Paycom Software (PAYC) Business Breakdown
Paycom Synopsis:
Paycom Software (PAYC) is a cloud-based SAAS HCM provider. Paycom helps businesses with payroll, hiring, timesheets, etc, to serve as an all-in-one HCM offering. The main problem they are trying to solve is that legacy providers lack integration with different offerings. For example, businesses may use ADP for payroll but use a third party for scheduling and time tracking. This creates complexity for the business. With Paycom's solution, the business can simplify its HR. They sell their HCM solution to a diversified range of businesses directly through their 55 sales offices. HCM is an essential service to businesses because of the regulatory tax filings that businesses need to file each year.
98% of revenues are recurring. The majority of revenue comes from payroll, which every client has to use. There are two ways Paycom generates revenue (1) fixed amounts charged per billing period plus a fee per-employee/transaction and (2) fixed amount per billing period. When interest rates are high, Paycom earns interest income on client funds they hold, thus providing a hedge in higher interest-rate environments, when the labor market may be unstable. Paycom earns higher revenues in Q1 and Q4 because of tax filings (1099), ACA filings, and end-of-year bonuses. Paycom has held a>90% client retention rate. The major KPIs to track are; the number of clients, annual revenue retention rate (ARRR), unemployment rate, and interest rates. Paycom's success depends on the labor market as a whole (the more people are employed, the more they can charge per employee).
Management discusses 4 areas of growth; 1) increase sales teams in current markets 2) expand into additional markets (currently 28 states and 4 international countries) 3) increase product mix and enlarge customer relationships, and 4) target higher clients. In 2023, management focused on areas 2, 3, and 4. Implementing Beti, which has reduced payroll time to 90 minutes instead of days, shows Paycom's efforts to increase value to clients, thus increasing the probability that clients stay with Paycom and not churn. Paycom's main competitors are ADP, Paychex, and Paylocity.
Paycom's business model allows them to scale more easily which improves operating leverage.
Paycom provides an essential service to businesses and operates on a capital-light business model which allows for scale and operating leverage
What is Paycom?
Paycom was founded in 1998, by Chad Richison, who still runs the business today. It offers a suite of products that a business’s HR department needs such as payroll, time clocks, scheduling, time off manager, and ACA filing. Paycom provides an all-in-one HCM software that businesses need to manage their workforce. Traditionally, a business may use one company for payroll and other 3rd party providers for other tasks such as scheduling, but Paycom brings all of these together in a seamless solution. Paycom uses the cloud to facilitate its solution. This service is essential for businesses. Paycom sells its solution directly to businesses by the use of its sales force, which is across 28 states. Paycom has a diversified client base of more than 36,800 with none have constituted more than 0.5% of its revenues. 98% of its revenue are recurring and majority of the revenue is generated by its payroll segment. Because of the high recurring revenue, free cash flow is highly resilient at 0.91 FCF Linearity.
There are 2 ways that Paycom generates revenue. The first way is the fixed amounts they charge per billing period plus a fee per employee/transaction processed. The next way is only the fixed amounts charged per billing period.
Paycom has 3 revenue segments. The first is recurring revenue from its solutions. The second is fees charged for form filings and delivery of client checks. The last is interest earned for holding client funds.
Due to the nature of payroll filing, the first and fourth quarters will be higher because of the annual processing of payroll tax and ACA form filing in Q1, and unscheduled payroll runs in Q4.
The Key Performance Indicators (KPIs) for Paycom are the number of clients and the Annual Revenue Retention Rate (ARRR). I would also note that the unemployment rate and interest rates should be monitored, because as the unemployment rate increases, the demand for HCM products/services decreases and vice versa. High interest rates increase the other income Paycom earns on client funds.
Paycom’s Financials:
Revenue:
Paycom’s revenue has grown at a 31.7% CAGR over the past 10 years. Back in 2014, when at its ipo, it earned $151 million in revenue. Today, Paycom earned $1.7 billion. Revenue growth has slowed from 2023 to today, as management has incentivized its sales force to push Beti onto its customers to increase user retention rates. This push has led to a drop in cross-product selling. On the Q1 earnings call, management noted that the revenue headwind created by Beti will be over in the second half of 2024. It is my belief that revenues will start to reaccelerate in 2025.
Profit Margins
Gross Profit:
Gross margins have remained high at 84% across the past 10 years. In 2014, gross profit was 81.9% and reached a high of 85.3% in 2020. Since 98% of revenues are recurring, the predictability of costs has helped Paycom to keep its margins very high.
Operating Profit:
Operating profit margins have expanded in the first two years after Paycom’s IPO, expanding to 30.9% in 2016. Operating profit took a hit in 2020 due to higher SG&A expenses. Since then, operating profit margins have continually expanded to 27% from the 22% in 2020.
FCF Margin:
Paycom’s historical median FCF margin is 16.9%. FCF margin has remained steady throughout the past 8 years. Paycom’s steady FCF margin tells us that the business can consistently convert revenue into free cash flow.
Balance Sheet
Paycom has not used excess amounts of debt to fund the business. Today, the business has $0 in long-term debt, while holding $294 million in cash. In part of its capital-light business model, Paycom doesn’t need lots of capital to fund operations and invest in growth. A strong balance sheet will provide Paycom opportunities in the future, as it doesn’t rely on debt to keep the business running, and with lots of cash to use to grow the business even more.
Growth
Earnings Growth:
Paycom’s earnings have greatly expanded at a 54% CAGR over the past 10 years. This growth is all operational with little help from share buybacks. As seen in the image below, shares outstanding have remained flat at around 58 million. Due to the Beti headwind, analysts have downgraded their earnings estimates to 10 %/annum for the next five years.
FCF Growth:
Paycom’s FCF has grown at a staggering 43% CAGR over the past 10 years.
Paycom’s Financials Summary:
Paycom has high and steady margins, no debt, with strong earnings and FCF growth. Paycom’s financials demonstrate the power of a capital-light business model with little need for leverage to compound.
Capital Allocation: ROIC
ROIC is a proxy for how well management is allocating capital. Over the past 10 years, Paycom’s ROIC was 26.7%. From 2014 to 2019, ROIC greatly expanded to a high of 53.4%, before dropping to 23% in 2020. This expansion of ROIC during 2014-2019 was a product of great demand for HCM tools as the unemployment rate fell from 6.6% to 3.6%. With the unemployment rate steady over the past two years, management has incrementally increased its returns on capital. Capital is being pushed into research and development by enhancing its product suite and entering into new markets internationally. Management’s capital allocation recently shows an effort to entrench their switching moat and increase revenues from large multinational companies.
Valuation
Paycom has historically traded at a 1.35% FCF yield. Today, Paycom trades at a 3% FCF yield. Adjusting for Share-Based-Compensation, Paycom’s FCF yield is 1.71%. Adjusting for SBC, Paycom historically trades at 0.81% FCF yield. If we assume 15% growth as the best case, 10% growth as the most likely case, and 5% growth as the worst case, we get an average buy price of around $322 for a 15% return. If Paycom earns 10% and multiples revert, Paycom can earn an 18.5% annualized return over the next 10 years.