Paycom Software, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations This Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity, and certain other factors that may affect our future results. The following discussion and analysis should be read in conjunction with (i) the accompanying unaudited consolidated financial statements and notes thereto for the three and six months ended June 30, 2020, (ii) the audited consolidated financial statements and notes thereto for the year ended December 31, 2019 included in our Annual Report on Form 10-K (the “Form 10-K”) filed with the Securities and Exchange Commission (the “SEC”) on February 13, 2020 and (iii) the discussion under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Form 10-K. Except for certain information as of December 31, 2019, all amounts herein are unaudited. Unless we state otherwise or the context otherwise requires, the terms “we,” “us,” “our” and the “Company” refer to Paycom Software, Inc. and its consolidated subsidiaries. All amounts presented in tables, other than per share amounts, are in thousands unless otherwise noted. Forward-Looking Statements The following discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are any statements that look to future events and include, but are not limited to, statements regarding our business strategy; anticipated future operating results and operating expenses, cash flows, capital resources, dividends and liquidity; trends, opportunities and risks affecting our business, industry and financial results; future expansion or growth plans and potential for future growth; our ability to attract new clients to purchase our solution; our ability to retain clients and induce them to purchase additional applications; our ability to accurately forecast future revenues and appropriately plan our expenses; market acceptance of our solution and applications; our expectations regarding future revenues generated by certain applications; our ability to attract and retain qualified employees and key personnel; future regulatory, judicial and legislative changes; how certain factors affecting our performance correlate to improvement or deterioration in the labor market; our plan to open additional sales offices and our ability to effectively execute such plan; the sufficiency of our existing cash and cash equivalents to meet our working capital and capital expenditure needs over the next 12 months; our plans regarding our capital expenditures and investment activity as our business grows, including with respect to our new Texas operations facility and research and development; our plans to repurchase shares of our common stock through a stock repurchase plan; and the impact of the novel coronavirus (COVID-19) pandemic on our business, results of operations, cash flows, financial condition and liquidity. In addition, forward-looking statements also consist of statements involving trend analyses and statements including such words as “anticipate,” “believe,” “could,” “expect,” “intend,” “may,” “might,” “plan,” “potential,” “should,” “will,” “would,” and similar expressions or the negative of such terms or other comparable terminology. Forward-looking statements are neither historical facts nor assurances of future performance, and are based only on our current beliefs, expectations and assumptions regarding the future of our business, future plans and strategies, projections, anticipated events and trends, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict and many of which are outside of our control. Therefore, you should not rely on any of these forward-looking statements. Important factors that could cause our actual results and financial condition to differ materially from those indicated in the forward-looking statements include, among others, the following: • the impact of the COVID-19 pandemic on the U.S. economy, including reductions in employment levels, business disruptions resulting from government-mandated mitigation measures and an increase in business failures; • changes in laws, government regulations and policies and interpretations thereof; • the possibility of security vulnerabilities, cyberattacks and network disruptions, including breaches of data security and privacy leaks, data loss, and business interruptions; • our compliance with data privacy laws and regulations; • our ability to develop enhancements and new applications, keep pace with technological developments and respond to future disruptive technologies; • our ability to compete effectively; • fluctuations in our financial results due to factors beyond our control; • our ability to manage our rapid growth and organizational change effectively; • the possibility that clients may not be satisfied with our deployment or technical support services, or that our solution fails to perform properly; • our dependence on our key executives; • our ability to attract and retain qualified personnel, including software developers and skilled IT, sales, marketing and operational personnel; • our failure to develop and maintain our brand cost-effectively; • seasonality of certain operating results and financial metrics; • the possibility that the Affordable Care Act may be modified or repealed; 18 • our failure to adequately protect our intellectual property rights; • our reliance on relationships with third parties; and • the other factors set forth in Part I, Item 1A, “Risk Factors” of the Form 10-K, Part II, Item 1A, “Risk Factors” of this Form 10-Q and our other reports filed with the SEC. Forward-looking statements are based only on information currently available to us and speak only as of the date of this Form 10-Q. We do not undertake any obligation to update or revise the forward-looking statements to reflect events that occur or circumstances that exist after the date on which such statements were made, except to the extent required by law. Overview We are a leading provider of comprehensive, cloud-based human capital management (“HCM”) software delivered as Software-as-a-Service. We provide functionality and data analytics that businesses need to manage the complete employment lifecycle, from recruitment to retirement. Our solution requires virtually no customization and is based on a core system of record maintained in a single database for all HCM functions, including talent acquisition, time and labor management, payroll, talent management and human resources management applications. Our user-friendly software allows for easy adoption of our solution by employees, enabling self-management of their HCM activities in the cloud, which reduces the administrative burden on employers and increases employee productivity. We generate revenues from (i) fixed amounts charged per billing period plus a fee per employee or transaction processed and (ii) fixed amounts charged per billing period. We do not require clients to enter into long-term contractual commitments with us. Our billing period varies by client based on when each client pays its employees, which may be weekly, bi-weekly, semi-monthly or monthly. We serve a diverse client base in terms of size