Paylocity Holding Corporation (PCTY) Earnings Call Transcript & Summary

Good morning, I'm Brad Reback with the Stifel equity research team. Thanks, everyone, for joining us and for joining on the webcast. This morning, we're starting out with Paylocity. With us are Toby Williams, Co-CEO; and Ryan Glenn, CFO. Gentlemen, thanks very much.

Yes, thanks for having us. It's good to be here.

So Toby or Ryan, either one, maybe we just, start kick off real quickly, a little history on Paylocity. How you've gotten here?

Yes, sure. So I think at the very beginning, the state of the industry was such that the largest players were really service bureau focused. So it was really not a SaaS offering. I think the beginnings of Paylocity were really to develop a SaaS payroll offering. And that was really, I think, phase 1 of the growth -- starting growth of the business. I think Phase 2 is really the expansion from a really solid core of SaaS payroll to the full HCM suite of products. So if you think about everything that surrounds payroll, so HRIS, talent recruiting, now into things like expense management and so on and so forth. I mean it was really the build-out of a full HCM SaaS suite of software modules. And I think that made our business very competitive versus some of the larger players who are still in that service bureau model. And now, I think as we look where we are today and as we look a bit forward, it's really now going beyond just payroll and HCM into things that probably extend the next click beyond that. So things like collaboration, a lot of the things that we're doing with our Community product, which really gives employees and admins and managers across the business a place within our product suite right on the platform to do all of their communication, which really drives a high degree of engagement across the employee bases. And so I think we're now full payroll and HCM suite, and now beyond that, into things that I think matter an awful lot in today's world, whether it's in the remote environment or just addressing what I think has become the expectation of the next generation of the workforce in terms of ability to communicate on the platform, use a modern tool on their phone to do everything they need to do for work, including things like collaborating on the platform and having -- giving them the ability to do work on the platform as well from a collaboration standpoint.

That's great. Lots to unpack there.

Sure.

Definitionally really quickly, because it took me a little while and I've covered the space for 20 years to fully understand this, when you say service bureau, what does that mean from a competitive landscape and, also technically, how those are different than what you guys do?

Yes. So if you go back to the earlier days, most of the payrolls would have been taken either by e-mail or by phone with someone actually taking the payroll. So if you're a business, you would call your payroll into a service bureau, they would take the data, they would input it into the system and they would actually cut physical paychecks. That was the state of the world for a long, long time. And I think that really opened the door for the modern players like Paylocity to develop a SaaS online -- fully online platform where there is a high degree of self-service, there is lower sort of manual touch. And so everything that you wanted to be able to do, which is certainly the expectation of the generation today, that you can do on your phone. And I think that was the -- probably the biggest shift in the industry landscape. And as I said, that was really the start. And then our ability to surround that with all the other HCM tools, whether that's recruiting modules or core HR systems, everything from a talent management and recruiting perspective, now sits on the platform. We further built that out so that you have communication capabilities in our Community product that also sit right on the platform.

And I know you -- look, this may be a hard question to answer because you're not a service bureau and you're not inside one of those companies. But as a long-time industry participant, because it's an important question that we get from investors a lot, why can't one of those bureaus do what you do?

Well, I mean, I think a lot of the -- there's 2 larger players in the industry, both of which, I think, invest a ton in their businesses and both very competitive in the market and they have the largest market share. I think over time, though, whereas we would have started as a software company, that's a pretty hard shift for any business to make. And it's not that they don't compete well in different segments of the market, but I think our view is this is -- the market where we play, so in that, call it, 10,000 to 5,000 space, there's over 1 million businesses. And as we sit here today, we would have over 30,000, but it's a pretty small share of a very large market at this point. And if you think about everything that I talked about in terms of our platform and what we offer, the breadth, from payroll to HCM and now beyond HCM with things like Learning Management, with surveys, with communication capabilities through Community and being able to do everything on your phone, which, again, I think really addresses the needs and wants and the expectations of the generation of the workforce today, which is, by the way, not just the employees in the workforce who are younger and younger, but it's also the admins that are making the decisions now about what technology they want. I think we really hit the sweet spot of hitting those needs and addressing those desires of the modern workforce. And so I think when you think about -- going to your question, Brad, that's a pretty big jump for any of those businesses to be able to make and it doesn't happen overnight. So it's not that they don't continue to be competitive in some sense and continue to invest, but we just started in a fundamentally different places as a software company.

