Feb. 5, 2020, 1:06 p.m. EST

10-Q: PAYLOCITY HOLDING CORP

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(EDGAR Online via COMTEX) -- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The statements included herein that are not based solely on historical facts are "forward looking statements." Such forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties. Our actual results could differ materially from those anticipated by us in these forward-looking statements as a result of various factors, including those discussed below and under Part II, Item 1A. "Risk Factors."

Overview

We are a cloud-based provider of payroll and human capital management ("HCM") software solutions for medium-sized organizations, which we define as those having between 20 and 1,000 employees. Our comprehensive and easy-to-use solutions enable our clients to manage their workforces more effectively. Our product suite delivers a unified platform for professionals to make strategic decisions in the areas of payroll, core HR, workforce management, talent and benefits, all while promoting a modern workplace and improving employee engagement.

Effective management of human capital is a core function in all organizations and requires a significant commitment of resources. Our solutions were specifically designed to meet the payroll and HCM needs of medium-sized organizations. We designed our cloud-based platform to provide a unified suite of modules using a multi-tenant architecture. Our solutions are highly flexible and configurable and feature a modern, intuitive user experience. Our platform offers automated data integration with over 300 related third-party systems, such as 401(k), benefits and insurance provider systems.

Our payroll solution was the first of our current offerings introduced into the market. We believe payroll is the most critical system of record for medium-sized organizations and an essential gateway to other HCM functionalities. We have invested in, and we intend to continue to invest in, research and development to expand our product offerings and advance our platform.

We believe there is a significant opportunity to grow our business by increasing our number of clients and we intend to invest in our business to achieve this purpose. We market and sell our solutions through our direct sales force. We have increased our sales and marketing expenses as we have added sales representatives and related sales and marketing personnel. We intend to continue to grow our sales and marketing organization across new and existing geographic territories. In addition to growing our number of clients, we intend to grow our revenue over the long term by increasing the number and quality of products that clients purchase from us. To do so, we must continue to enhance and grow the number of solutions we offer to advance our platform.

We believe that delivering a positive service experience is an essential element of our ability to sell our solutions and retain our clients. We seek to develop deep relationships with our clients through our unified service model, which has been designed to meet the service needs of mid-market organizations. We expect to continue to invest in and grow our implementation and client service organization as our client base grows.

We believe we have the opportunity to continue to grow our business over the long term, and to do so we have invested, and intend to continue to invest, across our entire organization. These investments include increasing the number of personnel across all functional areas, along with improving our solutions and infrastructure to support our growth. The timing and amount of these investments vary based on the rate at which we add new clients, add new personnel and scale our application development and other activities. Many of these investments will occur in advance of experiencing any direct benefit from them, which will make it difficult to determine if we are effectively allocating our resources. We expect these investments to increase our costs on an absolute basis, but as we grow our number of clients and our related revenues, we anticipate that we will gain economies of scale and increased operating leverage. As a result, we expect our gross and operating margins will improve over the long term.

As our business has grown, we have become increasingly subject to the risks arising from adverse changes in domestic and global economic conditions. If general economic conditions were to deteriorate, including declines in private sector employment growth and business productivity, increases in the unemployment rate and changes in interest rates, we may experience delays in our sales cycles, increased pressure from prospective clients to offer discounts and increased pressure from existing clients to renew expiring recurring revenue agreements for lower amounts.

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Paylocity Holding Corporation is a Delaware corporation, which was formed in November 2013. Our business operations, excluding interest earned on certain cash holdings and expenses associated with certain secondary stock offerings, have historically been, and are currently, conducted by its wholly owned subsidiaries, and the financial results presented herein are entirely attributable to the results of its operations.

Key Metrics

We regularly review a number of metrics, including the following key metrics, to evaluate our business, measure our performance, identify trends affecting our business, formulate financial projections and make strategic decisions.