and industry. None of our clients constituted more than one-half of one percent of our revenues for the six months ended June 30, 2020. Our revenues are primarily generated through our sales force that solicits new clients and our client relations representatives who sell new applications to existing clients. Our continued growth depends on attracting new clients through further penetration of our existing markets and geographic expansion into new markets, targeting a high degree of client employee usage across our solution, and introducing new applications to our existing client base. We believe our ability to continue to develop new applications and to improve existing applications will enable us to increase revenues in the future, and the number of our new applications adopted by our clients has been a significant factor in our revenue growth. We also plan to open additional sales offices in the future to further expand our presence in the U.S. market. Our principal marketing efforts include email campaigns, social and digital media, search engine marketing methods, tradeshows and outbound marketing including television and print advertising. In addition, we generate leads and build recognition of our brand and thought leadership with relevant and informative content, such as white papers, blogs, podcast episodes and webinars. Throughout our history, we have built strong relationships with our clients. As the HCM needs of our clients evolve, we believe that we are well-positioned to expand the HCM spending of our clients and we believe this opportunity is significant. To be successful, we must continue to demonstrate the operational and economic benefits of our solution, as well as effectively hire, train, motivate and retain qualified personnel. Growth Outlook, Opportunities and Challenges As a result of our significant revenue growth and geographic expansion since our initial public offering in April 2014, we are presented with a variety of opportunities and challenges. Our payroll application is the foundation of our solution and all of our clients are required to utilize this application in order to access our other applications. Consequently, we have historically generated the majority of our revenues from our payroll applications, although our revenue mix has evolved and will continue to evolve as we develop and add new non-payroll applications to our solution. We believe our strategy of focusing on increased employee usage is key to long-term client satisfaction and client retention. Client adoption of new applications and client employee usage of both new and existing applications have been significant factors in our revenue growth, and we expect the continuation of this trajectory will depend, in part, on the introduction of applications to our existing client base that encourage and promote more employee usage. Moreover, in order to increase revenues and continue to improve our operating results, we must also attract new clients. We intend to obtain new clients by (i) continuing to leverage our salesforce productivity within markets where we currently have existing sales offices, (ii) expanding our presence in metropolitan areas where we currently have an existing sales office through adding sales teams or offices, thereby increasing the number of sales professionals within such markets, and (iii) opening sales offices in new metropolitan areas. Our target client size range is 50 to 5,000 employees. While we continue to serve a diversified client base ranging in size from one employee to many thousands of employees, the average size of our clients has grown significantly as we have organically grown our operations, increased the number of applications we offer and gained traction with larger companies. We believe larger employers represent a substantial opportunity to increase the number of potential clients and to increase our revenues per client, with limited incremental cost to us. Because we charge our clients on a per-employee basis for certain services we provide, any increase or 19 decrease in the number of employees of our clients will have a positive or negative impact, respectively , on our results of operations. As discussed in more detail below, client headcount fluctuations are particularly relevant in light of the ongoing COVID-19 pandemic. Generally, w e expect that changes in certain factors affecting our performance will correlate with improvement or deterioration in the labor market. We collect funds from clients in advance of either the applicable due date for payroll tax submissions or the applicable disbursement date for employee payment services. Those collections from clients are typically disbursed from one to 30 days after receipt, with some funds being held for up to 120 days. We typically invest funds held for clients in money market funds, demand deposit accounts, commercial paper and certificates of deposit until they are paid to the applicable tax or regulatory agencies or to client employees. As we introduce new applications, expand our client base and renew and expand relationships with existing clients, we expect our average funds held for clients balance and, accordingly, interest earned on funds held for clients, will increase; however, the amount of interest we earn can be positively or negatively impacted by changes in interest rates. Even if our average funds held for clients balance increases, the impact of significantly lower average interest rates could partially offset the impact of such increased balance and, as a result, have a negative impact on recurring revenue growth. Growing our business has resulted in, and will continue to result in, substantial investments in sales professionals, operating expenses, system development and programming costs and general and administrative expenses, which have increased and will continue to increase our expenses. Specifically, our revenue growth and geographic expansion drive increases in our employee headcount, which in turn precipitates increases in (i) salaries and benefits, (ii) stock-based compensation expense and (iii) facility costs related to the expansion of our corporate headquarters and operations facilities and additional sales office leases. We believe the challenges of managing the ever-changing complexity of payroll and human resources will continue to drive companies to turn to outsourced providers for help with their HCM needs. The HCM industry historically has been driven, in part, by legislation and regulatory action, including COBRA, changes to the minimum wage laws or overtime rules, and legislation from federal, state or municipal taxation authorities. Our revenues are seasonal in nature. Recurring revenues include revenues relating to the annual processing of payroll forms, such as Form W-2, Form 1099, and Form 1095, and revenues from processing unscheduled payroll runs (such as bonuses) for our clients. Because payroll forms are typically processed in the first quarter of the year, first quarter revenues and margins are generally higher than in subsequent quarters. These seasonal fluctuations in revenues can also have an impact on gross profits. Historical results impacted by these seasonal trends should not be considered a reliable indicator of our future results of operations. For the three months ended June 30, 2020 and 2019, our total gross margins were approximately 84% and 85%, respectively. For the six months ended June 30, 2020 and 2019, our total gross margins were approximately 86% and 85%, respectively. Although our gross margins may fluctuate from quarter to quarter due to seasonality and hiring trends, we expect that our gross margins will remain relatively consistent in future periods. Nonetheless, as discussed in further detail below, operational challenges resulting from the ongoing COVID-19 crisis may negatively impact our gross margins throughout 2020. Impact of the COVID-19 Pandemic On March 11, 2020, the World Health Organization declared the COVID-19 outbreak to be a global pandemic. In response, federal, state and local governments imposed various restrictions on social and commercial activity to promote social distancing in an effort to slow the spread of the disease, and many such restrictions remain in place. Beginning in February 2020, we took various actions in order to minimize the risk of COVID-19 to our employees, our clients, and the communities in which we operate, and in March 2020, we prohibited all business-related travel until further notice and began transitioning our employees to work-from-home arrangements. Our sales employees have been conducting all meetings with current and prospective clients virtually since March 2020, and we expect this practice to continue for the foreseeable future. As of June 30, 2020, 96% of our employees were working remotely. We will continue to actively monitor the situation and may take further actions that alter our business operations as may be required by federal, state or local authorities or that we determine are in the best interests of our employees and clients. The COVID-19 pandemic has disrupted the operations of our clients and client prospects and may continue to do so for an indefinite period of time. Across many industries, temporary and permanent business closures as well as business occupancy limitations have resulted in significant layoffs and employee furloughs since late March 2020. Because we charge our clients on a per-employee basis for certain services we provide, decreases in headcount at our clients negatively impacted our recurring revenue in the second quarter of 2020, and we expect that our recurring revenue in future periods will continue to be negatively impacted by such headcount reductions until employment levels among our existing client base return to pre-pandemic levels. Further, at the onset of the COVID-19 pandemic, a limited number of new clients temporarily delayed service implementation. As the COVID-19 pandemic continues to create uncertainty and the potential for ongoing business disruptions, we may experience similar client-driven delays in service implementation in the future. In addition, during 2019, interest earned on funds held for clients contributed to growth in recurring revenue , due to both higher average interest rates and an increased average funds held for clients balance. Since August 2019, the Federal Open Market Committee has reduced the target range for short-term interest rates several times, with the most significant rate cut occurring in 20 March 2020 to support the economy and potentially reduce the impacts of the COVID-19 pandemic. Further , a provision in the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) allows employers to delay the payment of the employer’s share of Social Security taxes to a future date. To the extent our clients make such election, we are collecting less money from them to hold and then remit to the appropriate taxing authorities, which adversely affects our average funds held for clients balance and, consequently, interest earned on funds held for clients. In the second quarter of 2020, despite the growth in the number of clients in our base, employee headcount reductions at our clients as well as clients electing to defer payment of their share of Social Security taxes under the CARES A ct resulted in no growth in our average funds held for clients balance, relative to the second quarter of 2019. Due to s ignificantly lower average interest rates in 2020 and, to a lesser extent , the lack of growth of our average funds held for clients balance, interest earned on funds held for clients for the three and six months ended June 30, 2020 decreased from the comparable prior year periods , which had a negative effect on recurring revenue growth. Demand for our solutions remains high and, in the second quarter of 2020, we continued to aggressively invest in sales and marketing and in research and development to drive future growth and expand our market share. Lower headcount at our clients and the other pandemic-related factors described above, which had and may continue to have a negative impact on recurring revenue, combined with increased sales and marketing and research and development expenses, resulted in decreases in net income for the three and six months ended June 30, 2020 as compared to the respective prior year periods. Through the remainder of 2020, we expect net income to be negatively affected by the impact of the pandemic on our recurring revenue and our deliberate, increased level of investment to drive the growth of our business. Despite the economic challenges brought on by the COVID-19 pandemic, we remain confident in the overall health of our business, the strength of our product offerings, and our ability to continue to execute on our strategy. Internally, all applications within the Paycom solution, and more specifically Employee Self-Service, Manager on-the-Go, Documents and Checklists, Ask Here and our enhanced Learning Management System, have been instrumental in our ability to seamlessly manage and communicate with our remote workforce. As many clients have also transitioned their workforces to work-from-home arrangements, we believe they too are recognizing the benefits of these applications and our focus on employee usage, as well as the strengths and advantages of our single database solution. In contrast, we believe the remote work environment is exposing the weaknesses and disadvantages arising from the combination of disparate systems offered by some of our competitors. Prior to the COVID-19 pandemic, our salesforce historically traveled frequently to sell our solution. The current remote work environment presents a unique opportunity for our salesforce, in that each sales employee is able to meet virtually with a greater number of client prospects in a given day than he or she would if conducting in-person meetings. Although we have not experienced such challenges to date, if clients and client prospects are not as willing or available to engage via video conference and teleconference, the shift from in-person to virtual sales meetings could negatively affect our sales efforts, impede client acquisition and lengthen our sales cycles, which would negatively impact our business and results of operations and could impact our financial condition in the future. Although we currently have some insight with respect to the shorter-term effects of the COVID-19 pandemic on our business and results of operations, we are unable to estimate the full impact that the COVID-19 pandemic could have on our business and results of operations in the future due to numerous uncertainties, including the severity of the disease, the duration of the outbreak, actions that may be taken by governmental authorities, the impact to the business of our clients and other factors identified in Part II, Item 1A “Risk Factors” in this Form 10-Q. Further, while our revenue and earnings are relatively predictable, the effect of the ongoing COVID-19 pandemic may not be fully reflected in our results of operations and overall financial performance until future periods. 