The Uncommon Idea in Brief
Buy human resources software company Paycom (PAYC) for the intermediate and long terms. (Published July 5, 2017)
-Use any weakness and uncertainty around healthcare legislation to accumulate or increase a long position.
The Industry Opportunity
Companies of all sizes continue to look for ways to simplify management of employees, reducing costs at the same time.
Known as human capital management, or HCM, it involves responsibilities such as payroll, taxes, recruiting, deployment of employees and more.
The HRC market is expected to grow to $19.88 billion by 2021, based on a compound annual growth rate of 9.6%, according to RnR Market Research.
Paycom is focused on small-to-midsize businesses with its cloud-based software-as-a-service (SaaS) product.
What Paycom Does
Paycom offers cloud-based HCM software throughout the life cycle of an employee, from recruitment to retirement.
The company offers small and midsized businesses subscriptions to human resources tools under an Saas model. Its suite includes, but is not limited to, applicant tracking, candidate tracking, background checks, onboarding, E-Verify (employee verification via the internet), tax credit service applications, time management and labor management (scheduling, time-off requests and geo-tracking).
Paycom mainly caters to businesses with 50 to 2,000 employees, but recently signed several clients with an employee base as large as 8,000.
The Uncommon Market Position
Paycom should capture a growing portion of the market for small-to-midsize businesses.
It faces little competition in the Saas space. In addition, it should benefit from continued growth in the economy and the move of businesses to streamline HCR operations into the cloud.
Paycom will also benefit from rising interest rates.
It controls an average daily balance of $680 million in client payroll funds. Rising interest rates have the potential to pad the bottom line (think of the benefit of a float to banks). That increase is not calculated in the current company projections or growth rates.
A simply quarter-point increase in interest rates has the potential to increase the company’s bottom line by $1.7 million. This equates to an additional growth of 3.3% in the non-GAAP EPS, even if revenue and costs remain static. The larger the move in rates, the greater the benefit to the bottom line.
Given the company’s retention rate of more than 90%, along with current and predicted growth rates, this $680 million average daily balance should increase over the next three to five years. Additionally, if Paycom continues to add larger clients, the 3.3% growth rate per quarter point rise in interest rates is going to prove conservative.
It’s possible, interest rate increases could add 5% to 20% EPS growth over the next three to five years.
What Sets Paycom Apart
-Avoiding the Big Boys
While Paycom isn’t without competition in the small-to-midsize business space, it currently avoids challenging Salesforce.com (CRM) and Workday (WDAY) in favor of the smaller Paylocity Holdings (PCTY).
Currently, it is estimated there are 28.8 million small businesses in the United States alone, defined as businesses with fewer than 500 employees. Cost of health insurance benefits and managing regulatory burdens are two of the top four concerns of small business owners, with economic uncertainty ranking number one.
-High Clients Retention
Once integrated, budget constraints will generally prevent high turnover in smaller businesses.
The cost, plus the time to integrate a new system, creates a sticky client base. The company has achieved a steady 91% annual revenue retention rate from existing clients since 2012, all while growing margins from the mid-teens (16.7%) to 29%.
The result is steady clients with clarity of revenue
-Potential Healthcare Legislation Revenue Neutral
Current concerns regarding potential revenue loss if the Affordable Care Act is repealed seem misplaced and overstated. ACA risk is estimated between 3% and 5% of current revenue. But we view a repeal and replace of ACA as revenue neutral to Paycom.
-A Trusted Brand
A wide suite of product applications with a competitive pricing advantage makes Paycom a staple in the HCM market.
Financials: Paycom by the Numbers
Paycom’s sales growth, earnings-per-share growth, margins, return on equity and return on investment will earn it high marks from momentum investors.
The company recently reported fourth-quarter 2016 revenue of $87.8 million, up 34.8% from the prior year. Earnings before interest, taxes, depreciation and amortization (EBITDA) for the same quarter rose 97.4% and the company produced non-GAAP EPS of $0.18 per share.
For the full year, revenues rose 46.5% to $329.1 million, with non-GAAP EPS of $0.87 per share. EBITBA roared higher by 96.5%, reaching $94.5 million for 2016.
