Paylocity Holding Corporation (PCTY) Earnings Call Transcript & Summary

All right. I see the time has started. I -- can everyone hear me Okay? Great. Yes. Good morning, and thank you for joining us here today. For those of you who don't know me, my name is Sheldon McMeans, and I help support Raimo with our software equity research effort here at Barclays. I'm pleased to be joined with Ryan Glenn, CFO of Paylocity, on stage with us today. Ryan, thank you for being here.

Absolutely. Yes. Thanks for having me today.

Yes. Great. So to get started, I think investors are largely familiar with the Paylocity story, if not, reach out to us, and we can get you up to speed. But to get right into it, you recently just announced your Q1 fiscal year '26 results. Could you share some of the highlights in the quarter and how it played out for you?

Sure. Yes. We were really pleased with our first quarter fiscal year results. We had strong recurring revenue growth of about 14%, total revenue growth of 12%. We raised our guidance by more than our beat across revenue and profitability. We continue to both drive durable revenue growth as well as increase profitability. We continue to be active with share repurchases. So we were both active in Q1 as well as planning to do so over the balance of the year. So really good start to the first quarter. I think top of mind for investors is always a macro and demand environment, and both of those have been stable. So we see client workforce levels up a touch year-over-year, slightly better than expectations. Demand environment continues to be stable. So good start to the year. We're really pleased with the team's execution and feel like we're positioned as we head into the busiest part of our year with January being the biggest month of new client starts. We feel like the teams are very well positioned for the balance of fiscal '26.

And another thing was with the quarter results, you came out with some new long-term targets and not only performance in the quarter, but also maybe something you're seeing broader in the environment that's giving you confidence to raise those targets. So I would love to hear a little bit about that and what underpinned some of those decisions?

Yes, absolutely. So we had set our prior financial targets in August of '23, so just over 2 years ago. And we made really significant progress, I think, across each of those key targets. We've driven several hundred basis points of EBITDA and free cash flow leverage. We continue to expand adjusted gross margin, continue to drive strong and durable revenue growth. And I think as we looked at the start we had the fiscal '26 with over 110 basis points of operating EBITDA leverage, strong gross margin leverage and I think, starting to see the early benefits of both AI and automation benefits to our operational teams as well as efficiencies within our broader business. I think we looked at the trends that we're seeing and where we were relative to the prior targets and I think increase those, really an acknowledgment of the progress we've made as well as the opportunity and optimism we have around what the profile of this business can look like over the next several years. So we're really pleased with the start to the year and feel like we have a line of sight over a several year basis to continue to improve the financial profile of the business.

Yes. Understood. And going back to what you said earlier, macro certainly remains a key point of interest for investors. One of the things that we get a lot is a lot of questions on employment growth and how that affects your business and peers in the industry. You talked about how you saw client workforce levels up a touch. And I think maybe people put too much weight into that than maybe we should. And so maybe asking the question a little bit differently. It seems like macro was stable. You talked about that, but the employment data has been a little weaker in the last few months. When we're in an environment like that, maybe not as much robust hiring, how does that affect just more of the normal HR payroll buying decisions and kind of the activity there. Can you speak to that?

Yes. As I mentioned earlier, we continue to see a very stable demand environment. Our average client has about 150 employees. We've continued to move upmarket and have success with larger clients. But for the most part, we see a lot of stability over time in the demand environment. As you know, HCM and broader HR offerings are -- keep the lights on software. So these are not really decisionable related, decisions that companies are making within their HCM product suite. So we see a lot of durability in the demand environment. And I think equally so, we've been pleased with not only the team's execution, but our ability to tell a differentiated story. So across HCM and now finance and IT, being able to go to market with a collective set of offerings with powerful workflows across each of those products, deep integrations. I think we're able to tell a very different story and that has accrued to our benefit in the first quarter. And as I mentioned earlier, I think one of the elements that gives us a lot of optimism as we head into the back half of the year.

Yes. Speaking of that, we're certainly in the big buying, end of year selling season right now, and you recently had your big Elevate Conference. I think you hosted thousands of businesses at that virtual event. As you think about maybe some of the activity or demand signals that came off from the back of that, can you speak to that generally and how that gives you confidence in this part of the selling season and into next year?

Sure. So we had a virtual Elevate Conference, which is what we've had for the last several years, really strong engagement from both clients and prospects, really strong attendance at those events. I think those are opportunities both for us to really educate clients around the product as well as talk specifically around what the product road map could look like, features and functionality, both with new products as well as the existing base as well. So a lot of energy, a lot of momentum and great opportunity to have conversations with our clients around where the business is going.

