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In my August 3 Paycom Software (PAYC) post, I disclosed a new 200-share position in one of the 'Core' accounts within the FFJ Portfolio. I subsequently made a 50-share purchase on August 3 and another 50-share purchase on September 20. Fast forward to October 31 after the market close and PAYC released its Q3 and YTD2023 results and outlook for Q4 and FY2023. Following the October 31 release of Q3 and YTD2023 results and a weaker-than-expected revenue growth outlook, Paycom Software has been punished. On November 1, its share price plunged ~$94/share or ~38.50%!
If I step back and look at the big picture, however, I remain optimistic about PAYC's long-term outlook.
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 provide a good overview of the company.
CEO and NEO Compensation
The extent to which a company's CEO and Named Executive Officers (NEO) have 'skin in the game' matters greatly to me. Since I own so few shares in the companies in which I have exposure, my shareholder votes are irrelevant. I must, therefore, 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.
Page 46 of 122 of the 2023 Proxy Statement reflects the following:
In 2022, approximately 49% of our Chief Executive Officer’s total compensation was at risk. If the grant date fair value of Mr. Richison’s 2020 CEO Performance Award is annualized over the five-year period during which he is not eligible for additional equity awards, approximately 96% of his total compensation in 2022 was at risk. On average, approximately 74% of the total compensation for our other NEOs in 2022 was at risk. The overall design of our compensation program is intended to support a strong pay-for-performance culture and encourage longevity, sustained performance and retention of our NEOs, resulting in a dynamic compensation structure that aims to ensure alignment between the interests of our NEOs and the interests of our stockholders.
PAYC's senior executives are heavily incentivized to focus on PAYC's long-term success.
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.
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.
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.
In my August 3 post, I noted that PAYC had just announced the expansion of 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.
On October 31, PAYC announced that it is expanding its global payroll product to include Mexico.
Financials
Q3 and YTD2023 Results
Refer to PAYC's Q3 2023 Earnings Release.
In Q3, PAYC generated revenue of $406.3 million, a ~22% increase from Q3 2022. This growth, however, was below the company's guidance range as a result of lower-than-expected service revenues and unscheduled payroll runs.
PAYC's Client Relations Representatives ('CRR') also continue to focus on Beti® adoption and overall system usage which is resulting in lower cross-selling revenues.
Essentially, the adoption and usage of Beti® are creating value for clients as they experience perfect payrolls and eliminate errors, corrections and unscheduled payrolls; these would otherwise be billable items. With an increase in the number of clients seeing the benefits Beti® offers, the elimination of certain billable items is cannibalizing a portion of PAYC's services and unscheduled revenues.
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.
The outlook for Q1 and FY2023 was:
- Q1 total revenue of ~$0.443B - ~$0.445B, representing a growth rate over Q1 2022 of ~26% at the midpoint of the range;
- Q1 adjusted EBITDA of ~0.210B - ~$0.212B, representing an adjusted EBITDA margin of ~48% at the midpoint of the range.
- FY2023 total revenue of ~$1.713B - ~$1.715B, representing a growth rate over Q2 2022 of ~25% at the midpoint of the range.
- FY2023 adjusted EBITDA of $0.7B to $0.702B, representing a growth rate 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 outlook for Q2 and FY2023 was:
- Q2 total revenue of ~$0.397B - ~$0.399B, representing a growth rate over Q2 2022 of ~26% at the midpoint of the range;
- Q2 adjusted EBITDA of ~0.152B - ~$0.154B, representing an adjusted EBITDA margin of ~38% at the midpoint of the range.
- FY2023 total revenue of ~$1.713B - ~$1.715B, representing a growth rate over Q2 2022 of ~25% at the midpoint of the range.
- FY2023 adjusted EBITDA of $0.717B to $0.719B, representing a growth rate of ~42% at the midpoint of the range.
Outlook With The Release Of Q2 2023 Results
Management revised the 'Rule of 65" to the 'Rule of 67'.
