Paylocity Holding Corporation — Form 10-Q Summary
Business context and reporting period
Paylocity provides cloud-based payroll and human capital management software for medium-sized organizations, generally those with 20 to 1,000 employees. The filing covers the three and six months ended December 31, 2018, the second quarter and first six months of fiscal 2019. The financial statements are unaudited.
Financial performance and position
| Metric | Q2 FY2019 | Q2 FY2018 | Six months FY2019 | Six months FY2018 |
|---|---|---|---|---|
| Total revenue | $107.2 million | $86.0 million | $207.7 million | $167.5 million |
| Recurring revenue | $104.7 million | $83.1 million | $204.0 million | $162.0 million |
| Gross profit | $69.1 million | $49.2 million | $133.7 million | $95.7 million |
| Operating income | $7.0 million | $0.1 million | $10.8 million | $0.6 million |
| Net income | $5.7 million | $0.4 million | $15.6 million | $1.0 million |
| Diluted EPS | $0.10 | $0.01 | $0.28 | $0.02 |
| Adjusted EBITDA | $26.1 million | $15.2 million | $49.4 million | $29.8 million |
Q2 total revenue increased 25% year over year, while recurring revenue increased 26%. Recurring fees rose 23% to $100.3 million, primarily from new and existing clients. Interest income on client funds increased 150% to $4.5 million, driven by higher interest rates, higher average client-fund balances and greater investment in marketable securities. Implementation services and other revenue declined 16% to $2.5 million.
Gross margin improved to 65% in Q2 from 57% in the prior-year quarter and to 64% for the six-month period from 57%. Recurring gross margin increased to 70% from 69%. Operating margin improved to 7% from approximately 0%, while six-month operating margin increased to 5% from approximately 0%. Net margin was approximately 5% in Q2 and 7% for the six-month period.
Operating expenses increased with growth investments: Q2 sales and marketing rose 23%, research and development rose 38%, and general and administrative expense rose 25%. Stock-based compensation was $10.1 million in Q2 and $19.5 million for the six-month period, compared with $7.8 million and $14.4 million, respectively, in the prior-year periods.
Net cash provided by operating activities was $34.3 million for the six months ended December 31, 2018, broadly comparable with $34.2 million in the prior-year period. Net cash used in investing activities was $69.6 million, including $9.4 million of capitalized internal-use software costs and $7.5 million of property and equipment purchases. The company repurchased $35.0 million of common stock and paid $18.9 million in taxes related to equity-award net settlements. Cash and cash equivalents declined from $137.2 million at June 30, 2018 to $84.1 million at December 31, 2018.
At December 31, 2018, the company held $20.8 million of corporate investments and $1.259 billion of funds held for clients, matched by $1.259 billion of client-fund obligations. No debt balance is disclosed in the filing. Total liabilities were $1.329 billion, substantially consisting of client-fund obligations. Management stated that cash, corporate investments and operating cash flow should be sufficient for at least the next 12 months.
Material changes versus the prior comparable period
- Recurring revenue growth remained strong at 26% year over year for both the quarter and six-month period.
- Interest income became a more significant revenue contributor, increasing from 2% to 4% of total revenue.
- Implementation revenue declined because implementation fees for proprietary products are now deferred and amortized, rather than recognized upon completion.
- Adoption of ASC 606 on July 1, 2018 materially changed the balance sheet. The company recorded $82.3 million of deferred contract costs at December 31, 2018 and a $52.7 million cumulative increase to retained earnings upon adoption.
- ASC 606 also resulted in capitalization and seven-year amortization of qualifying contract acquisition and fulfillment costs. The company reported that the adoption did not materially affect the timing or amount of revenue recognized overall.
- The company completed a $35.0 million share-repurchase authorization during the first quarter of fiscal 2019, repurchasing and retiring 442,000 shares.
- The valuation allowance on substantially all federal and state deferred tax assets was released in fiscal 2018. The six-month 2018 tax benefit included $7.4 million of excess tax benefits from employee stock exercises.
Guidance, outlook, commentary and risks
The filing does not provide explicit quantitative revenue, earnings or margin guidance. Management expects to continue investing in sales and marketing, research and development, implementation and client service, personnel, data centers and infrastructure. Management expects these investments to increase costs in absolute dollars while producing greater economies of scale and improved gross and operating margins over the long term.
Management expects to fund operations and capital expenditures primarily with operating cash flow. Contractual obligations at December 31, 2018 totaled $113.9 million, including $109.8 million of operating lease obligations and $4.1 million of unconditional purchase obligations. The company expects to adopt the new lease standard on July 1, 2019, which it believes will add right-of-use assets and lease liabilities to the balance sheet.
Results are seasonal, with the fiscal third quarter typically benefiting from W-2 processing, year-end activity and higher client-fund balances. Management cautions that quarterly results are not necessarily indicative of full-year or future performance.
- Most client agreements are cancellable on 60 days’ notice or less, although the company has begun entering into generally two-year term arrangements.
- Client funds and corporate investments are exposed to interest-rate, credit, market and liquidity risks. A 25-basis-point rate increase was estimated to reduce the fair value of client-fund securities by approximately $0.1 million.
- The company depends on banking partners and ACH capacity to move payroll and tax funds. Client payment reversals or bank disruptions could require additional short-term liquidity.
- Key operating risks include cybersecurity or data breaches, service outages, software defects, regulatory and privacy changes, competition, employee retention, sales-force productivity and the ability to manage rapid growth.
- The company disclosed no material pending litigation and no material off-balance-sheet arrangements.
- Management concluded that disclosure controls were effective as of December 31, 2018, with no material changes to internal control over financial reporting.
Important facts for investors to verify
- Whether recurring revenue growth and higher interest income on client funds are sustainable if interest rates or client-fund balances decline.
- The effect of ASC 606 capitalization and seven-year amortization on future reported margins, operating cash flow and comparability with prior periods.
- Growth in deferred contract costs, including the $82.3 million balance at December 31, 2018, and the related amortization expense.
- Cash generation after share repurchases, capitalized software spending and continued growth investments.
- The impact of the planned July 1, 2019 lease-accounting adoption on reported assets, liabilities and leverage measures.
- Client retention, new-client additions, implementation capacity and the proportion of contracts that remain cancellable on short notice.
- Exposure to cybersecurity incidents, service interruptions, regulatory changes and potential losses involving client payroll funds.