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I have been closely monitoring Paycom Software (PAYC) in that I have been a long-term Automatic Data Processing (ADP) and Paychex (PAYX) shareholder. I was tempted to initiate a PAYC position in early May. However, I opted to wait until the release of Q2 2023 results in early August and acquired Blackstone (BX), BlackRock (BLK), and Agilent (a) shares instead.
Following the release of PAYC's Q2 and YTD2023 results after the August 1 market close, PAYC's share price has plummeted from ~$371 share price to ~$289.
In several previous posts, I have indicated that I am looking to establish a new position or to increase my exposure in great companies that appear to have temporarily fallen out of favour. PAYC is such a company. I have, therefore, initiated a 250-share position at ~$299/share in one of the 'Core' accounts within the FFJ Portfolio.
Business Overview
PAYC was founded in 1998 and became a publicly traded company through an initial public offering in 2014.
It is a leading provider of a comprehensive, cloud-based human capital management ('HCM') solution delivered as Software-as-a-Service. It provides functionality and data analytics that businesses need to manage the complete employment lifecycle, from recruitment to retirement. The solution requires virtually no customization and is based on a core system of record maintained in a single database for all HCM functions (ie. talent acquisition, time and labour management, payroll, talent management and human resources management applications).
The company's website and Part 1 Item 1 in PAYC's FY2022 Annual Report and Form 10-K provides a good overview of the company.
CEO and NEO Compensation
I think CEO and NEO compensation is often obscene relative to all other employees. However, I own so few shares in the companies in which I have exposure that my shareholder votes are irrelevant. I must resign myself to being unable to effect any changes to the compensation structure of senior executives, and therefore, must determine if the compensation structures of CEOs and NEOs align with my long-term interests.
If the long-term incentive component makes up a large percentage of the CEO's and NEOs' compensation structures, I envision they will make decisions that align with my interests.
Based on my review of their compensation structures, it appears they are incentivized to position PAYC to succeed over the very long term; I reference the Compensation Discussion and Analysis component of PAYC's 2023 Proxy Statement that commences on page 40 of 122.
Chad Richison, President, Chief Executive Officer, and Chairman of the Board of Directors founded PAYC. Before founding PAYC, he was a senior manager at ADP.
Mr. Richison has a vested interest in the success of PAYC in that a sizable portion of his ~$2.4B personal net worth is very likely his ownership interest in PAYC.
On the 2023 Forbes list of billionaires, he ranks #1368 and on the 2022 Forbes 400, he ranks #388. These rankings are subject to change.
International Expansion
In July 2021, PAYC launched Paycom’s Beti® (Better Employee Transaction Interface). This enhancement to the existing payroll offering further automates and streamlines the payroll process by empowering employees to do their own payroll, increasing efficiencies and reducing errors. Previously, employees were able to manage all other components of their paychecks, including timecards, expenses, PTO requests and benefits. With this enhancement, employees have the convenience within PAYC to also process their own payroll.
In April 2023, PAYC launched its Global HCM™ Solution (HCM - Human Capital Management). This application allows businesses and their domestic and international employees to manage their HR needs within one, easy-to-use system. With this product, PAYC is now able to expand access to users in more than 180 countries and is available in 15 languages and dialects.
On August 1, 2023, PAYC announced it will expand its payroll solution to all Canadian territories and provinces; PAYC has already had clients on the pilot project for some time. Now, this industry-first single solution for HCM, including employee-guided payroll, is available to support organizations with Canadian employees.
At present, there is no plan to have an office in Canada. It does, however, have a service centre in Canada.
PAYC intends to focus on countries that its US-based clients already have as an opportunity; it has identified ~20 countries that present the most opportunity.
PAYC was held back from going up-market because it did not have international capabilities. Now that it has a Global HCM™ Solution, it can target larger clients.
Cybersecurity Issue
On May 31, one of PAYC's vendors disclosed a previously unknown vulnerability in its MOVEit file transfer software that could enable malicious actors to gain unauthorized access to sensitive files and information.
PAYC continues to evaluate the impact of the Vendor Incident, including certain remediation expenses and other potential liabilities. Currently, PAYC does not believe the Vendor Incident will have a material adverse effect on its business, operations or financial results.
Financials
Q2 and YTD2023 Results
Refer to PAYC's Q2 2023 Earnings Release.
PAYC continues to succeed in selling across its entire target market range. With the recent launch into Canada, it has opened a new large cross-border opportunity. As PAYC continues to expand its geographic reach, management expects the move-up market to continue to accelerate. Given this, PAYC is redefining its target market range to include organizations with greater than 10,000 employees; this is a segment PAYC's sales reps did not previously aggressively pursue. With this new expanded market opportunity, PAYC estimates its market share is well below 5%.
