Paycom Performs Way Ahead Of Expectations

Summary

• Paycom bucked an increasingly established trend that we've seen across tech companies in the last two quarters, which is unabated growth.
• While it's a competitive market, the argument behind Paycom is that it's still a very small part of it, and there's still a lot of inefficiency in payroll tech solutions.
• The claim holds water, and the results reflect that too. Guidance points to continued performance and operating leverage all coming from predictable organic growth efforts.
• Reasonably, we can expect earnings to double without running into much trouble, although it will take as long as it takes for marketing methods to produce leads.
• That would bring forward multiple down a lot, but more growth would be required to make the current multiple reasonable, and that would be harder to bet on.
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Paycom Software (NYSE:PAYC) is a company that provides a payroll management solution to companies. The key proposition is that their system engages the employee to fill out their payroll data and make sure their checks are right - and there's a lot of adoption of this self-service premise by customers on their system. This reduces back-office workload between the employee and legacy payroll systems, as well as reduces corporate liability. The idea is good, especially when we've all had experiences with legacy payroll systems. They are opaque and usually very unwieldy for companies too. The TAM is large and PAYC is only at the beginning, although this is not a high moat business. While they have performed way ahead of other tech companies in these latest quarters, we still think the valuation is slightly too aggressive given growth prospects. We're passing, but we see why others wouldn't.

Paycom's Q3 2022 Earnings

While most tech companies are dealing with some degree of slowdown in selling, usually citing longer sales cycles and longer decision time as customers get more conservative with their cash, Paycom needs to make no such excuses. Deal sizes are rising, as is the profile of customers. Moreover, they are selling faster and are growing marketing headcount. Finally, they are even getting organic marketing as employees ask for Paycom in their new jobs, rather than go back to old ways of doing things. With higher turnover rates lately in the corporate world, that seems to have been a tailwind, at least that's the corollary of the management narrative.

Revenues are up 30%, and operating income is up about twice that at 60%. EPS is up about 40%. Gross margins are continuing to be guided on the same higher targets even though they took a depreciation hit on the opening of some new servers this quarter, and EBITDA is still almost three points below the levels guided for by management. Growth is guided at above 30%. Everything is displaying continued operating leverage.

How is it possible that the results were so good? One reason is turnover which we just mentioned, and is a nice theory. The other is simply down to the fact that the company accounts for very little of the pie still, and the pie continues to grow as legacy systems are beaten out by this new employee-driven way of doing things.

I mean, we only have 5% of the TAM. I mean we reported 33,800 clients at the end of last year. Our two largest competitors have a combined 1.7 million clients.

Chad Richison, CEO of Paycom

How can things improve from here? Some of the things that are relevant are further scope for productivity gains in marketing. New offices had been opened and we're almost a year past that, but it'll take more than two years for things to be in full swing.

Yes. I mean with the offices that we've opened up last year and I'm going to call it five, even though we opened up one late in the first quarter of 2021. And then I think we opened up four in the very -- at the very beginning of 2022 or this year. I mean all offices, just as a reminder, it takes offices 24 months to reach full maturity and that's having eight reps with the backlog and pipeline having been out in the field. Today, I mean, I would say our best one probably has four reps on quota right now, as we sit here today as they’ve been going through and selling.

Chad Richison, CEO of Paycom

The other thing is that there were strong bookings in September and October and they'll be contributing 100% to the next quarter, thus a technical reason for sustained growth. Still, the fact that the bookings spurt has come in that late is a very good sign. Deal sizes are also growing as Paycom starts to play in the big leagues.

Bottom Line

Paycom seems to be very well run. It's financials look great, the company is owned very substantially at more than 14% by the CEO, and the management narrative is clear and square. They are a company committed to organic growth, despite falling multiples, which is something that's to their credit as acquisitions are usually overpriced. Their sales productivity still has room to grow, there are ways of getting marketing organically too through turning over employees in the labour market, and there are broad secular and intra-sector horizons for Paycom to begin to occupy.

PAYC trades at around 54x PE in forward earnings. We think that assuming continued operating leverage at these levels, a doubling in earnings is not going to be a problem for the sales force to accomplish. After that, we think things may slow down. Halving the multiple on a more secular earnings forecast brings it down to earth, and starts looking like a more ample earnings yield. However, the sales force can only answer so many phones, so that will take a while and we have to take into account discounting effects. Also, this is not a high-moat business. We think at 10% TAM things will slowdown, and then even a halved multiple still doesn't come across as a screaming bargain. We think there are still no-brainer investments in the market. We'd rather go look for them.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.