Got it. And so maybe just -- is that more of an existing company opportunity for you, new client opportunity? Is it -- maybe sometimes a little harder to get a new client to join -- like recognize and join that event. How do you...

It's a mix of both. We do have strong participation, both from the existing 40,000-plus clients that we have today. as well as an increasing number of prospects that engage with us at that event. We also have several other events throughout the year in ways to be able to talk with prospects either in person or virtually. So it's a combination of both. And I think the outcome or message that I saw from that event is a lot of energy and interest across what we're doing, whether that is within the AI or automation side within the HCM side of the business. Some of the early offerings across finance and IT as well.

And you've alluded to it there, and you continue to take market share in the HCM payroll space. First, how do you think about industry growth? Is that high single-digits. How -- like what's the level that you about if you grow faster, you take share in the market? And then you did allude to it a little bit, but what are some of the driving factors that allow you to keep taking share? And what gives you confidence to be able to keep doing that going forward?

Yes. I think the HCM market continues to grow. I think there's been a multiyear tailwind there. We see that both with our existing clients as well as prospects continuing to drive not only unit growth, which we've been able to drive in the mid- to high single digits for the last several years, really high single-digits as well as increasing average revenue per client, and that is coming from both new and existing clients buying a broader array of our product suite. So as we continue to expand the HCM offering, we're able to go back to existing clients and upsell them. As we continue to expand the product suite, likewise, we're able to go to larger clients as well and land larger deals. And as you think about -- early stages, but as you think about the offerings across finance and IT, that is another opportunity for us, not only differentiate against the competitive set, but also go back to that client base as well as prospects and sell them those collective offerings.

And I believe you've grown sales head count about 8% in the last 2 years entering the year, and I talked about in the most recent quarter, 14% recurring growth, which is great to see. You -- from that perspective, you're seeing revenue per rep continue to climb higher. And so why not expand sales head count more aggressively? That's always a question. And how are you thinking about the letting that efficiency fall or territory expansion? Are there any limiting factors like I can only expand so quickly in a certain ZIP code to let that digest. How do you think about that?

We've been really pleased with the start to the year for our sales team. You saw that, as we talked about earlier in our Q1 results, the -- I think confidence and momentum we have in the business to be able to raise the year by more than the beat and then I think, yet still feel good about the guidance we have over the balance of the year, such that if that team continues to perform well, we'd be in a spot to be able to have really good results over the balance of the fiscal year as well. So it's always a little bit of a balance I think for us, the bias is towards driving revenue growth. We continue to invest back into that sales team, whether that is people, process or technology investments to put our reps in the best position possible to win. You see us continue to invest back into the product. So we grew R&D investment larger than revenue growth in Q1. I think that continues to be an area that we will invest in over the balance of the year. And as you think about attracting and retaining the top reps in the industry, you've got to have the best product, right? You've got to have not only the best product, you have to have strong operations as well, and you have to have a really good go-to-market motion. And we feel good about across the board, the ability for those teams to execute and the momentum that they have.

Yes. Understood. And maybe getting towards the last end of the macro demand type questions. But you talked about solid unit growth, that high single-digit that you've had. When you think about this industry, it's certainly, a lot of growth, but maturing. You've been around since, I think, '97. '98, and then you also have some newer entrants in the market, kind of the rippling Augustus of the world. When you think about those client wins, are they coming from different sources? Are you increasingly winning from kind of those Gen 2 players at all got a lot of their client wins from the legacy players in the past? Or how should we think about that?

Well, I think as you look at the revenue growth, the recurring revenue growth that we had last year and the guidance this year, I think to be able to drive that level of durable growth, it's a combination of growth, unit growth and ARPU. So not over relying on one or the other. And we've been able to strike that balance pretty well, which is adding clients on an annual basis amidst very strong client retention as well, but also being able to drive increasing average revenue per client. And the market is competitive for sure. It has always been the case. We see a lot of stability across the competitive set. Win rates are stable. I think who we're taking business from has been stable as well. So you do see probably some changes in the industry as you look out over the last 7 to 10 years. But in the short term, it's been not only a stable demand environment. But I think the competitors that we're seeing in the win rates, we haven't seen any real changes there.

Yes. Understood. And one of the biggest debates right now for software investors is how AI is going to affect the overall space. And there's certainly some fears that on the AI application side, there are some areas that are going to be roadkill, certainly don't see that for your space. But when you think about that idea, how should we think about the defensibility of your business in the moat against newer AI technologies. I'm sure you can't just vibe code a payroll engine that complies with 16,000 different tax jurisdictions in the U.S. But is there -- could you help us with that debate? And certain -- are there certain areas of your platform that you can call out, maybe such as payroll compliance that would be difficult for a theoretical AI start-up to come in and start taking share.

