Paycom Software Inc (PAYC) — Q2 2019 Earnings Call Transcript

Thank you, and good afternoon, and welcome to Paycom's Second Quarter 2019 Earnings Conference Call. 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 made or made 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 most recent annual report on Form 10-K. You should refer to and consider these factors when relying on such forward-looking information. Any forward-looking statements may speak 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, including adjusted EBITDA, non-GAAP net income, adjusted gross profit, adjusted gross margin, and certain adjusted expenses. We use these non-GAAP financial measures to review and assess our performance and for planning purposes. 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'll now turn the call over to Chad Richison, Paycom's President and Chief Executive Officer. Chad?

Thanks, James, and thank you to everyone joining us on our call today. I'll begin my remarks by reviewing another strong quarter and provide you with some perspective on how our groundbreaking Direct Data Exchange and employee usage initiatives are redefining the relationship employees have with their Human Capital Management or HCM software in the workplace. I'll finish by discussing some additional business highlights, and Craig will review our financials and outlooks, before taking your questions. The second quarter results came in strong, thanks to robust new business adds, and we remain well positioned for another excellent full year. Q2 revenue was approximately $169 million, representing growth of 31.5% versus the comparable prior year period. Our adjusted EBITDA of $69.4 million represented a 41% margin. With these results and our momentum, we are raising guidance for the full year, which Craig will discuss in more detail in his remarks. Employee usage of HCM technology is the future of our industry, and our clients and their employees are embracing the digital transformation faster than ever. With Paycom, they can measure the estimated ROI on their HCM investments and benefit from higher employee engagement, increased productivity, and better job satisfaction. Our early investments in employee usage are driving strong sales growth, but we believe this digital transformation is still in the early stages. Last quarter, we released our Direct Data Exchange or DDX for all of our clients, a highly differentiated enhancement to our software offering that reports all data changes made directly into the HCM database by employees, as well as all duplicative data changes typically input by other client representatives. As employee usage gains traction, our clients notice the financial benefits of eliminating these duplicative data inputs. Clients choose the pace of their digital transformation, and Paycom can go as fast or as slow as they want. However, we are seeing clients embrace the transformation at a faster pace today than a year ago. Before the DDX, no one in our industry, let alone HR professionals, knew what appropriate employee usage looked like or how to measure it. Now they can and they are embracing it. Turning to our sales initiatives. In addition to continuing to innovate our product offering, we are also innovating our sales strategy as buying habits across the industry continue to change with more companies becoming comfortable buying online. This means we will increasingly employ a combination of traditional sales teams and non-traditional sales teams, such as our inside sales group. We recently brought one of our most successful outside sales managers to lead our inside sales initiative because we have found that prospective clients are embracing this non-traditional sales model and buying online. We believe this initiative will aid our sales growth and complement our existing sales efforts. We also recently opened a new sales office in New Orleans. While we continue to expand our sales footprint, I want to emphasize that the largest driver of our sales growth is coming from the sheer mass of our existing sales force and their increased productivity. On the technology side, we continue to add talent to our outstanding development teams to focus on new products and software enhancements. We are experiencing a lot of success, and I'm very pleased with the product line. In fact, we recently released Ask Here to all of our clients. This newest tool gives employees a direct line of communication to ask work-related questions of their company representatives and receive timely answers, all through the convenience of Paycom self-service technology. I'm excited about the many benefits companies and their employees gain, such as one online communication resource that ensures all inquiries are addressed, actions are taken, and eliminates the need for employees to follow up through email, phone call, or added foot traffic. Now employees don't need to know exactly who to ask questions to, as this functionality empowers them to ask any business question, which has been routed to the most appropriate client representative with the relevant expertise. This latest innovation further enhances the employee-employer experience and strengthens the clients' employee usage initiatives. To conclude, we believe Paycom is leading the digital transformation of the HCM industry, which positions us well to deliver value to our clients and their employees throughout the year and beyond. With that, I'll turn the call over to Craig for a review of our financials and updated guidance. Craig?