21 Results of Operations The following table sets forth consolidated statements of income data and such data as a percentage of total revenues for the periods presented: Three Months Ended June 30, Six Months Ended June 30, 2020 2019 % Change 2020 2019 % Change Revenues Recurring $ 177,950 98.0 % $ 165,998 98.0 % 7% $ 416,445 98.2 % $ 362,862 98.3 % 15% Implementation and other 3,637 2.0 % 3,315 2.0 % 10% 7,510 1.8 % 6,394 1.7 % 17% Total revenues 181,587 100.0 % 169,313 100.0 % 7% 423,955 100.0 % 369,256 100.0 % 15% Cost of revenues Operating expenses 23,257 12.8 % 20,289 12.0 % 15% 47,373 11.2 % 45,065 12.2 % 5% Depreciation and amortization 6,301 3.5 % 4,950 2.9 % 27% 12,231 2.9 % 9,492 2.6 % 29% Total cost of revenues 29,558 16.3 % 25,239 14.9 % 17% 59,604 14.1 % 54,557 14.8 % 9% Administrative expenses Sales and marketing 56,064 30.9 % 41,575 24.6 % 35% 111,082 26.2 % 81,220 22.0 % 37% Research and development 21,778 12.0 % 16,775 9.9 % 30% 43,399 10.2 % 35,264 9.6 % 23% General and administrative 40,837 22.5 % 27,460 16.2 % 49% 80,971 19.1 % 72,658 19.7 % 11% Depreciation and amortization 6,774 3.7 % 5,378 3.2 % 26% 13,059 3.1 % 10,183 2.7 % 28% Total administrative expenses 125,453 69.1 % 91,188 53.9 % 38% 248,511 58.6 % 199,325 54.0 % 25% Total operating expenses 155,011 85.4 % 116,427 68.8 % 33% 308,115 72.7 % 253,882 68.8 % 21% Operating income 26,576 14.6 % 52,886 31.2 % -50% 115,840 27.3 % 115,374 31.2 % 0% Interest expense (3 ) 0.0 % (258 ) -0.1 % -99% (19 ) 0.0 % (534 ) -0.1 % -96% Other income (expense), net 162 0.1 % (263 ) -0.2 % -162% (768 ) -0.2 % (363 ) -0.1 % 112% Income before income taxes 26,735 14.7 % 52,365 30.9 % -49% 115,053 27.1 % 114,477 31.0 % 1% Provision for income taxes (1,854 ) -1.0 % 3,603 2.1 % -151% 23,449 5.5 % 18,433 5.0 % 27% Net income $ 28,589 15.7 % $ 48,762 28.8 % -41% $ 91,604 21.6 % $ 96,044 26.0 % -5% Revenues The increase in total revenues for the three and six months ended June 30, 2020 compared to the same periods in 2019 was primarily the result of (i) the addition of new clients and productivity and efficiency gains in mature sales offices, which are offices that have been open for at least 24 months, (ii) contributions from new sales offices opened in 2018 and 2019 that are progressing to maturity and (iii) the sale of additional applications to our existing clients. In addition, the strong performance of our tax forms filing business in the first quarter contributed to the increase in total revenues for the six months ended June 30, 2020 as compared to the same period in 2019. The COVID-19 pandemic has resulted in, and may continue to result in, headcount reductions across our client base. Because we charge our clients on a per-employee basis for certain services we provide, the drivers of revenue for the three and six months ended June 30, 2020 described above were partially offset by the negative impact of headcount reductions within our existing client base. Additionally, lower employee headcount at our clients as well as clients electing the Social Security tax deferral under the CARES Act negatively impacted our average funds held for clients balance for the three and six months ended June 30, 2020. Significantly lower average interest rates in the first six months of 2020 as compared to the same period in 2019, as well as no growth in the average funds held for clients balance, resulted in a decrease in interest earned on funds held for clients and, consequently, had a negative effect on recurring revenue growth for the three and six months ended June 30, 2020. We expect that the foregoing adverse macroeconomic factors will continue to have a negative effect on recurring revenues in future periods for so long as such conditions persist. The increase in implementation and other revenues for the three and six months ended June 30, 2020 from the same periods in 2019 was primarily the result of the increased recognition of non-refundable upfront conversion fees that are charged to new clients to offset the expense of new client set up. These fees are deferred and recognized ratably over the ten-year estimated life of our clients. 22 Expenses Cost of Revenues During the three months ended June 30, 2020, cost of revenues increased from the comparable prior year period by $4.3 million. Depreciation and amortization expense increased $1.4 million from the comparable prior year period, primarily due to the development of additional technology and purchases of other fixed assets. Additionally, for the three months ended June 30, 2020, as compared to the same period in 2019, employee-related expenses increased $1.8 million due to growth in the number of operating personnel, non-cash stock-based compensation increased $1.4 million, and automated clearing house fees increased $0.1 million in connection with the increase in revenues. These increases in cost of revenues were partially offset by a $0.4 million decrease in shipping and supplies fees during the three months ended June 30, 2020, as compared to the prior year period, primarily due to the remote work environment. During the six months ended June 30, 2020, cost of revenues increased from the comparable prior year period by $5.0 million. Depreciation and amortization expense increased $2.7 million from the comparable prior year period, primarily due to the development of additional technology and purchases of other fixed assets. Additionally, for the six months ended June 30, 2020, as compared to the same period in 2019, employee-related expenses increased $2.6 million due to growth in the number of operating personnel, and automated clearing house fees increased $0.4 million in connection with the increase in revenues. These increases in cost of revenues were partially offset by a $0.3 million decrease in non-cash stock-based compensation and a $0.6 million decrease in shipping and supplies fees during the six months ended June 30, 2020, as compared to the prior year period. Administrative Expenses Sales and Marketing During the three months ended June 30, 2020, sales and marketing expenses increased from the comparable prior year period by $14.5 million due to a $14.0 million increase in marketing and advertising expense due to increased spending