Sure. So I think for context, we continue to invest, as I mentioned earlier, at a significant level back into the product. And we have elements of AI embedded in every single one of our products today. We've talked about this year, incremental investment back into the product. A lot of that is to drive AI and broader automation efforts. So it's certainly embedded in what we do today. We're seeing the benefits of that within the product suite we're seeing. As I mentioned earlier, strong client retention as well, all of those accruing to our benefit. I think to your point, there is a significant amount of defensibility across the HCM market. As you had referenced, payroll is highly complex. So you've got 10,000-plus taxing jurisdictions. If you want to be a vendor across the U.S., you have to be able to process payroll in all 50 states. There is highly complex regulatory elements as well. And remember, as you think about the growth that we've had over several years, it is not just a payroll story. So we've been able to grow the business by expanding deeper into traditional HCM functionality, now beyond traditional HCM functionality and clients in our target market of 10,000 to 5,000 employees, they are not looking for individual best-of-breed point solutions. They're not just looking for a payroll provider or an HR or benefits provider, they want a collective platform with a single vendor that is fully integrated as well. So there's a real differentiator there in being able to have the full suite. I think the other key element that is not always appreciated is this is a high-touch service and implementation business as well. So with an average client of 150 employees, they are interacting with you on a regular basis. They are consulting with you on different things that they're doing across their business. They are processing payroll with you, right? So we have relationships with several banks who're processing billions of dollars of client transaction on an annual basis. So there is a significant amount of back-office and scale required to be able to do that beyond just sort of your core payroll engine, which in and of itself has significant complexities as well.

Right. Yes. Understood them. I feel like that's underappreciated a little bit here. So sticking on that AI topic, you recently rolled out your next-gen AI assistant. Would love to hear -- I know it's early there, but would love to hear a little bit about how the reception has been? And any early usage trends or anecdotes on how that's affecting client engagement and helping your solution?

Absolutely. Yes, we called out on the earnings call last month, significant year-over-year increase in adoption and usage within clients of our AI assistant able. They're able to leverage the AI assistant to both from the administrative standpoint as well as the client employees to be able to get answers to their questions more efficiently. So they don't have to engage with their HR Director and they don't have to engage with Paylocity. They're able to get questions answered in a more efficient way. And I think beyond the AI assistant, as I mentioned, there are elements of AI across every single product that we think, over time, absolutely will accrue to our benefit within the overall client experience as well as client retention. So we're absolutely seeing increased adoption and usage. I think it is one of the key elements that has and allows us to continue to differentiate as far as providing the most modern set of products. And we continue to see week-over-week and month-over-month increase adoption, usage and activity across the AI elements of the platform.

Interesting. And so one thing -- I did want to go a little bit deeper here. So it does seem like AI is changing how we consume software and it seems like that's only going to accelerate in the future. For example, with your AI assistant, instead of going through a drop-down list of the different modules, why don't I just ask the AI assistant for whatever answers and your solution is allowing that. How do you see that changing either the industry or maybe the monetization strategy that you have? And how do You think about that?

Yes. I mean I think for us, we, as I said, are investing across AI. And we think beyond navigation-related benefits, we think there are agentic capabilities over time as well. So real true business or strategic recommendations for clients. As an example, within our time and attendance module, being able to recommend the clients the right way to schedule their shifts for the hourly employees to reduce over time or to make sure that they have the right staff from a safety or compliance perspective to be able to curate learning paths within our Learning Management product based on time enroll or recent promotions or other performance-related feedback. So I think it is real benefits within the workflow across the product set, but also agenetic capabilities across each of the products that improves not only the workflows, but the ability for clients to get work done within our product and to be able to really provide a strategic set of HR and HCM products for those clients. So that is, I think, the path that we're focused on.

Got it. Got it. And you -- we talked about it a little bit, but you launched Paylocity for Finance Paylocity for Finance in July. Similar question there. What's been the early reception? Where are you in kind of your integration level there, selling it as like a combined Paylocity solution? And yes...

