Hello Paycom investors (or at least investors wanting to learn about Paycom). Like you, I found this company interesting and I’ve decided to offer quarterly earnings analyses, at least for now. But before I dig into Paycom, please let me share a bit about my background.
I was born and raised in New York City and grew up fascinated by the stock market. I’ve worked for several of the Wall Street brokerages, but always as a database engineer (hence the “database” in my handle). That said, part of my job required me to learn the brokerage business – at least the back end. I’ve since moved to Boulder, CO. My undergraduate degree is based on a dual major of Mathematics and Computer Science, with a healthy dollop of Accounting thrown in. I guess you could say I like numbers. I also received an MBA from New York University’s Stern School of Business. Although I majored in Computer Applications and Information Systems (my employer paid for the degree and required that be my major), the school is best known for its Finance classes, and I took those with every elective slot in my curriculum. As I studied and worked, it occurred to me that my REAL skill was “analysis”, and I was just applying that skill in a computer-related setting.
So, now I have the opportunity to exercise those analytical skills in a Finance setting, kind of fulfilling that childhood dream, and also allowing me to keep those skills well-honed as I enter the early years of my retirement. My posts tend to be long, but I hope you’ll find them well-organized, informative, and occasionally amusing.
Please forgive me this time if my analysis is on the shallow side. I’m still learning about Paycom, and I hope my analysis of this company will become more insightful and incisive with time.
One quirk in my reporting style that you may notice and I should explain. I’ll say “Paycom” when I’m talking about the company and “PAYC” when I’m talking about the stock. I try to be rigorous about this because I think it’s important to distinguish between the two. In the long-term, they should move in tandem. In the short-to-medium term, they may not. For example, competitor Automatic Data Processing (ADP) issued a bad earnings report a few days ago, impacting the PAYC share price, with some traders concerned that the issues at ADP (the company) might pervade the entire sector. Looking at Paycom’s results a few days later, it clearly wasn’t so, and PAYC rebounded. Keeping the company and the stock in separate mental buckets is a useful tool for an investor, and I try to choose my wording in ways that reinforce that point.
Earnings Report Highlights
The earnings press release can be found here: http://investors.paycom.com/press-releases/press-release-det…. Seeking Alpha’s transcript of the conference call can be found here: http://seekingalpha.com/article/4044130-paycom-softwares-pay…. (Thanks, Seeking Alpha.) Unless stated otherwise, all italicized quotations are from the Seeking Alpha transcript.
4Q16 Revenue: $87.8 million This is a 35% improvement over 4Q15. Management had guided towards $85-87 million. Yahoo! Finance indicates that Wall Street expected $86.3 million, so this is a nice beat. While most companies would kill for a 35% revenue gain, please look at the table below, and you’ll see that 35% is actually kind of substandard for PAYC. So, slowing revenue growth is something we’ll have to keep an eye on, especially since the midpoint of 1Q17 guidance suggests only 28% revenue growth next quarter. Those are still great numbers, but less than we’re used to. Thinking about seasonality, I note that the 4Q result is typically the high-water mark for the year. But this year’s 1Q result topped the 4Q result. I think that it is not problematic in this case, as 1Q16 was unusually strong due to Affordable Care Act (ACA) spending. We’ll watch to see whether that was a one-time fillip, or instead, it marked the beginning of a change in seasonal patterns. Arguably, 4Q also presented a tough comparison too, as some companies signed up with Paycom in December ’15 to ensure full ACA-compliance for the entirety of 2016.
In millions (GAAP). 1Q 2Q 3Q 4Q Comments 2013 $27.6 $23.9 $25.8 $30.3 2014 $37.0 $33.3 $36.6 $44.0 Y-o-Y 34.1% 39.3% 41.7% 45.4% 2015 $55.2 $49.0 $55.3 $65.1 Y-o-Y 49.2% 47.1% 51.1% 48.0% 2016 $90.1 $73.9 $77.3 $87.8 1Q16 ACA spending Y-o-Y 63.2% 50.8% 39.8% 34.8%
FY16 Revenue: $329.1 million This is a 46.5% improvement over FY15.
