Business Context and Reporting Period
Paylocity Holding Corporation provides cloud-based payroll and human capital management software to medium-sized organizations through a SaaS platform. This Form 10-Q covers the three and nine months ended March 31, 2017, compared with the corresponding periods ended March 31, 2016. The filing was signed May 5, 2017.
The March quarter is seasonally stronger because of W-2 preparation, higher client-fund balances, payroll-tax collections and increased new-client implementations. Accordingly, quarterly results may not be indicative of full-year performance.
Financial Performance and Position
| Metric | Three Months Ended March 31 | Year-over-Year Change | Nine Months Ended March 31 | Year-over-Year Change |
|---|---|---|---|---|
| Total revenue | $90.3 million | Up 28% | $223.9 million | Up 31% |
| Recurring revenue | $86.4 million | Up 29% | $215.1 million | Up 32% |
| Gross profit | $58.2 million | Up 34% | $133.1 million | Up 34% |
| Operating income | $14.9 million | Up 140% | $10.7 million | Up $9.2 million |
| Net income | $14.8 million | Up 140% | $10.6 million | Up $9.0 million |
| Diluted earnings per share | $0.27 | Up from $0.12 | $0.20 | Up from $0.03 |
| Adjusted EBITDA | $26.8 million | Up 84% | $44.7 million | Up 78% |
Gross margin improved to 64% from 62% in the quarter and to 59% from 58% for the nine-month period. Recurring gross margin increased to 74% from 72% in the quarter but was unchanged at 71% for the nine months. Implementation services remained loss-making at a gross margin of negative 146% for the quarter and negative 222% for the nine months.
Recurring fees were $85.3 million for the quarter and $212.6 million for the nine months. Interest income on client funds was $1.0 million and $2.5 million, respectively. Implementation services and other revenue was $3.9 million for the quarter and $8.9 million for the nine months.
Operating expenses increased with continued investment in growth: sales and marketing rose 20% in the quarter and 28% for the nine months; research and development rose 3% and 13%; and general and administrative expenses rose 19% and 28%, respectively. Stock-based compensation was $6.2 million in the quarter and $18.7 million for the nine months.
Net cash provided by operating activities was $43.3 million for the nine months, compared with $29.1 million in the prior-year period. Capitalized internal-use software costs were $10.1 million and capital expenditures were $13.9 million. Cash and cash equivalents were $101.5 million at March 31, 2017, versus $86.5 million at June 30, 2016.
Funds held for clients were $1.17 billion, matched by client-fund obligations of the same amount. These balances are restricted to client payroll and tax obligations and should not be viewed as available corporate liquidity. Total liabilities were $1.21 billion and stockholders’ equity was $145.8 million. The filing does not report outstanding corporate debt. Contractual obligations consisted primarily of $119.6 million of operating lease obligations and $2.6 million of unconditional purchase obligations.
Material Changes Versus the Prior Comparable Period
- Recurring fees increased 29% in the quarter and 33% for the nine months, driven by new and existing clients and, for the nine-month period, the ACA compliance solution launched in fiscal 2016.
- Recurring revenue represented 96% of total revenue in 2017, compared with 95% in 2016.
- Quarterly operating leverage improved substantially: total operating expenses declined to 48% of revenue from 53%, and operating margin increased to 16% from 9%.
- The sales organization increased by 104 personnel, and research and development personnel increased by 62. Additional office space and personnel drove higher operating costs.
- Operating cash flow increased by $14.3 million year over year, while investment in internal-use software and property and equipment increased.
- Recurring fees from new clients declined to 42% from 48% for the quarter and to 37% from 43% for the nine months, as defined by the company’s metric.
Guidance, Outlook, Risks and Unusual Items
The filing does not provide formal quantitative revenue or earnings guidance. Management expects continued investment in personnel, product development, data centers and infrastructure, with expenses increasing in absolute dollars and potential long-term margin improvement from scale and operating leverage. Management states that cash on hand and operating cash flow should be sufficient for working capital, capital expenditures and other investment needs for at least the next 12 months.
Management identified seasonality, low interest rates, economic conditions, client employment levels, competition, client retention, implementation capacity, cybersecurity and data privacy, service outages, software defects, dependence on banking and ACH partners, and the ability to recruit and retain personnel as key risks. Client agreements are generally terminable on 60 days’ or less notice.
Client funds create significant liquidity and operational exposure: Paylocity may pay employees or taxing authorities before client funds finally settle, and rejected or reversed client payments could require additional short-term liquidity. The company uses nine banks for ACH and wire transfers.
The ACA compliance solution contributed materially to recurring revenue growth, but repeal, modification or delayed implementation of the Affordable Care Act could reduce revenue and margins and potentially require write-downs of related capitalized software. The company also expects adoption of the new revenue recognition standard in its fiscal year beginning July 1, 2018 and expects a material change in the treatment of certain contract-acquisition costs, including commissions.
The company reports no material pending legal proceedings, no material off-balance-sheet arrangements and effective disclosure controls as of March 31, 2017. It is involved in litigation concerning the validity of a bylaw fee-shifting provision and intends to appeal an adverse Delaware Court of Chancery ruling.
Important Facts for Investors to Verify
- Whether recurring revenue growth and new-client additions remain strong after the seasonally favorable March quarter.
- The sustainability of the sharp improvement in operating margin and net income, particularly as sales, service and infrastructure investments continue.
- The impact of declining recurring fees from new clients on future growth.
- The proportion of cash and cash flow attributable to restricted client funds versus corporate operating liquidity.
- Exposure to client-fund settlement failures, bank or ACH disruptions, interest-rate changes and investment losses on client funds.
- The eventual effect of ACA legislative changes and the adoption of revenue recognition and other accounting standards.
- Potential liabilities from cybersecurity incidents, data breaches, service outages, software errors, regulatory changes and the Delaware bylaw litigation.