That's great. You mentioned about sort of the people you're selling to. What causes someone to decide to change? Why do they pick up the phone or why do they take your phone call when you call on them?

Yes. Well, I think if you look at our business, we would believe that we have market-leading product, which I just described, but it's also combined with market-leading service. So our retention rates are at all-time highs. And I think you've seen higher retention rates across the industry, but we're sitting at, over the last 5 years or so, all-time high retention rates. And I think what underlies that is world-class service, which is a large component in our industry for sure. And if you look at the primary reasons why anyone would switch providers, it tends to go to either product or service. And so from a service perspective, it's things like, hey, if you -- because our average-sized customer would have just over 100 employees, and that's been the case for a long period of time. If you think about the level of sort of internal manpower, woman power that a business like that would have, they don't have somebody who's a specialty in every single area. So they wouldn't have a centralized IT function with a bunch of headcount dedicated to that. They wouldn't have large tax functions. And so if they need to do something like add an employee in a new state, where they don't have the expertise to do that, that's something they might call us for help on. And so your ability to respond in a timely manner, so answer time for a phone call or for an e-mail and getting back with the correct information and be able to help them through that, is really important in our industry and certainly in our segment of the industry. And so being able to help resolve problems or questions in a timely fashion is really key. That helps drive the retention rate. That's the world-class service part. And then you go to the product piece, where I think the expectations are fundamentally different, is that digital transformation has sort of overtaken HCM land, including in the area of the market where we serve. I think the expectations around products are just fundamentally different and it goes beyond just the breadth of the suite that you have. When we think we have market-leading and clearly differentiated suite, both from a breadth standpoint and then with everything we're doing with our modern workforce solutions, which is everything from Community, from a communication perspective on to things like driving employee engagement with surveys or our Learning Management System or video, all capabilities that sit within the platform, those are the parts from a product perspective that really drive differentiation. So when you combine the product and service pieces, those are the reasons why someone would take a call from us or have a conversation with us.

Got it. And how often is the sales cycle competitive versus -- okay.

Very often. Yes, most of the time it's a competitive sales cycle. And that's been the case for a long time. So it has always been a competitive industry. Very rarely are we the only one that's in a conversation. But at the same time, I mean, I think those are the primary things that people focus in on. It's the product piece and the service piece, and we have a clear ability to differentiate on both.

And while pricing is always important, does it tend to be the primary decision motivator for customers?

It's not really. I mean, Ryan, do you want to talk about the pricing sort of environment for a little bit?

Sure. Yes, absolutely. The primary drivers are really the product and service discussion, right, what can the software do for me, how can I engage my workers in a fundamentally different way. And I think a lot of those discussions have accelerated through the pandemic. Pricing is an element, but probably would not be in the top 2 or 3 or 4 things. It's important. But our average client is paying us about $20,000 to $25,000 a year. So it's inoften that you would see a company switch to save x number of dollars. It is really about the efficiencies, the automation, the ability to drive that culture that is much more important. So pricing is an element, but typically not a key driver.

Got it. And maybe sticking on sort of the pricing theme here for a moment. Rough math, right? So if I go back 20 years ago, companies like yourself were maybe $3, $4, $5 per employee per month, right? Gross to net, very simple type of functionality. And today, once again, rough math, $15 to $20 on a realized basis. How much higher can that go? I mean, obviously, it's an order of magnitude almost bigger over 20 years as you've added product. Do you see a road map for continued expansion?

