Paylocity Holding Corporation (PCTY) Earnings Call Transcript & Summary

Thanks, everyone, for joining us. I am Matt Pfau, the analyst that covers Paylocity at William Blair. For a complete list of disclosures, please visit williamblair.com. With that, very happy to have with us here today, Steve Beauchamp, Co-CEO of Paylocity. So Steve, thanks for joining us. I think a lot of people here are familiar with Paylocity, but in case they're not, let's just kick it off with the quick intro on who Paylocity is and what you do.

Sure. Yes, I'll keep it relatively high level and quick so we can get into the questions. But -- so Paylocity offers payroll, HR software, really think about every aspect of an employee's life cycle from a software perspective, performance management, recruiting, onboarding, all of the key components so that we can completely digitize the back office for our clients. We really focus on kind of small, medium-sized business. So our target market starts to happen when a customer gets 10 or 20 employees and then all the way up to 5,000 employees. We went public back in 2014, and we've expanded a little bit up and a little bit down since that time in terms of the target market that we go after. We have about 30,000 clients nationwide, and our go-to-market motion is really kind of traditional salespeople, managing territories. They get about 25% of their new business from referrals, from financial advisers and health insurance brokers. And it's a -- growth pattern is really a combination of new client additions. We've been growing new clients pretty aggressively since going public. And at the same time, we're adding product capabilities. And so our average revenue per customer continues to increase. We've organically focused on building new modules, releasing those modules to new customers, growing the amount that they're buying and then also selling back to the customer base. It's a competitive market. So the traditional players that we would get customers from, you would see as ADP and Paychex are the big players that have been around for a long time. There's obviously a couple of other public companies out there in our market space, Paycom and Paycor, but we really try to differentiate ourselves by being the most modern platform in the industry, focused on engaging with employees, not just saving HR team's time, which is a big part of what we do, but actually finding different ways for them to engage with their employees, drive higher retention, increased engagement, higher productivity is really part of our focus on a go-forward basis.

Great. So coming out of the pandemic, demand for modern HCM payroll has been very strong. Maybe you can just discuss what's driving that? And do you think this demand environment we've been seeing is sustainable?

Yes. So if you go pre-pandemic, hard for us to even think back all the way back then, but we were growing kind of in the low to mid-20% range. It was that combination of more product and new customers we're adding to the platform. At the time, we are in a fairly low growth environment, still unemployment was still relatively low, kind of a low-growth environment. Pandemic hits, obviously, employee -- we get paid based on employees on the platform. If that gets reduces, our customers go through layoffs and then you get the COVID boom on the back half of that, where everyone's rehiring in that and growing. And so our growth rate then spiked up over 30%. For the most recent quarters, we've been the fastest-growing kind of HCM provider in our sector as we've come through that COVID boom. And so now as we sit here today, we're kind of forecasting kind of our next quarter being kind of back into that pre-COVID level of growth rate, more normalized. And from an economy perspective, we kind of get asked the question, what are we seeing the number of employees that our clients are employing, which is the way we get paid on our platform, is pretty flat. So pre-COVID, it was growing a little bit even in that environment, kind of 2% or 3%. Now it's pretty flat from a growth perspective. But we continue to be able to have success with the same concept as before. We're going to save you a little time. We're going to provide you more modern solution than many of our peers, and we're going to grow with new product conditions and bringing on new customers.

Great. Let's dig into the comments about competitive differentiation a bit? And you said you strive to be the most modern platform out there. What does that mean? What are the areas that you're focused on differentiating yourself versus competitors?

