Ultimate Software: Mature Software Company Quietly Powering Ahead

Summary

• Ultimate Software continued its outperformance in Q2, with results beating analyst expectations on both the top and bottom line.
• Most notably, the company's 23% y/y growth in recurring revenues marked solid overachievement relative to the company's guidance for "at least 20% y/y" growth.
• Free cash flow in the first half of the year also grew 67% y/y, as Ultimate Software improves its operating margins.
• While no longer the growth stalwart that it used to be, Ultimate Software remains a profit-focused story with GAAP earnings up more than 3x year over year.

Precious few SaaS software companies have reached the age of maturity. By that, I mean most SaaS companies are still in their hyper-growth stages: with growth in the 30-40% range, an unpredictable revenue trend, and a focus on "growth at all costs" that prioritizes investments in sales headcount expansion rather than profitability.

No doubt this is the right move for high-growth companies, within SaaS especially - landing recurring revenue deals that can provide steady income streams for multiple years is worth running at a loss in the near term. But over the past year, these high-growth SaaS companies have become immensely popular (and one could say, overvalued) in the markets, especially with the addition of overhyped IPOs like Avalara (AVLR), a sales tax compliance software company that shot up when the Supreme Court ruled unfavorably against Wayfair (W) on the subject of sales taxes, or Zscaler (ZS), which pioneered a "security-as-a-service" model to cybersecurity. With the spotlight so squarely focused on these types of names, older SaaS companies that have gone through their growth phases and emerged as a slower-growing, yet more stable and more profitable company, have been largely ignored.

Ultimate Software (NASDAQ:ULTI) is an example of one of these old-school SaaS names that have been left in the dust. With its growth rate in the low 20s, Ultimate Software has largely moved out of the mainstream, which is a shame as its underlying fundamentals have never been stronger. The company just reported Q2 results that featured a respectable boost in recurring revenues.

Earlier in the year, Ultimate Software guided to a "minimum of 20% y/y" growth in recurring revenues. This quarter, it posted recurring revenue growth three points above that guided minimum, at 23% y/y - and in addition, it upped its outlook to 23% y/y growth in recurring revenues. No, that's not as impressive as newer, smaller SaaS companies that are posting 40-50% y/y growth - but with Ultimate Software, what you're getting is a known quantity that has a proven track record for execution.

Nor is Ultimate Software simply sitting still. It has turned to the standard playbook of larger software companies like Salesforce.com (CRM) and Oracle (ORCL): powering incremental growth through M&A. Ultimate Software just paid $300 million for a European HC company called PeopleDoc, paid in a mix of cash and stock ($75 million cash upfront, $50 million in one year, and the rest in Ultimate shares). Ultimate's Q3 guidance notes that PeopleDoc will contribute $5 million in recurring revenues in the third quarter, or about 2% of PeopleDoc's recurring revenue guidance range of $250-$252 million. Though not a cheap acquisition (if we annualize PeopleDoc's Q3 revenue guidance, we roughly calculate a purchase multiple of 15x recurring revenues), PeopleDoc can add two points of inorganic revenue growth to keep Ultimate Software's revenue growth from slipping into the teens.

In addition, Ultimate's CEO has laid out a new long-term revenue target on the earnings call:

We are continuing to grow our infrastructure in preparation for achieving our objective of $2 billion in revenues in 2022."

A $2 billion revenue run rate is about 2x this year's revenue guidance of $1.138 billion, and represents a CAGR of 15% y/y over the next four years. Considering Ultimate has been steadily growing revenues at a 20% y/y pace for the past several years, this target should be easily achievable - perhaps even several quarters before 2022.

Investors shouldn't overlook Ultimate Software just because it's a less flashy name now, relative to its higher-growth peers. Ultimate Software has become a bulwark of the HCM space, the second-most important pure-play HCM company behind Workday (WDAY) with a trove of recurring revenues. In my view, Ultimate Software is a long-term hold.

Valuation-based opportunity

Valuations have glided upward in the SaaS sector by several turns. By this, I mean that a "typical" SaaS valuation for a company growing at 30-40% y/y would be 7-8x forward revenues; now, with the influx of richly valued IPOs like Avalara, 9-12x forward revenues have become much more the norm. And for many IPOs like DocuSign (DOCU) and Zscaler, trading at a revenue multiple in the mid or high teens is also not unheard of.

Ultimate Software, by contrast, has maintained a reasonable valuation multiple at 7x forward revenues. Yes, the company's lower growth merits its slight discount to the wider SaaS sector, but Ultimate Software also carries the added benefit of being one of the few SaaS companies to be profitable on a GAAP basis. And, like Dropbox (DBX), Ultimate Software generates respectable free cash flow margins.