Sure. So we completed the Airbase acquisition. We're just past 1 year. The integration, I think, has gone really well. We're probably ahead of schedule and certainly realize the intended cost synergies at a higher level than we would have expected. So I think the integration has gone well. That is now in the hands of our sales reps for the last kind of 90 to 120 days. So still very early, but as we called out on the earnings call last month, that is trending as we would have expected. We see and continue to believe there's a lot of opportunity on a multiyear basis, not only with prospective clients, but being able to go back to the 40,000-plus clients we have today. And we think over multiple years, being able to get to 10% to 20% adoption is absolutely the right target. And in addition to the revenue or monetization opportunity, we think being able to tell a really differentiated story around not only what we can do across HCM, but now finance and IT, being able to offer in a single pane of glass, all of your labor and nonlabor spend. There's really nobody else in our target market that has that offering. And likewise, early days, just starting to go GA now, but what we can do from an IT standpoint across asset and access management, being able to leverage the employee system of record. We think there's certainly monetization opportunity there, but absolutely continues to be a way that we differentiate our story.

Understood. And so you have been seeing a trend of being increasingly pulled upmarket over the last few years. And it does seem like -- one, I would love to hear like oftentimes when we move upmarket, maybe especially to get 1,000 employees and above, like those type customers, there's more willingness for integrating best-of-breed solutions. You typically have more of a complex IT stack. You might have a different finance solution that's stand-alone, a different HR solution, et cetera. How does that comprehensive solution play up into that market strategy? It seems like the value proposition is resonating very well in kind of your core market, but how repeatable is that upmarket? Maybe let's just start there.

Sure. So we have definitely been pulled incrementally upmarket over the last handful of years. That has been one of the key drivers of success. I think our downmarket and mid-market teams have performed really well. But over the last handful of years, we've continued to expand and build out our enterprise team that's really focused on that 500-plus employee segment of the market. We increased our target market up to 5,000 employees. We have always had some number of clients in that 5,000 employee range and continue to have clients with greater than 5,000 employees. But as we've built out the entirety of the HCM suite, as we've moved beyond traditional HCM functionality, we have been pulled upmarket. So we've seen significant success there. The value proposition continues to resonate. So clients of that size absolutely realize and see the benefits of an integrated product suite across a single vendor. And over time, as you expand and add capabilities and features and functionality across that product set, I think that allows you to continue to have success. So as I think about going forward, that continues to be not only an area of growth for us, but certainly an opportunity over time within the finance and IT side, where we continue to increase attach rates.

Yes. Interesting. And one thing, I go to HR Tech every year. And I think there was 470 vendors there this year, 420 or 430 last year, 460, which is a lot of vendors. And when you just think about the general willingness for -- on the customer side for vendor consolidation, this is probably more of an upmarket type question. Are you seeing just more willingness like before I wanted these best-of-breed solutions. Now Paylocity has that solution, and I can just bring that together. And then does AI change that at all? Because when I think if I want a AI layer, if I have a bunch of different databases, that's going to slow that down.

Yes. I think we're still very early on the AI side. Our average client has 150 employees. So they're certainly seeing the benefits within the product set. But I think we're still very early relative to where AI specifically ranks in order of decision-making. But no question across our target market, clients see the benefit of having a unified platform. So whether that is a 50-person company, a 500-person company or a 5,000-person company, as you're able to expand features and functionality, as you're able to offer a set of products with fully integrated and tight workflows across those product set, they see the benefits of the offering. And I think that has been accruing to our benefit both with the increased success up market, but also driving increasing average revenue per client across the target market.

Understood. And so you've driven really strong margin expansion over the last several years, the last couple of years in particular. And you did raise the long-term targets as well. We talked about that earlier. How should we think about margin expansion going forward? And what are some of the key drivers for margin expansion? And within that specifically, when you're talking about -- I'll combine the next question -- when you think about AI and you're using that internally, it does seem like there's opportunity on the support side for that. But we also hear that you have best-in-class service levels and like that's something that you're known for, a differentiator. So how should we think about the balance of the AI efficiencies versus kind of maintaining that white glove type service that...

It's a balance for sure. And I think we have successfully and will continue to do thread the needle, meaning you got to do both. So you have to maintain high levels of client satisfaction. We mentioned on the earnings call, it continues to be the case, really pleased with client retention to start the year. So that team has executed really well. At the same time, we did talk about investments we're making across AI and automation to reduce case volumes, to be able to improve user experience, to be able to not only improve the overall product but be able to reduce the clients' need to actually engage with us to ask questions. And as you think about the benefits that we have seen in gross margin, the opportunity and optimism we have around being able to expand gross margin going forward, certainly, some of that is tied to AI automation as well as broader scale and pricing power as well as vendor consolidation. So we are really optimistic around the ability to expand profitability. As I mentioned earlier, I think the progress that we've made and the path we see over the next several years really gave us that confidence that now is the right time to increase those targets. And we think that we will have a very programmatic instruction approach over multiyears to be able to thread that needle, where you can still invest back into the client base, have that really high-touch service and implementation experience, but at the same time, be able to drive efficiencies and increase profitability.

