Paylocity Holding Corporation (PCTY) Earnings Call Transcript & Summary

All right. Welcome to TD Cowen's 51st Annual TMT Conference. I'm Bryan Bergin, Cowen Services and HCM Software Analyst. Next up, we have Paylocity. Paylocity is a leading SaaS HCM vendor primarily focused on the U.S. SMB market. It serves over 33,000 clients as of the fiscal '22, and it will exceed about $1 billion of revenue this year. With us, we have Paylocity's President and co-CEO, Toby Williams. Toby has been with Paylocity since 2017, initially as CFO, and was promoted to co-CEO last year. So Toby, first off, thanks for being here.

Yes, of course. Thanks for having us.

I want to just dive right into the demand on overall HCM. And if you can give us kind of the current state of the union on HCM solution demand, talk about how that's progressed over the last several quarters and really any nuances across employer segment size and the general industry?

Yes, sure. I mean I think the demand environment is in our industry, but also in our business been fairly stable over the course of the last 12 months or so. And I think that's probably in contrast to a lot of other categories in software where demand has been softer with concerns over macro, et cetera. I think payroll and HCM has been fairly well insulated. And so the demand environment has been fairly stable and for us, fairly strong over the course of the last year or so and certainly true over the last couple of quarters as well. And I don't see the other part of your question, I don't think there's been any perceptible difference in terms of demand relative to industry verticals or client sizes. All of that has been fairly stable.

Do you track things like decision-making, sales cycles, things like that? Any KPIs there that have changed at all?

We do. I mean, they haven't really changed. I mean it's -- and I think part of that for us at least goes to the segment of the world that we're serving. So our target market is companies in the U.S. that have between 10,000 and 5,000 employees, and our average-sized company or average-sized client has just over 100 employees. And so I think the more in that mid-market sweet spot, you tend to see just generally speaking, the less concern over deal elongation and deal cycles are fairly, fairly rapid, most deals happen in the course of the quarter.

So you've got good steady demand. It sounds like you continue to see that through the year. Some of your peers also talking about good U.S. SMB demand. Can you just maybe dig in a little bit on the reasons why -- like what are the purchasing decisions? And have those changed over the last several years, particularly since the pandemic?

Yes. I mean, I think probably a couple of different points there. I mean the first is from an overall industry perspective, the reasons why someone would switch from one provider to another would generally be focused on service or product. So if somebody has a service issue, there's dissatisfaction that goes along with that and payroll and HCM is an area where there's high visibility for both companies and their employees. And so if there's an issue there, they're more inclined to pick up their heads and look around and see what's available and be more willing to switch. On the other side of that, if they have a product need that their current provider can't meet, they're also inclined to pick up their heads and switch. And I think that's generally been the case over the course of time. And I think that's still the case today. For us, though, I think the main point of focus that we have from a go-to-market perspective would be around product differentiation. I think everything that we've done in our product set that's around our modern workforce solutions, giving a better and different way for employers and employees to engage with one another, really focused on the leverage that -- that can give and the positive impact that -- that can have from an employee attraction and retention standpoint, has been absolutely critical over the course of the last couple of years and continues to be so today.

How -- what about things like inflation and macro there? Like is inflation, is that having an impact on demand? Is any result in cost efficiency rationales for buyers?

I mean I think cost efficiency rationales have always been in the mind of buyers. I mean this is one of those areas where they do look to get an ROI. I think that's always been the case. And the ROI, whether it's from automation or utilization in different use cases across their businesses is very real. I think it's as important today to buyers in terms of what that experience is going to look like for their employees. They're very focused on providing new technology to the next generation of the workforce who has an expectation that is not the same as older generations in terms of the tech that they're engaging with. And so I think that's been an even more important part of pitch conversations and buying conversations over the last few years.

Okay. So certainly, demographics is a part of it.

It is, absolutely is.

Let's pivot to the employment front. So -- just maybe on the macro side of this, are there any distinctions you're seeing in employment based on the cohorts of clients that you deal with?

