Ultimate Software Group: The Last Man Standing In SaaS And The Most No-Brainer Short In Software

| About: Ultimate Software (ULTI)
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Significant relative outlier in the SaaS space; trades at 44% multiple premium to the SaaS peer group average on EV/2016 revenue basis.

Trades at 137% premium to LNKD on EV/adj EBITDA multiple despite LinkedIn guiding for same constant currency revenue growth in 2016 and having 300bps better adj EBITDA margins.

Trades at 181% premium to Tableau on 2015 EV/operating cash flow despite DATA's better growth and margins.

Benefiting from broad-based H2 2015/H1 2016 spike related to the Affordable Health Care reporting compliance deadline that will turn into a growth headwind in 2016/2017.

Ticker: Ultimate Software Group (NASDAQ:ULTI) US Equity

Recommendation: Short

  • Significant relative outlier in the SaaS space; trades at 44% multiple premium to the SaaS peer group average on EV/2016 revenue basis.
  • Trades at 137% premium to LinkedIn (LNKD) on EV/adj EBITDA multiple despite LNKD guiding for same constant currency revenue growth in 2016 and having 300bps better adj EBITDA margins.
  • Trades at 181% premium to Tableau (NYSE:DATA) on 2015 EV/operating cash flow despite its 21% 2015 operating cash flow margin and 30% 2016 revenue guidance versus 18% 2015 operating cash flow margin and 25% 2016 revenue growth guidance.
  • Benefiting from broad-based H2 2015/H1 2016 spike in North American payroll/HCM provider selection activity ahead of Affordable Health Care reporting compliance deadline that will turn into a growth headwind H2 2016 and into 2017.

Over the past six months, we have had a small short position in Ultimate Software as we've viewed it as one of the more inappropriately relatively valued SaaS stocks. The company has been around for 25 years, is very well run, is regarded as a great place to work, and generally speaking, has been a pretty steady eddy executor in the mid-market North American payroll/HR software space. Usually, it's very tough to get excited about shorting a name like this because it never turns into a valuation outlier. In recent months, it has caught more of our attention as it slowly started to push itself into outlier territory in an arguably compressing SaaS multiple landscape. This led us to do more work on the name as we tried to better understand the market dynamics in the SMB to mid-market payroll/HR space in North America. This has been a fruitful endeavor, and we believe that we have come away with a compelling short thesis based on our research.

Normally, that would be the entire focus of our report, but things in tech and more notably SaaS really have drastically changed over the past two weeks. The change has been so drastic as to basically render our stock-specific short thesis almost entirely irrelevant. This is because we were previously focusing on proving why Ultimate's discount multiple to SaaS and tech's high growth and relatively fresh faced stock story darlings should be relatively wider than it already was. This is something we no longer have to prove as ULTI now trades at a premium valuation to all these names. Consequently, we recently decided to aggressively up our short exposure post the company's Q4 results on Wednesday Feb. 2nd as the stock temporarily pushed into SaaS relative nosebleed valuation territory. We got some immediate return benefit out of this in the post LinkedIn/Tableau tech bloodbath on Friday, but we are now extremely confident there is a lot more to come. We believe that Ultimate Software is the most obviously blatant short in all the software space at this time.

Here is why...

This is what your SaaS darling valuation comp table looked like at close of market on Friday Feb. 4th. Almost every name (Splunk (NASDAQ:SPLK) and Medidata (NASDAQ:MDSO) being current exceptions) on this list has already provided guidance for 2016 top-line growth.

Enterprise Value $bln

EV/Rev 2016

2016 Rev consensus growth rate

Salesforce (NYSE:CRM)




Workday (NYSE:WDAY)




ServiceNow (NYSE:NOW)




NetSuite (NYSE:N)












Veeva Systems (NYSE:VEEV)












Cornerstone (NASDAQ:CSOD)




The group average ex-Ultimate is 4.38x EV/2016 est. rev. This puts Ultimate at a 41% premium to the average, and a 10% premium to the group leader. ULTI has typically traded at a 25% minimum EV/rev discount to the SaaS hyper growth darlings. This gap has narrowed somewhat as it has shown some slightly increased operating momentum over the past two quarters, which we will get to later, but to be clear, you are not going to find anyone on the sell side or buy side arguing that Ultimate should have the highest multiple in this group. In fact, almost every sell-side report gets at a valuation for the stock by applying some sort of EV/rev forward multiple discount to the likes of Workday (WDAY) or higher growing SMB payroll or broader cloud peers. So, for those who care about broker targets, Ultimate's numbers have to come way, way down and very, very fast.