Yes. So mic issue. All right. I would say, if you really got to take a step back and think of how the world has changed from an HR perspective, so our decision-makers are often the HR organization at our companies. And it has been really complicated for them. Obviously, COVID, remote work, Gen Z entering the workforce, gig economy. It has been really complicated for them to manage it. Traditionally, I think if you go back 4 or 5 years ago, our pitch to folks were, hey, we're going to digitize the back office and save your team a whole bunch of time. And we're going to do that with a solution that we've organically built that is going to allow employees, managers, supervisors to do more of the work for you. That's still part of the equation. It's definitely part of what we do. But now with solutions like we have community, we have LMS, we have surveys, we have video built into our platform. Part of our pitch is, we're actually going to deliver to you not only time savings, but we're going to deliver to you a more modern way to communicate and connect with your employees, particularly in this new world of work in terms of the way we operate. And if you take advantage of all those products, then you're actually going to be able to drive higher retention of your employees, you're going to be able to drive better learning and higher productivity over time. And so that value proposition has definitely evolved over the last 5 years as we've made investment in products and launched some of these capabilities.

And where are your customers coming from? Has that changed at all over time as you've grown?

I think it's been fairly consistent. A couple of highlights there. As we have grown our investment in product, we've added more modules and capabilities. We then -- when we launch a product, we then keep teams on that. We keep making it better based off client as a co-creator kind of mentality, feedback from the customer gets the product better. So those products get richer in terms of capability over time. As our product portfolio has gotten stronger in terms of the capabilities, we have moved upmarket a little bit. So when we went public, our target market was up to 1,000 employees. Today, it's up to 5,000 employees. So we are seeing and we've called out success over the last several quarters in terms of what we're seeing upmarket. That's really just a function of the fact that our products have scaled gradually over time based off that client feedback and become more competitive in that space.

Great. There's been a lot of VC funding in the HR space over 2020 and 2021. Has that changed the competitive environment at all? Have you seen any of those start-ups that got funded start to compete against you in any deals?

Yes. So I think it's definitely a competitive environment. It always has been, right? So there are a number of players in the space that the advantage that this business has, which makes it attractive as everyone is paying their employees somehow. So when we bring somebody on, we're often displacing from an existing competitor, that competitive set has remained largely the same. It's ADP, it's Paychex. You go upmarket, you might start seeing [ UKG ]. The other public players are the Paycom and Paycor of the world, that remain the same. There's always been investment in this space, and it's happened in 2 ways. It's like niche products for one of the modules that we have and/or maybe a solution that actually does payroll and broader. Those companies -- there's no meaningful player in that space realistically. We've had players in the past like the Zenefits and the Namely that had success for a period of time that we don't see really much anymore. You've got somebody new like Rippling or Gusto down market. So there's always been somebody like that in the market, and they can be reasonable competitors, but it doesn't change the overall dynamics of our competitive environment.

Got it. And I'll ask a question. I'm sure you've heard a ton of times. But just when you look at yourselves and Paycor and Paycom, it seems like everyone is doing really well and even the ADP and some of the larger players -- how is that possible that everyone seems to be succeeding in this market?

Yes. So I think I go back to the bit of that macro trend. It's harder to manage people. People are more recognized as a very valuable resource in running the business, particularly in a kind of low employment environment, particularly as baby boomers retire at a faster rate than Gen Z enters the workforce. There's a lot of challenges around people. And I think organizations are spending more time and energy around how they manage those valuable resources. They were already getting them paid. So that part of the equation was kind of soft. And so I think what's driven a lot of growth in the market is these other modules that we have and that some of our competitors might have and the fact that there is an investment back in the systems that help manage people. Like fundamentally, if you're a Gen Z employee and you enter the workforce, you expect the tools at work to look like the tools you use socially. So when I'm onboarding, it should look like an Amazon shopping cart experience, not the folder of paperwork that I have to fill out, right? If I'm learning, it should feel like a YouTube experience to be able to learn the information that I have, not necessarily a legacy-based LMS tool that's only compliance driven. And so I think overall, this idea of modernization and the trends in the workforce have made HCM more important and a bigger priority for organizations and that has allowed us to be able to grow. And lastly, it's a big market. We have 30,000 clients. There's over 1 million businesses in the segment that we target. We're just going to cross over $1 billion in revenue, and you could look at the TAM depending on definitions of $15 billion plus. So no matter how you cut it on a unit basis, we're less than 5% penetrated; on a revenue basis, less than 10% penetrated. So I think the new players are going after an environment with a pretty big TAM.