It's been fairly flat. So when you think about employees on the platform for us, it's been fairly flat over the course of the last year, which is the way that we thought about this year, and it's unfolded that way. So all of our guidance had flat employees on the platform numbers baked into it. And I think that's generally what we've seen in -- if you look at unemployment rates have remained fairly consistent, fairly steady over the course of the year or so. I think for us -- and this is true, I think probably of many people in the industry as well because we're all subject to the same macro dynamics from an overall employment perspective. Pre-pandemic, you would have seen in normal sort of positive GDP years, you would see between 2% and call it, 3.5% growth in employees in the platform. And that would have been a contributor in that order of magnitude to us from a growth perspective. So now as you look at Q4, we're in our fiscal Q4 end of June is the end of our fiscal year. And so -- this is the time when we're anniversary-ing the level of growth that we would have all enjoyed coming out of the pandemic as employees on the platform would have come back up from the dramatic falloff in sort of March or so of '20. So that's a dynamic that I think we're certainly seeing in our business. And you get back to as we look at this Q4 and then our next fiscal Q1, you're back into that normalized sort of growth rate that we would have seen pre pandemic.

Right with the -- obviously, with what we're assuming here on a similar level unemployment, things like that, I think the latter [indiscernible] per control as a reasonable [indiscernible].

That's right. Yes. We're assuming right now, certainly for the remainder of this fiscal and I don't see anything on the horizon that would change our perspective in terms of the next fiscal looking forward. We're assuming that employees on the platform is flat. And so you're back to that more normalized 20% plus level of growth, but you don't have the tailwind that we would have had pre-pandemic order of magnitude, call it, let's round off, call it, 3% growth coming from just employment growth and employees on the platform.

Okay. What about sensitivity of things like base fees and annual form filings as it relates to that, does that change sensitivity at all?

Form filings does a little bit just because -- I mean -- so this was more variable in the course of the pandemic. So as you had employees come out of businesses and you didn't have them replaced you saw a dip in the number of W-2s that were issued in the following year. And I think this past December, we finally started to get back towards that pre-pandemic level of form filing, or growth on a year-over-year basis. That's the main variability point.

Okay. I'd like to kind of unpack growth. So you've talked here coming off of outsized levels of growth over the last 2 years. You've discussed returning to more normalized, call it, pre-COVID levels this 20-ish percent go forward expectation. Can you kind of decompose that and -- meaning new client [indiscernible] upsells pricing, like what's the algorithm to get to that 20?

Yes. I mean, it's a mix. So we would be growing the sales team. Like coming into this fiscal year in the different buckets, we would have grown our sales headcount by about 18%. Roughly, I'd say, similar expectation as we come into this next fiscal year. We're now in the hiring season for our sales teams, and that's going pretty well so far. So you have headcount growth additions. Obviously, that scales in over time. So those folks aren't as productive on day 1 as they are on day 365. So you have a layering in of their productivity over the course of, call it, 1 year to 18 months. We look at pricing. This is the time of the year when we typically look at pricing. That's not a lever that we tend to pull very hard every year. I mean we try and you very frequently have instances where new clients would come in with some level of discount. And on an annual basis, we would look to sort of roll that back to get the list. And -- so that is a smaller contributor of that is very low single-digit contribution to growth. And then I think you have the mix between units and ARPU that you see coming in. And certainly, both of those are important factors for us. Some years, you -- and we don't -- we're not guiding to a specific mix of growth in terms of where that comes from, from a unit or from an ARPU standpoint, so much as to say that you need to be able to drive both. And in some years, we've seen outsized growth in units and lower on ARPU. In other years, we've seen outsized growth in ARPU and lower on units. The one thing that I would provide for context, which we've said pretty consistently over the course of the last year is that we've seen in the last, sort of 12 to 18 months, we've seen more traction than we would have seen before that period in the higher end of the market. So I think the implied contribution from that is probably higher ARPU and slightly lower on units. But that's a mix that is tough to drive specifically in any given year. And as long as we end up in the right spot, we're generally pretty happy.

And now considering the TAM, obviously, big TAM penetration, single digits, right? Why 20%? Why does it seem to land in that rate of normalized growth? I mean is it gating factors on the rate at which clients can adopt it? Is it more about the sale's organizational expansion?

Well, we've certainly had years, I mean -- and we're in one right now where the growth has been significantly higher than 20%. So I think with the 20% reference is more from a historical perspective, that's the financial target that we would have set out at the time of the IPO to be able to grow revenue at total revenue at 20% plus on a longer-term basis, and that's still our target today. I think if you look at how we were growing pre-pandemic, we would have been growing in that 20% to 25% range. And so going into that fiscal year, I think it was fiscal '20, I think we guided in the low 20s. And for the first 9 months before the pandemic, we were performing around 25%. And we had, call it, 3 points of growth embedded in that from a tailwind from employees on the platform growth. So I think we're kind of -- there's not -- it's less -- there's something magical about the 20% market more -- we're probably coming back to the level that we were at pre-pandemic. And that's -- I think we're obviously a much bigger business today so that -- the goal when we went into it all was to be able to continue to invest and to lead the business in a fairly consistent way, focused on driving product innovation, continuing to invest in product and to be able to come out of everything, continuing to grow at that 20% plus rate. And I think that's where we're.

At a comfortable level within the organization as well to appropriately staffed.

Yes, exactly.

Yes, with a much greater size.

Even a greater size and with a much -- with getting leverage from a profitability standpoint all along the way. So coming out of it is a bigger business, still growing at 20% plus and with a better profitability profile as well.

Yes. Sure. Okay. Let's pivot to product development. So as a product certainly, it has always been a key area of investment for the company with a history. Can you just dig into some of the recent major releases or the ones that you get most excited about?

Yes. So right when we were entering the pandemic, we released a handful of new solutions. Video was new, surveys, LMS community, which is the communication heart of our platform, were all new releases. And I think they were -- the timing was, I think, incredible from an adoption standpoint because the ability for folks to engage with employees in a remote environment and through our community platform became critical. And I think that was a big part of the differentiation that we've seen ever since then. So the adoption levels that we were seeing in those newly released solutions, whether it was video or LMS or surveys or across the board was really, really strong. It was higher than we thought it would be. And I think that's absolutely continue to be the case today. And I think part of that is driven by the expectations of the workforce today. That is the way that people are used to engaging outside of work, from a mobile and social perspective and from a technology perspective more broadly, and that's the experience that's delivered via our platform. So I think whether we're in the course of the pandemic or coming out of it, that the expectations of the workforce are new, it's all digital, and it is very much mobile and social, and that is absolutely what our platform has built out around.

Exactly on that point. You would have historically thought about collaboration communication in the HCM suite, how you pulled that in.

Absolutely.

Are there other adjacencies you think that there's the potential to absorb those and expand the offering that are not currently there?

Yes. I mean I think it gets to how do employees want to work. And that's been the broader theme that we've been sort of focused on before the pandemic even. And that's -- I think that's the theme that we continue to focus on. The more that we can drive through, whether it's just the experience within the suite or if it's incremental modules, which in some cases, it has been with things like collaboration, that's the focus. And I think that's where we can drive incremental value and incremental differentiation. And part of that goes to the experience that HR admins might have or hiring managers might have, but I think even more in focus for the businesses of today is the experience that their employees have. That is much more important today than it would have been 5 or 10 years ago.

How involved are big customers in that product development roadmap?

We learn a ton from our customers. So a lot of the -- the interesting thing about product development is as we launch solutions and we get clients live and we look at what -- how they're using the solutions, a lot of times, you see use cases that you never would have imagined. And that becomes the cornerstone of then the product direction within parts of the suite. And we absolutely are paying great attention to how our customers use the product and you learn a lot from doing so.

Generative AI. So you've got something in the market here. So you announced AI just a couple of, I guess, months back now. Can you talk about that and how that how you're leveraging Generative AI on the product, what it's doing for your clients?

Yes. So in that specific example, you're right on last earnings call, we announced AI [indiscernible], which is basically giving within our community feature, which is the communication heart of the platform, giving our admins the ability to start at a different place. So it's helping them craft messages. So hey, I need a message to go out and celebrate year-end for all of my sales team and being able to get with typing that and a message back that is surprisingly well crafted to hit the mark on that. And so that's the initial use case that we started with, and we've seen having just rolled it out, I mean, the feedback has been great. It's been, hey, this is actually really helpful saves time from an HR communication perspective. And I think there is the ability to then see other use cases, whether something like creating a new job spec, which is next on the list. Or some other function where it's something that largely the HR team would be tasked with doing. It's not particularly value-added task and it's critical. It has to be done, but it takes time and it's somewhat manual. And I think those are the types of areas where you can easily see expansion from a product perspective.

[indiscernible] charging for you?

We're not. I think that's an open question with some of the things that we've been using AI for, it definitely creates a better experience. It adds value from a product perspective. Whether those things are individually something that people would pay extra for, we've treated it more on differentiation versus incremental SKU. But...

Any early productivity savings that you've seen out of this, sort of like quantifying and saying, "Wow, this is real."

Yes. I mean we've looked at -- I mean, this is very early. So having just released this, the wealth of data is still coming together. But I think you hear anecdotally people say, "Hey, like creating that message took me 30 seconds, where I would probably would have sat there for 10 minutes before." I mean I think this is anybody that sat down to actually craft an e-mail, can imagine, hey, having a starting point or a template to start from saves minutes, at least.

I want to pause here and see if there's any audience questions. Okay. Let's talk about PPY expansion. So let's PPY currently at 440. We've got a 500 on target that's been out there. You have consistently grown this since the IPO. But looking back at the prior pace of expansion, obviously, on lower numbers, you had a faster rate of expansion more recently. It's ticked up a little bit slower rate. How do you think about considerations going forward on the rate of PPY growth or any grow-over pressures in the near term that we needed [indiscernible] mindful of.

I think you've got to look at it over sort of the full length of time. Because in terms of product innovation cycles, you go through periods where you push out a lot of product and then you go through periods where you're building it and then you push it out again. So I mean, while we're releasing continuously from a new product launch perspective, you're right, we've gone through a period sort of 24 to 36 months ago where we had much more launch than we've had in the last 12 months. But I'm very bullish on what we're going to be able to release over the course of, sort of, the next sort of 12 to 24 months. So I think if you look at it over a period of time from, call it, 2014 to today, that's the right way to look at it versus anything else because I think the spikes and dips in between are just part of the product cycle.

They are naturally list as different than attached. Can you talk about at least see the attach of that, how that's trended recent years?

Yes. I mean I think we've been really happy with it from an attach standpoint. So we have -- when you look at the level of what we realize in terms of total available PPY, that's been typically close to that 50% to 60% mark, we're a little bit above that now. So I think the mark for us has been, hey, can you continue to develop and deploy and launch new products that add value and that people are interested in? And the mark of that is do they actually buy it. And I think what we've seen is a steady stream of increased PPY that's available and a steady stream of take rate on it in terms of realizing that PPY at an even higher clip than we would have before.

And that specific as far as the rate of adoption of some of the newer products, you're saying that that's going at a faster rate?

It is. Yes. I mean I think if you look at what we -- the attach that we've gotten off something like video, which I think we believed in or else we wouldn't have launched it initially, but we would have had expectations of that being, hey, can you attach that as sort of a 10% to 20% rate. You eventually in the first handful of years, gets you to call it, 20% penetration rate overall. I mean, that would have been something that we would have viewed as successful. And it's been much, much faster adoption that we've seen on something like that. Same is true for surveys and LMS. I mean that last batch of product that's everything in our modern workforce solution category, that's all been more heavily adopted than we would have thought. So it's been hugely successful.

Is there a ceiling in your view on how much clients are kind of willing to you talk about average levels here. But I mean, as you think about maybe the characteristics of clients that are attaching the highest level, what are those businesses doing differently?