Sure. Yes, I'll start. I think for context, when we went public in 2014, if you bought our entire suite of services, that was $200 per employee per year. And we've now more than doubled that product suite to $440 per employee per year with the latest offering being -- having made with Community Plus last quarter. To your point, we're at sort of 50% to 60% attach rate. Where that can go, I think, remains to be seen. We have a target to get to $500 PEPY. We are seeing increasing, not only usage, but attach rates in some of those newer products. So we're seeing great success with Premium Video. The Community offering had been free up to this point and now there's a free and a paid version. That has seen a lot of success. We got to about 1 million active users on Community in January. So we're seeing not only good usage but upticks in ARPU from that as well. So where that goes, I think, remains to be seen. But to us, there's no shortage of features and functionalities to add, as well as an ability to expand the product suite.

And I think the couple of things I'd add. I mean I think there's multiple growth factors from where we sit. One is just the overall growth in the market in terms of number of employees or number of businesses out there. I think the other piece is just, where we sit, we would have a, call it, 2% to 3% market share in terms of having over 30,000 businesses in a market with over 1 million businesses out there. And then I think to Ryan's point, you have the expansion of PEPY and realized PEPY. So we've continued to build out the product suite and that's driven us to PEPY capability of $440. But I think, going to one of your earlier questions, if you go back in time, the whole industry was focused on just payroll. And then it was -- there was an expansion into HR tools or HCM modules. And I think that next wave of expansion, which I think we're really leading the charge on, is going beyond payroll, beyond HCM. And those products are chargeable. And to Ryan's point. When we built things like surveys or LMS or video, we would have expected to get to take rates that might mirror some of the lower take rate applications in the platform over a longer period of time. And I think what we saw in the course of COVID was, primarily driven by, I think, the remote nature of how people were working then, but it created an expectation level that I don't think ever goes away, was things like asynchronous video, which is a chargeable product for us, things like doing pulse surveys with workforce, things like Community and Community Plus from an engagement and a communication standpoint, they all became expectations. And though we've seen the attach rates for those go to the levels of sort of the normal HR -- more higher demand parts like HR and core HRIS parts of the platform. So I think that's another lever of growth that is alive and well, at least for our business.

And if you think about the guardrails philosophically or strategically as you continue to expand the product set around collaboration or, more broadly, employee engagement, right, as you step beyond just historical core HCM, are there any firm sort of areas that, hey, we have no interest in?

Well, I mean, I think we would think about it in terms of the demands of our customers. And I think, as importantly, today anyway, is the demands of their employees. And so it's less about, hey, there's some area that's fundamentally off limits or that we have no interest in, it's more about getting customer feedback, understanding how people are actually working today and understanding what their expectations are in terms of how they engage with each other, how they engage with software like ours and learning from that and I think finding ways to provide more value to our customers. That's really at the core of this. It's, hey, how are people actually working today, what are their expectations and how can we do a better job as a provider of addressing those and being able to use that to create differentiation from the competition, which I think, as we sit here today, there's nobody else in the industry that's really taking the path that we are in terms of driving things like Community or video or at least doing any of those things in the way that we are. And that's -- I think that's what's really providing accelerated growth for us. As we look at coming out of COVID, the goal was to -- we were investing a lot in product as we went into COVID and the goal was to be able to come out with the same level of momentum as we were seeing at the beginning, and I think we've been able to do that.

Great. Historically, employment growth in the base hasn't been a huge driver for the industry in general. On the flip side, aside from COVID, contraction in the employment environment hasn't been a big headwind. So maybe sort of update us on your thinking given your size and scope today versus historical, and I don't know what you guys have said most recently about the current economic environment as you see it inside the installed base.

Yes, do you want to start with that one?

