Description

Business Model:

Paycom provides a comprehensive, cloud-based payroll and human capital management (HCM) software solution that is delivered to companies as software as a service (SaaS). This solution provides data and analytics that enable businesses to manage the complete employment life cycle of their employees from recruitment to retirement across multiple functions of HCM (talent acquisition, time and labor management, payroll, talent management and human resources). Paycom’s key advantage is that its solution operates on a single database, which allows customers to access all of their data seamlessly on one platform, rather than across multiple different databases for their various human resource or payroll needs. The Company focuses primarily on small and medium sized businesses in the 50-2,000 employee range (from which it generates 86% of its revenue) and produces new revenue via its fleet of 36 local sales teams (up 57% over the last 3 years). Paycom’s business is characterized by high predictability, stable revenue, and attractive margins. Over the past 3 years, Paycom’s annual revenue retention rate has been 91%, while annualized new recurring revenue (ANRR), or the annualized amount of new revenue signed during a period and a key indicator for future growth, has increased by 159%. The Company came public on April 14, 2014 at $15 per share.

According to the International Data Corporation, the US market for HCM applications will total $7.0 billion in 2015, with an additional $16.8 billion coming from payroll services, resulting in a total addressable market in the US of almost $24 billion. The HCM and payroll provider industry is highly competitive, with multiple players competing for market share in this large, but essentially mature, market. In addition to an estimated 40% of companies utilizing in-house software for their HCM needs, Automatic Data Processing (ADP) is the largest player and direct competitor to Paycom, with Ceridian, Paychex, The Ultimate Software Group, and Paylocity serving as other large providers of full outsourced solutions (there are a handful of up and coming competitors as well, like Zenefits and ZenPayroll). Paycom also competes with various other companies that focus on specific parts of the HCM and payroll suite, such as Workday, Intuit, Cornerstone OnDemand, Oracle, and SAP.

Customers typically choose an HCM provider based on a few key attributes: ease of use across business facets, breadth and quality of service, quality and knowledge of sales and service professionals, and cost. In speaking with a few Paycom customers, reviews on the Company’s solution were mixed. One prospective customer was impressed with the solution but was not impressed with the quality of the salesperson, and instead chose an alternative provider that aggregates multiple databases into a single solution. This customer noted she chose to stop using ADP because of cost and left Paychex because the offerings weren’t integrated into a single solution. Importantly, she also noted that in almost all of the solution options she reviewed more recently, a single, easy to use, integrated platform was available (reducing the perceived edge that Paycom claims to have). One current Paycom customer noted she is unhappy with the functionality and data analytics of Paycom’s system and prefers various other payroll systems that she’s used at prior companies. She also noted that in her one year of using Paycom, she’s already had three different service contacts. The third customer was much happier with Paycom’s solution, having used it for 5 years, and enjoyed both the ease of use of the online system as well has having a dedicated support person. This customer had used ADP previously and decided to change because of cost.

Management:

Chad Richison, President, Chief Executive Officer, and Director, founded Paycom in 1998. Mr. Richison began his career in sales with ADP. He then moved to Payroll 1 prior to founding Paycom. Mr. Richison currently owns 10.7 million shares of PAYC, or 19% of the Company, equivalent to $353.8 million. In 2014, he received $1.4 million in cash compensation, resulting in a 252.7x ownership to salary ratio.

Investment Thesis:

Although Paycom operates an attractive business model that will continue to grow into the future, the current valuation has gotten well ahead of itself. The Paycom investment thesis over the long term is predicated on a re-rating in the multiple back to more normalized levels based on the value of future free cash flows given the Company’s revenue growth will continue to decline looking forward as competitors reduce Paycom’s competitive advantage.

Paycom has been able to grow rapidly by taking market share in recent years largely due to its early mover advantage of having a solution offered on a single database across a single platform. More recently, however, Paycom’s competitors have been devoting resources to develop their own SaaS offerings that more seamlessly integrate their databases into a single solution. ADP, for example, migrated almost 100,000 existing customers in the small and medium-sized enterprise payroll space to its cloud platforms (which now total over 430,000 customers) in 2014 and expects to migrate all small businesses to its cloud payroll platform in 2015. Beyond payroll, ADP announced that growing its integrated suite of cloud-based HCM products is one of its 2015 “pillars for growth.” In addition, Paychex, which primarily competes for customers with fewer than 50 employees, introduced its Flex SaaS platform in October 2014 and has seen strong demand for its payroll offering. These moves will likely enable incumbents to improve their retention rates while also reducing any early mover technology advantage that Paycom currently enjoys, both of which negatively impact the Company’s future growth potential.

