Paycom Software: A Wonderful Company With Unattractive Valuation
Summary
- Paycom Software is a high-quality business with strong revenue growth and profitability metrics.
- The company has a solid balance sheet, healthy cash position, and returns funds to shareholders through dividends and share buybacks.
- Despite its positive outlook, the stock is currently overvalued and not attractively priced.
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Investment thesis
Paycom Software (NYSE:PAYC) is a high-quality business demonstrating best-in-class profitability across almost all key ratios. The company has a strong track record of revenue growth and is poised to remain at its impressive growth trajectory. The balance sheet is strong, and the capital allocation approach favors shareholders. All in all, Paycom looks like a wonderful company to me. But the valuation looks too generous even for a high-quality business like Paycom. I believe that better buying opportunities for PAYC are ahead and assign the stock a "Hold" rating.
Company information
Paycom Software offers an end-to-end SaaS Human Capital Management [HCM] solution that provides clients and their employees functionality and data analytics to manage the employment life cycle.
The company's fiscal year ends on December 31 with a sole operating and reportable segment. According to the latest 10-K report, the company had more than 36,000 clients as of December 31, 2022.
Financials
The company delivered stellar financial performance over the past decade with a 33% revenue CAGR and profitability metrics steadily improving. The operating margin has expanded significantly from 8.8% in FY 2013 to 27.5% in FY 2022. The free cash flow [FCF] margin ex-stock-based compensation [ex-SBC] has been relatively volatile over the past decade, but I like that it was mostly at double digits in the last five years.
Author's calculations
A wide gross margin means the company can continue investing heavily in marketing and innovation to fuel further growth. PAYC reinvests more than 10% of its annual sales into R&D to improve its product, which is a bullish sign. The SG&A-to-revenue ratio has moderated over the past decade, but it is still high at 42%, meaning there is substantial room for operating margin expansion as the business continues scaling up. Given the company's significant investments in marketing and R&D, I am not surprised that consensus estimates for the next decade are optimistic regarding the company's earnings. The EPS is expected by consensus to increase more than four times over the next decade, which is a massive growth.
Seeking Alpha
Having solid profitability metrics enables the company to sustain a healthy balance sheet. There is almost no leverage, and Paycom is in a solid net cash position above $500 million. Liquidity metrics are also in good shape. A stable FCF and a healthy balance sheet mean Paycom can return funds to shareholders. The company consistently conducts share buybacks; this year, Paycom announced its first-ever dividend payout. Given the company's strong profitability metrics, solid balance sheet, and positive consensus earnings outlook, I believe the dividend is safe and poised to grow consistently.
Seeking Alpha
The latest quarterly earnings were released on August 1, when the company was almost in line with consensus estimates with slight beats. Revenue growth demonstrated strong momentum with a 26.5% YoY increase. The adjusted EPS also expanded notably, from $1.26 to $1.62.
Seeking Alpha
The upcoming quarter's earnings release is scheduled for November 2. The adjusted EPS is expected to be flat sequentially, which is a solid sign amid the current uncertain environment. On a YoY basis, revenue is expected to sustain strong momentum with a 23% growth, and the adjusted EPS is forecasted to expand from $1.27 to $1.62.
Seeking Alpha
I like how the company demonstrates its ability to drive double-digit revenue growth together with notable profitability metrics expansion. Paycom operates in an industry expected to compound annually at 8.2% by 2030, which is also a bullish sign. But it is also important to underline that Paycom operates in a highly competitive environment which includes giants like Oracle (ORCL) and SAP (SAP), large players like Automatic Data Processing (ADP) and Workday (WDAY), and lots of other smaller competitors. All in all, Paycom competes with 226 competitor tools in the workforce management category. To assess Paycom's positioning amid competitors, I would like to assess how PAYC looks compared to its closest peers: Paylocity Holding Corporation (PCTY) and Ceridian HCM Holding (CDAY). As benchmarks, I would also like to look at the profitability metrics of much larger players like ADP and WDAY.
Seeking Alpha
As we can see, Paycom demonstrates much stronger profitability compared to its closest rivals across the board. It is also impressive that Paycom generates stronger profitability metrics than much larger competitors despite its much smaller scale. To add context, PAYC's revenue in FY 2022 was more than tenfold smaller than ADP's and about four times lower than WDAY's. That said, Paycom looks much more efficient than its competitors and has more profits to reinvest in its growth and improving its offerings. A three percentage point gap in the FCF margin compared to PCTY might not look that big. But if we extrapolate this gap ten years forward, the cumulative effect would be massive. Given Paycom's more comprehensive ability to reinvest in future growth, I expect this profitability gap to widen over time. Overall, I believe that Paycom is well-positioned to capture positive industry trends at the expense of its competitors.
Valuation
The stock price declined about 5% year-to-date, significantly underperforming the broader market. Seeking Alpha Quant assigns the stock the lowest possible "F" valuation grade due to substantially higher valuation ratios than the sector median. On the other hand, Paycom's current multiples are significantly lower than the historical averages.
Seeking Alpha
Since PAYC is a growth company, I want to continue my valuation analysis with the discounted cash flow [DCF] simulation. I use a 10% WACC as a discount rate. I have revenue consensus estimates projecting a 13% revenue CAGR over the next decade. I use a 15% TTM level FCF margin for my base year and expect it to expand by 50 basis points yearly.
Author's calculations
Based on the DCF, the business's fair value is nearly $13.5 billion. The stock is substantially overvalued since the current market cap is above $16.5 billion. Paycom's substantial half-a-billion net cash position does not help much to make the valuation look better. To sum up, I cannot say that the stock is attractively valued.
Risks to consider
As a growth company, Paycom's investors face significant risks that the company might fail to deliver the projected long-term growth pace. Paycom's valuation significantly depends on its revenue growth rate and profitability metrics expansion. Failing to meet these expectations can rapidly lead to investors' disappointment and a potential massive stock sell-off. Decreases in guidance or long-term outlook also significantly adversely affect the company's valuation. That said, Paycom's investors should be ready to tolerate short-term volatility and maintain a long-term mindset.
Paycom also manages vast amounts of the client's sensitive information, which puts the company at substantial risk of data privacy. Paycom will likely face legal actions, penalties, and reputational damage in a data breach. All these consequences will ultimately adversely affect the company's earnings and FCF.
Bottom line
To sum up, I like Paycom as a company. But I do not like it as a stock at its current price level. My valuation analysis suggests that PAYC is substantially overvalued despite recent post-earnings release weakness. The company is a high-quality business, and I will definitely add it to my watchlist, but not buy at the current stock price. To me, PAYC is a "Hold" at the current stock price.
This article was written by
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.
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