Got it. So I think the main point here is that the market has been expanding, particularly from a dollar perspective, what have you seen within your customer base in terms of ability to grow that per employee fee both with either new or existing customers?

Sure. So when we went public back in 2014, we really had about $200 per employee per year product that somebody could buy. And obviously, we attached at a rate lower than that. Since going public, we're up to $440 per employee per year. So we've more than doubled the amount of product that we can sell. And if you look at that percentage of attach because we give you -- every year, we give you client counts and we give you roughly the size. We've actually been able to -- all those new products, we've been able to expand so that, that attach rate stays pretty consistent across a portfolio that's doubled. And so adding all of these products, we primarily focus on selling them to new customers. And then I would say over the last 3 years or so, maybe 4 years, we've built an inside sales team that's also selling back to existing customers. And so most of our growth comes from the new units we bring on and the extra product that they're buying. On top of that, we get some sales back to existing customer base because they're also adding those new modules as well. And that's kind of the whole formula for success is adding the units and getting that average revenue per customer increase. The other thing I would mention is the products that we've added have been largely organic. So our growth is really all organic. We've done some M&A, but they've been product tuck-ins largely and technology accelerators. It's really been an organic growth story.

To drive that higher revenue per employee that you're seeing from new customers, what are some of the products that you're seeing the greatest interest in or that you're most excited about?

Yes. I'm actually super excited about the product road map and where we spend our time. And for me, that's where I spend more of my time. So definitely a product-oriented background. I would tell you 3 categories that we are making investments in that I'm pretty excited about. So first category would be our existing products. So think of those like payroll and time and benefits must have things that organizations need. We have an opportunity to modernize those and potentially come up with advanced capabilities or plus SKUs where we could either get some pricing out of that or we could actually get new monetizable modules. And so making investments in that category is there's a lot of opportunity there. The second category of opportunity really fits into our whole engagement and being the most modern platform. So things like community and video, there's new opportunities as we drive more utilization of customers in those products to be able to think of other categories where we could have new modules and just new capabilities to create more differentiation. That's a second level of investment. And I would say the third probably pillar of investments is our marketplace investments. So we have really valuable day about the people record, and we know a lot about that person. And so organizations who are managing people need to integrate with a variety of different software applications, sometimes to run their business, sometimes to run different processes. And so the more that we can make that automated APIs in real time, the more differentiation we can create for customers and sometimes some of those partners might pay us or access to that data and information. And so that marketplace investment is also a third category that we're excited about.

Got it. I'll ask one more thing on the product side. So there's been some focus recently on global HCM, global payroll, Paycom announced that they're doing that and actually ultimately made an acquisition yesterday. Is that something that's of interest to you? Is that something your clients are asking you for?

Sure. So our focus has been U.S. market. We still think we have a massive TAM in the U.S. market. Where international plays into it is a customer, who's generally U.S. headquartered for the most part, has employees abroad. And so the question then becomes, how do you help me with the employees that I have abroad. Remember, our average customer is a little more than 100 employees. So that typically ends up being maybe I've got 10 employees in 3 different countries or 20 employees in a few different countries. It does become a pain point for the customers. We made an acquisition of a partner. Now we were going to be 2 years in September that we brought on board that can actually help solve that problem, which is -- they have a network of partners. So we have a network of partners that we work with, and we put a middleware software between them so that the client doesn't have to manage the network of partners, and we can aggregate that information, and we can get those employees of that company paid in those other countries. That's been our approach to it. Others, more so in the upmarket, have decided they want to build native capabilities in each country. That's probably less of our strategy. Our strategy would be if global employment kind of increases, meaning U.S. companies with more global employees, we just want to help them solve the problem. They can still use products like community, even though they're in a different country or LMS or some of our other products. But the payroll part becomes a pain point for them. And we feel like the solution that we've got keeps us focused primarily on the U.S. market, but it allows us to be able to provide a solution for those customers with international employees.

Great. Let's move on to the macro a bit question on everyone's mind. How do you think about Paylocity's performance if the macro were to soften? And how sensitive is the model to employment levels?