across most components of our marketing program and a $1.3 million increase in non-cash stock-based compensation. These increases in sales and marketing expenses were partially offset by a $0.7 million decrease in employee-related expenses primarily related to our current work-from-home mandate. During the six months ended June 30, 2020, sales and marketing expenses increased from the comparable prior year period by $29.9 million due to a $21.1 million increase in marketing and advertising expense due to increased spending across most components of our marketing program, a $6.9 million increase in employee-related expenses, including commissions and bonuses, and a $1.9 million increase in non-cash stock-based compensation. Based on positive results from recent advertising campaigns, we plan to continue to make significant investments in our marketing program and may increase spending in future periods as we see opportunities for returns on our investments. Research and Development During the three months ended June 30, 2020, research and development expenses increased from the comparable prior year period due to a $5.0 million increase in employee-related expenses, including a $2.5 million increase in non-cash stock-based compensation expense. During the six months ended June 30, 2020, research and development expenses increased from the comparable prior year period due to an $8.1 million increase in employee-related expenses, including a $1.6 million increase in non-cash stock-based compensation expense. As we continue the ongoing development of our platform and product offerings, we generally expect research and development expenses (exclusive of stock-based compensation) to continue to increase, particularly as we hire more personnel to support our growth. While we expect this trend to continue on an absolute dollar basis and as a percentage of total revenues, we also anticipate the rate of increase to decline over time as we leverage our growth and realize additional economies of scale. As is customary for our business, we also expect fluctuations in research and development expense as a percentage of revenue on a quarter-to-quarter basis due to seasonal revenue trends, the introduction of new products, the amount and timing of research and development costs that may be capitalized and the timing of onboarding new hires and restricted stock vesting events. 23 Expenditures for software developed or obtained for internal use are capitalized and amortized over a three-year period on a straight-line basis. The nature of the development projects underway during a particular period directly impacts the timing and extent of these capitalized expenditures and can affect the amount of research and development expenses in such period. The table below sets forth the amounts of capitalized and expensed research and development costs for the three and six months ended June 30 , 2020 and 2019: Three Months Ended June 30, Six Months Ended June 30, 2020 2019 % Change 2020 2019 % Change Capitalized portion of research and development $ 10,975 $ 6,697 64% $ 20,721 $ 15,637 33% Expensed portion of research and development 21,778 16,775 30% 43,399 35,264 23% Total research and development costs $ 32,753 $ 23,472 40% $ 64,120 $ 50,901 26% General and Administrative During the three months ended June 30, 2020, general and administrative expenses increased $13.4 million from the comparable prior year period primarily due to a $10.4 million increase in non-cash stock-based compensation and a $5.4 million increase in employee related expenses. These increases in general and administrative expenses were partially offset by a $2.4 million decrease in accounting and legal expenses. During the six months ended June 30, 2020, general and administrative expenses increased $8.3 million from the comparable prior year period primarily due to an $8.9 million increase in employee-related expenses and a $2.2 million increase in accounting and legal expenses related to regulatory and compliance matters. These increases in general and administrative expenses were partially offset by a $2.8 million decrease in non-cash stock-based compensation. Non-Cash Stock-Based Compensation Expense The following table presents the non-cash stock-based compensation expense that is included within the specified line items in our consolidated statements of income: Three Months Ended June 30, Six Months Ended June 30, 2020 2019 % Change 2020 2019 % Change Non-cash stock-based compensation expense Operating expenses $ 1,733 $ 309 461% $ 2,931 $ 3,205 -9% Sales and marketing 3,801 2,526 50% 6,966 5,109 36% Research and development 2,984 505 491% 5,155 3,551 45% General and administrative 12,700 2,257 463% 21,977 24,803 -11% Total non-cash stock-based compensation expense $ 21,218 $ 5,597 279% $ 37,029 $ 36,668 1% During the three months ended June 30, 2020, our non-cash stock-based compensation expense increased $15.6 million from the comparable prior year period primarily due to the timing of vesting events for restricted stock subject to market-based vesting conditions during the first quarter of 2019. During the six months ended June 30, 2020, our non-cash stock-based compensation expense increased $0.4 million from the comparable prior year period. Depreciation and Amortization During the three and six months ended June 30, 2020, depreciation and amortization expense increased from the respective comparable prior year periods primarily due to the development of additional technology and purchases of other related fixed assets. Interest Expense The decreases in interest expense for the three and six months ended June 30, 2020, as compared to the comparable prior year periods were due to the timing of construction of our expanded operations facility in Grapevine, Texas, which resulted in more capitalized interest in 2020. 24 Other Income (Expense), net The increase in other income (expense), net for the three months ended June 30, 2020 and the decrease in other income (expense), net for the six months ended June 30, 2020, was primarily due to the change in the fair value of our interest rate swap as compared to the three and six months ended June 30, 2019, respectively. Provision for Income Taxes The provision for income taxes is based on a current estimate of the annual effective income tax rate adjusted to reflect the impact of discrete items. Our effective income tax rate was 20.4% and 16.1 % for the six months ended June 30, 2020 and 2019, respectively. The higher effective income tax rate for the six months ended June 30, 2020 primarily resulted from a decrease in excess tax benefits from stock-based compensation related to vesting events as compared to the six months ended June 30, 2019. Liquidity and Capital Resources Our principal sources of capital and liquidity are our operating cash flow and cash and cash equivalents. Our cash and cash equivalents consist primarily of demand deposit accounts, money market funds and certificates of deposit. Additionally, we maintain a senior secured revolving credit facility (the “Facility”), which can be accessed as needed to supplement