Paycom Software Inc (PAYC) — Q3 2016 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 these statements are based on our current expectations and are subject to risks and uncertainties. These risks and uncertainties are discussed in our filings with the Securities and Exchange Commission, including our quarterly report on Form 10-Q for the quarter ended June 30, 2016, and our Annual Report on Form 10-K for the year ended December 31, 2015. You should refer to and consider these factors when relying on such forward-looking information. Any forward-looking statements speak only as of the date on which they are made, and 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. The third quarter marked yet another success for our organization as we grew revenue, added new clients across the country, and further extended our product development. The Paycom solution continues to gain traction in a wide range of industries. Revenue of $77.3 million represented growth of 40% over the comparable prior-year period. Our profitable cash-generative business model continues to deliver results with third quarter 2016 adjusted EBITDA of $18.2 million, as compared to $10.8 million in the third quarter of 2015. In addition to our business success in the third quarter, we continue to drive value for our stockholders. Since financing our repurchase plan on May 26, 2016, we have repurchased over 525,000 shares within the last five months. Our unified single database payroll and human capital management or HCM solution is designed to help companies and their employees realize their full potential. With our solution, companies can become more efficient and strategic, allowing them to spend their valuable time focusing on the business rather than navigating the ever-changing tax code and HR regulations. Within our target market segment of core mid-market and upper mid-market, we believe that our value proposition is increasing. Companies in this segment typically choose not to deploy the resources necessary to manage and continually integrate multiple vendors and products to meet all of their HCM needs. At the same time, they are becoming increasingly aware that it is vital to use technology to attract, train, retain, and manage their employees in order to remain competitive. We believe that adoption of our solution will continue to be driven by the trend of growing technology sophistication among the C-Suite and HR Executives and also the increasing complexity of tax codes in HR regulation. At Paycom, we are experts in navigating this complexity, and this capability is core to our value proposition. What makes our solution even more attractive is the accurate and reliable data that the Paycom solution delivers as a result of our foresight to build our solution on the foundation of a single database. Our single database foundation not only provides precise actionable data, but also allows us to comprehensively enhance our offering with those features we believe will best help our clients. A great example of our ability to develop and deploy crucial functionality that can have an immediate and significant impact is our Fair Labor Standards Act or FLSA toolkit. In August, we introduced the FLSA toolkit as a preemptive response to the new Department of Labor rules regarding overtime pay that will go into effect on December 1. We believe that this change will have a broad impact on many companies, as it provides that certain employees whose annual salaries are less than $47,476 are eligible for overtime pay. We believe that our FLSA toolkit is the best option for companies seeking to minimize both the impact of increased compensation costs and the cultural challenges that may arise in the workforce as the compensation gap between entry-level and senior employees becomes compressed as a result of the new rule. The rule will potentially have a much broader financial impact on companies than the Affordable Care Act or ACA. In contrast to the ACA, which called for employers to prove they were offering affordable