Before I review our second quarter results for 2019, as well as discuss our outlook for the third quarter and full year 2019, I would like to remind everyone that my comments related to certain financial measures will be on a non-GAAP basis. As Chad mentioned, we were pleased with our second quarter results, with total revenues of $169.3 million, representing growth of 31.5% over the prior year period. Our revenue growth continues to be primarily driven by new business wins. Within total revenues, recurring revenue was $166 million for the second quarter of 2019, representing 98% of total revenues for the quarter and growing 31.1% from the comparable prior year period. Total adjusted gross profit for the second quarter was $144.4 million, representing an adjusted gross margin of 85.3%. For the full year 2019, we anticipate that our adjusted gross margin will be within a range of 84% to 85%. Total adjusted administrative expenses were $85.9 million for the quarter as compared to $61.7 million in the second quarter of 2018. Adjusted sales and marketing expense for the second quarter of 2019 was $39 million, as compared to $30.2 million in the second quarter of 2018. Adjusted R&D expense was $16.3 million in the second quarter of 2019, or 9.6% of total revenues. Total adjusted R&D costs including the capitalized portion were $22.3 million in the second quarter of 2019, compared to $14.6 million in the prior year period. Adjusted EBITDA was $69.4 million or 41% of total revenues in the second quarter of 2019, compared to $53.5 million in the second quarter of 2018. Our GAAP net income for the second quarter was at $48.8 million or $0.83 per diluted share based on approximately 58 million shares versus $35.7 million or $0.61 per diluted share based on approximately 59 million shares in the prior year period. Our effective income tax rate was 6.9% for the second quarter and 16.1% for the six months ended, June 30, 2019. For the full year, we expect our effective income tax rate to be roughly 22% to 23%. For the third quarter, we anticipate non-cash stock-based compensation expense to be approximately $5 million to $7 million. Non-GAAP net income for the second quarter of 2019 was $43.7 million or $0.75 per diluted share based on approximately 58 million shares versus $34.8 million or $0.59 per diluted share in the prior year period. We anticipate fully diluted shares outstanding will be approximately 58 million shares in the third quarter of 2019. Turning to the balance sheet, we ended the quarter with cash and cash equivalents of $94.8 million and total debt of $33.5 million. As a reminder, this debt represents a financing of expansion-related construction at our corporate headquarters. The average daily balance of funds held on behalf of clients was approximately $1.2 billion in the second quarter of 2019. Now let me turn to guidance. For the third quarter of 2019, we expect total revenues in the range of $170 million to $172 million, representing a growth rate over the comparable prior year period of approximately 28% at the midpoint of the range. We expect adjusted EBITDA for the third quarter in the range of $61 million to $63 million, representing an adjusted EBITDA margin of approximately 36% at the midpoint of the range. For fiscal 2019, we are increasing our revenue guidance to a range of $728 million to $730 million or approximately 29% year-over-year growth at the midpoint of the range. We are also increasing our full year 2019 adjusted EBITDA guidance to a range of $306 million to $308 million, representing an adjusted EBITDA margin of approximately 42% at the midpoint of the range. With that, we will open the line for questions.

Hey, first of all, congrats from me for another great quarter. Chad, my question is around the new sales strategy. Can you expand a little bit on the move toward inside sales? That's obviously a big step for you, because you had a very strong direct model? Inside sales historically has been more kind of slightly lower in the market. How do you plan, like how big is that going to get and how do you try to do the client segmentation? Thank you.

Yes, so I appreciate the question. So if this is a shift in strategy, we've been having success selling online. You did allude to the fact that we've had a small inside sales organization here, that does sell to smaller prospects that call us or potentially clients that have an easier situation. But anyway, we continue to have increased lead volume in both inside and outside sales, and these inside sales efforts are just augmenting our traditional sales model, it's not replacing it, and so this should be accretive. The plans we have to continue to expand our footprint and outside sales haven't changed. As I just mentioned, we did open up an office in New Orleans. So we continue to open up new offices in a staggered approach, when it makes sense, but we also are having increased lead volume coming in through inside sales. In addition to innovating our product, we're also innovating our sales strategy as well. But I wouldn't call this a shift in strategy, we're expanding in both areas.