Yes. So I've been in this industry my entire career. So I've seen a bunch of different cycles that places either Paylocity or larger organizations that I work for. The primary impact ends up typically being the number of people you have on the platform. And so whether the organizations that you serve are adding employees or losing employees because you're getting paid based off a per employee kind of per month revenue model. And we saw that in COVID. If you look at recent history, you saw that dip down as people reduce their employment levels and you saw the tailwind we got on the rebound of that. Now in a normal kind of historical recessionary environment, that gets narrowed dramatically. And so if all of a sudden, you're in a recession and you're talking negative 2% or 3% GDP, you typically see that type of employment levels reduced by roughly those percentages. In a low-growth environment of 2% to 3% GDP, you see a 2% to 3% kind of bump in your revenue. And so that's the way to think about the primary impact. Depending on the cycle, you also have interest impact, which typically can also go with the cycles as well. Now that's the opposite right now. So we've obviously had the tailwind from interest revenue. Prior cycles, you typically would see interest revenue decline as you're going into a lower economic cycle. But I would say we're pretty resilient. It doesn't mean we're not impacted. We absolutely are impacted. We've definitely demonstrated the ability to sell through downturns, we've been able to sell in a down market and an upmarket. You saw in COVID, we're able to have pretty good success, continue to sell our products and solutions, even if you go back to the prior recession. So I think that the primary impact comes to employees on the platform.

Got it. In terms of what you're seeing now, you mentioned employment levels have sort of flattened now within your customer base. What about in terms of new customer demand and pipeline? How has that been trending?

Well, we've had some pretty good historical quarters coming out of COVID. Some of that has been the employees increasing on the platform, but we've given guidance around what that looks like. And even if you back that out, we've been able to have some nice growth coming out of COVID. We're in a position now where we're the fastest-growing kind of HCM company for the last several quarters, which we're pretty proud of. And I think that goes to the product investments that we've made in this modern employee solution that we're offering. I would say, like just from a recency perspective, we still are having good success. We feel good about the pipeline that's there. We think our value proposition sells regardless of the employment environment that we're in. We're focused from a long-term model really at 20% plus growth. That has not changed. We're still focused on that. We went into COVID at kind of the low to mid-20s. We're guiding kind of in that same range next quarter kind of pre-COVID. So it's almost like a journey back to kind of where we were prior to entering COVID.

Right, right, especially if you normalize it out for the decline in COVID...

If you normalize interest revenue and employees on the platform, there's a lot of noise in there, for sure. But it probably feels different when you look at it externally than internally in terms of how we are running the business.

Great. The other question on everyone's mind is AI. Maybe you can just discuss, are you doing anything with Generative AI? Do you see any potential products that you can use it for?

Yes. So we definitely have a history of investing in machine learning algorithms and AI. So we've started really kind of an AI and data practice probably about 4 years ago. And we actually have examples of that in our products. So we have a modern workforce index that takes the data from 30,000-plus customers and it scores people by industry based off of what they're doing in our product and then provides recommendations to others. So if you're a restaurant and your average turnover is much higher than the rest of your peers, we actually make recommendations to you. And that's all powered with algorithms that we're running. We have a retention risk dashboard that tells you which employees are mostly likely to be flight risk. So we've been investing in this space for a while. Our more recent investment using Generative AI is using community, which is essentially like an HR portal to communicate with your employees to actually do some of the writing tasks. So think about writing announcements. And so that's available to our customers right now. You could think of examples like job descriptions on the horizon. So because we get a lot of interaction, whether it's surveys, whether it's community, even video interactions, we accumulate a lot of data from that. And longer term, we see opportunities for insight. There's obviously the normal margin opportunities that every business can kind of go after with AI, but I think we're really well positioned because of the investments we've made over a multiyear time period.

Got it. I'll ask one more and then see if there's any from the audience. But on interest income, maybe just talk about how that works. What are you investing in? Is there any interest rate or other risks around that?

