Why Dilution May Mute Paylocity Investors' SaaS-Industry Linked Growth

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About: Paylocity Holding Corp (PCTY)
by: Kelly Stewart
Summary

Share dilution reduces current shareholders' proportional ownership.

As SaaS investors know, SaaS is on pace to attain more than ~15% compound annual growth by 2020.

Unfortunately, if Paylocity continues its rate of dilution, returns may be muted for its shareholders.

Over the last five years, Paylocity has increased its shares outstanding by 69%. During the same period, it increased its stock-based compensation by over 15K%.

For this, it trades at 5.6x industry average on a P/E basis.

As per its 10-Q, Paylocity (NASDAQ:PCTY) is a cloud-based SaaS payroll and human capital management software provider for medium-sized companies. 95% of its revenue comes from recurring fees - usually including a base fee, as well as a fee based on the number of client employees and products a client uses. Clients don't have a specified term and can cancel PCTY's service with less than 60 days' notice. Let's begin.

Share Dilution

When analyzing a stock, one of the first things I look for is a recent, sustained reduction of outstanding shares. If instead the company has recently significantly diluted the shareholder base, it may be, in my opinion, a reason to give pause before investing in the said company.

As we know, share dilution reduces current shareholders' proportional ownership. This isn't great for shareholders. It's so not great that even acquisitions funded with dilution are not generally favorable as researchers have found:

In studies covering more than 1,200 major deals, researchers have consistently found that, at the time of announcement, shareholders of acquiring companies fare worse in stock transactions than they do in cash transactions. What's more, the findings show that early performance differences between cash and stock transactions become greater - much greater - over time.

This is a problem for shareholders that, while obvious, I believe is underrepresented in the literature, and often goes ignored by investors overly focused on top-line growth. So bringing the discussion back to the question at hand: how much, if at all, has PCTY diluted shareholders in the last five years? Let's take a look.

Chart PCTY Average Diluted Shares Outstanding (Annual) data by YCharts

Looking at the chart above, we see that PCTY has diluted its shares by nearly 69% over the last five years.

Before I go further into this, first, I'd like to discuss the strong industry tailwinds that SaaS companies may enjoy over the next several years, and then, discuss the ongoing relevance of, in my opinion, that dreaded, dreaded dilution.

SaaS's Future Growth

SaaS and cloud computing have some obvious growth potential. Forbes notes that:

[...] SaaS is on pace to attain 15.65% compound annual growth throughout the forecast period, also outpacing the total cloud market. The following graphic compares revenue growth by cloud services category for the years 2016 through 2020. [...] Gartner predicts by 2021, 28% of all IT spending will be for cloud-based infrastructure, middleware, application and business process services.

The growth forecasts can be seen in the chart below:


Source: Forbes (Ibid)

It seems obvious that cloud-based SaaS companies like PCTY would be strategically placed to profit from these industry tailwinds. In a perfect world, that's how it would play out. But we're not in a perfect world - we're in a world when management sometimes dilutes shareholder value by issuing more and more shares.

Back To Dilution

A big problem with dilution is that, in my opinion, it prevents investors from fully enjoying revenue-based growth per share. Let's look at that in the following example, so I can explain what I mean.

Let's say you buy 1,000 shares of Paylocity today at ~$52.40. At the moment, PCTY has about 52.5m shares outstanding.

Source: Author's work; YCharts data for shares outstanding and revenue

Let's say, over the next five years, those strong SaaS and cloud computing headwinds have a marked impact on PCTY's revenue, and the company achieves the unbelievable feat of doubling its revenue. Let's say, because PCTY investors love to reward revenue and not much else, the stock price rises to reflect that.

Your risk has paid off! (Or has it?)

Source: Author's work

Strong revenue growth doesn't guarantee simultaneous share increases, as we are rewarded on a per share basis. If management dilutes shares, your return is negatively affected.

Holding all else constant: Even though the company doubles its revenue, in this charitable scenario, it also repeated its past behavior and increased its share count by 69%. As such, instead of revenue per share increasing from $6.03 to $12.06, it's only increased to $7.13.

  • Instead of your shares being worth $104.80 per share, because of the dilution, they're now worth only $62 per share.
  • Instead of your share of ownership being worth $104,800, even though you made the correct directional call, they're only worth $62,011.83.

Simply because of management's decision to dilute those shares.

Dilution is just one of the many risks that investors face. Business risk, market risk, opportunity risk, inflationary risk, and legislative risk. This risk - dilution risk - is one that a shareholder should attempt to avoid to limit his or her downside. Avoid investing in companies with a recent history of dilution. One way to avoid it is to look for companies engaged in intelligently-priced, value-oriented share buybacks.

The Return-Relevance of Buybacks

Intelligently announced stock buybacks have a positive impact on price return, as Ken C. Yook writes in The Quarterly Review of Economics and Finance:

[...] Chan, Ikenberrry, and Lee (2004, 2007) reexamined long-term stock return drifts following openmarket repurchase announcements. Their study found robust and significant evidence of positive long-term stock return, using both the buy-and-hold returns method and calendar-time portfolio method. They concluded that managers possess some timing ability and that pseudo-market timing explains, at best, only a small portion of the buyback return drift.

Indeed, firms that effect buybacks enjoy significant price returns in the following period:

[...] firms that initiate repurchasing shares during the four quarters from the announcement quarter experience significant returns over a 3-year period after the announcement. Firms that do not initiate repurchasing shares experience negative return, although not significant, over the same period.

Unfortunately, Paylocity does not have a strong history of buybacks.

Chart PCTY Stock Buybacks (TTM) data by YCharts

It does, however, have a storied history of stock-based compensation, increasing about 15K% in five years. And during that roughly same period, earnings have stagnated.

Chart PCTY Revenue (TTM) data by YCharts

Yes, sales have grown - but we already know how sales will translate into investor return given dilution over that same period (poorly). Investors can decide for themselves whether the performance of this company warrants 15K%+ increases in stock-based compensation. I personally don't think so.

Valuation

To make matters worse, PCTY is trading at a premium. At a P/E of 298.47 and an industry average P/E of 53, it is 5.6x more expensive than the industry on a P/E basis. The reason I harken back to P/E even though it's fallen out of favor with revenue-obsessed investors is simply because the evidence supports it: research links high P/Es to lower returns and lower price appreciation in the following decade. And, in my opinion, a P/E over 5.6x the industry average is too high.

Conclusion

It's highly possible that as PCTY matures, it will reduce its shareholder dilution and engage in buybacks. Shareholders will do well to wait and see. For now, PCTY's history of shareholder dilution, 15K% increases in share-based compensation, and a premium P/E priced at 5.6x industry average, in my opinion, leave a lot to be desired. PCTY is still young, and it has room to improve. For now, I'd suggest investors avoid this company and look elsewhere for value.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.