healthcare coverage to their employees, the new FLSA rule will likely change core compensation structures for many companies and will impact almost every company to some degree, particularly those in certain industries, such as those with salaried managers who work long hours and make a salary below the $47,000 threshold, or companies that have workers who receive a significant portion of their compensation in bonuses and commissions. In our view, this rule change will require CFOs and CEOs to take a very strategic approach to minimizing costs while achieving compliance. I want to emphasize that we do not anticipate a large impact on our revenue from our FLSA toolkit since it is included within our government and compliance module. However, we do see the new FLSA rule as an extremely effective conversation starter for our sales representatives seeking to engage with prospective clients. Our bi-monthly webinars on this topic are the most popular webinars we've had to date, indicating that awareness of this potential issue among executives is likely trending at least as strong as it was for the ACA. I'd like to note that an important part of our development process is derived from feedback from our sales and service organizations. We have strong and open lines of communication between our sales, service, and development groups. This creates a positive feedback loop where our R&D organization receives direct feedback from our sales team regarding real-time customer needs and is then able to develop features and products based on this information. This, in turn, empowers our sales force to go to market with the best solution that can drive customer success. Our FLSA toolkit is a great example of this feedback loop. This internal communication is just one example of the cohesive and energetic culture at Paycom, where team members are passionate about doing their jobs well and helping our clients succeed. I believe that our unique culture at Paycom is our most important attribute, and that foundation has allowed us to grow into one of the largest payroll and HCM providers in the United States. With that, I would like to provide some highlights of clients we brought into the Paycom family in the third quarter. First, we signed a staffing company with over 2,000 employees. When we first engaged with the company, they had been processing their payroll and HCM functions with an antiquated in-house system. This client initially chose one of our largest competitors based on price but switched to Paycom in the middle of implementation due to our strong service model and robust functionality. Next, we welcomed a media production company with nearly 5,000 employees. This company had been using a competing vendor for payroll, as well as separate systems for time and attendance and HR management. Lack of integration among the separate products led to poor analytics. They wanted to partner with a company that allowed them to avoid integration issues and gain actionable intelligence to meet the compliance needs of multiple jurisdictions and a diverse employee base. In addition to much of our core product, they are also using our pre-hire background checks, onboarding, and tax credit application. Finally, we welcomed a nonprofit organization with 2,500 employees. They were previously using a large competitor and selected Paycom due to our robust and easy-to-use reporting features, as well as our ability to categorize workers at a granular level down to a specific project or grant. Additionally, our GL Concierge tool has proven to be very helpful to this point. Their controller is using this tool to easily allocate funds where needed, all before processing payroll. This ability has increased reporting accuracy and helps position this client well to pursue opportunities to raise additional funds in the future. To conclude, we had a very productive quarter and are optimistic for a strong close to the year. I will now turn the call back over to Craig for an update on our financials and our guidance.