So just to explain for those that might be new. So when we run a payroll for a company, we debit the company for all the money. We put it into our account and we disperse it to the employees, and we disperse it to the tax agencies. There are some -- we want to make sure that we have the money. So there's some float that you get overnight for that kind of employee disbursement. And then the tax agents have various time lines for which you have to remit it. So you end up holding the money in trust for those customers for a period of time. We earn interest revenue on that money. We process that through all the big banks that you might imagine. And so we then have to go to those banks and say, hey, we're holding the money at your bank versus another bank, what are you going to pay us from an interest revenue perspective? And then there's a portion of that, that we're able to go slightly longer on the curve on. We have like an investment policy. It's very similar to all the big -- the other places it's available on our -- in our 4 docks and so those are very risk -- or very risk averse in terms of how we invest that money. And you can actually look at, we give you on a quarterly basis what we earn from a basis point and we give you our average balance and so you can see that's usually a little bit behind where the interest rate is in the current time. And that's how we kind of manage it. I don't think we do anything very different than the rest of the industry. It's a very conservative approach towards doing it, but it certainly has a nice tailwind as it's gone from near 0 to where it is today.

Sure. Great. I'll see if there's any questions from the audience. Yes.

So the [ $200 million ] that you started with and now [indiscernible] terms of the potential user, where is that in terms of the buckets between onboarding, payroll and anything [indiscernible]

Yes. So we don't give an exact breakdown, but I can give you some color around that. So payroll is definitely less than 50% of our total revenue. Often people think about it as a payroll company. But the reality is that these other products that become differentiators and are actually even a more meaningful revenue stream for us today. I would say, realistically, the big buckets kind of in order of size and impact is payroll, then it's really time and labor, then it benefits. The talent category has several products like onboarding, performance, recruiting. That has risen to a point of size to scale more similar to talent and benefits than it has historically. So that's been a really nice fast growth area for us. Engagement is still probably relatively small, whether video, LMS, surveys, but growing probably at the fastest rate. And we see opportunity to be able to, quite frankly, add product -- monetizable product capabilities in all those categories.

Yes.

Can you just discuss if you have any thoughts about international opportunities?

Yes. I do think, overall, you will see more companies be comfortable having employees abroad. I think remote work, obviously, is a trend that isn't stopped. And as the talent pool remains tight in the U.S., then it's natural for companies to be able to go abroad. So I -- but that's a gradual trend. I don't think that that's kind of happening overnight in the SMB market largely anyways. So our viewpoint is that we're focused on the U.S. opportunity. And when that U.S. opportunity as international employees, we want to have a solution for them, and that's the way that we're approaching it. And we want to have a competitive solution and a differentiated solution for those companies. I wouldn't say as we think about our long-term model that international is a core component of us hitting our growth rates. It's more about do you have a solution to service the customers who will probably increasingly so have international employees. So it's important, but it's not necessarily a core growth driver.

Steve, you mentioned that your growth target is 20% plus for revenue. Why is that the right target? And what are the components to get to that growth rate?

Yes. It's a great question. So a couple of things. So first, our industry, you need to also be able to service your customers. So they have a lot of questions, especially in the SMB place. They call us, they e-mail as, they chat with us. There's some handholding going in onboarding. So we implement all our customers ourselves. There's no outsourced implementation. So there's a touch element to what it is. And so you've got to make sure that you can scale your organization from a people perspective and a knowledge perspective at a rate that you're bringing on new customers. I don't think that's a limiting factor, but it's an element that you have to consider when you target growth rate. Secondly, I think we have had a history of really balancing investments for growth while at the same time driving margin and having a more profitable business over time. And so balancing that equation, we feel like 20%-plus growth allows us to drive margin expansion over time. We've seen significant free cash flow expansion most recently. As an example, if you go to that line item, and we're kind of committed to balancing growth margin over time. Now there's times where we make a little bit more growth investment and there's time we drive a little bit more margin. But over the long period of time, we look at this as gradually making progress while we're growing top line revenue at 20%. And so that's probably philosophically how we run business.

Got it. Yes.

Are you involved in this employee retention credit...

