Paylocity Holding Corporation (PCTY) Earnings Call Transcript & Summary

All right. Everyone, we're going to get started. My name is Brian Peterson, I'm the application software analyst at Raymond James. Very happy to have the Paylocity team back here again this year, right, multiple years in a row actually.

Yes, third year.

Third year in a row. Great. Well congrats, great to have you back. So maybe, Toby, just to kind of -- well, we have Toby Williams, the CFO; Ryan Glenn, VP of FP&A and Investor Relations. So maybe, Toby, just for -- we have kind of a generalist audience here but, certainly, maybe spend a minute or 2 just giving the background of Paylocity.

Sure. Yes, it's great to be back. So Paylocity is a payroll and HCM software company. And we're -- so that's things like payroll, time and attendance, benefits administration, core HR and talent products focused on the SMB space. So when we say SMB, it's focused on the 20 to 1,000 employee market segment. And our average customer size would be around 100 employees, and we've been focused on that segment for a better part of the decade. We've been public since 2014 and a lot of our growth will do just under $575 million this year. A lot of our growth has been driven by both expanding from a geographic coverage standpoint. So we're focused on the U.S. market and also by developing and delivering incremental HCM products, the human capital management software products.

And so maybe just start on the TAM, I know you mentioned the 20 to 1,000 employee market. You have no work. I think there's, what, 600,000 businesses, 45 million employees. So like looking at the TAM, how penetrated are you with that opportunity today?

Yes. So we ended last year, so our -- June is our fiscal year-end. So we ended last year with just over 20,000 customers, again, with an average size of around 100 employees. And that's against the market segment in the 20 to 1,000 market space that Brian referenced of north of 600,000 businesses. So we have a pretty small share of what we consider to be a pretty large market.

And so there's some other cloud vendors that are attacking this opportunity. We hear about them quite a bit. Can you talk about your point of differentiation versus some of these other vendors? I think you mentioned some of the SMB. I know we're going to talk about some of the product focus. But how would you differentiate yourself and maybe how often you see some of these cloud payroll or HCM competitors?

Yes. So in our space -- and again, it largely depends on the segment, which is why I come back to us focusing on the 20 to 1,000 part of the market. So we would get most of our businesses historically from a new business standpoint, people using ADP and Paychex, who are the 2 biggest players. Both large businesses with probably 1.2 million, 1.3 million clients between them. And so that's the biggest source of business for us, people moving from one of the legacy providers to what is essentially a cloud-based set of payroll and HCM solutions. And in our market, I mean, I think there are more providers that are focused upmarket, more in the enterprise space. We view ourselves as having a smaller set of competitors that we might see on a day-to-day basis in the sort of the 20 to 1,000. Again, most of those deals, we would be either taking business from or competing with ADP and Paychex.

And so would you see them in most of the RFPs or bake-offs? It's mostly against kind of some of the legacy service groups.

Right. Yes, it would be atypical for us just given the size of clients that we're serving or pitching to. It would be atypical for us to see people doing the formal RFP. It might be we're talking about a business owner that is also the head of finance, is also the head of sales, who is also the office manager who might have the capacity to look at usage. It is competitive. So I don't mean it's just now, but the number of providers that you might be competing with in any given deal would be smaller versus larger, and it would be less formal.

And so just thinking about the service bureaus, I get this question a lot, like, obviously, that's the big source of new customers for you. They're typically the share donors. Is it possible that they start to fix that? Or how do you see their product road map kind of evolving and maybe the competitive landscape changing?

Yes. So to that question and your prior one, too. I mean, we would view product differentiation as an important part of how we win new business. So having a full suite, both in terms of payroll but then all the other HR offerings from, again, talent management to core HR, things like recruiting and onboarding, time and attendance, benefits administration, giving employees the -- of our clients, the ability to do all those -- all of the tasks either as a manager or as an employee on their iPhone or their iPad. So enabling all of those functions with consumer-oriented software on your iPhone or iPad is really, I think, the differentiator for us versus some of the legacy competition.