How much lower you may ask?

Well, if Ultimate trades…

At the peer group, EV/sales forward avg., the stock should be $117. At Workday's current forward EV/sales multiple, it should be $152. At a 20% discount to Workday and ServiceNow's forward EV/sales multiples, it should be $119. And what about if traded at Tableau's forward EV/sales multiple which has essentially the same revenue base and is expected to grow at 30% this year. Well, at that multiple, it's a $67 stock. And if you want to get into cash flow, well, it's even worse. At Tableau's 2015 operating cash flow multiple, Ultimate is worth $59. And if it traded like LinkedIn on an EV/adj EBITDA multiple of 2015 EBITDA, the stock should be $70. Blend these all together and you are looking at on average 40% downside from here or a $100 stock.

Now you may say, hey, wait a minute Ultimate has much better operating margins than Workday and ServiceNow, so maybe that matters more in this environment. Ok, yes that could be the case. Then again those two companies are global SaaS players with much bigger TAMs whose current growth rates are also understated because of significant currency headwinds. However, if adjusted EBITDA multiples are the story, the downside looks even worse when you compare them against Tableau and LinkedIn or the vertically-focused SaaS names. Ahh, but the data visualization market is more niche and there is serious competition there, so that's why that trades where it is at.

Yeah, ok, and then what do you think the North American payroll/HR SMB and mid-market is like? Is that more niche than the global DV market? Well, we can tell you that it is a heck of a lot more crowded, and it's going to get even more crowded. Where do you think pricing is headed in this market with startups giving away the software for free? How much more desperate are those startups going to be to win new business in this environment? By the way, Ultimate's growth story and the other niche payroll/HR NA market focused players has been about a replacement trade against the service bureaus; do you want to pay a huge premium for that? Ok, fine, maybe this all resonates, but LinkedIn is not a good comp as the market is discounting job market headwinds in the name as we get into the back half of the year. Do you think those same headwinds don't apply to payroll/HR provider whose growth is coming from small- and medium-sized businesses?

We can go on with back and forth, and in a stable or expanding growth multiple environment, that is precisely what we all do. That conversation is for a different market. In a normal environment, there will be several outliers on the high and low end. This stock's discount is warranted because the TAM is smaller. No its premium is warranted because the margins are far higher. No, don't focus on margins here as they are in investment mode, and the top-line growth is off the charts and justifies the premium. No, no, no, the names with much lower top-line growth and more narrow market focus deserve a decent discount to the big boys. The valuation battle goes on and on and on...

But in this tape, there is no such battle. There are faster-growing and higher-EBITDA-margin software and related tech companies trading at huge discounts to Ultimate, and huge TAM global SaaS giants with the previously loved "land grab" top-line revenue stories also trading at discounts. Basically, thanks to a broad rerate of how technology stocks are valued, it is the most identifiable outlier we have ever come across in a deep public market tech sub segment. Normally, when you come across something like this, there is some new paradigm story you need to work hard to disprove like a Mobileye (NYSE:MBLY), and even then, there may be a few similarly situated names in the same neighborhood that skeptics can point to and say, "well, what about that one as well?" That's not the case here. Ultimate's model is well understood, and the universe that exists to value it well established. The problem is that universe just drastically changed, and it is now sitting there all alone simply waiting for the laws of market gravity to quickly bring it in!

If you made it this far, you should stop here as this is essentially all we are focused on in this short. It is really that straightforward. But for those looking for more conviction, here is some icing on the cake!

Ultimate Software: A Brief Short Thesis

When we first started shorting Ultimate late last year, we really didn't have an infallible thesis. We knew the company was exceptionally well run, and that it was growing at a measured pace in the North American payroll/HR market. It was essentially one of the few names to make a smooth on-premise to cloud transition, and there was pretty much nothing we didn't like about the business. We just thought that the market was starting to overpay for the slight uptick in operating momentum that it was experiencing.

We were familiar with the company's decision to push into the 300-500 employee firm space over the past 12 months, and believed it was getting a decent boost because of this decision, thanks to heightened payroll/HR provider selection activity around the Affordable Care Act (ACA) compliance reporting deadlines. Basically, we developed a view that while ACA filing enhancement capabilities were not going to be a big revenue boost, the Spring 1094/1095 IRS forms filing deadline was spurring firms in the SMB to mid-market space to evaluate new vendors and or upgrade existing suites. So essentially ULTI was catching a nice regulatory-driven spike in overall business activity at the same time it had decided to push more downstream into the market most affected by that spike.

