Paycom Software Inc (PAYC) — Q1 2018 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 or make in this presentation 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 filings with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the year ended December 31, 2017. You should refer to and consider these factors when relying on such forward-looking information. Any forward-looking statements speaks only as of the date on which it is 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 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 our call to review our first quarter 2018 results. I will start with some comments on our performance this quarter, provide an update on our perspective into payroll and human capital management or HCM software market, and then address some exciting developments at Paycom. We kicked off another new year with robust numbers. We recorded revenue of $153.9 million representing growth of 29% over the comparable prior year period. Our adjusted EBITDA of $80.7 million represents a 52% margin. We were pleased with our performance and also that both metrics came in above the high end of our guidance range. Paycom continues to demonstrate leadership in the HCM sector. Earlier this year, one of the industry's most popular publications HR.com honored our organization at the 2018 Leadership Excellence & Development Awards. Our lead training and development program won the award for innovation and the deployment of leadership programs. This acknowledgement is a testament to our dedication towards training and developing our workforce which is one of Paycom's core values. I'm very proud of this recognition and look forward to continuing to foster a winning culture with a strong focus on leadership development. Additionally, our marketing initiatives continue to receive positive recognition. In addition to winning several American advertising awards for our branding and national television campaign, Paycom also earned national recognition at the 2018 Killer Content Awards. We won the influencer marketing category which recognized our brand for successfully tapping influential industry leaders to help validate content campaigns, increasing message credibility to our clients and prospects. These accolades are a testament to the strength of our culture and brand within the market and together with our service and software work to power our growth. Our single database HCM solution continues to gain converts in the marketplace. Our prospective clients are typically large enough to have significant HCM needs that span multiple areas, including not just payroll but also recruiting, talent management, benefit administration, and many others. With the Paycom solution, our clients receive a powerful yet flexible system that provides highly accurate employee data that allows HR executives to obtain actionable insights into their workforce. We believe the Paycom solution is the best option for companies looking to leverage the power of HCM technology to improve their organizations. At Paycom, we believe that today's workforce places increasing importance on an intuitive and easy-to-use HCM system; because of this preference, we are highly focused on providing the best possible user experience. We recently released our redesigned employee self-service desktop and mobile app and feedback from our clients and their employees has been stellar. We believe these enhancements to our employee software make it even easier for employees to use the Paycom system to its full potential. Having an easy-to-use HCM system can lead to higher employee engagement, increased productivity, drive job satisfaction and improve employee retention. Our product, especially our mobile app, empowers our clients' employees to take control of their HR functions. Today's generation is accustomed to using mobile apps for virtually every activity and our solution provides employees easy access to onboarding, training, enrolling in benefits and much more, when and where it's most convenient. Additionally, we continue to maintain and improve every aspect of our solution to ensure that it remains best-in-class. We publish monthly system-wide updates to our client base and are constantly improving our offering in order to preserve our competitive lead. Some examples of enhancements we released this quarter include improvements to our analytics dashboard. This tool now features improved chart and drilldown functionality and offers employers a clear view into the crucial data that can help drive operational decisions. Additionally, we debuted taxes by geolocation; clients use this functionality to automatically suggest the appropriate tax jurisdiction for inclusion in an employee's tax profile. We also enhanced our current mileage tracker by introducing smart mileage costing; this allows employers to save money by creating customized reimbursement programs that use the make, model and year of an employee's vehicle combined with the cost of fuel in the employee's region along with other factors, which allows the client to reimburse mileage at a lower rate. These were just a few of the many enhancements that launched in the quarter as part of our relentless focus on driving value for our clients. Turning to our sales efforts; we've recently announced the opening of our new sales office in Rochester, New York. This office is in addition to our Salt Lake City office that we opened in February and brings our total sales team count to 47. We are excited to bring our solution to prospective clients in the Rochester area. As many of you know, we take a very deliberate and unique approach to expanding our sales organization by moving a successful sales manager to a new city or region and then building a new team around that relocated manager. We believe this gives new teams the strongest foundation possible and the greatest chance at future success. While we are committed to continuing to expand our sales organization through 2018 and beyond, we will do so at a pace that is most appropriate for our business and that we believe will allow us to achieve the greatest revenue growth which is our first priority. I'd like to address some developments among our leadership team. In February, we added Janet Haugen to our Board of Directors. Janet brings a wealth of financial and operational experience to Paycom, most recently serving as CFO of Unisys Corporation. Paycom will benefit from her insight and experience as we continue to grow. Next, we were very pleased to announce that we are promoting John Evans from Senior VP of Operations to Chief Operating Officer. John joined Paycom four years ago and has worked in both our finance and operations departments. He has been instrumental in driving important operational improvements over the past few years and we look forward to his continued contributions. Additionally, we are promoting Brad Smith from Director of Software Development to Chief Information Officer. Brad has been leading our software developments for some time now, and we have benefited greatly from his vision and dedication. I'd like to also extend congratulations to both John and Brad for their promotions. Finally, I'd like to thank Stacey Pezold for her many years of service. Stacey is moving on from Paycom after several years in different roles and we are grateful for her contributions. We will wish her the best in her future endeavors. In conclusion, we had a very strong start to the year and I look forward to continued success through 2018. With that, I will turn the call over to Craig for a review of our financials and guidance.