Revenue Growth

Our recurring revenue model and high annual revenue retention rates provide significant visibility into our future operating results and cash flow from operations. This visibility enables us to better manage and invest in our business. Total revenues increased from $107.2 million for the three months ended December 31, 2018 to $132.4 million for the three months ended December 31, 2019, representing a 23% year-over-year increase. Total revenues increased from $207.7 million for the six months ended December 31, 2018 to $259.1 million for the six months ended December 31, 2019, representing a 25% year-over-year increase.

Adjusted Gross Profit and Adjusted EBITDA

We disclose Adjusted Gross Profit and Adjusted EBITDA because we use them to evaluate our performance, and we believe Adjusted Gross Profit and Adjusted EBITDA assist in the comparison of our performance across reporting periods by excluding certain items that we do not believe are indicative of our core operating performance. We believe these metrics are used in the financial community, and we present them to enhance investors' understanding of our operating performance and cash flows.

Adjusted Gross Profit and Adjusted EBITDA are not measurements of financial performance under generally accepted accounting principles in the United States ("GAAP"), and you should not consider Adjusted Gross Profit as an alternative to gross profit or Adjusted EBITDA as an alternative to net income or cash provided by operating activities, in each case as determined in accordance with GAAP. In addition, our definition of Adjusted Gross Profit and Adjusted EBITDA may be different than the definition utilized for similarly-titled measures used by other companies.

We define Adjusted Gross Profit as gross profit before amortization of capitalized internal-use software costs, stock-based compensation expense and employer payroll taxes related to stock releases and option exercises. We define Adjusted EBITDA as net income before interest expense, income tax expense (benefit), depreciation and amortization expense, stock-based compensation expense and employer payroll taxes related to stock releases and option exercises and other items as defined below. The table below sets forth our Adjusted Gross Profit and Adjusted EBITDA for the periods presented.







                                   Three Months Ended         Six Months Ended
                                     December 31,              December 31,
                                    2018         2019        2018         2019
                                     (in thousands)            (in thousands)
        Adjusted Gross Profit    $   74,871    $ 93,105    $ 145,241    $ 183,384
        Adjusted EBITDA          $   26,100    $ 30,265    $  49,363    $  60,742
        


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                                                             Three Months Ended         Six Months Ended
                                                               December 31,              December 31,
                                                              2018         2019        2018         2019
                                                               (in thousands)            (in thousands)
        Reconciliation from Gross Profit to Adjusted
        Gross Profit
        Gross profit                                       $   69,134    $ 86,950    $ 133,696    $ 171,040
        Amortization of capitalized internal-use
        software costs                                          4,418       4,690        8,630        9,147
        Stock-based compensation expense and employer
        payroll taxes related to stock releases and
        option exercises                                        1,319       1,465        2,915        3,197
        Adjusted Gross Profit                              $   74,871    $ 93,105    $ 145,241    $ 183,384
        








                                                             Three Months Ended         Six Months Ended
                                                               December 31,              December 31,
                                                              2018         2019        2018         2019
                                                               (in thousands)            (in thousands)
        Reconciliation from Net Income to Adjusted
        EBITDA
        Net income                                         $    5,704    $  5,467    $  15,556    $  19,373
        Interest expense                                            -         103            -          188
        Income tax expense (benefit)                            1,669         932      (4,138)      (6,500)
        Depreciation and amortization expense                   8,569       9,328       16,801       18,261
        EBITDA                                                 15,942      15,830       28,219       31,322
        Stock-based compensation expense and employer
        payroll taxes related to stock releases and
        option exercises                                       10,158      12,829       21,144       26,858
        Other items*                                                -       1,606            -        2,562
        Adjusted EBITDA                                    $   26,100    $ 30,265    $  49,363    $  60,742
        


Represents nonrecurring costs including the settlement of a certain legal matter and related litigation costs of $1.6 million and $2.0 million for the

Basis of Presentation

Revenues

Recurring and other revenue

Beginning in fiscal 2020, we simplified the presentation of revenue. Recurring fees and Implementation services and other have been combined into one revenue line: Recurring and other revenue. We changed the presentation of revenue as Implementation services and other has become a smaller component of our overall revenue mix as our HCM suite has become a larger part of the portfolio. Previously reported results for the three and six month periods ending December 31, 2018 have been reclassified to conform to the current presentation.