our operating cash flow and cash balances. The Facility provides us the ability to borrow funds in the aggregate principal amount of $75.0 million, which may be increased to $125.0 million, subject to obtaining additional lender commitments and certain approvals and satisfying certain other conditions. We believe our existing cash and cash equivalents and cash generated from operations will be sufficient to meet our working capital and capital expenditure needs over at least the next 12 months. Given the rapidly changing market and economic conditions related to the COVID-19 outbreak, we will continue to evaluate the nature and extent of the impact to our business, financial position and liquidity. We have historically funded our operations from cash flows generated from operations, cash from the sale of equity securities and debt financing. Although we have funded most of the costs for ongoing construction projects at our corporate headquarters from available cash, we have incurred indebtedness for a portion of these costs. Further, all purchases under our stock repurchase plans were paid for from available cash. Term Credit Agreement. As of June 30, 2020, our indebtedness consisted solely of term loans (the “Term Loans”) made under a senior secured term credit agreement (as amended from time to time, the “Term Credit Agreement”) among the Company, certain of our subsidiaries, JPMorgan Chase Bank, N.A., Bank of America, N.A. and Kirkpatrick Bank. All Term Loans were used to finance construction projects at our corporate headquarters. Our obligations under the Term Loans are secured by a mortgage and first priority security interest in our corporate headquarters property. The Term Loans mature on September 7, 2025 and bear interest, at our option, at either (a) a prime rate plus 1.0% or (b) an adjusted LIBOR rate for the interest period in effect for such Term Loan plus 1.5%. Under the Term Credit Agreement, we are required to comply with certain financial and non-financial covenants, including maintaining a fixed charge coverage ratio of not less than 1.25 to 1.0 and a funded indebtedness to EBITDA ratio of not greater than 2.0 to 1.0. Additionally, the Term Credit Agreement contains customary affirmative and negative covenants, including covenants limiting our ability to, among other things, grant liens, incur debt, effect certain mergers, make investments, dispose of assets, enter into certain transactions including swap agreements and sale and leaseback transactions, pay dividends or distributions on our capital stock, and enter into transactions with affiliates, in each case subject to customary exceptions for a credit agreement of this size and type. As of June 30, 2020, we were in compliance with all covenants set forth in the Term Credit Agreement. Interest Rate Swap Agreement. In connection with entering into the Term Credit Agreement, we also entered into a floating-to-fixed interest rate swap agreement to limit the exposure to interest rate risk related to the Term Loans (the “Interest Rate Swap Agreement”). The Interest Rate Swap Agreement, which has a maturity date of September 7, 2025, provides that we will receive quarterly variable interest payments based on the LIBOR rate and will pay interest at a fixed rate. We have elected not to designate this interest rate swap as a hedge and, as such, changes in the fair value of the derivative instrument are recognized in our consolidated statements of income. For the three and six months ended June 30, 2020, we recognized a loss of $0.1 million and $1.7 million, respectively, for the change in fair value of the interest rate swap, which is included in Other income (expense), net in the consolidated statements of income. For the three and six months ended June 30, 2019, we recognized a loss of $0.8 million and $1.4 million, respectively, for the change in fair value of the interest rate swap, which is included in Other income, net in the consolidated statements of income. Revolving Credit Agreement. On February 12, 2018, we entered into a senior secured revolving credit agreement (the “Revolving Credit Agreement”) with JPMorgan Chase Bank, N.A. and Bank of America, N.A. that provided for the Facility in the aggregate principal amount of $50.0 million (the “Revolving Commitment”), which could be increased to up to $100.0 million, subject to obtaining additional lender commitments and certain approvals and satisfying certain other conditions. The Facility includes a $5.0 million sublimit for swingline loans and a $2.5 million sublimit for letters of credit. The Facility was scheduled to mature on February 12, 2020. On April 15, 2019, we entered into the First Amendment to Revolving Credit Agreement (the “First Amendment”). Pursuant to First Amendment, Wells Fargo Bank, N.A. was added as a lender and the Revolving Commitment was 25 increased to $75.0 million, which may be further increased to $125.0 million subject to obtaining additional lender commitments and certain approvals and satisfying other conditions , and the scheduled maturity date of the Facility was extended to April 15, 2022. Borrowings under the Facility will generally bear interest at a prime rate plus 1.0% or, at our option, an adjusted LIBOR rate for the interest period in effect for such borrowing plus 1.5%, in each case subject to certain conditions set forth in the Revolving Credit Agreement. As of June 30, 2020, we did not have any borrowings outstanding under the Facility. Stock Repurchase Plan and Withholding Shares to Cover Taxes. In May 2016, our Board of Directors authorized a stock repurchase plan allowing for the repurchase of shares of our common stock in open market transactions at prevailing market prices, in privately negotiated transactions or by other means in accordance with federal securities laws, including Rule 10b5-1 programs. Since the initial authorization of the stock repurchase plan, our Board of Directors has amended and extended and authorized new stock repurchase plans from time to time. Most recently, in March 2020, our Board of Directors authorized the repurchase of up to $250.0 million of our common stock. As of June 30, 2020, there was $174.8 million available for repurchases under our stock repurchase plan. Our stock repurchase plan may be suspended or discontinued at any time. The actual timing, number and value of shares repurchased depends on a number of factors, including the market price of our common stock, general market and economic conditions, shares withheld for taxes associated with the vesting of restricted stock and other corporate considerations. The current stock repurchase plan will expire on March 12, 2022. During the six months ended June 30, 2020, we repurchased an aggregate of 295,227 shares of our common stock at an average cost of $227.35 per share, including 90,157 shares withheld to satisfy tax withholding obligations for certain employees upon the vesting of restricted common stock. Our payment of the taxes on behalf of those employees resulted in an aggregate cash expenditure of $23.1 million and, as such, we generally subtract the amounts attributable