Summary
- The $27 billion total addressable market is huge and significant enough for Paycom to continue growing despite the historical strong growth.
- PAYC can continue to capture share as companies look to adopt cloud solutions and regional/traditional payroll providers become share donors due to widened product gap.
- Competitive dynamics are overstated as HCM software is almost a necessity in most companies.
Thesis Overview
I recommend going long Paycom Software ( NYSE: PAYC ) as the company has a huge market opportunity (~$27 billion annual total addressable market, or TAM). Given the nature of the business and world-class product, in a strong macro context, PAYC benefits from the expansion in TAM (more firms), yet in a poor macro climate, it may easily take market share from smaller competitors by virtue of its superior offering. Paycom's profitability and product innovation should continue to support market share gains over the next decade.
Company Description
PAYC is a SaaS business that offers an all-inclusive, cloud-based human capital management (HCM) software solution for the whole employment lifecycle. Paycom's key activities include talent recruiting, time and labor management, payroll, and human resources management. It targets SMB clients with 50 to 50,000 seats.
Competitive Advantages
- Product is built from ground up: Paycom's solution was wholly developed in-house, and the firm has never made an acquisition. Due to the organic product development handled using a single database strategy, clients do not need to integrate, update, or access numerous databases - this is a frequently cited challenge by many companies based on my experience
- Differentiated GTM strategy: PAYC enters the market through direct sales. Historically, the company has educated its own sales force, who are subsequently sent to regional sales offices to further penetrate the respective markets. PAYC does not rely on brokers, consultants, or other channel partners to acquire consumers, unlike some of its competitors. I believe this is mostly due to their desire to pursue larger clients, where brokers and consultants often have less impact on which HCM software to adopt.
- Product focuses on ROI and productivity: Another advantage stems from Paycom's emphasis on ROI, as well as product simplicity. The platform is user-friendly, and employee self-service is central to their product proposition. In that sense, PAYC has made the most progress in lowering the administrative load on the HR department to manage HCM.
Thesis Discussion
TAM is extremely huge at ~$27 billion/year
In FYE21, PAYC handled 5.7 million workers (~10% of domestic TAM and 4-6% of revenue TAM) on their platform. My TAM assessment assumes PAYC would continue to concentrate on its core area (50 - 1,000 employees), and the TAM estimate is predicated on a $600 PEPY number (the figure should have naturally increased from $400+ during the IPO as new modules were deployed), assuming that each client was on the entire suite.
Own model
On average, a client will acquire half of Paycom's 29 modules upon platform adoption (as per 1Q17 earnings call). Overall, despite years of 20%+ revenue growth, I think PAYC can continue to outpace market expectations with Automatic Data Processing Inc's ( ADP ) $15 billion in annual sales, with incumbent providers not completely adopting a single database platform approach, and small regional payroll providers migrating to modern cloud solutions.
According to market studies , there are easily over >5,000 payroll companies (figure is lesser if we look at regional payroll providers). On the basis of my TAM estimate of $27 billion, it is reasonable to expect that there will be enough growth opportunities in the next decade (Paycom's revenue as of FY21 is $1 billion). I expect PAYC to continue to grow at historical rates as a result of a heightened degree of sales force productivity, now under the guidance of Chief Sales Officer Holly Faurot, along with continuous roll out of new products to further entrench itself in the workflow process.
We can see the willingness of companies to adopt cloud solutions in real time (ask around your circle of friends). As cloud solutions are less expensive (less CAPEX upfront) and are more scalable, an increasing number of businesses are seeking to transition to them. Also applicable to HCM, major organizations will ultimately integrate their HCM providers to boost ROI , by using a single platform with wide capabilities, as opposed to integrating many point solutions.
PAYC can continue to capture market share
Industry-leading product
The market potential for PAYC is substantial, especially after a decade of constant growth. I think PAYC's industry-leading product will enable it to increase market share over the next decade. PAYC's ROI-driven product strategy continues to beat the market's high-single-digit to low-teens growth, according to industry statistics (see here and here ). In my opinion, PAYC delivers a solution that is mission-critical, a small part of a large process, and crucial for businesses to survive.
It is important to note that practically every client gained by PAYC already uses a payroll solution, thus PAYC is basically stealing market share from an existing provider (evidence of PAYC product lead). ADP is the major reason for the company's market share increases, and this is a critical aspect of PAYC's growth narrative as it continues to win market share from ADP. Management has indicated that 40% of their new logos originate from ADP. In addition, 40% come from incumbent providers such as Ceridian ( CDAY ), Paylocity ( PCTY ), and UKG, among others. 20% of net new clients are generated through regional payroll solutions (Pacific Crest Global Technology Leadership Forum 12 Aug 2015). Putting things into context, ADP has $16 billion revenue as of FY22, which is 16x larger than PAYC's FY21 revenue.
The typical client size for Paycom is around 168 workers, which is greater than that for PCTY and Paycor ( PYCR ), but smaller than those of CDAY, UKG, and Workday ( WDAY ). Consequently, PAYC's position in the mid-to-upper market is well-positioned to attract clients who previously used separate solutions for payroll services, talent management, and core HR. I think that the inherent synergies created by integrating these three solutions for the majority of U.S. enterprises presents PAYC with good opportunities to capture share.
PAYC has 33,900 customers as of FY21, which represents 4-6% of yearly dollar TAM (as analyzed above). Customer growth has grown at 13.8% CAGR over the past 8 years, and I believe PAYC should continue to grow at the historical pace (low teens, which is in line with management guidance).