Before I review our first quarter results for 2018 and also our outlook for the second quarter and full year 2018, I'd like to remind everyone that my comments related to certain financial measures will be on a non-GAAP basis. As a reminder, we adopted a new accounting standard, ASC606 from January 1, 2018 using the full retrospective method of transition which required us to recast the prior period presented. Our comparisons discussed in today's call reflect those adjustments. We use adjusted EBITDA, non-GAAP net income as supplemental measures to review and assess our performance and for planning purposes. Adjusted EBITDA, non-GAAP net income are non-GAAP financial measures that exclude non-cash stock-based compensation expense and certain transactions and other expenses that are not core to our operations. Non-GAAP net income also reflects adjustments for the effective income taxes, reconciliations of the GAAP to non-GAAP measures discussed today are included in the earnings press release issued earlier this afternoon. As Chad mentioned, we were pleased with our first quarter results with total revenues of $153.9 million representing growth of 29% over the comparable prior year period. Our revenue growth continues to be primarily driven by new business wins and we are pleased with our continued excellent performance. Within total revenues recurring revenue was $151.9 million for the first quarter of 2018 representing 98.7% of total revenues for the quarter and growing 28.8% from the comparable prior year period. Total adjusted gross profit for the first quarter was $133.2 million, representing an adjusted gross margin of 86.5%. For the full year 2018 we anticipate that our adjusted gross margin will be within a range of 82% to 84%. Total adjusted administrative expenses were $58.7 million for the quarter as compared to $46.9 million in the first quarter of 2017. Adjusted sales and marketing expense for the first quarter 2018 was $30.4 million. Adjusted R&D expense was $9 million in the first quarter of 2018 or 5.8% of total revenues. Total adjusted R&D cost including the capitalized portion was $13.1 million in the first quarter of 2018 compared to $9.2 million in the prior year period. Adjusted EBITDA was $80.7 million or 52.5% of total revenues in the first quarter of 2018 compared to $60.3 million or 50.5% of total revenues in the first quarter of 2017 as adjusted. Our GAAP net income for the first quarter was $41.2 million, or $0.70 per diluted share based on approximately 59 million shares versus $33.7 million or $0.57 per diluted share based on approximately 59 million shares in the prior year period. Our effective income tax rate for the first quarter 2018 was 21%, this lower effective income tax rate was primarily the result of the decrease in the federal corporate tax rate that went into effect in December 2017 with the enactment of the Tax Cuts & Jobs Act of 2017. In the first quarter our non-cash stock-based compensation increased by $20 million over the prior year period due to the issuance and subsequent investing of restricted stock with market-based conditions. For modeling purposes, we anticipate stock-based compensation to be $5 million to $6 million per quarter for the remainder of 2018. This vesting of shares had an impact on our first quarter tax rate lowering it by approximately 150 basis points. We anticipate our full year income tax rate to be 23% to 24% on a GAAP basis. On a non-GAAP basis, we anticipate our full year effective income tax rate to be 25% to 26%. Non-GAAP net income for the first quarter of 2018 was $55.8 million or $0.95 per diluted share based on approximately 59 million shares versus $35.5 million or $0.61 per diluted share in the prior year period. In the first quarter we returned value to our stakeholders by repurchasing nearly 170,000 shares including over 60,000 shares purchased in the open market. Since we initiated the repurchase program less than 24 months ago, we have repurchased over 2.5 million shares including nearly 1.7 million shares in the open market. We anticipate fully diluted shares outstanding will be approximately 59 million shares in the second quarter of 2018. Turning to the balance sheet; we ended the quarter with cash and cash equivalents of $68.1 million and total debt of $35.3 million. As a reminder, this debt represents financing of construction at our corporate headquarters. Construction of our fourth building is nearing completion. Cash from operations was $57.7 million for the first quarter reflecting our strong revenue performance and the profitability of our business model. The average daily balance of funds held on behalf of clients was approximately $1 billion in the first quarter of 2018. Now let me turn to guidance for the second quarter and full year for fiscal 2018. For the second quarter of 2018 we expect total revenues in the range of $123 million to $125 million representing a growth rate over the comparable prior year period of approximately 26% at the midpoint in the range. We expect adjusted EBITDA for the second quarter in the range of $43 million to $45 million representing an adjusted EBITDA margin of approximately 35% at the midpoint of the range. For fiscal 2018, we are increasing our revenue guidance to a range of $545 million to $547 million or approximately 26% year-over-year growth at the midpoint of the range. We are increasing our full-year 2018 adjusted EBITDA guidance to a range of $220 million to $222 million, representing an adjusted EBITDA margin of approximately 40% at the midpoint of the range. With that, we will open the line for questions.

