then. Thanks a lot.