The outlook for Q3 and FY2023 was:
- Q3 total revenue of ~$0.41B - ~$0.412B, representing a growth rate over Q3 2022 of ~23% at the midpoint of the range;
- Q3 adjusted EBITDA of ~$0.156B - ~$0.158B, representing an adjusted EBITDA margin of 38% at the midpoint of the range;
- FY2023 revenue of ~$1.715B - ~$1.717B, representing a growth of ~25% YoY at the midpoint of the range; and
- FY2023 adjusted EBITDA of ~$0.722B - ~$0.724B, representing an adjusted EBITDA margin of ~42% at the midpoint of the range.
Outlook With The Release Of Q3 2023 Results
Throughout 2023, PAYC has been seeing a moderating upside to its guidance model, which corresponds with increased Beti® usage and inflation headwinds that impact each client differently. As noted earlier, the improved efficiency and accuracy resulting from the increased usage of Beti® are eliminating certain billable items. This is cannibalizing a portion of PAYC's services and unscheduled revenues.
The outlook for Q4 and FY2023 is now:
- Q4 2023 total revenue of ~$0.42B - ~$0.425B, representing a growth rate over Q4 2022 of ~14% at the midpoint of the range;
- Q4 adjusted EBITDA forecast of ~$0.169B - ~$0.174B, representing an adjusted EBITDA margin of 41% at the midpoint of the range;
- FY2023 revenue of ~$1.679B - ~$1.684B or growth of ~22% YoY at the midpoint of the range; and
- FY2023 adjusted EBITDA of ~$0.712B - ~$0.717B. This is an adjusted EBITDA margin of ~43% at the midpoint of the range.
The FY2023 outlook is well below PAYC's previous guidance. The company, however, is on track to achieve the 'Rule of 65'.
PAYC has a number of strategic initiatives it believes will further strengthen the value clients receive from its offering. While the success of Beti® will negatively impact PAYC's results in the short term, decisions are being made on what PAYC feels is best for its long-term client relationship.
PAYC's guidance for the next 15 months calls for 2024 YoY revenue growth of 10% - 12%. This is well below the FY20217 - FY2022 growth rates of 31.6%, 30.8%, 30.3%, 14.1% (COVID), 25.4%, and 30.3%.
Formal FY2024 guidance is to be provided in early February 2024.
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 9 months of FY2023, it generated $214.8 million of FCF versus ~$144.6 million over the same timeframe in FY2022.
Credit Ratings
PAYC has minimal debt, and therefore, no rating agency rates its debt.
At the end of Q3, PAYC has ~$484 million of cash and cash equivalents. Its Current Liabilities before client funds obligation is ~$168.3 million. In addition, it has:
- deferred income tax liabilities of ~$145.5 million;
- other long-term liabilities of ~$84.8 million; and
- $29 million in long-term liabilities.
These liabilities total $427.6 million. The ~$105.6 million in Long-term deferred revenue represents funds from clients in advance of providing services. I, therefore, exclude this amount to arrive at the $427.6 million.
PAYC has sufficient cash and cash equivalents to fully offset all its liabilities with ~$56.4 million remaining.
I reference Note 6 - Long-Term Debt in PAYC's Q2 2023 Form 10-Q (page 12 of 210); the Q3 2023 Form 10-Q is unavailable as I compose this post. The long-term debt at the end of Q3, however, is $29 million which is identical to the balance owing at the end of Q2. This balance is owed under PAYC's July 2022 Revolving Credit Agreement and is due July 29, 2027.
Various financial covenants in PAYC's debt agreements include the need to maintain established interest coverage ratios and 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; this increase is timely and I refer to the Share Repurchases section below.
Dividend and Dividend Yield
On May 2, 2023, PAYC announced that its Board adopted a dividend policy (see dividend history). On October 30, PAYC declared its 3rd consecutive $0.375/share quarterly dividend. This is to be paid on December 11 to all stockholders of record as of the close of business on November 27.
With shares trading at ~$150, the dividend yield is ~1%.
Despite PAYC's recent share price performance, I still envision the bulk of PAYC's future total investment return will 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. In Q3, PAYC repurchased over $76 million worth of stock; the diluted weighted average shares outstanding in Q3 was 57.966 million versus 58.033 million in Q2 and 58.175 million in FY2022.