to such withheld shares from the aggregate amount available for future purchases under our stock repurchase plan. Cash Flow Analysis Our cash flows from operating activities have historically been significantly impacted by profitability, implementation revenues received but deferred, our investment in sales and marketing to drive growth, and research and development. Our ability to meet future liquidity needs will be driven by our operating performance and the extent of continued investment in our operations. Failure to generate sufficient revenues and related cash flows could have a material adverse effect on our ability to meet our liquidity needs and achieve our business objectives. As our business grows, we expect our capital expenditures and our investment activity to continue to increase. We are currently focused on the ongoing construction of our new Texas operations facility in Grapevine, Texas. Capital expenditures related to the construction of the facility began in the second quarter of 2019. Depending on certain growth opportunities, we may choose to accelerate investments in sales and marketing, acquisitions, technology and services. Actual future capital requirements will depend on many factors, including our future revenues, cash from operating activities and the level of expenditures in all areas of our business, as well as the duration and extent of remote work arrangements due to the COVID-19 pandemic. As part of our payroll and payroll tax filing services, we collect funds from our clients for federal, state and local employment taxes, which we remit to the appropriate tax agencies. We invest these funds in money market funds, demand deposit accounts, commercial paper and certificates of deposit from which we earn interest income during the period between their receipt and disbursement. Our cash flows from investing and financing activities are influenced by the amount of funds held for clients, which can vary significantly from quarter to quarter. The balance of the funds we hold depends on our clients’ payroll calendars, and therefore such balance changes from period to period in accordance with the timing of each payroll cycle. Our cash flows from financing activities are also affected by the extent to which we use available cash to purchase shares of common stock under our stock repurchase plan as well as restricted stock vesting events that result in net share settlements and the Company paying withholding taxes on behalf of certain employees. The following table summarizes the consolidated statements of cash flows for the six months ended June 30, 2020 and 2019: Six Months Ended June 30, 2020 2019 Change % Net cash provided by (used in): Operating activities $ 107,512 $ 122,768 -12% Investing activities (189,993 ) (46,930 ) 305% Financing activities (705,420 ) 119,688 -689% Change in cash, cash equivalents, restricted cash and restricted cash equivalents $ (787,901 ) $ 195,526 -503% 26 Operating Activities Cash provided by operating activities for the six months ended June 30, 2020 primarily consisted of payments received from our clients and interest earned on funds held for clients. Cash used in operating activities primarily consisted of personnel-related expenditures to support the growth and infrastructure of our business. These payments included costs of operations, advertising and other sales and marketing efforts, IT infrastructure development, product research and development and security and administrative costs. Compared to the six months ended June 30, 2019, our operating cash flows for the six months ended June 30, 2020 decreased primarily due to our increased spending across most components of our marketing program and the impact of COVID-19 conditions on our revenues. Investing Activities Cash flows used in investing activities for the six months ended June 30, 2020 increased from the comparable prior year period due to a $161.5 million increase in purchases of short-term investments from funds held for clients and a $17.8 million increase in cash used for purchases of property and equipment. The increase in cash used in investing activities was partially offset by a $36.1 million increase in proceeds from maturities of short-term investments from funds held for clients. Financing Activities Cash flows used in financing activities for the six months ended June 30, 2020 increased from the comparable prior year period primarily due to the impact of a $788.3 million change related to the client funds obligation, which is due to the timing of receipts from our clients and payments made to our clients’ employees and applicable taxing authorities on their behalf. Additionally, cash flows used in financing activities increased by $52.0 million in repurchases of common stock. These cash flows used in financing activities were partially offset by a $15.1 million decrease in withholding taxes paid related to net share settlements and a less than $0.1 million decrease in payments for debt issuance costs. Contractual Obligations Our principal commitments primarily consist of long-term debt and leases for office space. There have been no material changes to our contractual obligations disclosed in the contractual obligations section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in the Form 10-K. For additional information regarding our leases, long-term debt and our commitments and contingencies, see “Note 5. Leases”, “Note 6. Long-Term Debt” and “Note 12. Commitments and Contingencies” in the Form 10-K and “Note 6. Long-Term Debt, Net” and “Note 12. Commitments and Contingencies” in the notes to our unaudited consolidated financial statements included elsewhere in this Form 10-Q. Off-Balance Sheet Arrangements As of June 30, 2020, we did not have any off-balance sheet arrangements that had or were reasonably likely to have an effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources that may be material to investors. Critical Accounting Policies and Estimates Our consolidated financial statements and accompanying notes have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”). The preparation of these consolidated financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses, and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions to ensure that management believes them to be reasonable under the then-current facts and circumstances. Actual amounts and results may materially differ from these estimates made by management under different assumptions and conditions. Certain accounting policies that require significant management estimates, and are deemed critical to our results of operations or financial position, are discussed in the critical accounting policies and estimates section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in the Form 10-K. There have been no material changes to the critical accounting policies disclosed in the Form 10-K. Adoption of Accounting Pronouncements Discussion of our adoption of ASU 2018-13 and ASU 2018-15 can be found in Note 2 in this Form 10-Q. 27 Non-GAAP Financial Measures Management uses adjusted EBITDA and non-GAAP net income as supplemental measures to review and assess the performance of our core business operations and for planning purposes. We define (i) adjusted EBITDA as net income plus interest expense, taxes, depreciation and amortization, non-cash stock-based compensation expense, certain transaction expenses that are not core to our operations (if any) and the change in fair value of our interest rate swap and (ii) non-GAAP net income as net income plus non-cash stock-based compensation expense, certain transaction expenses that are not core to our operations (if any) and the change in fair value of our interest rate swap, all of which are adjusted for the effect of income taxes. Adjusted EBITDA and non-GAAP net income are metrics that provide investors with greater transparency to the information used by management in its financial and operational decision-making. We believe these metrics are useful to investors because they facilitate comparisons of our core business operations across periods on a consistent basis, as well as comparisons with the results of peer companies, many of which use similar non-GAAP financial measures to supplement results under U.S. GAAP. In addition, adjusted EBITDA is a measure that provides useful information to management about the amount of cash available for reinvestment in our business, repurchasing common stock and other purposes. Management believes that the non-GAAP measures presented in this Form 10-Q, when viewed in combination with our results prepared in accordance with U.S. GAAP, provide a more complete understanding of the factors and trends affecting our business and performance. Adjusted EBITDA and non-GAAP net income are not measures of financial performance under U.S. GAAP, and should not be considered a substitute for net income, which we consider to be the most directly comparable U.S. GAAP measure. Adjusted EBITDA and non-GAAP net income have limitations as analytical tools, and when assessing our operating performance, you should not consider adjusted EBITDA or non-GAAP net income in isolation, or as a substitute for net income or other consolidated statements of income data prepared in accordance with U.S. GAAP. Adjusted EBITDA and non-GAAP net income may not be comparable to similarly titled measures of other companies and other companies may not calculate such measures in the same manner as we do. The following tables reconcile net income to adjusted EBITDA, net income to non-GAAP net income and earnings per share to non-GAAP net income per share on a basic and diluted basis: Three Months Ended June 30, Six Months Ended June 30, 2020 2019 2020 2019 Net income to adjusted EBITDA: Net income $ 28,589 $ 48,762 $ 91,604 $ 96,044 Interest expense 3 258 19 534 Provision for income taxes (1,854 ) 3,603 23,449 18,433 Depreciation and amortization 13,075 10,328 25,290 19,675 EBITDA 39,813 62,951 140,362 134,686 Non-cash stock-based compensation expense 21,218 5,597 37,029 36,668 Change in fair value of interest rate swap 131 833 1,706 1,372 Adjusted EBITDA $ 61,162 $ 69,381 $ 179,097 $ 172,726 Three Months Ended June 30, Six Months Ended June 30, 2020 2019 2020 2019 Net income to non-GAAP net income: Net income $ 28,589 $ 48,762 $ 91,604 $ 96,044 Non-cash stock-based compensation expense 21,218 5,597 37,029 36,668 Change in fair value of interest rate swap 131 833 1,706 1,372 Income tax effect on non-GAAP adjustments (13,997 ) (11,457 ) (16,470 ) (21,099 ) Non-GAAP net income $ 35,941 $ 43,735 $ 113,869 $ 112,985 Earnings per share, basic $ 0.50 $ 0.85 $ 1.59 $ 1.67 Earnings per share, diluted $ 0.49 $ 0.83 $ 1.57 $ 1.64 Non-GAAP net income per share, basic $ 0.62 $ 0.76 $ 1.98 $ 1.97 Non-GAAP net income per share, diluted $ 0.62 $ 0.75 $ 1.95 $ 1.93 Weighted average shares outstanding: Basic 57,568 57,569 57,611 57,464 Diluted 58,237 58,410 58,363 58,396 28 Three Months Ended June 30, Six Months Ended June 30, 2020 2019 2020 2019 Earnings per share to non-GAAP net income per share, basic: Earnings per share, basic $ 0.50 $ 0.85 $ 1.59 $ 1.67 Non-cash stock-based compensation expense 0.37 0.10 0.64 0.64 Change in fair value of interest rate swap — 0.01 0.03 0.02 Income tax effect on non-GAAP adjustments (0.25 ) (0.20 ) (0.28 ) (0.36 ) Non-GAAP net income per share, basic $ 0.62 $ 0.76 $ 1.98 $ 1.97 Three Months Ended June 30, Six Months Ended June 30, 2020 2019 2020 2019 Earnings per share to non-GAAP net income per share, diluted: Earnings per share, diluted $ 0.49 $ 0.83 $ 1.57 $ 1.64 Non-cash stock-based compensation expense 0.36 0.10 0.63 0.63 Change in fair value of interest rate swap — 0.01 0.03 0.02 Income tax effect on non-GAAP adjustments (0.23 ) (0.19 ) (0.28 ) (0.36 ) Non-GAAP net income per share, diluted $ 0.62 $ 0.75 $ 1.95 $ 1.93 29 I t em 3. Quantit ative and Qualitative Disclosures About Market Risk Interest Rate Sensitivity We had cash and cash equivalents totaling $113.5 million as of June 30, 2020. These amounts are invested primarily in demand deposit accounts and money market funds. We consider all highly liquid debt instruments purchased with a maturity of three months or less and SEC-registered money market mutual funds to be cash equivalents. The primary objectives of our investing activities are capital preservation, meeting our liquidity needs and, with respect to investing client funds, generating interest income while maintaining the safety of principal. We do not enter into investments for trading or speculative purposes. Our cash equivalents are subject to market risk due to changes in interest rates. The market value of fixed rate securities may be adversely affected due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates, or we may suffer losses in principal if we are forced to sell securities that decline in market value due to changes in interest rates. As described elsewhere in this Form 10-Q, the Term Loans made under the Term Credit Agreement bear interest, at our option, at either (a) a prime rate plus 1.0% or (b) an adjusted LIBOR rate for the interest period in effect for such Term Loan plus 1.5%. As a result, we are exposed to increased interest rate risk. To mitigate the increased interest rate risk, we entered into the Interest Rate Swap Agreement. The Interest Rate Swap Agreement has effectively fixed our interest rate at 4.0%, eliminating a portion of the variable rate and coinciding interest rate risk associated with the Term Loans. As of June 30, 2020, an increase or decrease in interest rates of 100-basis points would not have had a material effect on our operating results or financial condition. As described elsewhere in this Form 10-Q, the Revolving Credit Agreement, as amended, provides for a Facility in the aggregate amount of $75.0 million, which may be increased to up to $125.0 million. Borrowings under the Facility will generally bear interest at a prime rate plus 1.0% or, at our option, an adjusted LIBOR rate for the interest period in effect for such borrowing plus 1.5%. As of June 30, 2020, we have not made any draws under the Facility. To the extent we make draws under the Facility in the future, we may be exposed to increased interest rate risk.