We derive the majority of our revenues from recurring fees attributable to our cloud-based payroll and HCM software solutions. Recurring fees for each client generally include a base fee in addition to a fee based on the number of client employees and the number of products a client uses. We also charge fees attributable to our preparation of W-2 documents and annual required filings on behalf of our clients and implementation fees for professional services provided to implement our payroll and HCM solutions. Implementations of our payroll solutions typically require only three to four weeks at which point the new client's payroll is first processed using our solution. We implement additional HCM products as requested by clients and leverage the data within our payroll solution to accelerate our implementation processes. Our average client size has continued to be over 100 employees.

We derive revenue from a client based on the solutions purchased by the client, the number of client employees as well as the amount, type and timing of services provided with respect to those client employees. As such, the number of client employees on our system is not a good indicator of our financial results in any period. Recurring and other revenue accounted for 96% and 97% of our total revenues during the three months ended December 31, 2018 and 2019, respectively, and 96% of our total revenues during both of the six months ended December 31, 2018 and 2019.

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While the majority of our agreements with clients are generally cancellable by the client on 60 days' notice or less, we also have entered into term agreements, which are generally two years in length. Our agreements do not include general rights of return and do not provide clients with the right to take possession of the software supporting the services being provided. We recognize recurring fees in the period in which services are provided and the related performance obligations have been satisfied. We defer implementation fees related to our proprietary products over a period generally up to 24 months.

Interest Income on Funds Held for Clients

We earn interest income on funds held for clients. We collect funds for employee payroll payments and related taxes in advance of remittance to employees and taxing authorities. Prior to remittance to employees and taxing authorities, we earn interest on these funds through demand deposit accounts with financial institutions with which we have automated clearing house, or ACH, arrangements. We also earn interest by investing a portion of funds held for clients in highly liquid, investment-grade marketable securities.

Cost of Revenues

To correspond with the simplification of the presentation of revenue discussed above, we also simplified the presentation of cost of revenue. As a result, Cost of revenues - recurring revenues and Cost of revenues - implementation services and other have been combined into one line: Cost of revenues. Cost of revenues includes costs to provide our payroll and other HCM solutions which primarily consists of employee-related expenses, including wages, stock-based compensation, bonuses and benefits, relating to the provision of ongoing client support and implementation activities, payroll tax filing, distribution of printed checks and other materials as well as delivery costs, computing costs, and bank fees associated with client fund transfers. Employee costs for recurring support are generally expensed as incurred whereas such costs for implementation of our proprietary products are capitalized and amortized over a period of 7 years. Our cost of revenues is expected to increase in absolute dollars for the foreseeable future as we increase our client base. However, we expect to realize cost efficiencies over the long term as our business scales, resulting in improved operating leverage and increased margins.

We also capitalize a portion of our internal-use software costs, which are then all amortized as Cost of revenues. We amortized $4.4 million and $4.7 million of capitalized internal-use software costs during the three months ended December 31, 2018 and 2019, respectively, and $8.6 million and $9.1 million of capitalized internal-use software costs during the six months ended December 31, 2018 and 2019, respectively.

Operating Expenses

Sales and Marketing

Sales and marketing expenses consist primarily of employee-related expenses for our direct sales and marketing staff, including wages, commissions, stock-based compensation, bonuses and benefits, marketing expenses and other related costs. We capitalize certain selling and commission costs related to new contracts or purchases of additional services by our existing clients. Commissions are typically paid the following month after the start of service, and bonuses for attainment of certain annual performance criteria are subsequently paid annually in the first fiscal quarter of the following year. We generally recognize these costs over a period of 7 years.