Sure. So where we sit today is our client base is largely back to pre-COVID levels of employment. We've seen consistent and steady month-over-month improvements in employment levels, and that extended through the third quarter and into April as well. So our client base on average is back to those pre-COVID levels. And to date, we have not seen any softness from a macro perspective. So we're not seeing any contractions. Broadly speaking, the sales momentum continues to be strong. We obviously had a record selling season with January being the biggest starts month, and a lot of momentum as we head into the fourth quarter. You saw that in the revenue growth, 3 straight quarters of 30% plus. The guide for Q4 of sort of 31% in the top end. I think where that could go, obviously, is something we are watching closely. We -- most of our revenue is generated on a per employee per month basis. So to the extent you do see softness, that would show up in recurring revenue. I think we're in a unique space in that we have a natural hedge with a rising interest rate environment as well. But we average over $2 billion overnight of client-held funds. So as rates go up, we benefit. That is revenue to us and that is high profit revenue as well. So certainly, there's the potential for some headwinds there given macro challenges. We haven't seen that to date, but feel like we can certainly grow through it. The pandemic, obviously, was a good example of that, of a steep decline in a short period of time and we still grew in the 10% to 15% ZIP code. So certainly something we're watching. Haven't seen anything to date. But as I said, feel like there's a lot of momentum in the business, nonetheless.

Ryan, to your point on the float income, you're one of the few, putting valuations aside, that benefits from a rising interest rate environment. Philosophically and strategically, what do you do with the extra money?

Yes. I mean I think those are the conversations that we would have internally. So you can do the math on what a 25 or 50 basis point rate increase may mean to us. And if you go back and look at fiscal '18, fiscal '19, we had upwards of $20 million of interest income. This year, we'll do $4 million or $5 million. So low interest rates, obviously, do hurt. Higher rates, we see that benefit. Where that goes, I think a lot of it does fall to the bottom line for sure. But at the same time, we are actively having internal dialogue around reinvesting that into growth-driving initiatives. And I think a lot of that goes to sales and marketing, and a lot of it goes to R&D. So there's no shortages of areas that we'd like to invest in that we feel are high ROI projects, and we'll certainly have those discussions and likely reinvest a portion of those to the extent we continue to see interest rates go up.

And maybe wrapping up on this point around that $20 million number that you mentioned. That's a massive operating income headwind that you guys absorbed, right? 100% margin disappeared. Obviously, margins contracted a bit with COVID, which you did a phenomenal job holding the line. So internally, like how did you react? What type of things did you do to get more efficient in order to achieve that?

Sure. So I think to your point, we were happy with our ability to manage through the headwinds due to COVID and due to the interest rate contractions we saw over that same time period. And I think where we sit today is guiding the full year to about 32% or 33% revenue growth and adjusted EBITDA margins to 27%. So we'll be right at the Rule of 60 for this fiscal year, which we feel really good about. And I think for us, it goes back to being able to scale from a margin and G&A perspective, and making sure that we're continuing to invest in sales and marketing and R&D. And you've seen us continue to have that balance. So there's certainly some choices you have to make in those time periods. But feel good about the investments we've been able to make despite some of the challenges we've seen.

Yes. I think maybe just a quick add to that, because I think it's one of the outstanding probably dynamics in our industry and then in our businesses, as Ryan said, we continue to grow and invest through the COVID period. And we maintained -- if you look at the last sort of 12 months of COVID, we came out of that with still Rule of 40 performance with a mix of growth and profitability. And obviously, guiding to Rule of 60 as we look at this fiscal year. So I mean I think the dynamic of where we've been able to grow with the combination of really strong profitability has given us, I think, the ability in -- to invest. And all eyes -- when we look at your question around what do you do with the extra money, I mean, all eyes are on investing for growth. I do think a good bit of that falls to the bottom line. But I think the day in and day out conversations that we have inside of the business are all around, hey, what are the growth opportunities and how do we look at investing those to drive future growth of the business.

Great. Anyone in the audience have any questions? Okay. I'll keep going. M&A has been part of the strategy here, predominantly smaller tuck-in type of deals. As you look forward, any thoughts around the strategy? Is there an opportunity to go a little bigger as valuations contract broadly in the private market?