Yes. I mean I think that question has always existed, going back to 10-plus years ago when there was only focus on payroll and the concern was, well, people won't buy anything else. That's the most important thing. And I think that question has been fairly consistent over the course of the last decade. And I think that the right way to think about it is, can you find things that people actually care about and that make their lives and their days and their time at work easier and that adds enough value that they will actually pay for it. And I think we've done an exceptional job of being able to identify those use cases, taking probably a broader view of client needs overall, something like learning and video and what we've done from a community perspective. All of those things have added value that 10 years ago, people would have said, well, I don't really understand what that means. And then you launch a product. And not blindly, you get a bunch of client feedback, and you build the things that you know are going to add value to them. But I think they have been willing to pay the incremental dollars to solve the problems.

Okay. So sales naturally adjacent to the product investments that you're making, can you talk about where you're spending most around the sales organization?

Yes. I mean I think in recent years, we've continued to grow sales headcount fairly consistently in that sort of upper teens ZIP code. I think we came into this fiscal year growing at 18%. Expectations are probably fairly consistent as we start to build the plan for fiscal '24. And then, also, we've certainly done a bunch of spend on digital marketing from a lead gen perspective. That's something that I think a handful of years ago, we would have had less maturity around. That's been an increased area of focus over the last, call it, 2, 3, 3.5 years. And has certainly been productive for us from a sales force leverage and from a productivity standpoint. Then obviously, we get 25% plus of our business referred to us from channels, and that's primarily financial advisers and insurance brokers. And so that's a category of lead gen that we've continued to invest in, that's been very successful for us.

Okay. You mentioned digital marketing. Are there other technologies that you're leveraging within that S&M organization?

Yes. I mean the -- our -- we have tried to provide our sales and marketing teams with the most modern tech to make their jobs as easy as humanly possible. We'd rather have them focused on out there and selling and actually generating revenue and making their actual sales motion as easy as it can be. So leveraging technology across the sales and marketing teams has been a focus for us, certainly, over the last 5 years, but certainly over the last 2 to 3 years. And again, the focus is on not just being able to grow sales headcount, which we've continued to do. But over time, you want that headcount to become more and more productive and get as much leverage out of that growth as you can.

As far as productivity goes, do you see have seen strong gains over the last several years, as you've layered on at least the last 2, 3 years with the digital marketing tools?

We have. I mean, obviously, you've got the ups and downs in the pandemic. So if you try and isolate out all of the noise from the pandemic, which is a little bit hard to do. But I think, yes, you continue to see sales force productivity over the course of, call it, the last handful of years.

Now more recently, you've talked about success in landing larger clients, so about 500 employees. Can you talk about what's driven that dynamic? And is there -- give us a sense on maybe the larger clients that [indiscernible] -- more of a limiting factor of ceiling?

Yes, there's no artificial ceiling. I mean I think we've talked about our target market being businesses with between 10,000 and 5,000 employees. And there's no artificial ceiling on the 5,000. I think it's more been just kind of a -- we've talked about it more in the last 18 months or so, and that's less -- it's less then, hey, we've pivoted the business to that. It's more a -- probably talking more about an area of our business that has just gotten more and more traction, more naturally. So I don't think we've had any significant pivot and focus so much as over the last 5 years. As we continue to build out the product set you naturally get drawn into some of those larger deals. And I think we've had a great deal of success there, particularly over the last 18 months. And there's no -- I think in terms of getting up into the top end of that market, it's less about the scalability of the platform or something like that. You tend to run into conversations of people sometimes wanting customized solutions and things like that, which isn't really our business model. So I think we found a ton of success there. And I think a lot of the product differentiation that we've talked about with the release solutions over the last couple of years has also resonated at that top end of the market.

Is there a different sales acumen or inbound individual you need to target those organizations? Or are you happy to rescaling ones that were at the low 100 level?

Yes. I mean what you tend to find and when we're pitching bigger deals is you tend to find our most experienced reps are handling those interactions. And same thing would be true from an implementation standpoint.

Okay. Any other -- you mentioned customization in certain cases. Any other limiting factors or areas of complexity for larger clients?

Not really, no.

How about the international front? What are you looking for there -- specifically around Blue Marble, maybe talk a little bit about that.