Understood. And how do those interest rate trends influence that? Certainly, we -- and the subsequent impact on float revenue there? Certainly in a declining rate environment, that's going to be a little bit of a headwind to your profitability given that high-margin revenue. Should we think -- or how do you think about in terms of -- do you think about a certain level of ex float expansion per year and I'm going to ignore what happens in the interest rate environment if interest rates are going to be a headwind, do I -- would I be more willing to lean into a little bit more margin expansion and tapping areas of efficiency. Sure it's not as cut and dried and it depends on [indiscernible].

Yes. I mean, I think from a guidance standpoint, we have multiple rate cuts assumed in our guidance for this fiscal year. So we feel covered from a guidance standpoint relative to what may happen with interest rates over the balance of our fiscal year. And day-to-day, we run the business ex-float. And our expectation has and continues to be that there is scale and profitability ex-float within the business, which we have continued to demonstrate it. And to the extent you see a declining or increasing rate environment on a multiyear basis, I think those are elements that we consider. But at the same time, I think running the business ex-float allows us to invest back in the business to drive growth on a go-forward basis. So you don't want to be in a position where you're making very short-term decisions and stopping investments in R&D or stopping investment back in the go-to-market team that you look back and regret in 12 months. So it's a balance for sure, and we're certainly focused on overall profitability as well as probability ex-float. But day to day, we do run the business with float to the side. And with that, I feel like there is more profitability to increase and try to have a pretty prudent approach relative to where the rate environment may go.

And you've conducted significant buybacks recently. You talked about that earlier today. So how do you think about that? You've got a healthy cash position. You're generating a lot of free cash flow. It seems like you're able to finance a lot of the AI R&D and different things that you need through your strong margin profile. Is there -- how do you think about that capital returns and levels there? Are you targeting a certain payout ratio, dividend, how do you think about that broader decision?

Yes. I think at the highest level, we have plan to utilize the share repurchase program to offset dilution from annual equity grants. We have opportunistically been much more aggressive with buybacks more recently. So we've repurchased $500 million of stock dating back to May of 2024. As of the end of Q1, we had $500 million remaining under our current authorization, and we did call out the expectation that we'll be active to some extent going forward. So I would view it as table stakes to our capital allocation policy on a go-forward basis. We will have some level of buybacks embedded in our annual plan. And have the ability to sort of scale up or down based on stock price and overall movement in the market.

I'd just love to ask about M&A philosophy. You made the Airbase acquisition a little bit bigger than some of the tuck-ins that you've made in the past. How are you thinking about that in that build versus buy decision? And then when you think maybe a little bit on your ambitions on the IT side, like certainly, you have a great stronghold in HR, you've Airbase. IT, it seems like a little bit more organic development. So is there certain opportunities there? Or...

Yes. I think we approach the product set with a build, buy and partnership framework. The bias is obviously to build the vast majority of our products that we have built. But certainly, to the extent there are products that speed our go-to-market that we think our capabilities that fit really well with our -- whether that is our tech stack or the culture of our business and high-quality software, we are absolutely in a position across our balance sheet as well as cash flows to be able to be opportunistic. And that continues to be the case. So we are looking across each of our products as well as adjacency on a continuous basis. And we continue to be picky. So we've only done a handful of acquisitions over the last several years. But to the extent there's something of interest, we feel like we've got the team to be able to execute as well as integrate an acquisition going forward.

Maybe last question for me. I see we have a minute left here. Just an update on international. I know it seems like a large part of that strategy there is to be able to serve the larger multinational corporations that have some employees overseas. It does seem like we're also seeing a trend and I would say, maybe the last 5 years, post-COVID maybe accelerated this of smaller business being more willing to have the disparate [ workshops ], not everyone in the same ZIP code. So just an update there and how that's playing into your broader customer acquisition strategy?

Yes. So we made the acquisition of Blue Marble going back several years ago. That continues to be a differentiator for us. We've been pleased with not only how that business has performed, but also the capabilities that it provides because I think the trend that you're referencing is accurate. You are seeing, over time, even smaller businesses having interest. War for talent continues to be a struggle finding the right fits for certain roles has resulted in some clients turning to international hiring. And I think we feel good about the capabilities that, that offers. And I think over time, international more broadly would be something that we would look at potentially even closer.

Okay. Great. We'll end it there. We're out of time. Thank you very much.

Thank you.