Thanks Chad. Before I review our third quarter results and also our outlook for the fourth quarter and full year 2016, I would like to remind everyone that my comments related to certain financial measures will be on a non-GAAP basis. We use adjusted EBITDA and non-GAAP net income as supplemental measures to review and assess our performance and for planning purposes. Adjusted EBITDA is a non-GAAP financial measure that excludes non-cash stock-based compensation expense and certain transaction expenses that are not core to our operations. Non-GAAP net income is a non-GAAP financial measure that also reflects adjustments for non-cash stock-based compensation expense and certain transaction expenses that are not core to our operations, which are further adjusted for the effect of income taxes. A reconciliation of the GAAP to non-GAAP measures discussed today is included in our press release. We experienced a strong third quarter with total revenues of $77.3 million, representing year-over-year growth of 40% from the comparable prior-year period. As a reminder, during the third quarter of 2016, we anniversaried the initial ACA-related revenues that we experienced in the third quarter of 2015. Within total revenues, recurring revenue was $75.9 million for the third quarter of 2016, representing 98% of total revenues for the quarter and growing 40% from the comparable prior-year period. Total adjusted gross profit for the third quarter was $63.9 million, representing an adjusted gross margin of 83%. For the full fiscal year 2016, we anticipate adjusted gross margin will be within a range of 83% to 84%. Total adjusted administrative expenses were $49.1 million for the quarter, as compared to $38.3 million in the third quarter of 2015. Adjusted sales and marketing expense for the third quarter of 2016 was $27.6 million. Adjusted R&D expense was $5.7 million in the third quarter of 2016, representing growth of over 158% over the comparable prior-year period. As part of our initiative to maintain our world-class solution, we have continued to invest in R&D. As a reminder, a portion of our R&D expense is capitalized. Our total adjusted R&D costs for the third quarter of 2016, including the capitalized portion, was $7.6 million, or 9.8% of total revenue. Total adjusted R&D costs for the nine months ended September 30, 2016, including the capitalized portion, were $18.8 million, or 7.8% of total revenues. As everyone may note, this is a significant increase from past years. Adjusted EBITDA was $18.2 million, or 23.5% of total revenue in the third quarter of 2016, compared to $10.8 million, or 19.5% of total revenues in the third quarter of 2015. Our strong adjusted EBITDA performance was driven in part by sales outperformance and also achievement of cost efficiencies across our organization. Additionally, we are pleased to announce that we are updating our long-term adjusted EBITDA margin target to 30% to 33% and we are able to target this level while still enjoying robust growth and making substantial investments in R&D, which underscores the strength of our business model. Our GAAP net income for the third quarter was $6.2 million. During the third quarter of 2016, we adopted accounting standard update 2016-09 or ASU 2016-09 which simplifies the accounting for certain aspects of share-based payments to employees. We recognized a discrete benefit to income tax expense of $6.8 million for excess tax benefits due to the vesting of certain share-based payment awards for the three and nine months ended September 30, 2016. As a result, our effective income tax rate decreased to 20.87% for the nine months ended September 30, 2016. Non-GAAP net income for the third quarter of 2016 was $9 million, or $0.15 per diluted share based on approximately 59 million shares, versus $4.7 million, or $0.08 per diluted share based on approximately 58.4 million shares a year ago. ASU 2016-09 had no impact on non-GAAP net income or non-GAAP earnings per share. As Chad mentioned, we remain focused on returning value to our stockholders. We repurchased 402,626 shares during the third quarter under our $50 million stock repurchase plan. As of today, we have repurchased 525,040 shares under our stock repurchase plan. Turning to the balance sheet, we ended the quarter with cash and cash equivalents of $74.5 million and debt of $30.1 million. As a reminder, this debt represents the financing of construction at our corporate headquarters. Construction of our fourth building has commenced and is proceeding well. Cash from operations was $19.9 million for the third quarter, reflecting our strong revenue performance and the profitability of our business model. With that, let me turn to guidance for the fourth quarter and for fiscal 2016. For the fourth quarter of 2016, we expect total revenues in the range of $85 million to $87 million, representing a growth rate over the comparable prior period of approximately 32% at the midpoint of the range. As a reminder, we will be anniversarying our ACA-related revenues that we experienced in the fourth quarter of 2015, as well as the pull forward of starts that we mentioned in the fourth quarter of 2015 related to declines that began early in order to gain ACA compliance that normally would have started in the first quarter of 2016. We expect adjusted EBITDA for the fourth quarter in the range of $14 million to $16 million, representing an adjusted EBITDA margin of approximately 17% at the midpoint of the range. For fiscal 2016, we are increasing our revenue guidance to a range of $326.5 million to $328.5 million, which implies approximately 46% year-over-year growth at the midpoint of the range. We are also increasing our full-year adjusted EBITDA guidance for fiscal 2016 to a range of $88 million to $90 million, representing an adjusted EBITDA margin of approximately 27% at the midpoint of the range. With that, we will open the line for questions.