Yes, for sure. So we acquired the Blue Marble business maybe 1 year, 1.5 years ago. And the thesis behind that acquisition was that there was clients in our base, but also deals that we were pitching, U.S.-based companies that would have, in many cases, a handful of employees outside of the U.S. and that would look to leverage a third-party solution. In many cases, that was Blue Marble, to integrate that data between the payroll that's getting done in the country and the system they were using here in the U.S. And that was really the thesis behind our acquisition of Blue Marble. And I think the underlying sort of macro employment thesis was that as the labor markets continue to be tight, you would see businesses either because of economics or just access to talent looking outside of the U.S., and I think that has continued to be the case.

Okay. Is there an approximate mix of the base that -- that's applicable to?

I think in terms of the client base or new deals that we're pitching, this is a generalized statement, but the larger the business, the more likely it is to have employees outside of the U.S. But -- and this goes to, I think, the tightness of the labor market and access to talent. You're seeing that come down further and further in terms of the size of the business and whether or not they're willing to look at talent that's outside of the U.S. just purely to get access to the skills that they need.

Let's talk about retention. Revenue retention has exceeded 92% consistently over recent years. Talk to what's driven that strength? And do you see further upside? Or was there but stability from here?

Yes. I mean I think the industry -- in fairness, the industry in total has seen high retention rates. I think coming through the pandemic, everybody in the space has seen higher retention rates, we certainly have. I think from a focus standpoint, from a service perspective, we were really happy with our ability to, I think, serve our customers as well or better than anybody else in the course of the pandemic with the increased number of questions that people had in terms of navigating PPC loans and otherwise. So I think we were really happy with our performance on service as we came through the pandemic. I think that's part of what contributed to our overall higher retention rates. They've been sort of at a 5-year high throughout. And I think we always want to believe that there's an incremental match that we can turn in terms of driving retention. But I mean the facts are that we're operating at sort of a 5-year high and to be able to sort of have some stability there is great.

How should we think about the level of uncontrollable churn?

Yes, uncontrollable churn in terms of out of business or change in ownership, things like that has typically been in the low single digits, call that 2%, 3%, 4% ZIP code. And that's the part that is typically owing to one of those factors that's outside of the control of anything that we can do.

Okay. Margin has been a good story for you over many years now. It's good, continues to expand. Can you talk about some of the primary levers that have driven that? And as you think about the 35% adjusted EBITDA margin target, how do you get there?

Yes. I mean that's certainly the higher end of the existing target. And I think we're in the range now. And I think the primary drivers for us year in and year out have been continuing to drive G&A leverage and continuing to get leverage from a gross margin standpoint as it relates to the size and scale of the business. And that's been the case year in and year out. We have continued to -- I mean, a big part of our differentiation strategy is around product differentiation. And so our spend on product has been relatively consistent in the 10% to 15% range. Last few years has been in the higher end of that range. But again, that's focused on driving future growth from a product perspective. Sales and marketing has been in that 20%, 25% range, sort of in the middle-ish of that. And again, future growth driving. So those are the 2 areas that we haven't focused on in terms of getting leverage, but we've driven meaningful leverage in the business, both from the G&A side and then also at the gross margin level from an operating perspective. And I think as you think about where we are right now, great quarter this last quarter in driving free cash flow. And I think we're getting to a place where you start to see adjusted EBITDA, free cash flow, gross margin also continuing to drive leverage on a year-over-year basis.

Can you bring float into that conversation? How is that impacting margin levels, free cash flow? And how should we, maybe calibrate expectations, moving forward?

Yes. I mean float has -- float has certainly increased. So you've seen their interest on client funds has increased over the course of the last 12, 18 months. Part of that, you see naturally year in and year out from client growth and growth in employees in the platform, which tends to roughly track client growth. But the bigger part has been going from, I think, what would have been before rates started coming up, call it, $20 million in annual revenue coming from interest on client bonds to where we sit today. That's obviously also uncontrollable. It's a tailwind when you get the rate increases. And if you think about a world where rates come down, also uncontrollable. And so I think the thing that we focus on day in and day out is being able to drive the true operating leverage across the business, and everything you get from float is extra.

We've covered a lot of ground. We've run out of time. I do want to thank you. Thank you all for joining us.

Yes, thanks, Bryan.