Larger clients segment extends growth runway
Also, the average employee/client has been increasing from ~13k in FY14 to ~33k FY19, but fell to ~28k in FY21 (companies lay off employees during the pandemic). Employee/client should re-accelerate to pre-COVID levels as PAYC continues to capture larger size clients. This is reinforced by management comments that, excluding companies with <50 employees, the average number of employees is rising. Given the increasing emphasis on obtaining larger clients, I expect employees/client to grow in the low-teens, which will support historical revenue growth of 25-30%. In addition, PAYC originally targeted clients with 50 to 5,000 employees , but increased the target range to 10,000 employees last year (which means a longer runway to capture larger size companies).
Product innovation and the willingness of larger corporate clients to adopt a platform-based product approach will determine Paycom's chance of success in the large enterprise segment. Historically, a client in the upper mid-market or enterprise segment had separate suppliers for Payroll, Core HR, Talent Management, Workforce Management, Analytics, and even specialized apps like employee surveys. However, my research suggests that most businesses would settle for adequate modules (Microsoft's ( MSFT ) products are not the greatest in every subject, but most people use them because they are adequate and, on average, less expensive). Hence, I believe PAYC to profit from this trend.
Market seems to be over worried about competitive dynamics
Despite the intense competition in the HCM software market, PAYC's market-leading product strategy positions the company for continued market share growth. It is true that there are a number of scalable modern solutions, but they all have their own value propositions and compete in relatively different market segments. For example:
- CDAY was able to progressively transition its sizable network of bureau clients to the Cloud Dayforce platform because to the acquisition of Dayforce in 2012. In terms of workforce management, time and attendance, and cloud payroll, Dayforce was a market leader. As a result, they have gained significant installs for Payroll and Time and Attendance, and as their other products—including Talent Management and Learning Management Systems—have developed over time.
- Ultimate Software and Kronos Group were combined to establish UKG, which then developed two systems that cater to different market segments. They are currently attempting to cross-sell these items to their respective bases by combining them. Known for its mid-market corporate software, Ultimate Software shared PAYC's primary client targeting. Although their WFM solutions were typically integrated by means of an external solution, Ultimate Software offered a well-rounded portfolio of payroll and talent management solutions.
In addition to current payroll/HCM systems, PAYC competes with established and regional enterprises. In my perspective, it will be a breeze for PAYC to grab market share from established corporations over the next decade, and the almost $20 billion in revenue generated by ADP and Paychex ( PAYX ) represents an opportunity to continue acquiring customers.
Expert network calls (from Tegus) indicate customers' growing discontent with ADP's customer support, which acts as motivation for companies to switch. As potential customers study current payroll systems like the one from PAYC, I believe the compelling ROI, features and functionality, and greater levels of service will cement the deal for the implementation of a modern HCM/payroll solution.
PAYC benefits from a rising interest rate environment
For every 25-basis point increase in the Fed Funds rate, PAYC revenue from interest income kept for clients increases by $5 million/year. This income contributes over 100% incremental profit to the bottom line. While management has only accounted for interest rate increase to 2.25% in its current guidance for FY22, I believe they are being conservative, as we can see from Powell's recent commentary - the Feds maintain an aggressive stance to bring down inflation. As a result, I anticipate another 75-basis point rate increase at the September FOMC meeting, with rates eventually reaching 3.75% to 4% by the end of the year. While this is difficult to calculate precisely, qualitatively, it represents a near-term upside for my projections.
Valuation
In my model, I expect the number of clients to grow at a 11% CAGR and revenue/client to grow at a 15% CAGR until FY25, equating to revenue growth of 28% CAGR, within a range of historical growth rates. As PAYC continues to grow off its fixed cost post (80+ gross margin and expanding) and a reduction in CAPEX % of sales, EBITDA and FCF should expand accordingly.
- EBITDA: I assume it reaches near maturity levels (40%) in FY25.
- FCF: While I do expect CAPEX to fall off dramatically, I am being conservative by assuming EBITDA to FCF conversion of 60% (same as FY21). My assumption would bring us to PAYC generating $673 million FCF in FY25.
PAYC currently trades at ~110x FY21 FCF, and this multiple should compress moving forward as the market recognizes lesser growth potential post FY25. Assuming PAYC trades at 40x FCF in FY24 (slightly lower than in FY16 when growth started to slow for PAYC), PAYC could be worth ~$28 billion in market cap or $490/share, implying an almost 40% upside potential over the next 2 to 3 years.
Own model
Key Risks
PAYC would be badly impacted if the United States and Canada entered a severe recession. Unlike other SAAS players like WDAY that bills on an annual basis, PAYC bills clients on a monthly basis, which makes them vulnerable to a rapid reduction in the number of employees billed on the platform. For perspective, during COVID, PAYC's revenue growth rate shrunk to single digits - this would shatter the valuation that PAYC receives.
Also, if competitors slash pricing, PAYC is likely to follow to maintain market share, hurting margins (a key assumption of our FCF projections). That said, as described above, each competitor operates in their own field and differentiate via value proposition.
Conclusion
PAYC offers a direct channel to invest in the growing HCM space that is ripe for disruption. The huge TAM, PAYC’s leading product, and the avenues to further gain share/improve profitability (by targeting larger customer segments) support a very long runway of growth ahead. Relative to other high-growth software companies that are typically loss-making, PAYC is profitable and generates a ton of FCF. So long as the company continues to innovate and execute, and capture share from incumbents, I believe the PAYC stock will be a great compounder for many years to come.
For further details see:
Paycom Software: Well Positioned To Capture Share From Legacy Vendors