Thank you. Craig you said that the third quarter anniversary, the benefit of the ACA - the ACA benefit from last year. But you never really quantified that last year. I mean - I think you and Chad had talked about some very minor revenue contribution. But we know the third quarter was really strong last year. Was there any - have you ever quantified any pull-forward vis-à-vis like you did for the fourth quarter - for the third quarter of last year? Is there some way we can start to think about that? I guess that’s the question.

Yes John, this is Chad. The third quarter of last year was actually the very first quarter that we started billing for ACA. We did call out a number in the third quarter of last year of how much that represented - not necessarily new business that we brought on due to ACA as far as bringing the client on in its entirety. But as far as current clients that had adopted ACA, as well as new onboarded clients that had the ACA module. I forget the exact number, but I want to say it was around $800,000 maybe for third quarter, that's well down, fourth quarter obviously was a lot stronger and we did apply a percentage to that, which I would have to check with to give you that exact number.

Okay. And did you see - do you think you saw any Pull Forward in the third quarter of last year? I'm just trying to look at year-over-year comps and listen looks good but it doesn't - it's not the kind of I guess the kind of beat that I think the people have come to expect from you.

I mean we’ve had - we obviously last year we had some – what I’m going to say are positive surprises. I mean anytime you're bringing a half-to-half product which I believe ACA was our enhanced version. Anytime you bring a half-to-half product to market especially to a current client base, there is not a long backlog on that; I mean you're able to sell to clients and set them up and begin billing within two or three days versus the pipeline and backlog you get from selling new business. So we didn't have a lot of insight into exactly how much of that business we would be onboarding and what exactly the uptake would be and how immediate it would make an impact. And so the first thing I would say about that revenue overachievement about maybe what have been our guide last year, so we had some positive surprises that began billing immediately. The second I would say is so much of our new business onboarding depends on when a client starts within the quarter; something that we've explained before. If a client starts at the beginning of the quarter, we’re going to receive 100% of total revenue opportunity for that client; and if that client starts in the last month or last two weeks of a month, then obviously we received a proportionately smaller portion.

I'm sorry Chad, so you think in this particular quarter was it more back-end loaded as far as when you started?

I saw this quarter as a great quarter, obviously we're tracking new business sales week-to-week here and I really didn't see anything that would cause me to want to go in and look to see exactly when a deal started when, I’m just more explaining that from the standpoint of guidance overachievement. We had a lot of positive surprises, I mean 98% of our revenues are recurring so we do have pretty good insight into subsequent quarters. Oftentimes the outperformance, especially some of that that we achieved last year in the fourth quarters where we had just began to initially bill for ACA. Those were positive surprises and they were positive to the extent that not only were they sold, but they began billing immediately.

Okay. Thank you.

Thank you. Chad, can you talk a little bit about on the sales force productivity side and main driver for the group we’ve seen is basically the existing officers seem to be selling better. We hear stories about some of your sales guys kind of making some really big numbers or selling some really big numbers. Can you talk a little bit about how you see that evolving over time? And then also has there been an impact for you since you are a public company in terms of the hiring and the quality of the people that you are getting? Thank you.

Yes, so definitely one leads to the other. I mean if you’re hiring quality people that are ready to go to work and learn, we’re going to have great success with that. I’ve pointed out before that our executive reps have a very, very strong retention rate, better than 90%. And then I've also pointed out before that when we lose people we're losing them before they achieve executive rep status, and we've identified that it's extremely important to get those people to executive rep status as quickly as we can; we're very focused on that. By doing that, that does increase what an office can sell because you have more reps selling at larger numbers versus the traditional sales model where your top reps can be carrying a larger load proportionately than the others. And so, again this is something that in different patterns of our sales career, we go through with being able to increase our sales capacity by gaining efficiencies through those new reps by implementing skills that allow them to get there quicker—we’re very focused on that right now. But you're right, we have been continuing to increase our number based on the success of the mature offices and that's not different today and it was indifferent to this quarter, but we definitely do see an opportunity to ramp up these newer offices.

Hi guys, nice quarter, thanks for taking my questions. Just a couple ones, Chad can you just maybe comment on the sales office productivity this quarter; was it in line with your expectations, and how were the newer offices ramping in terms of productivity?

Yes, I mean definitely. The mature offices were definitely in line; in fact the new offices, as we’ve talked in the past, they do continue to ramp. We've been very consistent in how we announce new office openings and how we actually open them and we’re still very confident we can get to 120 sales teams across the U.S. The earliest we've ever opened up an office is February, and the latest is October. And right now our new business sales performance capacity with the current offices we’ve opened is greater than $260 million. So by new business performance capacity, what I mean is the amount of new business that our total sales teams could sell today if they were achieving top performance levels. Now this doesn’t include any sales to current clients as far as upsells to current clients and it also excludes inside sales of small deals. I'm only talking about our outside sales force, which does represent the overwhelming majority of all of our sales. Now how we calculate the sales performance capacity is by reconciling our top-performing office with the average sales performance of our top reps who went to President’s Club, and then we multiply that by the number of territories that a team has. And so to that end, we believe a top-performing office can sell roughly $6.5 million in new business at performance capacity. We’re working very hard on bridging the gap there that exists between actual sales achievement and new business sales performance capacity. And so I guess the answer to your question is yes. Our mature offices are doing well. We do believe that they could be doing better because we would like everyone to get to the top level. And we’ve still got new reps and new teams that we’re continuing to build up and improve those skills as well as increase capacity.

Great, thanks guys. Just a really quick question from the balance sheet, client funds held seem to decrease sequentially, almost about $400 million or so? Any seasonal issues there or what caused that?