As far as we are concerned, regulatory deadline driven spikes in business activity are great because they distort baseline demand and are always followed by predictable hangovers in activity. From a short-selling perspective, all you need is a market that all of a sudden decides to get carried away by this spike to create an opportunity for you to exploit. In our view, that opportunity started to materialize last year. FX headwinds took a lot of the steam out of the SaaS heavyweights, leaving Ultimate as one of the few names with a very jubilant conference call for investors to get excited about it. The melt up seemed like a nice and easy short opportunity as you sat back and waited for its luster to wear off in H2 2016 and going into 2017. The problem with that view though was we were not that confident in it as management had us really believing what was going on here was very unique to ULTI.

When asked about ACA driving activity in Q3, here is what Ultimate's CEO had to say on that conference call:

Scott Scherr

No, I don't its accelerating deals. I think it's just something that we have. I would think people who are competitors probably have the same thing, but I don't think that's an acceleration of the deal. I think obviously we have to have it and I think obviously our competition has to have it.

And here is what he had to say on the Q4 conference call last week:

Brad Reback

Scott, how much do you think ACA helps the strategic business?

Scott Scherr

I don't think at all. I think just part of the whole thing. I mean I don't think at all. We have prospects out there, we have prospects who are looking and I think we're in a place where the strategic sales people are able to sell them. And I said it before; I think there's no one we compete against who doesn't have ACA. I think it's just part of being in this business you have to take care of that, so I would say zero.

Brad Reback

Just as a follow-up to that, do you think it encouraged people to begin looking a little more aggressively for solutions in the back half of the year for the need to debt compliance?

Scott Scherr

I don't, because again I think that whoever they were with, unless they're with some in house solution that they had to deal with. But 50% of our - well, 65% of our business comes from service bureaus and there isn't a service bureau that doesn't handle ACA. So, no; I do not think that.

While we get Ultimate's management being dismissive of ACA functionality as a differentiator/revenue booster, we really were not sold on it, denying its role in new business generation momentum.

This is because on the same conference call, it highlighted metrics like this:

For the 2015 year, we had the highest number ever in the year of responders looking to buy a new HCM solution within 12 months, a 48% increase over 2014. - Ultimate Q4 CC, opening remarks

So, a 50% y-o-y increase in new potential business interest has nothing to do with ACA? The deadline isn't helping the new strategic sales team close deals in the 300-500 employee firm range? We had a hard time reconciling this after the Q3 call, but, by the Q4 call, the picture cleared up a lot for us. The reason for this was actually a short thesis we were pitched on payroll/HR provider Paycom Software (PYCM) just a few days after Ultimate reported its Q3. We were admittedly ignorant to the name until this thesis found its way to us, but thankfully, it did because it opened our eyes to what was going on in the sector. Despite the appeal of the thesis, we didn't short Paycom, but as its target market was exclusively in the SMB/mid-market space that was delivering a boost to ULTI, it naturally caught our attention. Then, a week later, Paycom reported its results and delivered 51% y-o-y revenue growth which was 400bps above consensus and an acceleration from Q2's 47% . The stock jumped nearly 30% the next morning, which naturally got us thinking maybe we are shorting the wrong name, but that at the same time, our ACA demand boost thesis was more likely accurate.

So we started going through Paycom's conference calls as well as the even more SMB-focused Paylocity's (NASDAQ:PCTY) (100 employee average payroll/HR customer size) conference calls and results. What we discovered was pretty clear. Paycom started 2015 guiding for 29% revenue growth and it is going to end up delivering close to 50% growth. PCTY guided for similar 30% growth and also raised that closer to 50% when it reported last Thursday (the Paylocity numbers are eye-popping as growth spiked to 60% y-o-y in the most recent quarter). Clearly, both these firms experienced significant accelerations in demand into year-end.

Now put this all together and you have a much clearer picture of what is going in the space. The demand pulled forward, thanks to ACA, is as clear as day. All three firms have seen the spikes at the same time, so you can't really argue with that; but that's not even the whole story here.

