Paycom Software, Inc. quarterly report, Q1 FY2019

Business context and reporting period

Paycom Software, Inc. filed this unaudited Form 10-Q for the three months ended March 31, 2019. The company provides cloud-based human capital management software, including payroll, HR, talent, and time-management applications. Comparisons below are with Q1 2018 unless noted.

Financial performance and position

Gross margin was approximately 85% (versus approximately 85% in Q1 2018; calculated from reported cost of revenue, about 85.3% versus 84.7%). Operating margin declined to 31.3% from 33.1%, and net margin to 23.6% from 26.7%. Management-defined adjusted EBITDA was $103.3 million versus $80.7 million; non-GAAP net income was $69.3 million versus $55.8 million. These non-GAAP measures are supplemental and are not substitutes for GAAP results.

Cash and cash equivalents were $91.3 million at March 31, up from $45.7 million at year-end. Total debt, net of issuance costs, was $34.0 million, including $1.8 million current; no revolver borrowings were outstanding at quarter-end. The company reported compliance with debt covenants. The $1.405 billion of funds held for clients was matched by a $1.405 billion client funds obligation and is not ordinary operating liquidity. Reported current assets and liabilities are therefore substantially inflated by these matched balances.

Material changes versus the prior comparable period

• Revenue growth reflected new clients, maturing sales offices, additional applications sold to existing clients, strong tax-form filing activity, and higher interest earned on client funds. A March price adjustment had an immaterial Q1 effect.
• Operating expenses rose 34%, faster than revenue. Research and development increased 64% and general and administrative expense increased 38%; management cited staffing growth and higher stock-based compensation among the drivers.
• Stock-based compensation expense increased 33% to $31.1 million, primarily due to market-based restricted shares vesting after enterprise-value targets were reached. The vesting generated $28.8 million of recognized compensation cost for the two disclosed February events.
• Operating cash flow increased, while investing and financing cash flows were heavily affected by the timing of client-fund receipts, investments, and disbursements. Investing cash use was $452.4 million and financing cash provided was $417.6 million.

Outlook, commentary, and risks

• No specific full-year revenue or earnings guidance is provided in the filing. Management said Q1 is typically seasonally stronger because payroll tax forms and certain unscheduled payrolls are concentrated in the first quarter; Q1 results may not indicate full-year performance.
• Management expects gross margins to remain relatively consistent, while acknowledging quarter-to-quarter effects from seasonality and hiring. It expects R&D spending to rise in absolute dollars and as a percentage of revenue, with the rate of increase expected to moderate over time.
• The March 2019 price adjustment is expected to contribute approximately 1% of projected 2019 revenue.
• Management believed cash, operating cash generation, and available credit would cover working-capital and capital-expenditure needs for at least 12 months. Capital spending was expected to increase, including for a new Grapevine, Texas operations facility; construction began in April 2019.
• On April 15, 2019, after quarter-end, the revolving facility was amended: commitment increased from $50 million to $75 million, with potential expansion to $125 million, and maturity extended to April 15, 2022.
• Key risks include seasonality, dependence on attracting and retaining clients and expanding application use, sensitivity to clients’ employee counts and labor-market conditions, rising growth-related costs, and interest-rate exposure. The company disclosed ordinary-course legal proceedings whose resolution could have a material adverse effect, but provided no clear quantified estimate of exposure. It reported no material changes to the risk factors in its 2018 Form 10-K.
• Adoption of the new lease standard on January 1, 2019 recognized operating lease assets and liabilities; lease liabilities were $24.9 million at March 31. Management reported effective disclosure controls and no material control changes beyond lease-related updates.

Investor verification priorities

1. Assess whether revenue growth and client expansion can continue beyond the seasonally strong first quarter, and monitor client retention and employee usage of additional applications.
2. Track expense growth, particularly stock-based compensation and R&D, and reconcile GAAP performance with management’s non-GAAP measures.
3. Separate client funds from operating liquidity when evaluating cash flows, working capital, and liquidity; client-fund timing materially affected quarterly investing and financing cash flows.
4. Review the economics and covenants of the amended revolving facility, the secured term debt, and interest-rate swap exposure.
5. Monitor capital spending for the Texas facility, lease commitments, and the outcome or any quantification of the disclosed legal proceedings.