ULTI data by YCharts

Though operating in entirely different segments of the SaaS sector, Dropbox presents an interesting comp. The company is currently trading at about 9.0x forward revenues, despite a growth rate that's only a few points higher than Ultimate Software - and like Ultimate Software, Dropbox also faces stiff competition from incumbents like Box (BOX) and Google Drive (GOOG). Ultimate Software's ~15% FCF margins in the first half of FY18 are lagging behind Dropbox's FCF margins in the mid-20s, but with FCF growth a top priority for Ultimate Software (FCF grew 67% y/y in the first half of 2018), it's catching up quickly.

In my view, there's no reason Ultimate Software can't continue to rise to ~8-9x forward revenues, given how richly the SaaS sector is trading at the moment. For illustration's sake, Ultimate Software would need to hit $340 to attain a 9x EV/FY18 revenue multiple (based on FY18 revenue growth guidance of 21% y/y, as given by the company concurrently with Q2 earnings) and achieve an in-line valuation with Dropbox, or 20% higher than current levels.

Q2 download: increased focus on higher margins

For several quarters now, Ultimate Software has posted stable revenue growth in the low-to-mid 20s. With a moderate M&A strategy behind it and a strong base of recurring revenues to rely on each year, it's fairly easy to bet that the company can continue to post ~20% y/y revenue growth for the foreseeable future.

The focus now, in my opinion, is on improving Ultimate's margin and its free cash flows, even if top-line growth begins to decelerate. The company's most recent quarterly results show Ultimate doing just this. See the company's Q2 results below:

Figure 1. Ultimate Software Q2 resultsSource: Ultimate Software investor relations

Total revenues grew 21% y/y to $271.2 million, beating Wall Street expectations of $268.6 million (+19% y/y) by a respectable two points. Within this total revenue base, the most important revenue stream, recurring revenues, grew 23% y/y to $239.5 million.

It's important to note the significance of Ultimate Software's high recurring revenue mix. In the first half of this year, Ultimate Software produced $476.0 million of recurring revenues, or 86.9% of its total. That's up 190bps from 85.0% in the year-ago period. This has huge implications both on growth and profitability. On the growth front, having such a high mix of recurring revenues means that the company can have a baseline revenue stream to start each year with, and new business becomes purely incremental. From a profitability perspective, the sinking mix of services revenue, which is performed at a loss (which can be seen above, with cost of services exceeding the revenue generated from it), contributes to a boost in Ultimate Software's gross margin, which has operated at a small deficit to peers like Workday for quite some time.

Total gross margin this quarter, on a pro forma basis, came in at 64.5%, which the company claimed "was also slightly better than we expected" on the earnings call.

What is more impressive, however, is the huge boost in Ultimate Software's operating income, driven by flat y/y sales and marketing expenses despite the boost in revenues. This indicates how "mature" software companies can benefit from large recurring revenue bases - it's no longer necessary to dole out huge gobs of cash to build large sales headcount, as renewal activities can support revenue growth at a lower cost. Operating income grew nearly 3x to $20.1 million, or an operating margin of 7.4%, versus just 3.1% in 2Q17.

Ultimate Software warned that the PeopleDoc acquisition will initially come with some near-term margin dilution. Over the long run, however, the added recurring revenues should be folded in well into Ultimate Software's base at little incremental cost, and become long-term accretive to Ultimate's profits.

Pro forma EPS in the quarter of $1.32 muscled past Wall Street expectations of $1.28, and as previously mentioned, free cash flow in the first half of the year totaled $77 million, growing 67% y/y and representing an FCF margin of 14%.

Key takeaways

It's unwise to use the allegory "slow and steady wins the race" with any technology company, as any association with the word "slow" is anathema to tech investors. But it's the closest phrase to describing the long-term bullish thesis behind Ultimate Software. The company has its bases covered on all fronts - it has stabilized growth in the mid-20s, is balancing profit margin increases alongside its growth, and has a top-ranked product that is consistently featured as one of the top HCM suites. In addition to that, Ultimate Software has a clean balance sheet with $200 million in cash and no debt, not to mention free cash flows coming in every quarter at a mid-teens margin - an enviable position from which to execute M&A.

It should also be noted that Ultimate Software is exactly the kind of company that tech-focused private equity funds like Thoma Bravo are interested in buying - profitable and mature, with large recurring revenue bases. Though the news stream of software PE deals has died down of late, seeing a PE exit for Ultimate Software similar to Qlik's ~$3 billion purchase in 2016 wouldn't be implausible. Stay long on this name for the long term.

Analyst’s Disclosure: I am/we are long ULTI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.