On the Q2 earnings call, management states that it is starting to book larger deals ($2 and $3 million deals) which it had not previously booked. Strong growth is being achieved with 'outside sales' which is typically required when targeting companies with larger payroll and HCM needs; 'Outside sales' experienced the strongest growth in 3 years from a percentage basis.
When it comes to 'inside sales', this is generally done when dealing with small or smaller emerging businesses with 50 or fewer employees. These sales are up YoY.
The Client Relations Representatives ('CRR') Sales metric within PAYC's business model is down Y0Y; this group upsells current clients. The reason these results are weak is that the company is very disciplined when it comes to converting the client base to Beti. This requires much work on the part of the CRRs but there is very little revenue opportunity for them. As a result, PAYC has implemented compensation accelerators to incentivize the group even though it is a smaller revenue product or billing item for PAYC. Management estimates that this course of action has cost PAYC ~$15 - $20 in bookings YTD.
Beti makes servicing clients so much easier. However, while Beti improves PAYC's clients' ROI and dramatically changes the way payroll is done, PAYC is not forcing a client to use Beti. Clients need to be sold on the advantages of using Beti and this can take time. In addition, once a deal is sold, CRRs have to be out there to convert clients. A CRR spends 3 days converting a very small revenue item that produces strong ROI.
PAYC still has ~40% of its client base not on Beti. While Beti is not a significant revenue generator, it produces strong employee and employer advocates. This, in turn, produces more leads for PAYC's outside sales group. With less than 5% market share, PAYC believes it will be able to recapture the delayed opportunities in due time.
As with ADP and PAYX, PAYC benefits from having client deposits from which it can generate additional income; PAYC had, on average, $2.2B in daily 'funds held for clients' in Q2. PAYC strives to earn 80% - 90% of the Fed funds rate. In a rising interest rate environment, PAYC typically generates ~$5 million annually with every 5 basis point increase.
FY2023 Outlook
Outlook With The Release Of Q4 and FY2022 Results
PAYC's initial FY2023 outlook used the 'Rule of 65'. This is the estimate of the implied revenue growth rate plus adjusted EBITDA margin.
It forecast FY2023 revenue of $1.7B - $1.702B or ~24% YoY growth at the midpoint of the range. In addition, the adjusted EBITDA forecast was $0.7B - $0.702B, representing an adjusted EBITDA margin of ~41% at the midpoint of the range.
Outlook With The Release Of Q1 2023 Results
With the release of strong Q1 results and an encouraging outlook for the remainder of the current fiscal year, management expected to exceed the 'Rule of 65'.
The revenue outlook was raised to $1.713B - $1.715B or ~25% YoY growth at the midpoint of the range. The adjusted EBITDA forecast was also revised to $0.717B - $0.719B, representing an adjusted EBITDA margin of ~42% at the midpoint of the range.
Outlook With The Release Of Q2 2023 Results
Management has now revised the 'Rule of 65" to the 'Rule of 67'.
PAYC now expects FY2023 revenue of $1.715B - $1.717B or ~25% YoY growth at the midpoint of the range. The adjusted EBITDA forecast is now $0.722B - $0.724B, representing an adjusted EBITDA margin of ~42% at the midpoint of the range.
In Q3, management expects total revenue of $0.41B - $0.412B or $410 million to $412 million or ~23% YoY growth at the midpoint of the range. The Q3 adjusted EBITDA forecast is ~$0.156B - $0.158B, representing an adjusted EBITDA margin of ~38% at the midpoint of the range.
Free Cash Flow (FCF)
In FY2014 - FY2022, PAYC generated FCF of (in millions of $) 8.07, 26.42, 55.01, 70.76, 124.91, 131.33, 133.11, 193.17, and 228.31. In the first half of FY2023, PAYC generated $168.6 million of FCF versus $101.3 million in the first half of FY2022.
Credit Ratings
PAYC has minimal debt, and therefore, no rating agency rates PAYC's debt.
At the end of Q2, PAYC has ~$536.5 million of cash and cash equivalents. Its Current Liabilities before client funds obligation is ~$180.6 million. In addition, it has Deferred income tax liabilities of ~$143 million, Other long-term liabilities of ~$83.1 million, and $29 million in long-term liabilities. These liabilities total $435.7 million. The ~$103 million in Long-term deferred revenue represents funds PAYC from clients in advance of providing services. I, therefore, exclude this amount to arrive at the $435.7 million.
PAYC has sufficient cash and cash equivalents to fully offset all its liabilities with ~$100 million remaining.