Hi. This is Howard Ma on for Samad. Thanks for taking the question. I have one for Chad, and one for Craig. So for Chad, I'm curious, are you seeing any cases of larger customers that are showing resistance to this fully employee self-service approach to HR? So it could be due to organizational complexities or industry or regulatory barriers? Or I guess another way of asking is, on the flip side, are there any industry verticals that have fewer organizational complexities and thus, they are more likely to switch to self-service? And then for Craig, just if I'm looking at the revenue guidance and if I want to back into EBITDA, I think it implies that you guys are going to see tremendous sales and marketing leverage in the 4Q. And so, is that true? And then, if that is true, what are the drivers? Thank you.

Yes. So I'll take the first question. I'm sure I could single out a specific prospect that for one reason or another might not embrace the strategy of employees having a direct relationship with the database. But I can't think of a good reason why any prospect, regardless of size, wouldn't want their employees to have a direct connection with the database. In fact, I believe that's what the enterprise market has been trying to build too with the multiple interfaces, and now you're even seeing companies lay over areas of technology onto those back end so that employees can actually have some level of experience with their data. I think that whether you're a large client or a smaller prospect, this is the future of our industry, and we're experiencing that future today. And so I would expect that all enterprise-level type clients would receive the same type of value that the others. We're actually seeing that, and we do continue to sell at the upper end of our range and even above that.

Yes, in terms of the adjusted EBITDA in the back half. We would expect to see some leverage in the sales and marketing, but also in the G&A line as well in the back half.

Okay. And if I may, just a follow-up, Craig. Have you updated long-term operating margin guidance, long-term targets, or sales and marketing? Could we possibly see it dip below 20% of sales in the next few years?

We have not given any long-term guidance on adjusted EBITDA.

Hi. This is Pinjalim on behalf of Mark. Congrats on the quarter, guys. Two questions from me. Chad, you said you have opened one office this year, I think it was four offices in the first half of last year. How do you feel about the balance between the need for office openings and the productivity gains of the existing offices? And in that context, I mean, could you talk about how sales productivity for mature offices is tracking, maybe versus last year?

Yes, well, first I'd say without productivity gains, you don't need to open up any offices; productivity gains are very important. We continue to drive that; we've opened up a lot of offices. I've said this in the past, now we're at 50 and once those offices are full, they are averaging about eight reps each. That's 400 reps for us, and that's quite a bit out there in the U.S. right now. So when we look at the TAM we already covered, there's quite a bit there already. Yes, we are going to continue to expand at times when it makes sense to us, but we also want to capture everything that's available to us now as well. Again, I didn't say this to signal a shift in strategy, it's more a little bit, and I wouldn't necessarily say that it's a shift. But we are seeing some buying habits change and a willingness depending on situation for people to buy online. As I've said earlier, as we're innovating our product, we're also innovating our sales strategy. I don't think people are going to potentially buy the same way 10 years from now that they're buying right now, and we want to be looking at that.

Yes, well, just to follow up on that. I know you don't disclose the revenue retention number quarterly, but any qualitative comment about directionally how that is trending this year so far would be helpful? And I've gotten this question a few times. How should investors think about a net dollar retention number that is something gross retention plus including upsells?

Yes, well, I mean, we've measured our retention the same since 2007, and it's a trailing 12, and so we've measured it the same. Last year was the very first time we saw an increase in that over a period of about seven years. Obviously, we're looking to increase that this year. Retention is something that improves throughout the year, you're going to typically have your largest losses in the beginning and then retention improves throughout the year. That's why we only update it once a year to stay consistent, but it's been our focus to improve retention and really what drives that is client satisfaction and the ROI that they're generating from using the software and how we're able to increase that ROI for them as well as for their employees. Those types of things drive retention for us and we're in the middle of the year and we'll report that number at the end of this year.

Great, thanks very much. Chad, can you update us a bit on how the price increase in the quarter was received?

Sure. So we made mention of a modest price increase last quarter. Moving forward, we're not going to communicate any pricing in the future as we don't want to discuss our pricing strategy publicly. But I will say this and I've said this in the past, as we drive greater ROI for our clients, it would only make sense that we would have the opportunity to share in the value that we're creating with our R&D spend. Ultimately, our clients are going to decide our value, and I feel really good about the amount of No Fee functionality we've added into the product to drive ROI for our clients as well as their employees, and I believe the clients are having a positive response to that enhancement.