Typically, on client funds, at the end of a quarter depending on what day that quarter ends, it could be that we’re holding a significant amount or at the end of the quarter is on a date that we’re not holding quite as much because typically those funds have to be remitted as early as a couple of days and as late as a couple of months. So you can have some seasonality just looking at the balance sheet. One thing we didn’t put in the prepared remarks is that we had around $660 million average daily balance on those funds sales. So we’re still holding a significant amount of client funds and we obviously look forward to a day when we’re getting a little bit more on the interest side on those.

Thanks for taking my call. I’m wondering when you think about the sales performance across the various regions, were there any areas that really stood out that you could denote?

No, I would not say that. I think you have your usual suspects, and then you continue to have new offices that are maturing. I would say oftentimes the measurement of how an office is going to do is really dependent upon the person that’s leading that office or the manager, not necessarily the geography. I think I pointed out last year our top reps sold $1.7 million and she was here in Oklahoma City. We had two other reps sell $1.6 million. And again, when I am talking about new business sales performance capacity, we’re choosing numbers below that because if you take 1.7 or 1.6 multiplied by eight, you’re going to get up to $13 million, and that’s not what we believe our current sales performance capacity is at.

Yes, good afternoon guys. Chad, what are you seeing out in the market and the economy or any uncertainty around the elections that changed at all?

I can’t really comment on that. I think I said this in the last call. I mean we are either going to have more legislative changes or a lot more legislative changes. I mean every year that goes by, we had something, and every time they try to fix something, it gets two or three times worse, or there is something else we have to deal with. And so anytime something that’s new, there are changes. And so I see changes regardless. It’s not our job to say whether or not we agree with the changes one way or the other. It’s our job to develop them to be able to put them out for the client so that they’re able to utilize them to make minimal impact on their overall cost, and we’re geared up to do that.

Okay, and then I saw the sales and marketing expense grew 23.1% I believe in the quarter, which is lower than it has been. Is there any particular reason for that?

The sales and marketing expenses are going to grow, but we’re going to see efficiencies throughout the organization both in the sales and marketing as well as in the G&A figure. You got to remember the sales and marketing include, it has several components. It has salaries, commissions, marketing, it has office space, and other things. So if I look at the offices that we opened this year, some of those fixed costs are lower than what we’ve had in some of the others where we were going into New York or LA or San Francisco. So you’ll see some there. As well as in the marketing area; for example, we attended the HR Tech conference this year, and that’s the same conference we attended last year. But we didn’t attend 40% more conferences in the third quarter. So we’re going to see some efficiency there. And then just on the G&A line, we’re also going to see some in terms of last year was the first year being SOX compliant. So in the back half of the year, we had some costs associated with that, and now we’re more on a maintenance level on that.

I might also add that one thing we are seeing with the new rep influx that we brought in with opening up new offices is that the new reps are selling; when they receive a commission, it is half the amount of an executive rep. Additionally, we did increase the amount that a new rep has to sell to become an executive rep, and so we do have reps that stay at the lower commission longer. I think all of that might contribute somewhat to the number you’re talking about.

Okay. Great, thanks.

Hi, thanks very much. The first question I had was regarding the FLSA. Did you see any increasing activity around the government compliance module or the time and attendance in terms of maybe more employees being applied to their product?

Yes, so from a government compliance piece as we bring on new clients that’s a very popular product for us already. And so FLSA was folded into government compliance and so clients already receive that. I would point out that what we’re getting the most activity in relation to FLSA is really the webinars. I mean the webinars we’re putting on for FLSA are doubling those same webinars that we put on for ACA. So I do think there are people still somewhat late to the party on gaining compliance with FLSA, up until about I think a month ago, maybe three weeks ago. They really felt like they were going to be able to kick the can down the road a little bit into next year and maybe stay off compliance for a little bit. It doesn’t look like that’s happening; it looks like it’s go-forward now December 1. So we’re continuing to have those conversations and go through both the education side as well as the analytical side to be able to determine what exactly our clients are going to do in the offset and then how they’re going to manage it on an ongoing basis because that’s extremely important that they do manage it on an ongoing basis to make sure that they’re paying the minimum amount that they need to pay.