First question for you, Chad. If you look at the industry's evolution, you started cross-selling beyond take-home in terms of HR functionalities. To ask, we probably saw an IPO in the space where workforce management became another area. Can you discuss how you view that space evolving for your company and where you currently stand in that regard?

We started adding additional products to payroll in 2004 and actually started out with workforce management from the time attendance perspective. And then we've continued to add on and build additional modules onto that as we've stated on a single system to eliminate the need for integration for clients. And now since that we've really focused on our employee usage strategy to be able to roll that out so that employees can assume and help with the responsibility for both the accuracy of data as well as information retrieval.

Perfect. And then can you talk a little bit about the progress that you do on the learning product that was focused on the last couple of quarters?

Yes, we've been focused on continuing to develop content, I believe I announced last quarter that we did develop 10 pieces of unique content developed internally with Paycom that we have included into our LMS system to again drive greater usage amongst that employee base for each of our clients. We have since added content to that, I think we've added another 12 to 14 courses to that as well, and over time we will be charging for those additional courses.

And then a quick question for Craig; so if I think about the EBITDA evolution, where would be the focus areas for investment for the remainder of the year? I mean, obviously you beat kind of nicely in Q1 and what's the stuff that puts some takes and need to think about for the remainder of the year in terms of investment focused areas?

In the first quarter, we exceeded our adjusted EBITDA expectations, largely due to a revenue increase that positively impacted our bottom line. We made some adjustments to our sales and marketing and R&D initiatives throughout the quarter, incorporating, modifying, and sometimes removing elements as needed. Our R&D spending rose in this quarter, with a higher percentage being capitalized; we capitalized 31% compared to 27% in the same quarter last year, resulting in about a 100 basis point increase as a percentage of total revenue. Additionally, we experienced some efficiencies in the general and administrative expenses. As we progress through the rest of the year, we plan to continue investing in R&D while hoping to see improvements in G&A efficiencies.

This is Alex for Michael, thank you for taking our questions. Chad or Craig, can you give us a sense of the increase and the productivity gains you've seen year-to-date compared to the prior year period now that we've been on this sort of staggered office opening timeline for more than a year? And I believe it's been a while since you've provided an update on the new business sales performance capacity metric, curious if you had an update on that metric or any data points perhaps even new A&R growth that you would like to share for Q1.

Certainly. The $260 million figure for our annualized new business sales capacity remains unchanged. Regarding the question about our productivity gains, we have consistently improved in that area. I look forward to providing updates as we progress through the year, but currently, the figure is still $260 million. The results we achieve drive this number; it's not just a decision we make. The data from this quarter, along with our ongoing forecasts, reflects this. We provide guidance based on what we can observe, and as we achieve more productivity gains throughout the year, I'll be happy to update that figure later.

I have a quick follow-up. I know you don't provide guidance on the total number of expected office openings, but could you give us a rough sense of whether we should expect office openings in 2018 to be higher than three in 2017?

We're very focused on the offices that we've opened up to now, the staggered approach has produced results for us as well as our focus on continuing to look for new offices and so we've opened up two so far this year, we're very focused on both development of our backfill opportunities as well as the relocation strategies of mature managers. And as we move throughout the year and identify those opportunities that work best for us, we'll definitely be making those decisions.

Chad, your focus on capturing new customers makes sense given the current market, and it's great to see that you're continuing to pursue this strategy. However, I'm interested in the potential for additional sales to existing customers. I know that typically, customers start with their first purchase, but it appears there might be opportunities to be more proactive in selling additional modules as your portfolio expands. Can you provide an update on your team's efforts in this area? Is there a plan to pursue this more aggressively, or perhaps it is already working, but we haven't been updated on it?