Sure. So for those of you who don't know, so employee retention credits are basically a COVID [ area ] incentive program that came out through some of the legislation changes that were put in at. We have reporting and data that we offer to our customers, but we're not monetizing employee retention credits. There are organizations that are out there trying to monetize employee retention credits. Part of the challenge with that is -- from my perspective, like it's onetime revenue that you get for a year or 2 and then it kind of goes away, and then you got to figure out a way to be able to grow over top of it. And we're providing the customers the data. So if they actually want to do it, they could do it on their own or they could leverage their CPA to do it or somewhere else. So it's a choice that we made with customers and our customers -- it's bigger in the small, small end of the market. Our customers with over 100 employees do often have advisers that can help them with that. If you get down into like the Paychex marketplace, which we do compete in, but it's smaller, it becomes a bigger solution. So we don't have any employee credit monetization offering.

From a measuring of ROI and the R&D spend, is it more important to grow the [ 200 to 450 ]? Or is it more important to lower the cost per user?

Yes. So I would say we try to look at R&D investments in a fairly balanced approach so that we're doing both of those things. Historically, early on, it was probably much more heavier on growing the amount of product that we have for our customers and therefore growing that average revenue per customer. I would say we're at a size and scale now where you can actually start to spread your investments out a little bit more. I went through the new product investment areas that we're investing in, but we're also investing in like modernizing the implementation process, which ultimately helps from a cost perspective, also creates a better experience for our customers. And so I think now crossing $1 billion in revenue, we invest roughly 15% when you look at what we capitalize in expense in R&D. We're at the size and scale that we can now manage all the investment area.

Just a follow-up on that, Steve. What does it do for the margin structure as you see non-payroll applications become a greater portion of the mix?

Yes. So the great thing about some of these non-payroll kind of engagement-oriented applications, they're much more self set up from a client perspective. So we can kind of turn the module on, we can give the client some guidance and they can be up and running relatively quickly. One of the challenges about the payroll business as a whole is that implementation process is a heavy lift. And it's generally you only earn money after holding the company on board for a certain period of time because you can't get enough implementation fees to defer your cost for that. But these other modules doesn't have that same dynamic. And so they go and become accretive to margin right away. And so one of the reasons why we've been able to expand gross margin over time is this dynamic of these newer products having a naturally higher margin. Second thing is it's a scale-oriented business, you certainly get scale over time. But that's the impact of that.

I'll finish off with in terms of your sales model, you do leverage partners for some of your sales. Maybe just discuss who these partners are? What percentage of sales does that account for? And is that differentiated versus your competitors?

Yes. So one of the unique parts of our go-to-market model is that we work closely with financial advisers and benefit brokers that also are approaching the HR teams and providing these services for 401(k) and health insurance and dental and vision and all the benefits that a company needs to offer. And our position with them is we can be a great partner because we've got great data exchange capabilities for the products that they are recommending. And on top of that, we're not competitors. So we're not in the PEO space, we don't have stand-alone insurance offerings. We're not in the 401(k) space, so they like that us being neutral when it comes to that. And so even -- so when we went public, it was 25% of our new business revenue. So we went public at $100 million in revenue. We're over $1 billion from a forecast perspective this year. And we're still over 25% of our new business revenue coming from those partners. Now to be clear, they don't sell our solution. What they do is they refer our sales rep who then sells the solution and they create those relationships so that they're sharing leads back and forth and us both growing the business. That's been really effective for us. I've been really pleased that our size and scale is still above 25%. And when we get leads from them, they're trusted providers and they close at a higher ratio. And so it's really the combination of the solutions that we have, the rich set of data exchange capabilities and marketplace capabilities that we have, combined with the fact that we've built trusted relationships over many, many years with a set of providers who are very local, and there's thousands of them across the country that has worked really well for us, and we're confident we can continue to scale that partnership.

Great. Well, I think we're about out of time. So Steve, thanks a lot for being here. Really appreciate it. And there will be a breakout in Richardson upstairs. Thanks, everyone.

Thanks, everybody.