Paycom Software, Inc. — FY2018 Form 10-K
Reporting period: Fiscal year ended December 31, 2018. The filing also reports fourth-quarter results; amounts below are U.S. dollars.
Business context and reporting period
Paycom provides cloud-based, subscription HCM software, with payroll as the required foundation for its other applications. Revenue is primarily recurring and linked to client payroll periods, employee counts and application usage. At year-end, Paycom reported 23,533 clients, 49 sales teams and a 92% annual revenue retention rate, up from 91% in 2017.
Financial performance and liquidity
| Metric | FY2018 | FY2017, as adjusted | Change |
|---|---|---|---|
| Revenue | $566.3 million | $433.0 million | +31% |
| Operating income | $173.7 million | $129.7 million | +34% |
| Net income | $137.1 million | $123.5 million | +11% |
| Diluted EPS | $2.34 | $2.10 | +11% |
| Operating margin | 30.6% | 30.0% | +0.6 percentage points |
| Gross margin | Approximately 84% | Approximately 83% | +1 percentage point |
| Operating cash flow | $184.8 million | $130.1 million | +42% |
Recurring revenue was $557.3 million, or 98.4% of total revenue. Q4 revenue was $150.3 million versus $114.0 million in Q4 2017; operating income was $43.4 million versus $36.4 million, while net income was $31.4 million versus $48.9 million. The lower year-over-year Q4 net income followed unusually low 2017 tax expense, including the benefit from remeasuring deferred taxes after the Tax Cuts and Jobs Act.
Cash and cash equivalents were $45.7 million at year-end, and working capital was $44.9 million. Funds held for clients of $967.8 million were matched by a $967.8 million client funds obligation; these balances are held to remit payroll and tax amounts and should not be treated as unrestricted corporate cash. Property and equipment purchases were $59.9 million. Management said available cash was expected to cover working capital and capital expenditure needs for at least 12 months.
Debt was $34.4 million, including $1.8 million current and $32.6 million long-term. The company had no revolver borrowings outstanding under its $50 million facility, which could be increased to $100 million subject to conditions; $24.5 million remained available under the term agreement. Paycom reported compliance with debt covenants. It repurchased 1.11 million shares for an aggregate $125.4 million during 2018, including shares withheld for employee taxes; $162 million remained authorized for repurchases at year-end. No cash dividends were paid.
Changes versus the prior comparable period
- Revenue growth reflected new clients, maturing and expanded sales offices, additional applications sold to existing clients, strong tax-form filing activity and higher interest earned on client funds.
- Operating margin improved modestly despite continued investment. Research and development expense rose 52%, while sales and marketing expense rose 30%; the latter included a national advertising campaign in the second half of 2018.
- Net income growth lagged operating income growth primarily because 2017 included a $24.9 million tax benefit from Tax Act-related deferred-tax remeasurement and other tax effects. Effective tax rates were 22% in 2018 and 3% in 2017.
- Operating cash flow increased to $184.8 million. Investing and financing cash flows were significantly affected by movements in client funds and related obligations, so reported investing cash flow is not a direct measure of operating investment.
- Adoption of revenue standard Topic 606 was applied retrospectively. It did not materially change revenue timing or amount, but changed accounting for certain contract acquisition and fulfillment costs, which are now capitalized and amortized; prior periods were recast.
Outlook, commentary, risks and unusual items
- Management plans continued U.S. sales-office expansion, increased sales to existing clients, broader employee use of applications and efforts to win larger clients. Construction of an expanded Grapevine, Texas facility was expected to begin in the first half of 2019.
- Management expected 2019 capital expenditures as a percentage of revenue to be consistent with 2018 levels, and gross margins to remain relatively constant, though margins may fluctuate with seasonality and hiring. The filing does not provide a specific revenue or earnings forecast.
- Seasonality is meaningful: first-quarter revenue and margins generally benefit from annual payroll and ACA-related form filings; fourth-quarter revenue can benefit from unscheduled payroll runs. Management estimated ACA application and filing revenue would be about 4% of projected 2019 revenue if employer reporting requirements remained in place.
- Key risks include cybersecurity and privacy breaches, data-center outages, changing employment and privacy regulation, competition and pricing pressure, execution of rapid growth and sales expansion, client retention, and potential changes to ACA reporting requirements. Paycom also cited risks from money-transmitter regulation, client funding failures or delayed ACH settlement, and interest-rate and investment risks on client funds.
- Debt agreements include financial covenants and restrictions on certain financing, distributions and other actions. Ordinary-course legal matters were pending; management did not expect their resolution to materially adversely affect the company, but noted outcomes are uncertain.
- Other notable items: the company recognized a $0.7 million gain from the interest-rate swap fair-value change in 2018; the swap is not designated as an accounting hedge. The auditor issued unqualified opinions on the financial statements and internal controls, and management concluded controls were effective.
Investor verification priorities
- Verify the drivers and durability of 31% revenue growth, including client additions, application adoption, retention and employee headcount trends.
- Assess the effect of the 2017 tax benefit on comparisons and the sustainability of current margins and tax rates.
- Separate Paycom’s own liquidity from client funds and obligations; review operating cash flow alongside deferred contract-cost capitalization and capital expenditures.
- Review debt covenant headroom, remaining term-loan availability, buyback spending and the planned Texas facility investment.
- Monitor ACA-related revenue exposure, regulatory developments, cybersecurity and service continuity, and any material developments in legal proceedings.