Paycom Software, Inc. — Q3 2016 Form 10-Q
Business and period: Paycom provides cloud-based human capital management software on a SaaS basis. This unaudited filing covers the three and nine months ended September 30, 2016, compared with the same periods in 2015.
Financial performance
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Revenue | $77.3 million | $55.3 million | $241.3 million | $159.5 million |
| Recurring revenue | $75.9 million | $54.2 million | $237.3 million | $156.4 million |
| Operating income | $0.6 million | $6.9 million | $45.3 million | $28.2 million |
| Net income | $6.2 million | $3.8 million | $35.2 million | $15.8 million |
| Diluted EPS | $0.10 | $0.07 | $0.59 | $0.27 |
- Growth and margins: Revenue increased 40% year over year in Q3 and 51% over nine months. Recurring revenue represented approximately 98% of revenue. Q3 operating margin fell to 0.8% from 12.5%; nine-month operating margin rose to 18.7% from 17.7%. Nine-month gross margin was approximately 84% in both years, according to management.
- Costs and profitability: Q3 operating expenses rose 58%, led by general and administrative expense, which increased 104%, and research and development, up 165%. Nine-month operating expenses increased 49%. Stock-based compensation was $14.2 million in Q3 and $18.7 million for the nine months. Q3 net income included a $6.8 million excess tax benefit from early adoption of ASU 2016-09; the resulting $6.1 million income tax benefit helped lift net income despite sharply lower operating income.
- Cash flow: Nine-month operating cash flow was $74.4 million, versus $34.1 million. Capital spending on property and equipment was $32.1 million, versus $10.2 million. Reported investing cash inflow of $71.5 million included a $103.7 million decrease in client funds held; financing cash outflow of $122.2 million included an equal decrease in the client funds obligation, as well as $14.4 million for employee tax withholding on vested shares and $8.4 million of open-market repurchases. Cash and equivalents increased to $74.5 million from $50.7 million at year-end.
- Balance sheet and debt: Total assets were $821.0 million, including $593.0 million of funds held for clients, matched by a $593.0 million client funds obligation. These client funds are not equivalent to unrestricted corporate cash. Total debt, including current maturities, was $30.1 million; the company also had an undrawn construction loan facility of up to $28.6 million. Stockholders’ equity was $131.0 million.
Changes and management commentary
- Revenue growth reflected new clients, especially in mature sales offices, sales of additional applications to existing clients, application enhancements, improved client training, and greater sales-representative productivity. Nine-month revenue also benefited from more client tax-form filings.
- Paycom opened six sales offices in the first nine months and reported 42 sales teams across 24 states. Management expects continued gradual increases in R&D expense as it adds personnel, and expects gross margin to remain relatively consistent. It also expects capital expenditures and investment activity to increase with growth.
- Management stated that existing cash and equivalents should meet working capital and capital expenditure needs for at least the next 12 months. The filing provides no specific revenue or earnings guidance.
- The company adopted ASU 2016-09 early in Q3, recognizing $6.8 million of excess tax benefits in the income statement. The filing also describes a subsequent October 4 grant of 721,100 restricted shares, with expected compensation cost of approximately $24.5 million.
Debt, risks, and contingencies
- Outstanding loans include a $25.2 million term note at 4.75% due in 2021 and a $4.9 million term loan at 3.4% due in 2022. The company reported compliance with loan covenants, including a fixed-charge coverage requirement. A new construction loan had no borrowings at quarter-end.
- The board authorized up to $50 million in share repurchases over 24 months. Through September 30, the company reported $22.8 million spent on repurchases, including shares withheld for employee tax obligations.
- Paycom is involved in ordinary-course legal proceedings; outcomes are uncertain and could materially affect the company. The filing highlights potential adverse sales, use, or other tax assessments, including possible retroactive application and liability if taxes cannot be collected from clients.
- Other risks include execution of geographic expansion and growth plans, attracting and retaining clients, expense growth, and sensitivity of investment income and values to interest-rate changes. Management said a 100-basis-point rate change was not expected to have a material effect. No off-balance-sheet arrangements were reported.
Key facts for investors to verify
- How much Q3 operating-margin pressure came from recurring growth investments versus the $14.2 million of stock-based compensation, and whether expense growth moderates.
- The sustainability of reported earnings and tax rates: Q3 net income benefited from a one-time $6.8 million excess tax benefit.
- Underlying operating cash generation after considering stock-based compensation, deferred revenue, and working-capital movements; client-fund cash flows should be assessed separately.
- Capital-spending requirements and the cost and timing of the headquarters expansion, including potential borrowing under the construction facility.
- Future dilution and compensation expense from outstanding and newly granted restricted shares, alongside remaining repurchase authorization.
- Potential exposure to changing state and local tax rules, legal proceedings, and the company’s ability to sustain client and revenue growth.