And so the go-to-market opportunity is a big opportunity in front of you. How are you tackling that, just thinking about sales headcount? And then maybe talk about some of your partner channel as well.

Yes. So for us, we go to market with a direct sales force. We have -- we came into the year with 382 sales reps. We've grown our sales force on a year-over-year basis in the sort of low to mid-20s year-over-year in the last handful of years. And we've continued to spend, from a go-to-market spend perspective, in that 20% to 25% of revenue range. And that's -- the buckets are growing sales headcount is probably the biggest, and we have certainly traditional marketing efforts. And then also, we have a channel -- referral channel, which has been really big for us. So we get north of 25% of our new deals that are referred to us from our partner channels. Those are things like brokers. So think about employee benefit brokers or 401(k) financial advisers who are partnered with our sales team in the field, in their local cities, towns, regions where they're operating every day. And think of those as we're still selling those deals, but those are warm leads coming to our reps based on the relationships that they have driven over time. And the value add that we bring to those referral partners is relative to somebody like an ADP or Paychex, who has a 401(k) product or who has an insurance brokerage. We're not competing for their business, and we are open in terms of our -- integrating to our platform with over 300, maybe more at this point, over 300 partners that we would integrate with, giving those brokers and their customers the ability to easily exchange data, employee demographic information that they need for their benefit in and out of our platform.

And I'm curious, just as you maybe target different areas within that kind of 20 to 1,000, are you addressing some of those differently? And how are you looking at kind of the overall go-to-market or sales productivity metrics?

Yes. So I mean, I think, for us, the driving growth has been a mix of both, continuing to invest in sales and marketing. So that has been the mix that I just described, but also investing in product to be able to drive -- if you think about the per employee per year chargeable product that we would have had, we would have started at $200 in available product if you bought our whole suite at the time of kind of the IPO in 2014. And today, that sits at $400 per employee per year of charge, and that is a result of our investment in R&D to be able to develop new modules. And so that's really been -- those are the 2 biggest growth drivers in the business. And I think as we've continued to roll out new product, it's driving the -- both sales back into the customer base and driving a higher level of new sales to new prospects.

And what are some of the new products that are really taking off? Kind of like really about, like I know it's $200 to $400 on a total kind of, I'd say, full price list opportunity. But in terms of adoption, what are you really seeing in terms of these kind of add-on to payrolls that are really ramping up?

Yes. So if you think back over the last year or 2 in terms of new product introduction, we've recently launched a learning management system, which gives customers the ability to launch either compliance or business-related training to their employees, again, on their mobile device. So it's fairly easy to roll out from that standpoint. And they can use their own content. We have some compliance-related content that they can use or they can use third-party content. So that's one of the latest products that we've rolled out. We've been pretty happy with the adoption rate so far. Also, over the last year or 2, spend things like expense management, performance management, surveys, third-party administration product. I mean it's actually been a pretty darn busy couple of years, so I'm sure I missed something in that.

It is. I think the other areas I'd highlight, too, would be onboarding and performance management. We've definitely seen some really good take rates there. And the other element that we've seen play out over the last year or 2 is clients in the smaller end of our target market, right? So a 20- or 50-employee person that, historically, would really be interested in payroll only or maybe payroll and HR. We're starting to see those clients in that size bucket wanting to add products like onboarding or performance management, right? So even if they're only hiring 5 or 10 employees a year, they still need to compete for talent. They're still likely hiring a younger workforce, and they feel those same pain points around their new employees not wanting to do things within pen and paper. They want a mobile experience. They want their business to look like a larger business. So we're definitely seeing trends there with clients across our target market who are adding products.

And to that extent, is some of this greenfield -- I mean, obviously, if you think about payroll, you can do that maybe as a little bit of a displacement. But thinking about maybe down market. They may not be using a lot of these things. So in that sense, you're actually enabling them for a lot of the HR suite, right? So you kind of view that as more of greenfield. Are there other systems that they typically have in place at the low end of the market?