The full year revenue projections of $422 million to $424 million would be a 28% rise. Management has a history of guiding on the conservative side of the playing field. Furthermore, this reduced our concern of the uncertainty surrounding the regulatory environment and possible repeal of the Affordable Care Act.
Why the Stock Is a Buy
Frankly, there are plenty of doubters in the market. But that could set the stock up for a short squeeze.
About one-fourth of the entire stock float is currently short. This is a rare instance where something perceived as negative could turn into something positive for bulls. It’s even understandable when judging Paycom by traditional metrics.
The company’s forward P/E sits in the low 40s, while measurements like Price to Sales or Price to Free Cash Flow push well beyond any limit of value. We’re not concerned with Price to Book, Price to Cash or even Price to Free Cash Flow. While a Price to Sales number under 10 would ease some valuation concerns, Paycom is a subscription-based Saas model and that means recurring sales.
None of Paycom’s value metrics stand out compared to its peers.
In fact, the only metric that does stand out is the short float. Paycom sports a short interest 2.5x greater than Workday and Paylocity. That balloons to 12x compared to Salesforce.com. This creates opportunity because of Paycom’s strengths. Forward P/E, despite its high number, is still lower than major competitors. Add in the strongest growth numbers, highest gross margins and strongest returns on equity and investment and you have all the ingredients for a dynamic short squeeze.
Doubters could morph to forced believers if Paycom continues to drive share price significantly higher, as they are forced to buy shares.
In addition, the company recently completed a $50 million stock repurchase plan and the Board of Directors has authorized an additional $50 million buyback authorization through January 2019.
Paycom screams growth and high margins, but unlike other small-cap growth names, it can significantly benefit from a rising interest rate environment. While shares currently trade with a forward P/E in the low 40s, we believe both Wall Street’s and management’s projections are conservative and pessimistic of little-discussed catalysts like rates and Paycom’s expansion into larger businesses.
Furthermore, the company is repurchasing shares, retaining client revenue rates at 90%+ and increasing margins despite client retention and competing for new clients.
The Technical Analysis — At $70 or lower PAYC is a BUY
Paycom’s lower-left-to-upper-right price action on the weekly chart is the picture of strength. Buy support, sell resistance or hold.
There has been nothing wrong with holding Paycom and even buying on the way up. Timing here is somewhat challenging as the stock’s action will test those without patience. While Paycom has marched higher, it has done so in a stair-step fashion pushing higher in a single week or two, then trying sideways for weeks at a time.
Paycom is currently fading after a recent spike into resistance.
Given the overbought condition found in both the Stochastics RSI and Full Stochastics, investors may be best served patiently awaiting a retest of the support level of the bullish trading channel. We would target $66.67, or even $65, for an entry. The 13-week simple moving average (SMA) has marked the intraweek lows going back to February 2017, which is how we arrive at our $65 target.
Below $65 and we’d anticipate a new trading channel developing between $57.75 and $65. If $65 fails to hold, we wouldn’t look to add to our holding until Paycom traded in the $58 to $60 range.
Catalyst for the Thoughtful Investor
Paycom has begun expanding its largest clients from businesses with 2,000 employees to those with 8,000 employees. While this expansion could place a portion of the business in the cross-hairs of larger competitors, it also increases the potential appeal as an acquisition target buy companies such as Salesforce.com or Workday.
Oracle could also be a suitor, but we would not use that as a primary driver for a bullish argument.
The Bottom Line
- Paycom is a dominant player in the small-to-midsize market for cloud-based human capital management.
- The small-to-midsize continues to grow and strengthen, along with the economy. This, along with a push into larger businesses, creates revenue and earnings growth higher than current projections.
- A rising interest rate environment has the potential to act as a tailwind direct to the bottom line of Paycom.
- In the range of $55 – $60, we posit PAYC a long-term buy and hold, although the small cap nature, high short interest and aggressive growth will make it volatile.
At the time of publication, neither the author nor the company held positions in the stocks mentioned, but positions may change at any time.