Company Overview
Paycom software is a human capital management (HCM) system. It provides talent acquisition, talent management, time and labor management, payroll, HR management and more. Paycom claims that it reduces costs, improves employee engagement and streamlines business operations. Paycom also allows employees to access and manage their own HR and payroll data through a single app. This reduces data entry errors and increases data integrity. Paycom offers dedicated service representatives to its customers. Paycom's single system offers a seamless user experience with one login and password.
Paycom has 2 main advantages. The first is that the software was completely developed in house. That means that it is not a patched together solution of multiple systems. It also means that everything that Paycom provides operates from a single data base. This eliminates repeated data entry and reduces incorrect information in the data base.
The second advantage is Beti. This application allows employees to manage, verify and approve their own payroll before submission. This reduces errors and increases accuracy. Beti's self-service payroll technology streamlines and automates payroll for businesses and their employees.
The market for HCM software was 23.60 billion in 2021. It's projected to grow at a CAGR of 9.1% to reach 46.85 billion by 2029. There are tailwinds including:
growing automation
increasing adoption of cloud-based HCM solutions
increasing need for talent acquisition and management
integration of advanced technologies like AI and chatbots.
HCM software providers compete on product and service quality, reputation, ease of use, breadth of offerings, and price.
Paycom had $1.3 billion in revenue in 2022, growing revenue by 30% between 2021 and 2022. Paycom has a 10-year CAGR of 33% for revenue and has grown earnings by 66.8% over the past 10 years. For comparison, ADP had revenue of $16.6 billion, with a 10-year CAGR of 4.11%. Paychex had $4.9 billion in revenue with a 10-year CAGR of 7.96%.
Investment Thesis
Paycom got my attention in a screen. It shows high rates of growth in revenue, earnings, operating and free cash flows. The company is well managed with very little debt and good capital allocation. Paycom operates in a large and growing industry. Investing in payroll and HR software is a large decision, with high switching costs. This provides a natural moat for HCM software companies. Paycom has a few other advantages besides this switching moat.
Paycom offers a single software platform that manages employees from recruitment to retirement. It is the only HCM software that I have found that operates on a single data base.
Beti allows employees to manage their own data. This reduces mistakes, as well as administrative tasks for the HR department.
Paycom's dedicated customer service model is also unique. This dedicated customer service is only available during business hours.
Paycom's stock has seen a significant sell off since last fall. It currently trades at just under $300. This is much lower than the 52-week high of $402. Paycom has also seen margin compression since last fall. It currently trades at a PE of 60, down from a PE of 168 in September of 2021.
Paycom's stock has declined for a variety of reasons. Some of the possible factors that have contributed to Paycom's stock decline are:
High inflation and rising interest rates which might have reduced the attractiveness of high-growth cloud stocks like Paycom.
High valuation and profit-taking which might have led some investors to sell their shares after a strong rally.
Fear of an upcoming recession due to the Fed's hiking of interest rates to fight inflation.
Despite the sell-off, Paycom has continued to deliver strong revenue and earnings growth. This presents a potential opportunity if the growth trajectory remains intact.
Industry Analysis
Let's take a look at some of Paycom's competitors.
First up is ADP. They are likely the largest player in this space. They provide many of the same services as Paycom. One difference is that ADP breaks it's platform into different packages and products.
Additional advantages that ADP has are:
Scale and market leadership: ADP is the largest provider of payroll and HR solutions in the world, serving over 800,000 clients in more than 140 countries. ADP has the most complete portfolio of products and services in the HCM market, covering all aspects of payroll, time and attendance, talent, benefits and HR services. ADP also has the broadest market coverage by geography and client size, ranging from small businesses to large multinational corporations.
Long-standing customer relationships: ADP has a high customer retention rate of over 90%, reflecting its loyal and satisfied customer base. ADP has been serving some of its clients for over 50 years, building trust and credibility in the market. ADP also provides dedicated service and support to its clients, with specialists who understand their business needs and offer best-practice guidance.
Innovation and technology: ADP invests heavily in research and development, spending over $1 billion annually on innovation. ADP also offers data-driven insights through its ADP DataCloud platform, which helps clients measure, compare, predict and apply insights from ADP's workforce data.
Next is Paychex. Some of Paychex's competitive advantages are:
Personalized service and support: Paychex provides a dedicated payroll specialist for each client, who acts as a single point of contact for all payroll and HR issues. Paychex also offers 24/7 customer service through phone, email and chat. Paychex also provides customized solutions for different industries, such as restaurants, health care, manufacturing and construction.