Thank you. One for Chad here and then a follow-up for Craig. Chad, just given the tight labor market, it seems like improving employee experience is gaining industry momentum as a tool to increase employee retention. I know this Direct Data Exchange product is early, but can you just talk about what portion of the customer base has embraced the new product so far? It's only out there for one quarter; is this 5%, 10% of the customer base now adopting the product? Just trying to gauge how fast this product can be embraced by the existing customer base. Given it is so differentiated? Thanks.

Yes. So the short answer is currently 95% of our clients have clicked through the DDX five times or more, and the DDX has been out for four months. We started the shift to employee usage to drive incremental ROI for the client and the employee about three years ago. We've already got 95% on click-through. Currently, if we look at our clients' usage in aggregate for all of them, we're in the high 80s. I will say this, high 80s isn't a B plus on DDX, but it does show that clients are progressing. We're now having clients that want us to break down the DDX per user and per department, and that tells us they're focused on it and they're using it to improve their scores as they are completing the digital transformation in HCM.

Got it. Very helpful. As a follow-up for Craig, growth in revenue and billings accelerated this quarter despite sales office locations remaining flat for the last four or five quarters. How much of that acceleration in growth came from productivity improvements, increased attachment rates of various modules, or the price increase? Any additional insights on what contributed to the acceleration would be greatly appreciated. Thanks.

I mean, as we mentioned in the script, new client wins is the majority of the revenue acceleration. We have 49 of our 50 offices out there that are bringing on new clients, and so that's going to represent the majority of that revenue acceleration.

Good afternoon. Let me add my congratulations. I was wondering if you could talk a little bit about the large client initiative and what we're seeing there in terms of the 2,000 to 5,000 employee range, just what the pipeline looks like, what the receptivity is, and how incremental has that been to the acceleration that we've seen in terms of the revenue growth? And then I've got a follow-up. Thanks.

Yes, and so we had been selling above the 2,000 employee range for quite a long time before we actually formalized it and said okay, now we're moving up to 5,000, and now we're even seeing clients come in above that. So I would just say that we are continuing to get more of those, but we also have more at-bats because we have more reps. As our value proposition is getting stronger, people who may not have been interested six years ago are more interested now because the value proposition continues to get stronger.

Okay. And then with regards to the acceleration in terms of the revenue growth, I know new logos have always been the primary contributor, but to what extent relative to prior second quarters and kind of adjusting for seasonality would the additional attach rates in terms of modules versus more pace per control be, and then of course, the pricing be impacting the acceleration? And can you also talk a little bit about the Ask Here module and is that an additional incremental charge?

Okay. Well, first, I'll tell you, our new client wins percentage and our upsell percentage have been very consistent as they have been in the past, with the exception of the ACA year. Our percentages have always been very consistent and always weighted heavily toward the new logo side. As for Ask Here, like the DDX and even like our app, Ask Here is one of those no-fee functionality products that we do include within our stack, so that people will use the product correctly. Ask Here helps employees embrace the technology even more. Ask Here has a lot of benefits for both the company and the employee as an online communication resource where they can ask their inquiries online, and it's set up by the client to have each question answered by their expertise. We just believe this strengthens employee usage and drives the ROI for the business. In answer to your question, we aren't charging separately for Ask Here.

Yes, hi, thanks for taking my question, this afternoon. I just have one. I think, Chad, we've talked before in the past. I know it hasn't been the business sales strategy; it's been a new customer acquisition story and clearly, that's working really well. We have talked about in the past about maybe tapping the install base going back to increase usage and get full penetration within the installed base. I don't know if I know any software company that's full penetration. The question I want to ask you was on the expansion of the inside sales force. Clearly, it sounds like that's geared toward continuing the new customer acquisition. But over time, do you think there is an opportunity to maybe leverage those investments and maybe look back into the install base and see if you can further the penetration within that base? Thanks.

Sure. Well, first of all, I appreciate the question, it allows me to put a little bit more clarity around the inside sales efforts and strategy that I was mentioning earlier. You are correct; those inside sales are completely for new business wins; they are not for upsells to current clients. When I was talking about relocating a manager to build inside sales, that's to handle new business leads, not upsells to current clients. We have now and continue to have and have had for some time, a group of client relations reps that do upsell or upsell to current clients. They also help us focus on usage and that group's really done both. It's important that clients use the products that we've sold them correctly, before we're selling them additional products. But I wanted to state, we have not ignored inside sales. It's not some grand plan that someday, we're going to come back and start selling everybody all the products they really need. We do that today, and we're focused on usage.