Yes. So from an M&A perspective, and we've done a handful of deals over the last 4 or 5 years, but to your point, they've all been smaller really product or technology-oriented tuck-ins. And I think that's been a key part of the strategy. So we would -- we have built the vast majority of the platform. Our preference as a software company would be to build everything. And yet at the same time, you do find certain circumstances. Video is a great example of a partner that we worked with to embed video capabilities into our LMS. And we bought that partner because we thought we could really accelerate our product road map by the acquisition, and we also believe that you can embed the technology in a way that it was absolutely seamless from a user experience perspective, which is one of the -- I think, the thresholds that we focus on from an M&A standpoint. If we're going to buy something that's, as you described, either a product or a technology tuck-in, which has really been our focus, you've got to be able to embed that technology or that product into the platform in a seamless way. So from a user experience and from a data flow perspective, the user wouldn't have any idea whether you built that or bought that. And I think that's really important to us from a platform standpoint because all of the focus is really on the user experience. So preference would be to build the next thing. But there are some instances where you find either a product or a piece of technology that's really interesting that can accelerate the road map. As long as you can really build that in and do the integration in a way that's seamless from a customer perspective or from a user perspective, those are the things that are interesting to us. And I think those do tend to be smaller things, but I don't think size is the primary gate for us.

Got it. On the hiring front, obviously, you guys have done a very good job, have been ahead of the curve or your internal plan, if I remember correctly, as it relates to sales hiring. Is it getting, on the margin, any easier? Are you seeing the time to requisition compress a little bit here or not yet?

I don't think we've seen any significant shift. I think it's been a pretty -- we've been really happy. I mean it's been a difficult hiring environment and a tight labor market for sure. But I think from a Paylocity standpoint, you've really seen our employee value prop shine through, and I think the culture has shined through as well. And we've had, I think, a great deal of success in bringing people onto the -- into Paylocity as employees. It's no doubt been a tough recruiting environment. But I think we've been -- we've continued to hire across the business in every area over the last 12 months, and we've been able to staff to our plans, including in the sales area. So we're just sort of coming through the heart of sales hiring season. We feel really good about our staffing levels there and the quality of candidates as well. I mean it's been tough, but I think we've come through it and I think that's where you really see the sort of the culture and the value prop from an employee standpoint really shine through.

And we'll save the other side of that question, has retention improved here a bit, not that you ever had a churn problem, but as the alternative gets a little less attractive?

Yes. I mean I expect that, that will be the dynamic. I don't know that we've actually seen it come through yet. I mean we've had -- I think relative to the competition, relative to other software companies, we've had relatively low levels of employee turnover. But we are not immune from the -- everything from a macro perspective that everyone else is seeing that has certainly ticked up over the last 12 months or so. But like I said, I mean probably the biggest point of satisfaction has been being able to still maintain reasonable retention rates and being able to attract people into the business to be able to fill the needs of our customers. So that's really been, I think, a point of success for us over the last 12 months.

That's great. If there's nothing from the audience, I'll see if you have any final thoughts that you want to add?

Well, I mean, I think final thoughts are we, first of all, appreciate everybody's time in being here. I think we are really encouraged as we close out this fiscal year with the growth that we've guided to and the level of profitability that we've guided to, as Ryan said, putting us at the Rule of 60 for the fiscal. And I think as we sort of cross over, over the next quarter or 2, the last lapse of COVID-impacted quarters, I think we're just really encouraged by what we're seeing in the business. The demand environment is back to where it was pre-COVID levels. Employees in the platform's back to where it would have been pre-COVID. And I think we are really encouraged about the level of differentiation we have from a product and service perspective. So I think while many things may remain to be seen from an overall macro perspective for the things that we can control and how we're competing, I think we're pretty happy with where we sit and continue to drive on both growth and profitability mix over time.

That's great. Well, thanks so much for joining us.

Thanks for having us.

Thanks, Brad.

Great to see you both.