Okay, that’s helpful. And then second question, obviously a lot of confusion among investors with ANRR. Is there anything you can talk about in terms of the pace of new deals or new business in the quarter?

Only to say that I haven’t seen any change in characteristic as far as what a client would buy this quarter versus last quarter or the one prior to that.

Okay, great. And then last one for Craig. So the stock-based comp was a little larger this quarter, and I think it may be related to some RSUs vesting, but could you maybe just give us a quick estimation since it was a pretty big jump? Thanks.

Sure. We had some performance RSUs that vested this year, and as I mentioned under the new rules on the tax side, we were able to gain some benefit to add on that on our GAAP earnings per share. It had no impact on non-GAAP earnings per share. So that’s really what happened. Moving forward, our stock-based comp, I think for the fourth quarter, we’re estimating it around 3.5 assuming, but we still have some performance RSUs out there. So that’s kind of the level it’s expected to go to.

Thanks for that earlier, I had a technical problem. Chad, can you talk a little bit about the sales force productivity side and main driver for the group we’ve seen is basically the existing offices seem to be selling better. We hear stories about some of your sales guys kind of making some really big numbers or selling some really big numbers. Can you talk a little bit about how you see that evolving over time? And then also has there been an impact for you since you are a public company in terms of the hiring and the quality of the people that you are getting? Thanks you.

Yes, so definitely one leads to the other. I mean if you’re hiring quality people that are ready to go to work and learn, we’re going to have a great success with that. I’ve pointed out before that our executive reps we’ve very, very strong retention rate with them, better than 90% and then I've also pointed out before that you know when we lose people we're losing them before they achieve executive rep status and we've identified that it's extremely important to get those people to executive rep status as quickly as we can were very focused on that. By doing that, that does increase what an office can sell because you have more reps selling at larger numbers versus the traditional sales model where your top reps can be carrying a larger load of proportionately than the others. And so, again this is something that in different patterns of our sales career. We go through with being able to increase ourselves capacity by gaining efficiencies through those new reps by implementing skills that allows them to get there quicker we’re very focused on that right now. But you're right we have been continuing to increase our number based on the success of the mature offices and that's not different today and it was indifferent to this quarter but we definitely do see an opportunity to ramp up these newer offices.

Hi guys, congrats on a great quarter. First, you talked about in your remarks that obviously the FLSA does not have any impact in terms of from a revenue perspective as its bundled governance and compliance, but I guess can you talk about if in terms of the conversations or the pace of business, can you talk about if you’re seeing any or have seen or are seeing any pull-forwards in new customers signing on as a result of trying to get onto the platform so they can get ahead of the deadline, ahead of the December 1 date so they can take advantage of the FLSA toolkit.

I haven’t and I would say similar to ACA, I definitely don't think, and I said this about ACA too, I definitely don't think that someone chooses Paycom just for the FLSA toolkit or just for ACA; it's for the overall value proposition that we put out there that needs to resonate as far as what they're going to do with turning data and information. And so yes, I wouldn't be able to comment, saying we’ve seen pull-forwards in starts. I think the one comment I made last year about pull-forwards was those people that would've started in January of 2016 that pulled forward in December for the sole purpose of gaining compliance for the 2015, but that was really a—but again those clients didn't necessarily use us for the ACA alone. Well, we are definitely having more prospects at the upper end reach out to us, for we really target companies that are acclimated to the process through using one of our competitors, and it’s our goal to get out there and get them to shift to us. It often times that people research out there who would be a company to use for their employee size we pop up and they give us a call, and so that does happen more and more but still from a proportionate level, I would definitely say that our business was coming from companies that currently use one of our vendors and still half of that comes from companies that use the largest vendors out there.

I'd like to thank everyone for joining us on the call today. We will be representing at the UBS Global Technology Conference in San Francisco on November 15, then the Credit Suisse Annual Technology Conference in Scottsdale on November 29, and the Barclays Global TMT Conference in San Francisco on December 7. We hope to see many of you at these events over the next couple of months, and thank you for your interest in Paycom. Bye.