Paylocity Holding Corporation — Q1 Fiscal 2018 Form 10-Q
Business context and reporting period
Paylocity provides cloud-based payroll and human capital management software through a SaaS platform for medium-sized organizations, generally those with 20 to 1,000 employees. The filing covers the three months ended September 30, 2017, compared with the three months ended September 30, 2016. The financial statements are unaudited and results for the quarter are not necessarily indicative of the full fiscal year.
Key financial metrics
| Metric | Q1 FY2018 | Q1 FY2017 | Change |
|---|---|---|---|
| Total revenue | $81.5 million | $65.0 million | 25% |
| Recurring revenue | $78.9 million | $62.6 million | 26% |
| Recurring fees | $77.3 million | $61.9 million | 25% |
| Interest income on client funds | $1.6 million | $0.7 million | 126% |
| Gross profit | $46.5 million | $36.7 million | 27% |
| Gross margin | 57% | 56% to 57% | Broadly stable |
| Operating income (loss) | $0.5 million | $(2.5) million | Improved |
| Net income (loss) | $0.5 million | $(2.6) million | Improved |
| Diluted earnings (loss) per share | $0.01 | $(0.05) | Improved |
| Adjusted EBITDA | $14.6 million | $8.0 million | 83% |
| Operating cash flow | $8.2 million | $1.9 million | Improved |
Recurring revenue represented 97% of total revenue, compared with 96% in the prior-year quarter. Recurring gross margin declined to 69% from 70%, primarily due to higher personnel, software amortization, delivery and processing costs. Implementation services remained structurally loss-making, with an implementation gross margin of approximately negative 320%, compared with negative 288%.
Operating expenses increased 17% overall to $46.0 million. Sales and marketing increased 18% to $21.2 million, research and development increased 22% to $8.9 million, and general and administrative expense increased 15% to $16.0 million. Operating expense leverage improved as a percentage of revenue, declining to 56% from 60% to 61%.
Liquidity, cash flow and capital structure
- Cash and cash equivalents were $97.4 million at September 30, 2017, compared with $103.5 million at June 30, 2017.
- Funds held for clients were $942.0 million and were matched by client fund obligations of $942.0 million; these balances are not equivalent to unrestricted corporate cash.
- The company reported no debt outstanding on the balance sheet. Principal contractual commitments were operating leases of $115.8 million and unconditional purchase obligations of $2.3 million.
- Operating cash flow was $8.2 million. Investing cash flow was $(7.3) million, including $3.8 million of capitalized internal-use software costs, $2.7 million of property and equipment purchases, and $58.8 million of purchases of available-for-sale securities funded from client funds.
- Financing cash flow was $(6.9) million, primarily reflecting $6.5 million of taxes paid related to net share settlement of equity awards.
- Management stated that cash and expected operating cash flow should be sufficient to meet working capital, capital expenditure and other investment requirements for at least the next 12 months.
Material changes versus the prior comparable period
- Revenue growth was driven primarily by incremental revenue from new and existing clients. Recurring fees increased $15.4 million.
- Interest income increased $0.9 million due to higher average interest rates, higher average client-fund balances and the start of investments in marketable securities in July 2017.
- The sales organization expanded by 110 personnel, while research and development added 37 personnel. These investments increased expenses but supported management’s growth strategy.
- Capitalized internal-use software increased, and related amortization rose to $3.4 million from $1.7 million.
- Stock-based compensation increased to $6.6 million from $5.8 million and remained a significant non-cash expense.
- Beginning in July 2017, the company invested a portion of client funds in investment-grade corporate bonds, commercial paper and asset-backed securities. Available-for-sale securities had a fair value of $58.3 million at September 30, 2017.
- The company adopted the updated stock-compensation accounting standard effective July 1, 2017; the adoption had no material impact because of the company’s deferred-tax valuation allowance.
Outlook, commentary, risks and unusual items
Management expects to continue investing in personnel, sales and marketing, research and development, client implementation, data centers and infrastructure. It expects absolute costs to rise while seeking longer-term economies of scale, operating leverage and improved gross and operating margins. No specific revenue, earnings or margin guidance was provided in the filing.
The company expects to adopt the new revenue-recognition standard in its fiscal year beginning July 1, 2018. It expects a material change in the treatment of certain contract-acquisition costs, particularly sales commissions, which will be deferred and amortized rather than expensed as incurred. The potential overall financial-statement impact remained under evaluation.
Key risks include quarterly seasonality, especially stronger activity in the fiscal third quarter; generally cancellable client agreements with 60 days’ or less notice; competition; execution risk from rapid growth; cybersecurity, privacy and data-security exposure; service outages and third-party data-center dependence; regulatory and tax-law changes; interest-rate, credit and liquidity risks related to client funds; and potential needs for additional capital or ACH capacity.
The company had a valuation allowance against most deferred tax assets and stated that it was reasonably possible that all or part of the allowance could be released within the next 12 months if operating results continued to improve. No material litigation was pending or threatened, and the company reported no material off-balance-sheet arrangements. Disclosure controls were deemed effective.
Facts investors should verify
- Whether recurring-fee growth and client additions continue to support approximately 25% revenue growth.
- Whether recurring gross margin recovers from 69% as investments in personnel and infrastructure scale.
- The sustainability of profitability after excluding or considering $6.6 million of quarterly stock-based compensation and increasing software amortization.
- The performance, liquidity and credit exposure of the $58.3 million available-for-sale securities portfolio funded from client funds.
- The eventual impact and transition method for the new revenue-recognition standard, particularly deferred sales commissions.
- Whether the deferred-tax valuation allowance is released and how that would affect future tax expense and reported earnings.
- Seasonal fluctuations, client termination rates, implementation losses, and the company’s ability to fund growth without additional borrowing or equity issuance.