In its press releases, the company doesn’t highlight gross margin (revenues minus cost of revenues, as a percentage of revenues) or operating margin (revenues minus cost of revenues AND administrative expenses, as a percentage of revenues). I think these are useful metrics to track, so I’ll add them to this analysis, at least for now. If trends seem to be uninteresting, I may stop reporting the metric.
4Q16 Gross Margin: 82% GAAP This compares to 84% in 4Q15. Often my eyes widen when I see gross margins this high, but then I remind myself that this is a software company.
4Q16 Operating Margin: 14.4% GAAP This compares to 9.6% operating margins in 4Q15. My guess (and hope) is that we’ll see continued improvement in this metric over time, as certain operating expenses may not grow as fast as revenues. As you’ll see when I get to the section on competitors, we probably should be thankful that Paycom has any positive operating margin, as some of its competitors don’t.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. I’m not a huge fan of this metric for two reasons. First, it is most useful when comparing companies in the same industry that have very different capital structures. Since my usual goal is to track a single company over time, it is less useful to me. Second, no less a luminary than Charlie Munger (of Berkshire Hathaway fame) suggests that every time you see the acronym “EBITDA” in a sentence, you should replace it with a mildly profane word used to refer to bovine excrement. It’s fun; try it! I wonder how he might augment that when faced with “Adjusted EBITDA”, where management seeks to further exclude costs like stock-based compensation. Such musings aside, Paycom management’s guidance for upcoming quarters only offers two metrics: Total Revenues and Adjusted EBITDA. Therefore, this quarterly analysis will dutifully include Adjusted EBITDA, and I’ll enjoy the amusement of silent word replacement.
4Q16 Adjusted Bull… err… EBITDA: $20.7 million This is a huge increase (97%) over the 4Q15 figure. Last quarter, management had guided towards $14-16 million for 4Q16.
4Q16 Net Income: GAAP $8.6 million ($0.15 per diluted share) and non-GAAP $10.8 million ($0.18 per diluted share) GAAP earnings per share are six cents better than 4Q15 and non-GAAP earnings per share are better by eight cents. I’m not sure I want to get into percentage growth rates since the numbers are still relatively close to breakeven, but you can see from the tables below that the growth rates are substantial and quite pleasing.
Earnings per Share (GAAP) 1Q 2Q 3Q 4Q Comments 2013 0.05 0.01 -0.01 -0.04 2014 0.02 -0.01 0.05 0.05 2015 0.11 0.10 0.07 0.09 2016 0.31 0.18 0.10 0.15 Earnings per Share (non-GAAP) 1Q 2Q 3Q 4Q Comments 2013 0.05 0.01 -0.00 -0.00 2014 0.03 0.04 0.05 0.06 2015 0.12 0.10 0.08 0.10 2016 0.33 0.21 0.15 0.18
FY16 Net Income: GAAP $43.8 million ($0.74 per diluted share) and non-GAAP $51.6 million ($0.87 per diluted share) This compares to GAAP $20.9 million ($0.36 per diluted share) and non-GAAP $23.4 million ($0.40 per diluted share) in FY15. That is very impressive year-over-year growth. I’ll share thoughts in a later section about whether this growth is sustainable.
4Q16 Cash Flow from Operations (CFFO): $24.5 million; CapEx: $11.4 million. I don’t have a data base of history for cash flow prepared yet, so it is difficult to say whether or not these are good (or bad) numbers. Just looking at 2016, they both seem about “average”, and I’ll leave it at that.
Revenue: $114.5-116.5 million (vs. $90.1 million in 1Q16; a tough comparison)
Adjusted EBITDA: $42-44 million (vs. $33.0 million in 1Q16)
Per Yahoo! Finance, Wall Street expected 1Q17 revenues of $113.3 million and $0.39 in non-GAAP earnings. As much as I dislike modeling (I think it gives a false sense of precision), it appears that I’m going to have to develop a rudimentary model to help me reconcile expectations for Adjusted EBITDA and non-GAAP earnings. Given the market’s favorable reaction this quarter, I’ll cheat and opine that the two compared favorably!
Revenue: $422-424 million (vs. $329.1 million in 2016; a 28.5% increase at the midpoint)
Adjusted EBITDA: $113-115 million (vs. $94.5 million in 2016; a 20.7% increase at the midpoint)
Wall Street expected 2017 revenues of $421.6 million and $1.04 in non-GAAP earnings.
PAYC earnings day share price: $51.32 +13.39% (vs. S&P 500 +0.58%) At first I had trouble understanding the enthusiasm, given the slowing growth implied by guidance. But as I studied the numbers, I became more comfortable with the current valuation, as you’ll see in another section later in this report.
Paycom and the Affordable Care Act
Since the ACA (a.k.a., Obamacare) is very much in the news as potentially being repealed or replaced with something different, and the ACA was identified as being partially responsible for a great 1Q16, founder and Chief Executive Officer (CEO) Chad Richison felt it was important to address the impact of potential legislation on Paycom. He estimated that if the ACA were to disappear tomorrow without replacement, only 3% of revenues would have to be replaced, and said, “we do not believe it would impact our overall value proposition or our new business on-boarding pace.”. He further noted that it is quite possible that the ACA will be replaced by different regulations, perhaps even individual state regulations. Later, during the Q&A, it became clearer that the ACA business represents closer to 5% of Paycom’s revenue – the 3% figure was for 2017 and excluded January and February billings.
Regardless of politicians’ stated intentions, the ACA remains law today and HR folks must still remain in compliance.
How Worried Should We Be About the Growth Slowdown Implied By Guidance?
On February 10, 2015, Paycom’s guidance revenue for 2015 was $194-196 million. Actual 2015 revenue turned out to be $224.6 million, or 15% ahead of initial guidance. On February 9, 2016, Paycom’s guidance for 2016 revenue was $309-311 million. Actual 2016 revenue turned out to be $329.1 million, or 6% ahead of initial guidance. As you can see, Paycom makes its initial revenue guidance conservatively, but not by a ridiculous margin. I wouldn’t be surprised to see full year revenue growth of greater than 30% for 2017 over 2016, but I don’t think we’ll see over 40%, as we did from 2015 to 2016.
Let’s switch over to Adjusted EBITDA guidance, and compare it with both actual Adjusted EBITDA results and earnings results to see if we can infer what 2017 earnings growth might look like. Initial 2015 Adjusted EBITDA guidance was $32-34 million. Actual 2015 Adjusted EBITDA turned out to be $48.1 million, or almost 46% above initial guidance. 2015 Adjusted EBITDA was $27.1 million above earnings, or 129% above earnings. Initial 2016 Adjusted EBITDA guidance was $63-65 million. The actual result was $94.5 million, or almost 48% above guidance. 2016 Adjusted EBITDA was $50.6 million above earnings, or 115%. Time to get hypothetical… If 2017 actual Adjusted EBITDA is 45% above initial guidance, it’ll come in at ~$165 million. If we assume that Adjusted EBITDA tends to be around 2.2x earnings (looking at some of the 2016 quarterly numbers, this doesn’t seem unreasonable), next year’s earnings could be in the $75 million ballpark, or 70% growth from 2016 to 2017. Now, there’s A LOT of room for error in this paragraph, especially around making assumptions about the percentage by which Paycom will beat initial 2017 guidance. Given that Thursday’s closing price implies a PE ratio of almost 70x, it is comforting to me to find an analysis that suggests 70% earnings growth is quite possible, yielding a Price Earnings to Growth ratio right around 1.0 (fairly reasonable for such a fast grower, although numbers further below one are typically preferred).
I think this will be a useful enough analysis for those of us just learning about the company, but I probably won’t include it in future quarterly analyses.
I view Paycom as being in the business of cloud-based Payroll and Human Capital Management (HCM) systems. While a company like Oracle (ORCL) has solutions that compete with Paycom, I’m not going to include them because Payroll and HCM are not their main focus. Instead, I’m going to limit the list to publicly-traded businesses focused on those two types of systems. That, in my opinion, limits the list to six: Automatic Data Processing (ADP), Paycom (PAYC), Paychex (PAYX), Paylocity (PCTY), Ultimate Software (ULTI), and Workday (WDAY). I’m going to present a bunch of metrics that may be interesting to investors, and the value of each metric as best I can determine it for each of the six companies. Please note that some metrics may not offer a perfect comparison. For example, not all of these companies end their fiscal year on December 31. Also, I should point out that I gathered most of the data from Yahoo! Finance, which is known NOT to be an immaculate data source.
ADP PAYC PAYX PCTY ULTI WDAY Market Capitalization $44B $3B $21B $2B $6B $17B Price Earnings Ratio 29x 69x 28x NMF 220x NMF Dividend Yield 2.4% 0.0% 3.2% 0.0% 0.0% 0.0% TTM Revenue Growth 6% 28% 7% 29% 57% 35% TTM Earnings Growth 12% 118% 6% 43% 26% NMF 52-Wk Share Price Growth 19% 92% 23% 33% 27% 72% Total Debt/Equity 52% 23% 6% NMF* 2% 46% Enterprise Value/EBITDA 16x 42x 16x 231x 81x NMF TMF Recommended ** YES YES NO NO YES YES * PCTY has no debt, but negative equity ** I’m not at liberty to say which service(s) recommend which company
To my eye, PAYC strikes a nice balance of growth, profitability, and even valuation. If they paid a decent dividend, that might be the quad-fecta!
What Attracted Me to Paycom in the First Place
My first inkling that PAYC was worth my attention came from “Saul’s Investing Discussions” a free board on The Motley Fool site that I highly recommend. Saul is a smart, disciplined, successful investor. He has also generously chosen to share his strategies so others can learn from them. His strategies are advanced, and they don’t adhere strictly to Motley Fool dogma (to the extent there is such a thing; we ARE motley). But it is a great place to discuss growth stocks, and to learn about one successful investor’s strategies. Personally, I can’t invest like Saul does. But I’m convinced that I have become a better investor by incorporating some of his strategies into those that have proven successful for my interests and temperament. On Saul’s board, I was pointed to Seeking Alpha articles about Paycom by Bert Hochfeld. There are links to these in a later section.
Subsequent to being mentioned on Saul’s board, Paycom was recommended by two Motley Fool newsletters. The Motley Fool has several newsletters and portfolio services. With no disrespect to any of the others, my affinity is strongest to Hidden Gems, Million Dollar Portfolio, Motley Fool One, Motley Fool Pro, Rule Breakers, and Supernova. I think those choices reflect my personal style and interests more than quantitative results from the services. In any case, two of these services have recommended Paycom. As confident as other people’s recommendations can make me feel, I think it’s also important to apply my own critical thinking. Out of all the investment vehicles out there, is Paycom among my best choices? Here’s what convinced me that it is.
As I mentioned much earlier, my working career was spent as a database engineer. Part of the Paycom story is that all of its software – all of the different modules it supports – adhere to a single unified database structure. Obviously, not everyone has access to everything within that database. Different clients purchase different modules (which access different parts of the data) and different user groups have different data access privileges within the same module. But a single database design based on real-world models supporting multiple applications strikes me as brilliant – exactly the right way to use databases (assuming you can get the model right). These guys appear to have done that for one interrelated set of applications. Bravo! I want to invest in that. Obviously, I’m not privy to implementation details, so I can’t know whether they’ve done a great job or not. Perhaps I’m susceptible to a story that touches on an area of my expertise, but one where critical details would never be revealed to the investor community. Still – based on what I know – they’ve taken a smart approach, and results seem to suggest that their implementation is at least reasonable, if not optimal. Also, since it is a payroll database at its core, bulletproof security has been designed in from the beginning and always remains vigilant.
ADP and Paychex seem to be the most entrenched incumbents in this space. For companies as large as they are, only sales to large organizations really “move the needle”. Paycom focuses instead on the small- to medium-sized business (SMB) space. This allows Paycom to grow without undue irritation to their most powerful competitors. They seem to have tailored their support staff in a way that is optimized for the companies they target. After the initial sale, the customer still feels nurtured by an on-boarding support staff, and they’re guided towards getting the most benefit out of what they’ve purchased (actually, “what they’ve subscribed to” would be a more apt description). Plus, this support staff is qualified to pursue further sales opportunities within the customer organizations they’re supporting, as they identify customer problems amenable to a Paycom solution. Every quarter, Paycom highlights several new clients that are larger than the client they typically target. To me, this proves they can grow their target market. As if the SMB market isn’t large enough.