I would like to say that we haven't been trying to do that aggressively but I mean, I would say that we have continued to try to deliver the correct software modules to each client whether that's at the beginning or whether we've developed something after the fact that we've recognized a client that's needed. What we've been focusing on is proper usage of all the additional functionalities we've developed. Oftentimes I can tell you it is easier to get a client to buy something than to use it and it's very important with our ROI strategy that we produce pricing that works for the client so that they can receive the ROI out of each item and so that's what we're focused on. I will tell you this, we are focused on usage strategy and the more a client uses a product, the more apt they are to buy additional products and so we are continuing to focus on that but it's really always been a focus for us.

I have a question about pricing. I understand that you maintain consistent prices for your customers, but I'm wondering if there is potential to raise prices over time. While I know that customer satisfaction is your top priority, is there any possibility for price increases at this point?

It is typical in our industry to implement routine price increases, and I believe we are the only ones who have not followed this trend. When we engage with clients, our aim is to work collaboratively and provide pricing that generates a return on investment. We are indeed doing this. As for opportunities for future price increases, there is potential as we continue to enhance our offerings for clients each month. However, any price increase must be justified by the ROI we deliver to our clients. I don’t think pursuing a price increase without ensuring a return makes sense. Therefore, we will keep our focus on usage and believe that growth in this area will yield opportunities over time. Our current strategy remains our priority.

And just a quick one for Craig; CapEx was just a little bit higher than we anticipated. I'm just curious, can you give us a little bit of guidance on how we should be thinking about that for the rest of the year?

Sure. As I mentioned, we're kind of coming to the completion of the fourth building and as a reminder, that building is the size of all three of our others combined. So it was a pretty large endeavor. As you see us coming to the completion of the building, you'll see elevated levels of the CapEx and after we get that completed, we would see that maybe it would moderate some after the second quarter.

This is Albert Chi on for Mark, congrats on the quarter. Asking about the redesigned employee self-service product; and that's great that you've gotten some pretty stellar customer service so far and especially with the employee retention; but do you think on the Paycom side that ever moves the needle for the company beyond the 91% retention rate?

Employee usage plays a significant role in driving retention, as does client usage. We have maintained a consistent retention rate of 91% over the past six years, and while we sometimes lose clients due to factors beyond our control, many times it's related to usage. It's crucial for clients to correctly use our products, as they differ from competitors' offerings. Regarding the employee redesign, we previously had a desktop version that was adjusted for mobile through responsive coding. Now, we have adopted a mobile-first approach, meaning that the desktop experience reflects a mobile view. This consistency simplifies navigation for employees, making their experience more user-friendly, which in turn encourages higher usage levels.

And maybe one more on the promotions, particularly the COO role. I want to know if you expect any change in sales strategy? With the new appointment it's worked really well so far but is there a preview that you can give us in terms of how the field might look going forward?

So as far as our COO, John has been running operations since about February of last year as our Executive Vice President of Operations. His promotion to COO will not change our approach to sales. We have made improvements in how we onboard clients and generate early usage of our product, and we will continue to focus on that. John will be and has been a key component of that.

Raimo alluded to the Ceridian IPO earlier and I thought it was interesting, one of the prospective growth drivers that they were talking about was an ability to address the GIG economy, right, freelance workers, it's all about same day onboarding and getting those folks up and paid quickly and it's something I really hadn't thought of before so I'm curious, do you think that that's a real opportunity? Is it something that Paycom could and would pursue? How do you think about that opportunity impacting the market?

I'll let Ceridian's strategy stand on its own. What I will say is this: as we create development that's going to be used by our clients and to the extent we see something that has a significant use case, it's something we would develop. The other part that I would say is, we're not a company that has talked about what we're going to be doing, we always wait until it's developed first. So, I guess I would just leave it with that.

Chad, let's discuss the new office expansions. We've had a few open this year, but they are staggered. How should we view the pace of these openings? What insights have you gained from staggering them, and do you believe this pace aligns with your growth ambitions?

Yes, we have a plan for staggered office openings to develop our team of sales managers. We relocate experienced sales managers to new offices, and then we fill those positions with individuals ready for management. This staggered approach helps us focus on developing these managers and allows us to effectively absorb clients and strategies as we expand into new cities. We are actively working on this, and I'm pleased that we have already opened two locations this year. Additionally, our productivity gains are progressing as planned, and we will continue to prioritize both these productivity improvements and the development of our management bench as we move forward.