We will seek to grow our number of clients for the foreseeable future, and therefore our sales and marketing expense is expected to continue to increase in absolute dollars as we grow our sales organization and expand our marketing activities.

Research and Development

Research and development expenses consist primarily of employee-related expenses for our research and development and product management staff, including wages, stock-based compensation, bonuses and benefits. Additional expenses include costs related to the development, maintenance, quality assurance and testing of new technologies and ongoing refinement of our existing solutions. Research and development expenses, other than internal-use software costs qualifying for capitalization, are expensed as incurred.

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We capitalize a portion of our development costs related to internal-use software. The timing of our capitalized development projects may affect the amount of development costs expensed in any given period. The table below sets forth the amounts of capitalized and expensed research and development expenses for the three and six months ended December 31, 2018 and 2019.







                                                             Three Months Ended        Six Months Ended
                                                               December 31,             December 31,
                                                              2018         2019        2018        2019
                                                               (in thousands)           (in thousands)
        Capitalized portion of research and development    $    5,547    $  6,674    $ 10,699    $ 13,280
        Expensed portion of research and development           12,798      15,410      24,198      29,804
        Total research and development                     $   18,345    $ 22,084    $ 34,897    $ 43,084
        


We expect to grow our research and development efforts as we continue to broaden our product offerings and extend our technological leadership by investing in the development of new technologies and introducing them to new and existing clients. We expect research and development expenses to continue to increase in absolute dollars but to vary as a percentage of total revenue on a period-to-period basis.

General and Administrative

General and administrative expenses consist primarily of employee-related costs, including wages, stock-based compensation, bonuses and benefits for our administrative, finance, accounting, and human resources departments. Additional expenses include consulting and professional fees, occupancy costs, insurance and other corporate expenses. We expect our general and administrative expenses to continue to increase in absolute dollars as our company continues to grow.

Other Income

Other income generally consists of interest income related to interest earned on our cash and cash equivalents and corporate investments, net of losses on disposal of property and equipment and interest expense related to our revolving credit facility.







        Results of Operations
        The following table sets forth our statements of operations data for each of the
        periods indicated.
                                                          Three Months Ended         Six Months Ended
                                                            December 31,              December 31,
                                                           2018        2019         2018         2019
                                                            (in thousands)            (in thousands)
        Consolidated Statements of Operations Data:
        Revenues:
        Recurring and other revenue                     $  102,739   $ 127,980    $ 199,741    $ 249,853
        Interest income on funds held for clients            4,465       4,394        7,967        9,241
        Total revenues                                     107,204     132,374      207,708      259,094
        Cost of revenues                                    38,070      45,424       74,012       88,054
        Gross profit                                        69,134      86,950      133,696      171,040
        Operating expenses:
        Sales and marketing                                 26,570      37,293       52,988       74,250
        Research and development                            12,798      15,410       24,198       29,804
        General and administrative                          22,739      28,133       45,707       54,872
        Total operating expenses                            62,107      80,836      122,893      158,926
        Operating income                                     7,027       6,114       10,803       12,114
        Other income                                           346         285          615          759
        Income before income taxes                           7,373       6,399       11,418       12,873
        Income tax expense (benefit)                         1,669         932      (4,138)      (6,500)
        Net income                                      $    5,704   $   5,467    $  15,556    $  19,373
        


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The following table sets forth our statements of operations data as a percentage of total revenues for each of the periods indicated.