Yes. I mean, the folks at that end of the market don't typically take a best-of-breed approach to their software needs. So they're likely -- they're more likely to be not using anything at all. So take expense management as a good example. So most of the customers that we would be delivering that product to would have been using either pen or paper or Excel or something similar. It wouldn't have an automated and integrated online tool for expense management. That's a good example. I think we do view that as more greenfield because I think what Ryan was just describing a second go, it's just a fundamental shift in the expectations of a whole segment of the market. And I think that's a big part of the driver of those fields, the sub-50 employee customers, as an example, taking more product from us.

And do you think that your buyer in certain areas of your market have changed a little bit, whereas maybe payroll or HR wasn't kind of seen as strategic in the past? It's just about getting checks. And now it's like in a tough labor market. We need to find ways to really attract employees, and there's a lot of better solutions out there. And do you think that the buyers are truly aware of that, and we're seeing that inflection point?

I do. I mean, I think the change is -- the fundamental change is that of the buyer and then that of the employee. So you always use the example of onboarding. So you think about the onboarding experience if you were a new employee 5 or 10 years ago. Regardless of size of the firm that you were joining, you would have been handed a stack of paperwork to fill out. So that just don't resonate today. So if we think about the onboarding experience that you're able to deliver with, onboarding of the new employee, filling out all of your information, demographic or benefits or otherwise on an iPhone or an iPad, which we enable today. That's the experience that we believe and that we see employees are expecting. That's also the experience that the administrators or buyers are expecting. So if I give you a set of paperwork, you may fill it out and you may not like that. But then you're going to give it back to me and I can do something with it. So I think the change in expectations from both a buyer or from an administrator from an employee perspective have all headed in the same direction and have been a fundamental shift.

And so I still get a lot of questions on PEPY. Obviously, that's ramping up. What do you think that could go to longer term in thinking about the customer that you're serving? What is that appetite to expand that to a certain level? Is there a ceiling there? And how should we think about that ramping?

Well, I mean, so for historical context, I mean it's ramped from $200 per employee per year at the time of the IPO, 5 or 6 years ago, to $400 today. We've had, I think, a great sort of last 2 years, the product launch with some pretty big items coming out, things like LMS and third-party administration, which are bigger chunks from a PEPY perspective. I don't necessarily think that we see a ceiling. We've called out a near-term opportunity of getting $400 to $500. I'm not sure. It's been an incredibly busy last 2 years. I don't know if that pace stays the same. But I don't think -- part of how we would view it is developing new product, but also developing existing products for incremental chargeable functionality. So I think there's a couple of avenues there. And then the other thing I would think about is just if you went back to the time of the IPO and you ask customers or you looked at the market and said, what are the things that would be on the horizon, I think that just changes over time. So with every day that goes by, we're talking to customers, we're looking at the market, we're continuing to develop a list of things that we think would be interesting from a product perspective. So I don't think that piece stays static.

But the product investments are still ongoing, right? Maybe just talk about what you spend in R&D and how that's grown?

Sure. Yes. So we would have called out a financial target of spending between 10% to 15% of revenue in R&D, and that's been a pretty -- a tighter range over the 12% to 14% zip code over the last year or 2. And I think we would not look at R&D as a place we would try and drive leverage from in the near term, given that the 2 biggest growth drivers in the business are product and investing and go to market. So I think those are areas where we continue to believe that we have investments that we can make that will drive growth in the business, and I think that has a pretty good runway of growing.

I feel like every time we catch up, I always ask you the upsell question. So it's obviously $200 to $400. You have 20,000-plus customers, like, clearly, there's an opportunity to monetize the installed base, right? Thinking about that motion, how big is that team? And is that an opportunity today or maybe more down the road?

Yes, it's an opportunity today that we've invested in, and I think it will continue to be an opportunity down the road. So if you go back, what, probably 3 years in time, we would have started around the ACA year, starting an inside sales team that was focused on selling back into our customer base. And that team has certainly grown. We've pressed the investment in that group. And I think as we continue to develop and roll out more product, we will continue to have the ability to sell back into the customer base, and that's been -- I think that's an area where -- it's a smaller team relative to the overall size of our sales force, but we've continued to invest in it, and we'll continue to.