Paycom and Ultimate get 50%+ of their business from the giant service bureaus like ADP (NASDAQ:ADP) and Ceridian. ADP reported results last week, and here is a nice little excerpt from its conference call:

"And now, I would like to give you an update on client retention. In the second quarter, ADP experienced a decline in retention of 120 basis points, which marks a sequential improvement over the first quarter. While we are disappointed to see this metric slip from its recent historical high, we are pleased that retention on our strategic platforms remains high. Consistent with the first quarter, the majority of the retention decline stems from clients on mature technology and we still believe that market activity from employers choosing their ACA providers has introduced a change event for our clients. Although disappointing, our management team remains focused on this metric and we have taken actions to address opportunities we have for improvement." - ADP CEO, Q2 2016 CC

Here is ADP telling you that, thanks to ACA, its customers, many of which they are trying to migrate at an accelerated pace from their legacy offerings to their cloud platforms, churn has spiked. So you've had both a combination of accelerated service bureau migrations and ACA deadline compliance as powerful tailwinds in the SMB/mid-market payroll/HR provider space. Set against that backdrop, Ultimate's 200bps bump in top-line growth at the same time it ramped up its strategic sales team doesn't exactly look all that impressive. Management can say what it wants, but broad demand bumps like this can turn into awful hangovers pretty fast.

So why not short Paycom and Paylocity instead?

We actually don't have a major problem with that idea, but both these names trade at around 20% discounts on EV/forward revenue basis to Ultimate's current multiple. This is despite the fact that Paylocity delivered 60% revenue growth last quarter and Paycom 51% versus 26% for ULTI. Also, these names already have pretty steep growth rate declines baked into forward estimates as well as coming off lower revenue bases. In our view, they also don't have the very likely increased competition headaches and headwinds that are likely looming for Ultimate on the larger enterprise side. Then, there are the questions around introducing more churn into ULTI's model by going down-market as well as exposing itself to core value proposition erosion as it goes up against more of these guys.

Going up market is great if you are in the down market, but going down market to get revenue comes with a whole bag of potential future headaches. That being said, we'd obviously rather own the well-established more broadly diversified Ultimate over either of them in the long term, and wouldn't be shocked to see both names cut by more than half. This is because we view these names as 2nd and 3rd tier stocks and not really part of the broader SaaS blue-chip comp universe, and obviously, because they are clearly a lot more levered to a slowdown in overall payroll/HCM selection activity going into next year. But as we pointed out at the start of this section, this is the icing on the cake. Our enthusiasm around this position is based on what is going on in the 1st tier names in software where you don't have liquidity and typically different type of shareholder base elements potentially creating thesis execution headaches.


Ultimate is trading at current levels simply because it reported what seemed like relevant good news right before a "bear market" stamp got placed on tech. It in fact got more expensive during Friday's LinkedIn/Tableau inspired sell-off despite a 10% decline on the day. This is because the likes of Workday, Splunk, ServiceNow, NetSuite, and Salesforce.com declined even more. Those investors long the stock are probably taking some temporary comfort in this "relative outperformance", but in this environment, that is not going to go very far. Sell-side models will be updated, and price targets on the name drastically cut. As for the buy-side picture here; investors who think tech is cheap now have dozens of great stories they can pick up at massive discounts to Ultimate, and will re-balance away from it. Meanwhile bearish inclined tech investors scavenging for what is left to short will be all over the name as it literally jumps off their Bloomberg screen at them. This is the stock market equivalent of a layup. You are welcome!


Suhail Capital is an exempted company registered in the Cayman Islands ("Suhail Capital") is an investment advisor to funds that actively participate in the buying and selling securities and other financial instruments.

You should assume that as of the publication date of this report, Suhail Capital (possibly along with or through our partners, affiliates, employees, and/or consultants) along with our clients and/or investors and/or their clients and/or investors has a short position in The Ultimate Software Group, "Ultimate" or "ULTI" (and/or options, swaps, and other derivatives related to the stock), and therefore stands to realize significant gains in the event that the stock price of ULTI should fall. You should also assume that as of the publication date of this report, Suhail Capital (possibly along with or through our partners, affiliates, employees, and/or consultants) along with our clients and/or investors and/or their clients and/or investors has a long or short position in any other publicly listed company mentioned in this report (and/or options, swaps, and other derivatives related to these stocks), and therefore stands to realize significant gains in the event that the price of any other company listed should increase or decrease.

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Disclosure: I am/we are short ULTI.

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