Ultimate Software (ULTI, Financial) reported double-digit growth in both revenue and earnings during the second quarter. Revenue grew 20.5% year over year to reach $224.7 million while EPS rose to 93 cents, translating into 22% year-over-year growth on a non-GAAP basis.
Revenue lagged behind consensus as analysts were looking for a revenue figure of $228.02 million for the quarter. Earnings came ahead, beating the consensus by 2 cents. The company expects the revenue to reach around $233 million during the third quarter. For the full fiscal year 2017, Ultimate Software expects the revenue to increase 20% as compared to last year. Despite double-digit growth, the market reacted negatively, and the stock is down ~16% since the earnings release. Let’s explore what went wrong.
GAAP and non-GAAP earnings aren’t exactly in line
Things aren’t as rosy as the earnings report portrays. For starters, there’s a large disconnect between GAAP and non-GAAP earnings. Although the company reported double-digit non-GAAP earnings growth, GAAP earnings fell 4.7% on a year-over-year basis.
Ultimate Software generously uses noncash stock compensations and noncash amortization of intangibles to arrive at the bottom line. Exclusion of these expenses from the non-GAAP figures boosts earnings.
These strategies can come back to haunt the company’s bottom line in the form of dilution and impairment. During the first half of 2017, stock-based compensation expense was around $73.14 million, which makes up 16% of the company’s revenue. As the company finances its operations heavily through noncash stock compensation, non-GAAP EPS isn’t the optimal way to gauge the company’s bottom line. See the excerpt below:
Amounts in thousand dollars, ULTI SEC Filing Q2 2017
The table demonstrates Ultimate Software’s generous use of noncash compensation. Note that noncash expenses make a part of cost-of-sales also. This indicates reliance of core operations on noncash expenses. Therefore, using non-GAAP measure to report earnings might not reflect the true performance of the company.
Business model is supported by high operating expenses
Operating expenses are increasing at a higher rate compared to revenue growth. Operating expenses grew 27.3% during the first half of 2017 while revenue grew 23.8%. This didn’t just start in the current quarter. Ultimate Software’s marketing and general and administrative expenses grew 37% and 54% during the first first-half 2015, well ahead of revenue growth of 20%.
Ultimate Software’s business model requires high expense in terms of marketing, commission on sales and whatnot. This leads to the problem of high variable expenses, which limits the economics of scale once the company grows past a certain point. That’s why despite a 61.6% gross margin, operating margin was a minuscule 2.2% during the first half. The margin stood at 4.8% during the first half of 2016 indicating that operating expenses, as a percentage of revenue, were higher during the first half of 2017. See the extract below:
ULTI SEC Filing Q2 2017
Then, there’s competition
There are quality players in the space including SAP’s (SAP, Financial) Success Factor, Oracle’s (ORCL, Financial) Taleo, Workday (WDAY, Financial) and Cerdian. The market isn’t just crowded; it’s crowded with quality players. Industry watchers are putting many players in the leader space.
Nucleus Research, in its human capital management (HCM) value matrix 2016, cites seven companies as leaders in the HR management space. Crowd-sourced data provided by the G2 crowd mention nine players as leaders in HR management suites. Overall, competition is intense. That’s why high OPEX will support revenue growth in the HCM space.
Delayed deployment doesn’t bode well for the company
In the second-quarter report, the company disclosed a delay in deployment, which is the time the company will take to implement and integrate its solution in clients’ system. The enterprise side is looking at a delay of two to three months while midmarket time to live is delayed by one to two months. Due to low switching costs, prospective clients can choose other solutions with less time to live. This can impact the revenue base of Ultimate Software.
Growth is expensive
Valuation is another red flag for Ultimate Software. Despite all noncash measures, the company is overvalued on a non-GAAP basis. The company trades at 43 time 2018 earnings. Given that earnings are expected to grow around 20% during the next five years, a multiple of 43 indicates expensive growth. GuruFocus’ price-earnings (P/E) valuation predictor also paints a negative picture for Ultimate Software.
A P/E multiple of 30 reveals a price of $173. Note that 30 is a generous multiple given that earnings are expected to grow at 20% p.a. during the next five years.
Final thoughts
On the surface, the company reported impressive top line and bottom line growth. But the devil is in the details. Earnings growth was supported by noncash compensation measures. Operating expenses consume up almost the entire gross margin, thanks to aggressive sales and marketing. Stiff competition isn’t helping the company’s case. Further, the company is trading on a higher side based on conventional valuation measures. The bottom line is that investors should stay away amid aggressive accounting, high variable cost structure and overvaluation concerns associated with Ultimate Software.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours
