I first got interested in Paycom (PAYC), in June of 2015 when Andy brought it to the board. My first purchases were at about $37.50. Here are some notes partly taken from what Andy said about it, but also from Bert Hochfeld’s two articles in May and November of this year, (2016) modified to bring all the information up to date, combined with my own observations. By the way I’d strongly recommend reading both of Bert’s articles if you are interested in the stock.
PAYC has a SaaS (Software as a Service) business model. They started as a web-based Payroll company, but now sell a complete suite of programs for mid-sized and small companies to use to manage their all Payroll and their Human Resources needs. They are cloud-based and allow all of the tools to be accessed through a single web page. They IPO’d in April of 2014 and have a market cap today of 2.8 billion. Their programs allow businesses to manage the complete employment life cycle, from recruitment, to retirement. This includes data analytics that lowers labor costs, drives employee engagement and reduces exposure. They are focussed on businesses with 50 to 2000 employees but have been signing up some larger companies recently.
Their CEO has a Glassdoor 88% approval. He now owns about 13% of the business, which means several hundred million dollars, and certainly enough to align his interests with ours.
The CFO has been with Paycom since 2006. He owns about half a million shares, less than 1%, but it’s worth close to $25 million, so his interests are also tied with ours…
Paycom’s sales model does not require a contract. The customer pays month-to-month. Paycom has about a 91% retention rate (some small companies go out of business or get acquired), and once the customer is in the system it’s very sticky. The retention rate stays high due to the difficulty in changing payroll systems. If the payroll processor is halfway decent, you stick with them just because it is so much hassle to change for a small difference in price.
There’s a seasonal aspect to their business. They file tax forms for their clients and this shows up in their revenue in the first quarter. In addition, last year they started filing ACA (Obamacare) forms for their clients as well, but that part may go away with the Trump administration. Paycom has over 12,000 clients and none of them make up more than one-half percent of revenues.
Recurring revenue is what SaaS lives on. Obviously if Paycom keeps its retention rate at 91% it will be very profitable. In addition, renewing clients often buy new services and spend more money each year than the year before. Paycom adds more modules onto their programs nearly every quarter, to get larger revenues and make their product stickier.
Now here is what their results look like:
**Revenue:**
2013: 28 24 26 30 = 108
2014: 36 33 37 44 = 150
2015: 54 49 55 65 = 225
2016: 90 74 77
**EPS:**
2013: 01 01 00 00 = 02
2014: 03 04 05 06 = 18
2015: 12 10 08 10 = 40
2016: 33 21 15
Their current stock price is $46.90
Trailing Earnings are 79 cents
PE is 57 and falling fairly rapidly.
Market Cap to trailing Revenue is about 9
Paycom’s trailing revenue growth rate is a little over 50% (It may be slowing slightly. The last 6 months were “only” up 45% over the year before).
Their trailing EPS Growth rate is a little over 100% (And up 100% for the last 6 months).
This strong growth of revenue and earnings allows them to bring on more sales staff which is a big cost due to training, staffing, and the opening of new sales offices. Since it takes 24 months to bring on a new sales team to full operation, the results above were brought about with only minimal help from the newest sales teams.
Cash Flow is also growing very fast.
Their stock based compensation is quite low (1.5% of revenue last I looked).
Someone on Seeking Alpha pointed out that the way they recognize subscription revenue is important for future earnings. Put simply, Paycom experiences “punitive” up-front expenses when it posts excellent quarters of growth, in that it pays a huge one-time commission expense up front (hitting the expense line of its income statement) while it recognizes revenue over the lifetime of the relationship with the customer (without that commission hit).
In Sept 2015 there was a secondary at $38. It was mostly venture capitalists, and some insiders, who sold shares. There was no dilution from this secondary.
Bert concluded that Paycom combines payroll processing and HCM software into an integrated offering and has built an niche with what appears to be a formidable moat. It has a far less costly business model than other SaaS vendors, which results in a huge advantage in operating margins and rapid growth, while using just a trivial amount of stock-based comp.
Paycom enjoyed a unique benefit from processing ACA payments for its clients during its March quarter. That may not last if ObamaCare is dismantled, but whatever replaces it will probably need paperwork as well, and probably won’t be as problematic for Paycom as some people think.
Bert felt that Paycom’s business model advantages seem likely to persist for the foreseeable future. He was surprised to find a vendor with a total cloud solution that has been growing for some years at 40%-50% when the HCM market CAGR is said to be around 10%. But equally surprising, the company actually makes money, quite rare among small SaaS vendors. It is not cheap but he felt it is growing about as rapidly as any small cloud-based subscription company can grow.
Do they have any moat? Their target market is mid-size enterprises with between 2,000-8,000 employees. Most of these companies already have some kind of payroll processing. But most of them don’t have HCM solutions. These days, there are many different HCM modules that users frequently need. For the most part, Paycom’s competitive takeaways come not because they have better payroll processing capabilities, or better HCM modules, but because a potential client has decided that they need an HCM suite that’s within the capability of a mid-size organization to use successfully.
Since Paycom uses its payroll database as the repository for all of its data, its entire solution is essentially a single application. There’s just a single data base and it has no requirements for integration. And because it is a payroll processor, it has a significantly higher level of security than companies that are just selling HCM solutions.
Paycom’s competitive moat starts with ease of use. That includes both maintaining a single database and having no integration issues. Their offering is optimized for their little niche in a huge market. Ease of use, minimal support requirements and price are the crucial factors in the mid-market.
Paycom is a minor factor within the market it sells to. It isn’t that companies like WDAY or ADP couldn’t do what Paycom does. But the economics aren’t there, and Bert simply couldn’t imagine them getting involved with payroll processing for mid-sized enterprises.
Two reasons that Paycom is able to have such good margins are first, that their sales and marketing expense is far smaller than other SaaS vendors. This is because selling payroll processing is relatively simple, and because selling to mid-sized companies means that there is far less bureaucracy to deal with, while most big SaaS companies are selling cumbersome seven-figure deals. Sales cycles are typically 4-6 weeks for Paycom while enterprise sales deals take 6-12 months to close. Simply put, fewer sales people can close more sales. PAYC just has a different business model and thus less S&M expense. The fact that its application runs off a single data base, and needs no integration, and requires administrators to understand just a single code base, are big selling points in organizations without huge, capable IT staff.
The second reason is their extraordinary low R&D spend. It’s just 3% to 4% of revenues, and much less than other SaaS companies. Supporting an R&D effort focused on payroll processing is far less costly than it is for a company trying to build out an enterprise software capability.
Paycom has had a continuous history of beating estimates significantly since it became public. The P/E is obviously not cheap but remember that they beat estimates every quarter.
Bert thinks that they can continue to achieve 30% growth for several years beyond 2016, and that EPS can grow 40% pre year or more, and that operating and free cash flow will grow more rapidly than that.
In May they announced a $50 million stock repurchase plan, and by the time they reported Sept quarter results they had already repurchased over 525,000 shares.
I have to remember that their March quarter this year, was an anomaly with exceptionally high revenue and earnings because they helped their clients file ACA (Affordable Care Act) forms during the quarter.
In June they were recommended by a MF paid service which reiterated the point Bert made: that the ability to centralize multiple functions in a single system is a strong selling point, and that simplification is the system’s organizing principle. By using a single, cloud-based database, Paycom avoids the complexity and errors that come from trying to paste together information from disparate systems. No rekeying employee information from one place to another, costing time and increasing errors. No more half-dozen logins for half a dozen platforms.
Margins have expanded steadily over the past five years.
A short summary of Bert’s take in Nov on the Sept quarter follows:
The earnings release was another beat and guidance was strong as well, but the stock, reacting both to the earnings and to the election, has fallen more than 20%. The issue is about Obamacare and the tailwind that the company has had since it began processing returns for its customers as part of fulfilling a mandate in the Affordable Care Act. There is expectation that that specific part of their busness may disappear.
It does seem likely that the ACA will be substantially revised, although it is said that outright replacement is technically difficult. Will those changes negatively impact the revenues Paycom gets from the sector? Bert doubts it. How large might the exposure be? Obviously that is not knowable. He believes that investor concerns regarding the impact on Paycom have been rather overdone. It seems likely that there will continue to be some species of ACA and some reporting requirements in the future. With regards to PAYC as a business, that is about all that investors need to know or care about.
Bert guesses that the company will exceed consensus numbers and will guide above the consensus next February when it releases results.
PAYC is showing a very rapid increase in Cash Flow from Ops thus far in 2016. In the first nine months of this year, CFFO has more than doubled. Bert imagines that full-year CFFO would be in the range of $115 million to $120 million for 2016. The company is spending a significant amount on a new headquarters campus. That will bring free cash flow down to about $80 million this year. Free cash flow should rebound nicely in 2017 without the expense of the new headquarters facility. He thinks free cash flow, again based on trends, could reach $125-$130 million. The free cash flow yield this year is about 3.3% but it should reach almost 5.5% next year.
25%-30% top line growth and a free cash flow yield of 5.5%. Bert thinks that represents a very reasonable set of valuation metrics and that the share price retracement provides investors with an excellent entry point.
So what’s my conclusion? Obviously I like it. It’s growing fast and almost all its revenue is recurring. It also has an odd sort of “deferred” revenue, in that it pays a big commission on the initial sale, so that first quarter profits on each sale are minimized. It has its own niche and it works very well for them. I have a mid-sized position which I will keep, and am adding to in small amounts from time to time.
Hope this was of help,
Saul
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