It is easy to find fast-growing companies writing and supporting cloud-based software. However, if you add “profitable” to that set of criteria, the list diminishes appreciably. Paycom passes that test. And the growth is still superb.
Paycom’s customers feel as if they are getting value from their software subscriptions. This is evidenced by a 91% customer retention rate achieved in 2016. I think that’s remarkable, but what’s even more remarkable is that 2016 is the sixth straight year where customer retention rates met or exceeded 91%!
Founder Chad Richison still runs the company and holds a significant number of shares (>13% of the company) according to the most recent annual proxy filing. While I certainly don’t screen for this, because it is rare, it is very nice to see. Even better, Chief Executive Officer (CEO) Richison is still a young man – only 45 years old as of that proxy statement.
Often, when Paycom wins a client, that client subscribes to modules for several HR functions, not just payroll, and often the client is replacing offerings from multiple vendors. Here is where the single database really shines. There’s just one login for all the modules, data is only entered into one system (reducing mistakes), and reports are integrated.
Paycom only has a presence in 24 states within the U.S., and it has been expanding – it opened five sales offices in 2015 and six in 2016. Management believes it takes two years for a new sales office to fully mature, and they have a well-honed process for creating new sales teams.
What Are My Biggest Concerns?
As I mentioned earlier, growth will likely slow at some point. I further mentioned that current guidance does indeed point towards slowing growth, but part of that is likely difficult comparisons due to strong growth in 1Q16.
CEO Richison’s total compensation package doubled from 2013 to 2014, and doubled again from 2014 to 2015. Much of this is due stock awards; salaries are reasonable. Other executives also received stock-based windfalls in 2015. In Mr. Hochfeld’s May 2016 article, he described stock-based compensation as “minimal”. I cannot say for certain whether or not he studied the 2016 annual proxy filing at that point. He had access, since it was filed in late March. I would have agreed with him having seen 2014 amounts, but I’m not sure I agree anymore. Stock-based compensation across the entire organization rose from $3 million in 2015 to $22.5 million in 2016. I am pretty sure that a certain portion of this increase is due solely to the rise in value of already-issued stock-based compensation. But I suspect there are a lot more shares being issued too. I’ll need to study the 2016 10-K and Proxy filing, when they become available. Paycom Investor Relations graciously sent me the 2014 and 2015 reports, and I am working my way through those.
Other Random Musings
Other Analysis You May Find Interesting
Here are the two Bert Hochfeld Seeking Alpha articles I mentioned, plus an analysis Saul did a few months ago. You can use that link as an entrée to his board, if you are not familiar with it.
Rising Interest Rates
One thing that payroll processors have in common is that they benefit from rising interest rates. Why is this so? Client companies deposit funds with the payroll processor, and eventually the payroll company cuts checks to employees. While the payroll processor holds the funds, it earns interest on the “float”, and the amounts increase as interest rates rise. The amount of float on deposit fluctuates a lot. At the end of 2Q16, it was over $1 billion, although it typically is less than that. The Federal Reserve has indicated that they intend to gradually increase rates several times this year. Whether they actually raise rates as many times as they suggest they will is a matter of opinion; they haven’t always done what they’ve suggested in the past. But it’s likely we’re in a rising rate environment, which helps Paycom.
As I pointed out earlier, I feel as if this company offers a nice balance of growth and profitability, at a fairly reasonable valuation. There seems to be ample room for further growth as the company expands its geographic reach. There are quite a number of things I like about the business model, as I described above. I opened a position earlier this year, having found its prospects intriguing, and I’m looking forward to following the company more closely.
If you have any questions or comments about this post, please do ask/share them.
Thanks and best wishes,
TMFDatabaseBob (long: ADP, PAYC, PAYX)
See my holdings here: http://my.fool.com/profile/TMFDatabasebob/info.aspx
Peace on Earth