I reference Note 6 - Long-Term Debt in PAYC's Q1 2023 Form 10-Q (page 12 of 80); the Q2 2023 Form 10-Q is unavailable as I compose this post. The long-term debt at the end of Q2, however, is $29 million which is identical to the balance owing at the end of Q1. This balance is owed under PAYC's July 2022 Revolving Credit Agreement that is due July 29, 2027.
Various financial covenants in PAYC's debt agreements include the need to maintain established interest coverage ratios and to not exceed established leverage ratios. The agreements also contain other customary covenants, none of which are restrictive to PAYC's operations. At the end of Q2 2023, PAYC complies with all debt covenants.
On August 1, PAYC disclosed a $0.35B increase to its credit facility from $0.65B to $1B.
Dividend and Dividend Yield
On May 2, 2023, PAYC announced that its Board adopted a dividend policy. The first quarterly dividend was declared on May 15, 2023 for distribution on June 12 (see dividend history). On July 31, it declared its 2nd $0.375 quarterly dividend which is to be distributed on September 11. The aggregate amount of cash payable under this dividend policy is likely to be ~$91 million annually.
Using my ~$299 purchase price, the dividend yield is 0.05%.
This low dividend yield is likely to dissuade some investors from investing in the company. Investors, however, should focus on an investment's total potential long-term investment return. The bulk of PAYC's future total investment return is likely to continue to be predominantly in the form of capital appreciation.
PAYC's weighted average shares outstanding in FY2014 - FY2022 are (in millions of shares) 52, 58, 59, 59, 59, 58, 58, 58, and 58. The diluted weighted average shares outstanding in Q2 2023 is 58.
In May 2016, PAYC's Board authorized a stock repurchase plan allowing for the repurchase of shares of common stock in open market transactions at prevailing market prices, in privately negotiated transactions or by other means in accordance with federal securities laws.
Since the initial authorization of the stock repurchase plan, PAYC's Board has amended and extended and authorized new stock repurchase plans from time to time. Most recently, in August 2022, the Board authorized the repurchase of up to $1.1B of common stock. At the end of Q2 2023, there was $1.1B available for repurchases under our stock repurchase plan.
Valuation
PAYC's FY2014 - FY2022 diluted PE levels are 117.59, 66.90, 75.78, 73.32, 92.90, 160.37, 140.74, and 72.17.
While the historical PE levels are high, this is a rapidly growing company. PAYC's FY2014 revenue (the year it went public) was $151 million. In FY2022, its revenue was $1.375B. Total revenue for the first half of FY2023 is ~$0.853B. PAYC has also expanded its capabilities thus opening new target markets.
PAYC's valuation is high if we look at the P/E metric in isolation. Using my ~$299 purchase price and the current broker estimates, the following are the forward-adjusted diluted PE levels:
- FY2023 - 21 brokers - mean of $7.68 and low/high of $7.50 - $7.78. Using the mean estimate, the forward-adjusted diluted PE is ~39.
- FY2024 - 21 brokers - mean of $9.24 and low/high of $8.50 - $9.56. Using the mean estimate, the forward-adjusted diluted PE is ~32.4.
- FY2025 - 11 brokers - mean of $11.23 and low/high of $10.52 - $11.79. Using the mean estimate, the forward-adjusted diluted PE is ~26.6.
PAYC generated ~0.169B in FCF in the first half of FY2023. If it generates a similar amount in the second half of FY2023, we get an FY2023 FCF of $0.338B. The weighted average diluted shares outstanding are ~58 million. We get an FCF/share value of $5.83 and a P/FCF value of ~51.3 using my ~$299 purchase price.
Although the valuations reflected above are very high, PAYC has minimal debt and tremendous growth opportunities.
Final Thoughts
Currently, PAYC has minimal debt. PAYC credit facility, however, is now $1B (previously $0.65B). I suspect PAYC might be looking to make a strategic acquisition in the not-too-distant future.
As noted at the outset of this post, I have been an ADP and PAYX shareholder for a long time. I would be naive to think that some of their clients may not switch to PAYC. If ADP and PAYX lose clients to PAYC, I hope to offset their losses with PAYC's gains.
Following PAYC's Q2 and YTD2023 earnings release, the share price has fallen ~$82. Despite this decline, the valuation is still high. We should, however, step back and look at PAYC's growth opportunities.
PAYC historically targeted companies with fewer than 2000 employees but with its Global HCM™ Solution, it has increased its target market to companies with 10,000+ employees. In addition, it plans to expand the countries it serves from the US and Canada to upwards of ~20 countries.
I have been looking to:
- establish a new position; or
- increase my exposure
to great companies that appear to have temporarily fallen out of favour. PAYC appears to be such a company.
I wish you much success on your journey to financial freedom!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclosure: I am long PAYC.
Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.
I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.