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, 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 Q3 2023, PAYX had $1B available for repurchases under its stock repurchase plan.
Given PAYC's:
- repurchase availability under its stock repurchase plan;
- share price plunge;
- $1B credit facility;
- low leverage; and
- profitability
I anticipate it will enter into an accelerated share repurchase plan and will use a portion of its credit availability. The portion used to repurchase shares will likely be termed out thus increasing PAYC's long-term debt. I am confident, however, that PAYC will be prudent when deciding how much to borrow.
Before the release of Q3 results, PAYC's shares traded at ~$245. Following the earnings release, shares closed at ~$150. If it were to repurchase $0.3B at ~$245/share, for example, PAYC would reduce the share count by ~1.2 million shares. With the drop in the share price, it could repurchase ~2 million shares.
Naturally, PAYC is unlikely to repurchase shares all in one fell swoop. This, however, gives us an idea of just how advantageous a significant share price decline can be when the underlying business has not fundamentally changed.
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. In the first 9 months of FY2023, revenue was ~$1.259B and ~$0.853B in the first half of FY2023.
My initial purchase price was ~$299 purchase price at which time the forward-adjusted diluted PE levels using current broker estimates were:
- FY2023 - 21 brokers - ~39 using the mean of $7.68 and low/high of $7.50 - $7.78.
- FY2024 - 21 brokers - ~32.4 using the mean of $9.24 and low/high of $8.50 - $9.56.
- FY2025 - 11 brokers - ~26.6 using the mean of $11.23 and low/high of $10.52 - $11.79.
PAYC generated ~0.169B in FCF in the first half of FY2023. If it were to generate a similar amount in the second half of FY2023, FY2023 FCF would be ~$0.338B. The weighted average diluted shares outstanding were ~58 million thus giving us an FCF/share value of $5.83 and a P/FCF value of ~51.3 using my ~$299 purchase price.
PAYC has generated $1.77 and $5.84 in Q3 and YTD2023 adjusted diluted EPS. The forward-adjusted diluted PE levels using current broker estimates and the current ~$150 share price are:
- FY2023 - 20 brokers - ~19.7 using the mean of $7.62 and low/high of $7.32 - $7.75.
- FY2024 - 20 brokers - ~18.1 using the mean of $8.27 and low/high of $7.57 - $9.53.
- FY2025 - 13 brokers - ~15.3 using the mean of $9.82 and low/high of $8.48 - $11.80.
PAYC generated ~$0.215B of FCF in the first 9 months of FY2023 and ~$0.169B in the first half of FY2023 with the difference being $46 million of FCF generated in Q3. If it were to generate $40 million of FCF in Q4, FY2023 FCF would be ~$0.255B. The weighted average diluted shares outstanding in Q3 were ~58 million thus giving us an FCF/share value of $4.40 and a P/FCF value of ~34 using a ~$150 share price.
These figures will change if PAYC capitalizes on its decimated share price to reduce the weighted average diluted shares outstanding. Furthermore, some analysts likely have yet to revise their earnings estimates.
Final Thoughts
On the Q3 call with analysts, Mr. Chad Richison, President, CEO and Chairman noted:
So we don't necessarily do what's easy. We do what creates value for our clients and drives the return on investment. And when we stay disciplined doing the right things, we accelerate opportunities for ourselves, the client and consequently drive shareholder value, which is very important to me personally.
Over 15% of all outstanding shares are held by insiders. Mr. Richison has a vested interest in the success of PAYC in that a sizable portion of his personal net worth is very likely his ownership interest in PAYC.
My PAYC purchases were premature and I should have been more patient. Now, despite the forecast reduction in PAYC's sales growth over the next 15 months, I think shares are undervalued.
I should be adding to my PAYC but I am building cash reserves for purposes other than investing. Regrettably, I am unable to take advantage of PAYC's very attractive valuation. I, therefore, hope that with shares having been punished, PAYC will repurchase a significant number of shares.
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.