                                                            Three Months Ended           Six Months Ended
                                                              December 31,                December 31,
                                                            2018          2019          2018         2019
        Consolidated Statements of Operations Data:
        Revenues:
        Recurring and other revenue                             96 %          97 %          96 %         96 %
        Interest income on funds held for clients                4 %           3 %           4 %          4 %
        Total revenues                                         100 %         100 %         100 %        100 %
        Cost of revenues                                        35 %          34 %          36 %         34 %
        Gross profit                                            65 %          66 %          64 %         66 %
        Operating expenses:
        Sales and marketing                                     25 %          28 %          25 %         29 %
        Research and development                                12 %          12 %          12 %         11 %
        General and administrative                              21 %          21 %          22 %         21 %
        Total operating expenses                                58 %          61 %          59 %         61 %
        Operating income                                         7 %           5 %           5 %          5 %
        Other income                                             0 %           0 %           0 %          0 %
        Income before income taxes                               7 %           5 %           5 %          5 %
        Income tax expense (benefit)                             2 %           1 %         (2) %        (2) %
        Net income                                               5 %           4 %           7 %          7 %
        








        Comparison of Three Months Ended December 31, 2018 and 2019
        Revenues
        ($ in thousands)
                                                       Three Months Ended
                                                         December 31,              Change
                                                       2018         2019          $         %
        Recurring and other revenue                  $ 102,739    $ 127,980    $ 25,241     25 %
        Percentage of total revenues                        96 %         97 %
        Interest income on funds held for clients    $   4,465    $   4,394    $   (71)    (2) %
        Percentage of total revenues                         4 %          3 %
        


Recurring and other revenue

Recurring and other revenue for the three months ended December 31, 2019 increased by $25.2 million, or 25%, to $128.0 million from $102.7 million for three months ended December 31, 2018. Recurring and other revenue increased primarily as a result of incremental revenues from new and existing clients.

Interest Income on Funds Held for Clients

Interest income on funds held for clients for the three months ended December 31, 2019 decreased by $0.1 million, or 2%, to $4.4 million from $4.5 million for the three months ended December 31, 2018. Interest income on funds held for clients decreased primarily as a result of lower average interest rates, partially offset by higher average daily balances for funds held due to the addition of new clients to our client base.

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        Cost of Revenues
        ($ in thousands)
                                         Three Months Ended
                                           December 31,             Change
                                          2018         2019         $       %
        Cost of revenues               $   38,070    $ 45,424    $ 7,354    19 %
        Percentage of total revenue            35 %        34 %
        Gross margin                           65 %        66 %
        


Cost of Revenues

Cost of revenues for the three months ended December 31, 2019 increased by $7.4 million, or 19%, to $45.4 million from $38.1 million for the three months ended December 31, 2018. Cost of revenues increased primarily as a result of the continued growth of our business, in particular, $4.6 million in additional employee-related costs resulting from additional personnel necessary to provide services to new and existing clients and $1.8 million in delivery and other processing-related fees. Gross margin increased from 65% to 66% for the three months ended December 31, 2018 and 2019, respectively.

Operating Expenses

($ in thousands)

Sales and Marketing

Three Months Ended December 31, Change 2018 2019 $ % Sales and marketing $ 26,570 $ 37,293 $ 10,723 40 % Percentage of total revenues 25 % 28 %

Sales and marketing expenses for the three months ended December 31, 2019 increased by $10.7 million, or 40%, to $37.3 million from $26.6 million for the three months ended December 31, 2018. The increase in sales and marketing expense was primarily the result of $6.8 million of additional employee-related costs, including those incurred to expand our sales team, and $1.4 million of additional stock-based compensation associated with our equity incentive plan.

Research and Development

Three Months Ended December 31, Change 2018 2019 $ % Research and development $ 12,798 $ 15,410 $ 2,612 20 % Percentage of total revenues 12 % 12 %

Research and development expenses for the three months ended December 31, 2019 increased by $2.6 million, or 20%, to $15.4 million from $12.8 million for the three months ended December 31, 2018. The increase in research and development expenses was primarily the result of $3.0 million of additional employee-related costs related to additional development personnel, partially offset by higher period-over-period capitalized internal-use software costs of $1.1 million.

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General and Administrative

Three Months Ended December 31, Change . . .

Feb 05, 2020

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