Hi, thank you for taking my question and congratulations on the results. I have a couple of questions, one regarding your marketing spend. Over the past few years, you have increased your marketing spending and achieved positive results. Can you share how much benefit you've observed in the first half concerning your results? Additionally, could you provide some qualitative insights on your marketing spend plans for the second half?

Yes. So, we did do a national ad campaign. Last year, we actually continued to use those assets. Some of those assets, we had to actually repurchase rights to. We've done that; we do continue to use that. We do have strong marketing initiatives both this quarter, as well as through the end of the year, and that is all baked into our current guidance. We are having success with showing an industry how to use a product in a different way.

Hey guys, this is Josh on for Ryan. I was just wondering what application into modules are helping drive the greatest increase in employee usage on the platform today. Maybe just some color around that would be helpful?

Sure. It somewhat depends on the client as far as when you talk about what product drives the greatest usage for them. If you have hourly employees with schedules, you're going to have a lot of usage in the system. If you have salaried employees, you're not going to have as much time and attendance as you might in other areas of usage. It's really somewhat client-specific. We're going to deliver all to them that meets their needs at the time, obviously. And then how they're using it is going to really depend on what type of industry they are in, how many employees they have, are they decentralized, are more of their people in one area. Usage will be different per client, but 100% usage looks like a 100% usage. We might be talking about the difference in a client that made 200,000 changes total in their database for a month versus a client that only made 80,000, because they have a different employee base that doesn't require the same level of data input retrieval as you're going to have with other types of employee bases.

Okay, great. And then just one other question. When looking at your larger customers with 2,000 employees and above, how much room is there for seat expansion with these customers? Or are they typically getting every employee on the initial deal front?

Well, for seat expansion, you would have it from the beginning. For us, let's say this: they wanted to add additional master users or department users, even after all their employees are users, they can add as many users as they want; we don't charge on a per employee basis, as far as the number of users, they can have as many users as they want on the platform.

But for your larger customers, you're typically signing up every employee in the company initially?

For any sized organization, we are signing up every employee, because we have to do the payroll; we have to input all the totals. We have to balance so even terminated employees are set up in our system. So anybody that had balances and we work through that with the client. You might have terminated employees that want access to their data, and it would be a best practice to keep HCM technology turned on for terminated employees, so that you do not have to respond on certain issues that they can actually gather that information for themselves.

Hi guys, good quarter. Just wanted to ask on, as you guys move into those larger businesses. I know you guys have already sold to that group, but just are you seeing any changes from what the client needs? You have to change your sales tactic at all as you move up that group?

I want to clarify that we're not altering our sales tactics; the team remains the same. To illustrate, consider the difference between an employee at a company with 200 employees and one at a company with 10,000 employees. Fundamentally, there isn't a significant difference. In the past, company size could indicate complexity, but the users—employees—are quite similar across different company sizes. An employee at a 300-person company will generally engage with similar tools and processes as someone at a 3,000-person company. Therefore, when it comes to impacting employees, companies with 10,000 employees view their employees in much the same way as companies with 300 employees. You'll still have department leads, salespeople, and so on. This convergence is helping everyone better understand the value proposition.

And then just one quick follow-up on the really strong adjusted EBITDA, any color on what led to that higher number specialty versus the guidance you guys were expecting?

I mean, primarily, you saw the revenue beat flow through to the adjusted EBITDA line, very similar. So a lot of the revenue beat was able to flow through to the bottom line.

All right, well, I want to thank everyone for joining us on the call today. Next month, we'll be on the road meeting with investors at the following conferences. I'll be presenting at the KeyBanc Technology Leadership Forum on August 13th in Vail; and Craig and James will be hosting investor meetings at both the Oppenheimer and Canaccord Technology and Growth conferences in Boston on August 6th and August 7th. We appreciate your continued interest in Paycom and look forward to meeting with many of you soon. Thanks, operator. You may disconnect.