And maybe just remind us on some of like -- you mentioned the R&D, but just some of the longer-term growth/margin ambitions. Where should you think that -- think about that long term?

Sure. Yes. Do you want to take down through the...

Sure. Yes. So the target from a revenue growth perspective is 20%-plus. Obviously, we've been north of that for every year since we've been public, and the guidance for this year is about 23% total revenue growth. From an adjusted gross margin perspective, the target is 70% to 75%. We're in the kind of 71%, 72% range. Today, sort of squarely in that range, but have been demonstrating leverage consistently since the IPO and within this fiscal year as well. And then from an operating expense perspective, Toby referenced 10% to 15% in R&D or in sort of the middle or high end of that range. Sales and marketing spend, 20% to 25% of revenue. Again, we've sort of been in the middle of that range. And I would think of sales and marketing investments similar to the way I would R&D. So that's an area where we'll continue to invest in over time, whether that is reps or other go-to-market investments to drive that 20%-plus revenue number. And then from a G&A perspective, 10% to 15% is the target. We're in the high end of that range today. We've demonstrated G&A leverage every year since we've been public and plan to continue to do so. And then lastly, from a profitability perspective, adjusted EBITDA target is 30% to 35% of revenue. We're in the kind of the 28% to 29% range today. And then lastly, on free cash flow, the target is 15% to 20%. We were just north of 16% free cash flow margins last year, growing 25% on revenue, as I said.

Got it. And I know some of the revenue comes in through interest on funds held for clients. Just remind us how that works and what are you -- what have you assumed kind of for interest rates and some of the stuff in your guidance for this year.

Sure. So we've obviously seen 3 rate cuts since the beginning of our fiscal year. And just by way of background for the group, we hold client funds for our clients in advance of payroll, in advance of certain funds being remitted to taxing agencies. So to the last quarter, we averaged about $1.3 billion of client funds overnight. So you can do that math of what a 25 basis point rate cut has done to the year or 3 rate cuts for that matter. We're really happy with the performance of the business for the first half of the year. We talked about on our call a few weeks ago, being able to raise revenue guidance with the headwind of 3 rate cuts and being able to maintain adjusted EBITDA guidance because that revenue is effectively 100% margin. So there's certainly a headwind for us and anyone in the space. And then on a go-forward basis, to the extent, we do see a rate cut here in a few weeks or any further rate cuts over the balance of '20, those would be incremental, so we don't have any further rates factored into guidance at this point.

The rates have definitely been a headwind with 3 rate cuts so far, and then it seems like potentially another one on the horizon. I think for us, that is not the portion of the...

I guess there's a breaking news on that.

We've been back to that, forgive us, but what I was going to say was we absorbed 3 so far. I think that has unquestionably been a headwind at the same time. If you look at the performance of really the core of the business from a recurring revenue standpoint through the first half of the year, we've actually accelerated year-over-year. And I think we're pretty happy with the execution that we've seen, which has largely been execution from the sales. So...

And just remind -- just the recurring revenue component, that's 90? What percentage of the revenue?

Yes, it's probably 96, 97.

Yes, I think for context, right? We had just under $470 million of revenue last year, and about $20 million was interest income. So it's a significant majority of the total revenue.

Yes, Well, I'll open up to the audience if there's any questions. [ John ]?

What's the average number of products per customer today [indiscernible] kind of stands from a $200 to $400?

Yes. For the webcast, it's just the average number of products per customer today.

Yes. So what I was saying exactly goes, we have $400 in -- per employee per year if you were to buy our entire suite. We've talked historically about, on average, customers taking roughly half that.

So last one, just in terms of growing the sales force and hiring and finding the right people and maybe just beyond even sales. I know the R&D team works remotely. Like in terms of hiring, is that an issue at all in bringing in the right people? Has that been a concern?

