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Ultimate Software Falls on Capacity Concerns

Small companies often face challenges in getting new business. Yet it can often prove equally dangerous for a small company to get too much business, because it can lack the capacity to handle an influx of clients quickly while retaining its reputation for quality and customer service. Cloud-based human resource management solutions provider Ultimate Software Group (NASDAQ: ULTI) appears to be going through that transition right now, and although it's a far better problem to have than not having any demand for products and services, Ultimate still has to figure out how best to handle the situation.

Coming into Tuesday's second-quarter financial report, Ultimate Software investors wanted to see a continuation of the company's impressive growth trends on the top and bottom lines. Ultimate delivered on the earnings front, but sales growth lagged what investors were expecting, and a cut to sales guidance for the remainder of the year raised questions about the HR cloud company's ability to execute well. Let's look more closely at Ultimate Software to see what happened and what's ahead for the company.

Image source: Ultimate Software.

Ultimate Software hits a speed bump

Ultimate Software's second-quarter results were mixed in most investors' eyes. Revenue climbed more than 20% to $224.7 million, but that was slower than the 22% growth rate that those following the stock had expected to see. GAAP net income fell from year-ago levels, but after making adjustments for extraordinary items, adjusted earnings of $0.93 per share topped the consensus forecast among shareholders for $0.91 per share.

Looking more closely at Ultimate's numbers, the key metric for most cloud-based businesses is how much revenue they collect from recurring sources. The HR cloud specialist performed reasonably well on that front, with recurring revenue climbing 23% to $195.1 million. Elsewhere, Ultimate's services revenue was up just 5% from the year-ago quarter, with growth slowing further from past results. Retention rates stayed stable at 96%, indicating how loyal customers are once they get established on Ultimate's platform.

Once again, Ultimate Software spent a lot of time in the release talking about recognition it gets from the industry. One set of enterprise product users gave their top rating to the company for satisfaction in the payroll grid, and the National Customer Service Association named Ultimate the top service organization of the year.

CEO Scott Scherr discussed the results. "Our sales teams exceeded objectives in our plan for the second quarter," Scherr said, "while the average size of our new enterprise clients continued to expand, and the numbers of new mid-market and strategic clients joining us grew." The CEO also pointed to new products like the UltiPro Learning and Perception solutions for employee development and surveys.

Why are Ultimate Software investors unhappy?

Ultimate Software's outlook for the future highlighted the downside of success. Strong sales have caused extended delays in fulfilling backlog, which now runs two to three months for the enterprise segment and one to two months for the mid-market segment. The company emphasized that these problems only affect the timing of revenue, and it anticipates that long-term value of recurring revenue from these customers should be unchanged. Ultimate therefore believes that delays won't dissuade customers from following through on their orders.

The immediate problem is that revenue for 2017 won't grow as quickly as previously thought. Third-quarter total revenue of $231 million to $235 million would represent growth of 17% to 19%, but the consensus forecast was looking for nearly 25% gains on the top line. For the full year, Ultimate cuts its growth projections from 24% to 20%, and reductions in recurring revenue also indicated that hoped-for gains there would be weaker as well.

Ultimate Software's shareholders weren't happy with the shortfall, and the stock plunged 12% in after-hours trading following the announcement. The concern is that if Ultimate is wrong and clients get impatient, sales losses from longer delays in execution could become permanent. To assure its investors, Ultimate Software needs to commit to do whatever it takes to sustain its customer service and get new clients on board quickly and efficiently.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Ultimate Software Group. The Motley Fool has a disclosure policy.