XSW - Paycom Software: Focus On The Bigger Picture

2024-01-10 16:52:25 ET

Summary

• PAYC appears to be out of favor with investors, slumping by -15% over the past couple of months, even as other software offerings have delivered healthy positive returns.
• We highlight why the reaction to the Beti issue may be overdone and pick out various other encouraging facets associated with PAYC's strategy.
• The risk-reward on the charts looks promising and buyback momentum could continue to step up.
• Forward valuations no longer look expensive and the budding dividend theme could well flourish given the strong FCF coverage.

Introduction

The stock of Paycom Software ( PAYC ), a specialist in providing cloud-based HCM (human capital management) solutions, has faced a challenging few months; whilst other software and service entities have managed to deliver returns of over 20% on average, PAYC has floundered, losing -15% of its value over the past couple of months.

Beti Cannibalization Concerns

Much of the weakness in the share price has been driven by concerns surrounding the impact of Beti on PAYC’s own revenue prospects.

For the uninitiated, Beti is an automated offering of PAYC that finetunes the overall payroll process, by enabling employees to work on their own payroll with no blemishes. The software abets employees of PAYC’s clients by identifying and correcting the myriad of payroll-related errors before submission. Ironically, the effective troubleshooting capabilities of Beti in the pre-submission phase has ended up wiping out a good chunk of billable corrections and unscheduled payroll runs which have traditionally served as a good source of service revenue for PAYC.

PAYC likely has less than 37000 clients across the globe, and management noted that close to two-thirds of their client base have now adopted Beti. In the coming periods, one will also see PAYC’s clients in the Canadian and Mexican markets adopt Beti with greater fervor.

In the short-term, this cannibalization is certainly not ideal because PAYC was a business that was delivering topline CAGR of 26% over the past three years. However, now, PAYC management believes that these recent developments where they focus on engendering greater long-term value for their clients, could shift the company’s revenue profile to that of a 10-12% growth entity.

Look At The Bigger Picture

Given the drastic shift in the revenue profile, the share price has understandably come under pressure, but we would urge investors to look at the bigger picture.

Under legacy payroll systems offered by competitors, there would be a lot of to-and-fro discussions between the employees and HR, which prevents the latter from focusing on higher-end initiatives and damaging productivity. As more prospective clients realize the value-add and savings provided by the Beti solution, it would be reasonable to suggest that what PAYC loses out by way of service-related billables, it makes up in terms of higher volumes from an even larger client base, who will increasingly see this solution as the HCM industry benchmark.

Investors also need to note that PAYC is currently not witnessing any decreasing momentum in terms of new logo sales or go-to-market momentum; if anything, that continues to be strong .

PAYC management has also described this phase as “transitory”, and once the company gets its foot in the door with fresh clients, it will also be better positioned to cross-sell more of its non-payroll applications which is something that will take on greater prominence in the coming years.

The other key point to note is that PAYC, has in recent periods, pivoted towards focusing more on acquiring larger clients, or those with an employee strength of more than 10,000 employees. Their recent expansion in Canada and Mexico should also give them a useful pool of larger diversified multinationals. Note that PAYC also has a new enterprise sales function that is only focusing on clients with more than 25,000 employees.

Don’t forget that principally this is a business that charges clients on a “per employee” basis, and thus, when larger clients come on board, the large employee strength associated with those clients will naturally filter through to solid business volumes.

Finally, it's also worth considering that whilst the topline may be slowing, it's not as if the margins have gone to the dogs. In fact, quite the opposite; over the last three quarters, the annual progression with the group-adjusted EBITDA margins has only continued to expand sequentially.

After witnessing such strong traction in the margins in 2023, PAYC may not see the same level of expansion in 2024, but based on consensus estimates for FY24, one is still staring at flattish EBITDA margins, which is nothing to be scoffed at.

A stable EBITDA regime also lays the foundation for greater conversion at the FCF level which continues to trend up encouragingly on a TTM basis and is currently 66% higher than the 5-year average.

The solid FCF generation landscape only lends further support to PAYC’s recent emergence as a dividend payer, where it has been spending around $22m in cash per quarter by way of dividends. Given the significant magnitude of the dividend coverage by the FCF (currently at around 13.5x), we don’t see any risks to a cut in dividends in light of a slowing topline.

Closing Thoughts

We also think the Paycom stock may be worth looking at because the risk-reward on the charts is now in a much better position.

The first chart highlights how PAYC's stock is positioned relative to other tech offerings. Across much of the post-pandemic era, it was difficult to make a case to tech-focused investors to rotate into Paycom given how elevated the relative strength ratio had looked.

However, this year, we’ve not only seen some mean-reversion, but a significant drop well below the mid-point to the lower half of the table. With the relative strength ratio now trading a good 44% off the mid-point of the long-term range, we think PAYC could benefit from some rotational interest.

Then if we pivot to PAYC’s own weekly imprints over the last 2-2.5 years, its rather clear that the stock has been trending lower in the shape of a descending channel. During the sell-off in October/November last year, note that the stock hit the lower boundary of the channel, and quickly recoiled from there in the following weeks.

What’s also slightly encouraging to note is that after four straight months of reducing their ownership stake in the PAYC counter, the smart money cohort recently upped their stake in the company.

All in all, given where the share price is currently perched (~$200 levels) within the descending channel, and given where the two boundaries are (~$320 and ~$125) we think the risk-reward looks quite tasty for a long position.

We also think the share price could get additional support from an increased pickup in buyback spend which has only continued to improve on a sequential basis. Paycom’s ongoing $1.1bn share buyback will expire in seven months, and within that plan, they still have around $1bn that has yet to be used.

Finally, also consider that the stock offers excellent value now. Over the last five years, the stock's rolling forward P/E average has been around 54x, but now you can pick it up at a whopping 60% discount.

For further details see: