Paycom Software, Inc. quarterly report, Q2 FY2014

Paycom Software, Inc. — Q2 2014 Form 10-Q

Reporting period: Three and six months ended June 30, 2014; comparative periods ended June 30, 2013. Unaudited. Paycom provides cloud-based human capital management software, primarily payroll processing, on a SaaS basis. The company completed its IPO on April 21, 2014.

Financial performance and position

Metric	Q2 2014	Q2 2013	First half 2014	First half 2013
Total revenue	$33.3m	$23.9m	$70.3m	$51.5m
Operating income	$3.1m	$3.2m	$6.2m	$8.7m
Net income (loss)	($0.6m)	$0.4m	$0.5m	$3.0m
Operating cash flow	—	$5.9m	$8.9m

Recurring revenue was $32.7m in Q2, up 39.6%, and $69.1m for the first half, up 36.6%. Recurring revenue represented 98.2% of Q2 revenue and 98.3% of first-half revenue.
Gross margin was approximately 81% for each six-month period, according to management. Q2 cost of revenue was $6.4m; operating income margin was 9.3%, compared with 13.4% in Q2 2013. First-half operating margin was 8.9%, versus 17.0%.
Q2 net loss included a $4.0m loss on early debt repayment. Interest expense declined to $0.7m from $2.3m. First-half net income fell despite lower interest expense, principally alongside higher operating expenses and the debt repayment charge.
Adjusted EBITDA, a non-GAAP measure, was $6.1m in Q2 versus $4.4m; for the first half it was $12.6m versus $12.6m. First-half EBITDA before adjustments declined to $6.9m from $11.6m. The company cautions that these measures are not GAAP and may not be comparable across companies.
Cash and cash equivalents were $14.0m at June 30, versus $13.4m at December 31, 2013. Funds held for clients were $315.6m, matched by a $315.6m client funds obligation; these client-related balances are not equivalent to unrestricted liquidity.
Property, plant and equipment purchases were $9.3m in the first half, compared with $2.8m. Reported investing cash flow of $130.9m included a $140.2m decrease in client funds; financing cash flow of negative $136.2m included the matching decrease in the client funds obligation.
Debt at June 30 was $27.4m, under a secured bank term loan bearing fixed interest at 4.75% and maturing in 2021. This compares with $82.0m total debt at December 31, including related-party notes. The company repaid the related-party notes in April using IPO proceeds and existing cash; it reported compliance with loan covenants at June 30.

Material changes and management commentary

Revenue growth was attributed to clients added in mature and newer sales offices, sales of additional applications, growth in client employee counts, and higher average revenue per client as Paycom served larger clients.
Operating expenses grew faster than revenue: first-half administrative expenses rose 53.2%, including sales and marketing growth of 58.2%. Management cited increased sales staffing and commissions, office expansion, public-company and IPO costs, and increased R&D staffing.
Sales teams increased to 31 from 25. Annualized new recurring revenue was $24.1m, up from $17.9m. The measure estimates annualized first-full-month revenue from new clients and clients purchasing additional applications; it is not a GAAP revenue measure.
The company opened five sales offices in the first half. Management said it planned to expand offices and expected to raise annual openings from three to four historically to four to six beginning in 2015. It also expects capital expenditures and investment activity to increase as the business grows.
Management expects growth to generally track labor-market improvement, a rising contribution from applications beyond payroll, and gradual gross-margin improvement from client growth, application adoption, and cost efficiencies. These are forward-looking expectations, not guaranteed results.

Outlook, risks and unusual items

Management believed existing cash would cover working capital and capital expenditure needs for at least 12 months, but warned that inadequate revenue or operating cash flow could impair liquidity and business objectives. No specific revenue or earnings guidance was provided.
The IPO generated approximately $64.3m in net proceeds. The proceeds, together with about $3.3m of existing cash, were used to repay 10% and 14% related-party notes. The payoff produced the $4.0m early repayment loss, including debt issuance costs and discounts.
Paycom became subject to corporate income taxes following its January 2014 reorganization. Management attributed higher effective tax rates to the change in tax status; the Q2 2014 tax benefit was $0.4m, and the first-half tax provision was $0.3m.
A patent dispute was settled confidentially on July 1, 2014, with dismissal with prejudice. The company also reported other ordinary-course legal proceedings whose outcomes could adversely affect results or cash flows. It reported no material changes to the risk factors in its April 2014 prospectus.
The loan is secured by headquarters property and includes financial and nonfinancial covenants and restrictions on, among other things, liens, affiliate transactions and additional funded debt. A prior covenant breach at December 2013 had been waived; Paycom reported compliance at June 30, 2014.
Operating lease commitments totaled $13.7m at June 30; a Boston office lease signed July 3 increased future minimum payments by $1.3m and was not included in that figure. The Oklahoma City development agreement requires job creation and investment; the company reported it had earned $1.8m of $2.0m in job-creation payments and expected to meet its obligations.
Disclosure controls were assessed as effective at June 30, 2014. No material change in internal control over financial reporting was reported for the quarter.

Important facts for investors to verify

Whether strong recurring-revenue and new-recurring-revenue growth converts into sustained operating-margin and cash-flow improvement as sales, marketing, and expansion costs rise.
How much of reported cash generation is attributable to operating performance versus movements in funds held for clients and their matching obligations.
The effects of IPO-related dilution, restricted-stock vesting, and ongoing equity compensation on per-share results.
Compliance with the secured loan’s covenants and the company’s capacity to fund planned office growth and capital spending.
Developments in other legal matters, the obligations under the Oklahoma City funding agreement, and lease commitments, including the Boston lease.