Brand recognition and loyalty: Paychex is one of the largest and most trusted providers of payroll and HR services in the U.S., serving over 680,000 clients across 100 locations. Paychex has a high customer retention rate of over 80%, reflecting its customer satisfaction and loyalty. Paychex also has a strong reputation in the market, having won several awards and recognitions for its products and services.
For comparison, Paycom has approximately 36,600 clients. Their revenue of $1.3 billion is significantly lower than ADP's revenue of $16.6 billion, and Paychex's $4.9 billion in revenue.
Financial Analysis
As I've stated, Paycom is growing at a high rate. Analysts predict 20% to 25% growth for Paycom in the next 5 years. That's much higher than the 13% predicted for ADP and the 8.3% predicted for Paychex.
Paycom has strong margins with a gross margin of 84% and an operating margin of 27%.
Management has done a good job, with very little debt and a high ROE of 23%. The ROIC is essentially the same due to the low debt load.
Paychex has a gross margin of 70% and an operating margin of 39%. They show a ROIC of 35% and a ROE of 45% due to a higher debt load than Paycom.
ADP has a gross margin of 41% and an operating margin of 20%. Their ROE is typically around 40% with a ROIC around 30%.
Valuation
I'm going to use a DCF for Paycom because it's the most appropriate way to analyze a fast growing company like Paycom. Using a growth rate of 22.5% and a PE of 45 with a 15% discount rate, we find Paycom is worth around $420 today. That puts Paycom at around a 28% discount to fair value.
Risk Analysis
Paycom faces macroeconomic risks. It hasn't been through a recession and if one shows up, we don't know how they'll perform. The low debt load and high gross margins make it unlikely that Paycom will go bankrupt. But Paycom bills per employee. They also don't have long term contracts. Customers can cancel service with 30 days written notice. If unemployment rises, revenue could take a serious hit.
Next, is the possibility that Paycom can't continue to grow at the rates it has been. Paycom is a small player in the space. Their fast growth could be related to their size, or because they are a niche player. There is an argument to be made that Paycom can't grow into the still-lofty PE ratio it currently sells at.
There's also an argument to be made that Paycom's solution is not particularly unique. ADP is huge. They claim their giant data base offers significant advantages and insights to customers. Paychex offers Pre-Check. This program allows employees to check their pay before the check is cut, offering many of the same advantages as Beti.
I ran searches like "best HCM software for medium sized business." This research did not turn up any articles that recommended Paycom as #1. In fact, most articles didn't mention Paycom at all. Paycom has been spending a lot on marketing. The CEO letter mentions the following:
We spent aggressively on advertising in 2022, and our deliberate investments in marketing contributed to high-margin revenues. We featured multiple campaigns that resulted in 2.6 billion impressions, driving quality demo leads for our sales teams
They have brought on celebrities including:
Barbara Corcoran of Shark Tank
Shemar Moore in their "Unnecessary Action Hero" campaign
social media influencer Corporate Natalie in Beti-focused TV spots
professional golfer Vikto Hovland as a brand ambassador
It's possible that Paycom is a very good sales company with an OK product. They only sell through their own sales team. Many of their competitors have partners such as Paychex who says:
we utilize other indirect sales channels such as our relationships with existing clients, certified public accountants (“CPAs”), and banks for new client referrals. More than 50% of our new small-market payroll clients (excluding business acquisitions) come from these referral sources.
Paycom does appear to have a unique salesforce. The majority of their salespeople have a four-year degree and are recruited from other successful sales positions. Their model is that when they open a new sales office, they appoint a sales manager. This person then recruits their own sales team. Paycom appears to generously compensate their salespeople with commissions, incentivizing sales. Their customer service representatives are also incorporated into their sales teams. This encourages good follow up, service and customer retention.
Conclusion and Recommendation
Paycom operates in a growing and necessary market. Their solution does appear to have some advantages. They have good customer ratings and their retention rate of over 90% backs this up. But I could not identify features unique enough to give them a clear advantage over their competitors. It is possible that Paycom’s growth is due to their small size. They may operate in a niche market which will prevent them from scaling at the rate they have been. Their primary moat is a switching moat. Their competitors all have the same moat. That means that Paycom may have a hard time taking market share from their larger competitors.
I cannot convince myself that Paycom's solution is particularly unique. I also don't feel confident predicting that they can continue to grow at the same rate long into the future. Because of these issues, I'm placing Paycom in the too hard box and passing on the stock.
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