With Quiver Quantitative’s recent institutional holdings data, we can see that hedge funds and asset managers have been increasing their holdings in Paycom Software Inc. (NYSE: PAYC). Firms such as Alyeska Investment Group, Dimensional Fund Advisors, and Geode Capital Management have all recently added to their PAYC positions. Most notably, Alyeska Investment Group entered a new position into Paycom Software (as filed on 9/30), bringing their total PAYC holdings to 419,219 shares worth around $81.2 million dollars at current market prices. With this in mind, we took a closer look at some of the reasons why many investors may be bullish on Paycom Software Inc.
In October, Paycom Software released earnings results for the third quarter of FY23. Highlights of the quarter included total revenues of $406.3 million dollars (21.6% increase YoY), GAAP net income of $75.2 million dollars (44.1% increase YoY), and flat total debt at $29 million dollars. Paycom Software CEO and Chairman Chad Richison had this to say about the quarter, “Our third quarter fundamentals were strong with solid revenue and earnings growth. Our innovations have transformed the payroll and HCM industry for 25 years, and we’re excited to deliver even stronger value to our clients for years to come.” Additionally, management provided guidance into FY23 revenue and adjusted EBITDA. Management guided total revenues for FY23 at $1.679 - $1.684 billion dollars, which implies a 22.1% YoY increase in revenue, showing the business’ continued top-line growth. With this earnings result in mind, we believe that Paycom Software is a compelling investment opportunity, especially as the business continues to grow at a steady pace while valuations continue to fall (which we will touch on later in this article).
Paycom Software, a leading provider of cloud-based human capital management (HCM) solutions, offers a comprehensive suite of services delivered as Software-as-a-Service (SaaS). Their product line encompasses the entire employment lifecycle, from recruitment to retirement, including talent acquisition, payroll, and HR management. Predominantly generating revenue through its payroll applications, Paycom's unique selling proposition lies in its single-database, user-friendly platform, which simplifies processes and enhances data integrity without the need for customization. This approach not only streamlines HR operations for businesses but also ensures high client satisfaction and retention, as evidenced by their strong annual revenue retention rates. Paycom's success is underpinned by their direct sales model and commitment to exceptional client service, bolstered by a dedicated team for each client.
The human capital management (HCM) solutions market is dynamic and fiercely competitive, characterized by rapidly evolving technology and varying client demands. Paycom operates in a sector where competition ranges from small, regional firms to large, well-established international entities, each offering diverse product portfolios. Key competitors include prominent companies like Automatic Data Processing, Ceridian HCM Holding, Oracle Corporation, and Workday, among others. This market is primarily driven by factors such as service responsiveness, product quality, breadth of service, and pricing, with the latter being particularly crucial for smaller businesses. Larger enterprises, in contrast, prioritize extensive features and customization options. Across all business sizes, a smooth and efficient implementation experience remains a critical competitive aspect, reflecting the industry's focus on both technological advancement and user experience.
Management is solid, and their capital allocation priorities do a great job of creating long-term shareholder value. Management likes to return excess cash in the form of share repurchases, which help to offset the dilutive nature of the business’ stock-based compensation. In 2016, Paycom Software’s Board of Directors authorized an original repurchase plan, which has been amended and extended over the last seven or so years. As of the end of FY22, there was still around $1.1 billion dollars available for future share repurchases. During FY22, Paycom Software repurchased 364,667 shares of common stock at an average price of $273.74. Historically, Paycom Software share prices have traded at absurd valuations, making share repurchases difficult over the last few years. From 2013 to today, shares outstanding have risen by 13.6%, however, from 2021 to today, shares outstanding have fallen 0.53%. While this decrease in shares outstanding from 2021 to today is essentially irrelevant, it shows a trend. Over the last 2-3 years, share repurchases have eclipsed stock-based compensation, reversing the dilutive effect of SBC. This protects shareholders from further dilution, and we believe that this trend will continue going forward. Additionally, as of the end of FY22, Paycom Software does not offer cash dividends on common stock. We think this is a stellar capital allocation decision based on the businesses stock-based compensation and high return on capital metrics. It makes much more sense, in our eyes, for management to repurchase shares to offset the dilutive effect of SBC and reinvest cash back into the business at high rates of return, rather than paying out dividends. These initiatives create much more long-term shareholder value than dividends.
Looking at management incentives, we can see that Paycom Software’s management team is incentivized well, with a compensation structure that does a great job of aligning shareholder and management interests while also doing a great job of retaining executive talent over the long-term. The executive compensation structure includes a base salary, an annual incentive plan, and equity incentives. The annual incentive plan rewards NEOs for the achievement of pre-established short-term performance objectives, while the equity incentive component rewards NEOs for the completion of long-term corporate performance goals based on share price and TSR (total shareholder return). This incentive structure is great, as management is incentivized to drive strong stock price returns for shareholders. If management is incentivized with millions of dollars to drive strong stock price performance over the long-term, you can best believe it will happen. As the late investor Charlie Munger famously said, “show me the incentive, and I'll show you the result”. Additionally, investors can feel safe knowing Founder and CEO Chad Richison owns nearly 8% of the entire business, with a large majority of his net worth tied up in the business. If the CEO and Founder is confident enough in the business to park a majority of his net worth in it, investors can feel comfortable knowing that the business is being run by a quality management team.