So just shifting gears, Craig, perhaps on the EBITDA margin side, obviously you guided the 39% kind of EBITDA margin at the midpoint. Entering the year you had very strong EBITDA margins here in Q1 raising EBITDA, how should we think about the full year EBITDA margins as we look out even further, how much room do you have to kind of improve the margin profile here? And the reason why I ask is, it sounded like there were some timing issues that drove some of the upside in Q1 and so I want to put together the perspective of kind of some of the timing issues that you benefited from this quarter versus what your kind of midterm aspirations are on the margin side? Thank you.

I would say it wasn't just the timing, but rather the various marketing initiatives we implemented related to the sales and marketing expenses. We will keep our focus on R&D spending to achieve efficiencies in the G&A line. For the year, we have raised our guidance to 40% at the midpoint, and we will continue to seek efficiencies throughout the year.

And any sort of update on aspirations, what the balance is as you think about sustaining a 20%, 25% plus growth rate in this market? Is 40% EBITDA the right balance to sustain investments, sustain 25% growth or do you think there is room for EBITDA margins to be higher than that while sustaining kind of that type of growth rate?

Under the new 606 I think we were asked are we going to update our long-term EBITDA margin guidance. We're really not prepared to quite at this point but we're continuing to look at that. So we'll probably be updating that in the future.

Chad, quick question. Can you give us any sense how the really strong economic backdrop is helping if at all on the growth side? Is it purely just you continuing market share gains?

Definitely, anything that impacts our clients positively I think impacts us positively now. At our scale and the way we grow this, I can't say that it's necessarily new employee or employee adds to our current client base and we rarely would see much of that. Whether it's to the positive or negative, as we've been doing this close to 20 years in the type of growth environment, and so our additions are primarily coming from new logo ads, that's been always been the overwhelming majority of all of our revenue growth and that remained so this quarter as well.

Could you discuss some of the differences you're observing across various regions and with different client sizes in terms of where you're achieving the most success? Additionally, can you provide insight into how the clients affected by the hurricane, who experienced delays and have now shifted into this quarter, might be impacting results for this period?

I'll address your first question regarding the hurricane. We didn't experience any lingering effects from the hurricane in the first quarter. All our clients were either established at the beginning or towards the end of the fourth quarter, and all were definitely set up by January 1. Therefore, we wouldn't have seen much of a negative impact from that. In terms of regional performance, the region that performs the best has the best regional manager, and similarly, the city that excels has the best city manager. Our top-performing sales person is also driving results. There are significant opportunities available, and we're often enhancing those results through both prospecting and collaborative sales efforts. The impact on any specific region will depend largely on the individual overseeing it. As for client sizes, they have remained quite consistent. We continue to sell within and above our typical range, and I haven't noticed any significant changes from what we've done historically regarding client size.

And then just to go back on the markets; are you still seeing like uniform levels of growth across the entire country or is there a little bit more disparity and are some of the older offices continuing to grow at a decent rate?

Yes, definitely, especially if we hadn't made any disruptions. If we have a mature office where we didn't replace a manager and we didn't move any representatives to backfill, then yes, you would still see growth in those mature offices with their original managers. Generally speaking, while it's possible for an office to behave similarly to how it has in the past, mature offices that remain undisturbed typically continue to grow.

And then just on the float balance; what sort of yield do you think you're going to be able to get with the way the systems are set up relative to what's happening in terms of short-term interest rates?

I mean, the interest rates have continued to tick up. I would say those are things that we try to negotiate. I will say even though the rates have changed, our investment strategy remains the same, these are client funds, we're very safe with that and we're very conservative in how we do things. However, I mean, as interest rates tick up so do overnight sweep account rates and such. So we haven't disclosed that other than to say that it is a part of the revenue that's out there. We don't disclose the specific interest and/or yield that we receive but that is something that as rates tick up should be accretive for our revenue.

Alright, I want to thank everyone for joining us on the call today. Over the next few months we'll be on the road meeting with investors at the following conferences; the Jefferies Global Technology Conference on May 9 in Beverly Hills; we'll be at the JPMorgan Technology Media & Communications Conference on May 15 in Boston; we will be at the Baird Consumer Technology & Services Conferences on June 5 in New York; and finally, we will be at the Stifel Cross Sector Inside Conference on June 12 in Boston. We appreciate your continued interest in Paycom and looking forward to meeting with many of you soon. Thank you, operator.