Paycom’s revenue growth is driven by growth in ANRR, which is driven by growth in the number of mature sales teams and growth in the amount of revenue generated per sales team. Looking forward, while the number of sales teams should continue to increase (management stated it believes it can support over 100 offices, versus 35 today), given limiting factors on the number of offices that can be opened in a single year (sourcing of office space, grooming team members to lead new offices, hiring supporting team members to fill offices, etc.), the rate of this growth should naturally decrease. In order to grow ANRR/team, Paycom must 1) sell to more customers per team each year, 2) sell more offerings to each customer (i.e. higher revenue per customer), or 3) sell to larger customers (Paycom generates revenue on a per employee basis). ANRR/team growth slowed to 24% in 2014 from 34% in 2013, and should continue to slow going forward until ultimately turning negative as each of the above three factors begins to impact growth: 1) the law of large numbers will make it difficult to grow the absolute number of new customers per team each year (a single person can only sell to so many customers in a year), 2) although Paycom continues to develop new offerings that can generate incremental revenue, as competitors continue to hone their offerings to more streamlined single solutions (as discussed above), pricing for Paycom’s offerings will come under pressure as any existing technology advantage that Paycom has is eliminated (as noted in the customer conversations, cost is a major consideration and customers are eager to switch to a solution that can save them money), 3) while Paycom has successfully signed some larger customers recently, attempts to move into the larger enterprise space will be difficult given the complex customizations that those customers require and entrenched competitors. As a result, Paycom’s rate of revenue growth will likely slow from 40% in 2014 to 36% in 2015 to the high teens range by 2018, to roughly 10% within 10 years, while the all-important forward-looking ANRR growth slows materially from 42% in 2014 to 34% in 2015 to 11% in 2018.

On the margin side, most of Paycom’s operating leverage will be driven by G&A given sales and marketing and operating expenses should largely increase in-line with revenue growth and R&D was only 2.9% of revenue in 2014. While G&A (23.5% of 2014 revenue) is unlikely to grow at the same pace of revenue, it will continue to increase as more offices are opened and employees are hired. Although Paycom has not explicitly guided to run-rate margin, in my conversation with the Company, it did note that a reasonable target EBITDA margin is in the mid-to-high 20% range over the long term (versus 18% in 2014). However, even if the Company were to achieve the high end of this margin range, the resulting free cash flow profile would still fall short of the free cash flows used by the Street to justify the current stock price.

Valuation:

On a trailing basis, Paycom currently trades at multiples of 11.1x EV/sales, 54.9x EV/EBITDA, and 130.3x P/E. Given the growth profile of the business, it makes the most sense to value Paycom using a DCF approach. Note that the price targets below use a diluted share count of 59.3 million, which includes the 2.7 million restricted shares that vest upon Paycom achieving an enterprise value of $1.8 billion.

Base: The base case incorporates many of the competitive headwinds outlined above that will likely impact both revenue growth and margin expansion. I assume that the number of average mature sales teams grows at an annualized rate of 11.6% over the next 10 years (5 teams added every year). However, after continuing to grow through 2016, ANRR per sales team and revenue per customer begin to decline slightly as a result of pricing pressure from competitors before stabilizing roughly 10% higher than 2014’s level. As a result, revenue grows at an annualized rate of 16.4% for the next 10 years before growing at 4% in perpetuity. On the margin side, I assume that EBITDA margin approaches ~31% (above the range outlined by management). The resulting cash flows discounted at a WACC of 9.7% imply a base case price target of $21.88, 39% below where the stock trades today, demonstrating how susceptible the value of these cash flows is to potential competitive pressures. At $21.88, Paycom would trade at a 2015 multiple of 6.0x EV/sales, roughly equal to its valuation at IPO.

As a point of reference, Concur, which operates a similar business model and had a similar growth profile as Paycom was acquired by SAP in September 2014 for ~8.4x estimated FY2015 sales.

Divergent View:

In valuing the Company, the majority of the Street justifies the current stock price by applying an elevated EV/sales multiple based on where comps currently trade. Notably, the multiples in this space have risen materially over the last couple of years (despite no material change in earnings or growth profile) to levels well above historical averages. For example, ULTI currently trades at 8.7x EV/trailing sales, versus a 5 year average of 7.2x and a 10 year average of 5.8x. The resulting multiples used by the Street appear to be unsustainably high for any meaningful amount of time given Paycom’s underlying growth profile.

Similarly, the firms that use a DCF approach to value Paycom apply a growth rate directly to free cash flow. Doing so results in free cash flow levels that appear unreachable unless that Company is able to somehow maintain the healthy growth in its ANRR/team for the next decade or materially exceed the EBITDA margin range outlined above.

Investment Risks/Considerations:

Minority shareholder risk: Given the significant ownership stakes of Welsh, Carson, Anderson & Stowe (12.0 million shares) and Mr. Richison, the two entities control 40% of Paycom’s shares. As a result, unless public stockholders are able to aggregate almost all of the remaining shares in a vote, they become essentially non-voting and have little ability to contest actions of management.

Competitor risk: As outlined in detail above, Paycom’s competitors are quickly developing their services to provide a more streamlined and unified solution, similar to what Paycom offers today. As the potential customer noted, almost all providers currently offer a single platform solution, and as incumbents like ADP continue to invest and improve their offerings, any competitive advantage that remains for Paycom today could be eliminated, resulting in drastically lower revenue growth.

Contract risk: Paycom does not sign long-term contracts with customers, instead only requiring customers to provide a 30-day notice prior to cancelling services. In speaking with the potential customer mentioned above, she confirmed that switching providers is simple, quick, and costs very little. As a result, should Paycom’s competitors develop a superior payroll or HCM solution, or should a new technology be introduced into the space that Paycom misses, the Company’s revenues could decline significantly as customers quickly change providers.

Acquisition risk: Should a larger player decide it wants to improve its offering or enter the payroll or HCM industry, Paycom’s market cap is small enough that it could be an easy acquisition candidate. Mitigating this risk is Paycom’s elevated current valuation (9.1x EV/2015 sales), which already exceeds the level that Concur was acquired in 2014.

Catalyst

Most likely catalyst is disappointing earnings guidance after somewhat artificial blowout last quarter.