Paycom Software is a very efficient business. The business currently operates at a LTM ROE of 27.1% and a LTM ROIC of 28.2%. With a WACC of 10.7%, Paycom Software operates at a ROIC to WACC ratio of 2.64x. This high ROIC to WACC ratio showcases the business’ ability to generate excess returns on capital relative to the business’ weighted average cost of capital. Businesses that operate with strong returns on capital are compounders, businesses that are able to rapidly compound earnings and intrinsic value over the long-term, much to the delight of long-term passive shareholders. Looking further, we can see that Paycom Software has had stellar sustained growth in operating income (EBIT), with strong EBIT margin expansion over the last ten years. Looking at operating income is important, as it shows the profitability of a business’ core operations. Since 2013, Paycom Software has grown EBIT at a whopping CAGR of 44.6%. This massive growth in EBIT over the last ten years can largely be attributed to expanding EBIT margins. In 2013, Paycom Software operated at an EBIT margin of 8.8% of revenue, compared to today where the business operates at a LTM EBIT margin of 27.6% of revenue.
Analyzing Paycom Software’s income statement, we can see some stellar sustained growth in revenue, gross profit, and earnings within the last ten years. Since 2013, Paycom Software has grown revenue at a CAGR of 29%, with gross profit growing at a CAGR of 29.8% during that same time period. Like many other software businesses, Paycom Software operates with a stellar margin profile. The business has consistently operated at a gross margin above 82% of revenue during the last ten years. Looking at earnings, we can see that Paycom Software has grown EBITDA at a CAGR of 40.3% over the last ten years, with EPS growing at a whopping CAGR of 73.2% during that same time frame. This growth in EPS is almost all because of stellar growth in net income. Over the last ten years, Paycom Software’s shares outstanding have actually risen, diluting shareholders during that time frame and putting sandbags over EPS growth. From 2013 to today, shares outstanding have risen by 13.6%. However, from 2021 to today, shares outstanding have actually slightly fallen due to share repurchases that helped offset the dilutive effect of the business’ share-based compensation. Paycom Software has a relatively low amount of shares outstanding (around 57.7 million shares), meaning that further share repurchases down the line can continue to offset the dilutive effect of share-based compensation while also lowering shares outstanding in the long run.
Looking at Paycom Software’s balance sheet, we can see that the business operates in solid financial health. Paycom Software currently holds around $484 million dollars worth of cash and equivalents on the balance sheet, with no short-term borrowings and very little long-term debt ($29 million dollars). With a net debt of -$455 million dollars (the negative value of net debt suggests that the business has $455 million dollars in surplus cash after all debt has been factored out), Paycom Software has little debt on its balance sheet and plenty of runway to pay off the small amount of debt that it has. For a compounding business like Paycom Software, a low debt load is a great characteristic to have. With management not having to worry about paying down debt, they can put cash into initiatives that create long-term value for shareholders. These initiatives can include things like further share repurchases to offset the dilutive effect of stock-based compensation, reinvestments back into the business at high rates of return, and dividend increases.
Analyzing Paycom Software’s cash flow statement, we can see some stellar sustained growth in net income and free cash flow within the last ten years, showcasing the business’ increased operational efficiency during that time frame. Since 2013, Paycom Software has grown net income at a whopping CAGR of 81.1% (the business operated at a net income of only $740k in 2013, compared to today where it operates at a LTM net income of around $339 million dollars), with free cash flow growing at a CAGR of 45.3% since 2014* (we used 2014 instead of 2013 to calculate FCF CAGR since Paycom Software operated at a negative FCF in 2013). This large growth in FCF can largely be attributed to expanding FCF margins. In 2014, Paycom Software operated at a FCF margin of 5.3% of revenue, compared to today where the business operates at a LTM FCF margin of 18.6% of revenue. Strong top-line revenue growth (10-year revenue growth rate of 29%) and expanding FCF margins act as a “twin engine” for free cash flow generation. As revenue continues to grow at a healthy pace and margins continue to incrementally expand, Paycom Software will be able to compound free cash flow over the long-term. With an ever increasing pile of cash, management can put this cash to use by repurchasing shares, reinvesting cash back into the business at high rates of return, and increasing dividends. All of these initiatives create long-term value for shareholders.
After conducting a reverse discounted cash flow analysis, we can see that Paycom Software is trading at share prices that imply a 19.43% growth rate (CAGR) in free cash flow over the next ten years, using a perpetuity growth rate of 3% (largely in line with US GDP growth) and a discount rate of 10.7% (Paycom Software’s WACC). As discussed above, Paycom Software is a fast growing, high quality business. While Paycom has enjoyed incredible growth over the last ten years, we are skeptical as to whether this high growth will continue, and we believe that a 15% growth rate may be a better valuation to enter a position. Historically, Paycom has traded at extremely high valuations (the stock is down nearly 65% from its peak price of $547/share in October of 2021), and this valuation is very cheap relative to Paycom’s historic valuations. While this is a good sign, we still think that a larger margin of safety is best utilized on businesses like Paycom where high growth is expected to taper off over the long-term. A growth rate of 15% implies a share price of $145.91/share with a downside of around 25%. Please note that these valuations and projections are based entirely on our proprietary models, and we encourage all investors to do their own due diligence before entering a position into Paycom Software.
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