Yes. I mean that's been -- that has been and will continue to be, I think, a key challenge for us, just finding the level of talent whether it's on the sales team or the dev team or our ops team. I mean, I think, the advantage that we've had has both been one of, I think, a culture that people have really enjoyed, but also, you've mentioned it, allowing people to work remotely. So probably half of our employees are roughly that, work remotely today across all of our different teams. And that's been a huge advantage in terms of both, I think, acquiring talent, keeping good talent, and certainly, there's a cost advantage there, too, but...

And so you guys actually have a pretty decent cash balance as well. So I think there's been some tuck-in M&As. How are you thinking about spending that organically, your M&A, your capital deployment? How do you think about that?

Yes. I mean, I think, the way we tend to think about the business from an investment standpoint, whether it's investing from an expense perspective or from a use-of-cash perspective is really around continuing to drive growth. So you mentioned, 1.5 or so ago, we did first acquisition. It was in the vein of smaller tuck-in type acquisitions. That's, I think, the thing -- type of thing that will be interesting to us going forward. I think less interested in the larger disruptive acquisition. Something that would be small and product-oriented will continue to be interesting to us. I think from an acquisition standpoint, the things that are, I think, critical to us would be investing in something that's very strategic to us from a product perspective that you can believe you could integrate really tightly from an employee experience and from a data perspective. Those are the things that would be interesting to us.

I always get -- your retention numbers have been pretty good. But given the SMB exposure, I always feel like we get the retention question, I'm sure you get it a lot. What -- how has the customers have turned it? And any thoughts on retention?

Yes, so retention rates have historically been 92%-plus from a revenue retention standpoint, probably slightly lower than that on a unit basis. But I mean they've been very consistent over the course of the time, so the time meaning pre-IPO. So I think we always try, and we're not perfect. So we do lose some. But I mean, I think, from a retention perspective, we've tried to drive product and service-oriented experiences to our customers that keep them sticky and keep them with us, and that's been 92-plus percent over time.

Alex?

Yes. On the sales hiring investment, growing the sales force, just over 20% a year. Where are you finding them from? And are you hiring to a particular segment within your kind of 20 to 1,000 employees? Or...

So the question -- sorry, the question is on where are you getting most of your salespeople?

So it's a mix. So we have -- we would get a significant number of our new reps coming into the business who would have either immediately prior or somewhere in their background, industry experience. They tend not to be folks right out of school. So they would have maybe on their second or maybe third out-of-sales job or go-to-market job out of school, a significant portion would come from the industry, but a significant portion also comes from outside the industry. If it's outside the industry, we would tend to look for some B2B go-to-market or sales experience that ends up very greatly. I would tell you, we've seen, I think, great success with folks regardless of background from outside the industry and inside the industry. So it really comes down to our ability to find talent that we think will fit from a performance and from a cultural standpoint of being able to onboard them and train them as efficiently as possible and then get them out into the field and selling and enjoying some success.

We have time for one more. Maybe just last one for me then. So we get a lot of talk about the Rule of 40. You guys have been there for a while. And so Ryan, I know you mentioned 20%-plus growth. But if we're thinking about longer term, durable growth, margin expansion, how do we think about the ramp in gross versus margins going forward?

Yes. So I think the first goal for us is that 20%-plus revenue growth, and that's why we've talked about continuing to invest in R&D and sales and marketing. Our nearest term goal is $1 billion of revenue. And I think if we maintain just a bit over 20% CAGR for the next 3 to 4 years, we hit that target of $1 billion of revenue. A close second is continued expansion of margins, right? You've seen us expand gross margin consistently. You've seen us leverage G&A. And when we IPO-ed, now kind of about 6 years ago, adjusted EBITDA margins were about 5% of revenue, and now we're just north of 28%. So we've continued to scale the business and would expect to do so as we get closer to that 30% to 35% adjusted EBITDA target.

Great. That's the all the time we have. Thanks, everyone.

Thanks for having us.