Paylocity Holding Corporation — Fiscal 2019 First Quarter Form 10-Q
Reporting period: Three months ended September 30, 2018; comparative period ended September 30, 2017. The filing was signed November 2, 2018. Paylocity provides cloud-based payroll and human capital management software to medium-sized organizations, generally those with 20 to 1,000 employees.
Financial performance and position
| Metric | Q1 FY2019 | Q1 FY2018 | Change |
|---|---|---|---|
| Total revenue | $100.5 million | $81.5 million | 23% |
| Recurring revenue | $99.3 million | $78.9 million | 26% |
| Recurring fees | $95.8 million | $77.3 million | 24% |
| Interest income on client funds | $3.5 million | $1.6 million | 117% |
| Implementation services and other | $1.2 million | $2.6 million | (52%) |
| Gross profit | $64.6 million | $46.5 million | 39% |
| Operating income | $3.8 million | $0.5 million | Higher |
| Net income | $9.9 million | $0.5 million | Higher |
| Diluted EPS | $0.18 | $0.01 | Higher |
| Adjusted EBITDA | $23.3 million | $14.6 million | 60% |
Margins: Gross margin increased to approximately 64% from 57%. Recurring gross margin increased to 71% from 69%. Operating margin increased to approximately 4% from 1%, while net margin increased to approximately 10% from 1%. Adjusted EBITDA margin was approximately 23% versus 18% in the prior-year quarter.
- Sales and marketing expense increased 25% to $26.4 million.
- Research and development expense increased 28% to $11.4 million; $5.2 million of development costs were capitalized.
- General and administrative expense increased 44% to $23.0 million, including higher employee-related and stock-based compensation costs.
- Stock-based compensation expense increased to $9.4 million from $6.6 million.
Cash flow, liquidity, debt and balance sheet
- Cash flow from operations was $7.3 million, compared with $8.2 million in the prior-year quarter.
- Investing activities provided $29.1 million, primarily reflecting investment sales and changes in client funds; capitalized internal-use software costs were $5.0 million and property and equipment purchases were $2.4 million.
- Financing activities used $109.9 million, including $34.7 million for share repurchases and $17.9 million of taxes paid on net share settlements of equity awards.
- Cash and cash equivalents declined to $63.7 million from $137.2 million at June 30, 2018. Corporate investments were $21.2 million on the balance sheet; management reported total corporate investments of approximately $22.1 million for liquidity purposes.
- Funds held for clients were $1.168 billion, matched by client fund obligations of the same amount. These balances are not available for general corporate use.
- Total assets were $1.464 billion and stockholders’ equity was $232.6 million at September 30, 2018.
- The filing does not report outstanding debt or borrowings. Principal commitments were operating leases of $112.1 million and unconditional purchase obligations of $4.6 million.
- Management stated that cash, corporate investments and operating cash flow should be sufficient to meet expected needs for at least the next 12 months.
Material changes and unusual items
- Effective July 1, 2018, Paylocity adopted ASC Topic 606 using the modified retrospective method. The adoption did not materially affect the timing or amount of total revenue but materially changed the balance sheet and expense recognition.
- Implementation fees for proprietary products are now generally deferred and amortized over up to 24 months rather than recognized upon completion. This contributed to the 52% decline in implementation revenue.
- Certain contract acquisition and fulfillment costs are now capitalized and amortized over an estimated seven-year benefit period. Deferred contract costs totaled $75.3 million at September 30, 2018.
- Topic 606 increased retained earnings by $52.7 million at adoption, principally from deferred contract costs and implementation-related contract assets, net of tax.
- Remaining performance obligations related to minimum monthly fees on term contracts were approximately $29.0 million, generally to be recognized over the next 24 months.
- The income tax benefit of $5.8 million was primarily driven by $6.9 million of excess tax benefits from employee stock exercises. Management also substantially released its valuation allowance on U.S. federal and state deferred tax assets; a $0.4 million state valuation allowance remained.
- The company repurchased approximately 442,000 shares for $35.0 million, completing the authorized repurchase program.
Outlook, commentary and risks
- Management intends to continue investing in personnel, sales and marketing, research and development, data centers and infrastructure. It expects absolute expenses to rise while longer-term scale may improve gross and operating leverage.
- No quantitative revenue or earnings guidance is provided in the filing.
- Results are seasonal, with the fiscal third quarter typically benefiting from W-2 preparation, higher client funds and related interest income. Quarterly results are therefore not necessarily indicative of full-year performance.
- Key risks include competition, execution of rapid growth, client cancellations, sales-force productivity, implementation capacity, service outages, cybersecurity and privacy breaches, software defects, reliance on third-party data centers and banking partners, and regulatory or tax changes.
- Most client agreements are cancellable on 60 days’ notice or less, although the company has begun entering into generally two-year term arrangements.
- Client payroll processing creates liquidity and operational exposure if client payments are rejected after Paylocity has funded employee and tax payments. The company processed more than $110 billion of payroll transactions in fiscal 2018.
- Interest-rate changes affect income earned on cash and client funds and the market value of available-for-sale securities. A hypothetical 25-basis-point rate increase would have reduced the value of securities held in client funds by approximately $0.2 million at September 30, 2018.
- Management reported no material pending legal proceedings, no material off-balance-sheet arrangements, and effective disclosure controls as of September 30, 2018.
- The company expects adoption of the new lease standard in fiscal 2020 and anticipates a material balance-sheet effect, although the impact had not yet been quantified.
Investor verification checklist
- Verify the sustainability of revenue growth, recurring revenue retention and the contribution from higher interest rates on client funds.
- Reconcile GAAP results with Adjusted EBITDA and assess the effect of substantial stock-based compensation.
- Evaluate how ASC 606 capitalization and deferral of commissions, implementation costs and implementation revenue affect comparability and future margins.
- Monitor cash excluding client funds, corporate investment liquidity, share repurchases and the company’s ability to fund planned growth without debt.
- Assess exposure to client payment failures, banking-partner capacity, investment losses and interest-rate movements.
- Review the effect of lease accounting adoption and the company’s significant operating lease commitments.
- Track cybersecurity, service availability, regulatory compliance, competition and the largely cancellable client-contract base.