2023-11-02 12:08:49 ET
Summary
- Paycom's stock dropped almost 40% after missing revenue estimates by 1.22% and providing lower guidance for Q4 and FY 2024.
- The miss in revenue was attributed to lower service revenue and fewer unscheduled payroll runs due to the success of Paycom's automated software, Beti.
- Paycom's focus on its Beti software, which allows employees to do their own HR and payroll, impacted revenue and guidance.
- Paycom's potential has become much higher, but execution risk as well.
Introduction
As you may have seen, Paycom's ( PAYC ) stock dropped dramatically yesterday after it had announced its earnings on Tuesday. At the moment of writing, after the market hours on Wednesday, the stock lost 38.5% of its market value in a single day.
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What happened here?
Let's look at the results first and then analyze everything.
The Numbers
Revenue was up 22% year-over-year to $406 million, missing estimates by almost $5 million, or 1.22%. Not great but not a disaster. Management blamed lower service revenue and lower unscheduled payroll runs for the miss. That's because Beti, Paycom's fully automated software, did better than expected. More about Beti and what this means for the company later in this article, as this is extremely important.
The non-GAAP EPS came in very strong, at $1.77, a beat by $0.16 or 9.94% and up 39% year-over-year. On a GAAP basis, this was $1.30.
The reason for this big beat was probably interest rates, although management wasn't asked about this on the conference call, as all analysts asked about the negatives we come back to later in this article. But Paycom holds an average daily balance of funds held for its clients of $2.1 billion and it earns money on this money through interest. So, higher interest rates mean higher profits.
Gross margins remained very high at 83%, just like in Q2, but down from 85% last year. Operating margin, though, was up 2%, both quarter-over-quarter as year-over-year, to 24%.
Adjusted EBITDA margin was 41%, up 2% quarter-over-quarter and 3% year-over-year.
You shouldn't worry that Paycom will go out of business any time soon. The company has just $29 million in debt and it has $484 million in cash.
During the quarter, Paycom repurchased $76 million worth of stock and paid nearly $ 22 million in dividends. In total, the company now has retired 5 million shares and combined with dividends, it has returned more than $700 million already to shareholders.
Of course, you could say that these share buybacks were not done with perfect timing. And that's right, but companies can only judge on the information they have and can't see into the future perfectly, although many seem to expect they can. The good news is that the company still has more than $1 billion left that is earmarked for buybacks. Seen in that context, that $76 million to offset stock-based compensation was not that much.
In mid-December, you can expect to be paid your quarterly dividend of 37.5 cents per share. That's $1.5 per year, or a yield of 1% at the current price.
The Bomb: Guidance
There was a small miss on revenue, 1.2%, but that doesn't warrant a nearly 40% drop. The bomb that Paycom dropped was guidance.
For Q4 2023, so the next quarter, Paycom guided for 420 million to 425 million, while the consensus stood at $452 million. That's a guidance miss of about $30 million at the midpoint or 6.6%. In percentages, that's growth of 14%, not 20.5% year-over-year.
That also had an impact on the revenue projection for the whole year 2023, in which management now sees 22% growth to $1.682 billion, versus previous guidance of $1.716 billion. That's a miss of $34 million.
This is the first thing that shocked investors. But this is not the bomb yet, just a hand grenade.
The bomb was the statement about revenue for next year, FY 2024. Management said investors should expect revenue growth of 10% to 12%. Compare that to the estimate of almost 21% and you start to understand why the stock dropped so much.
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Management said this was not formal guidance and that formal guidance will be given in February, when there will be more visibility.
Beti's Role
Just like everyone else probably, I thought the economy had hit Paycom hard. With its focus on small and medium-sized businesses, it's logical to think of this with this challenging macro environment. And, let's be honest, many companies also abuse the macro circumstances to hide their own mistakes. But while Paycom's management shortly named macro headwinds because of inflation, it didn't call this the main reason for the lower guidance. The reason is Beti.
Now, what's Beti? No, it's not a woman who can't spell her own name. Beti stands for "better employee transaction interface."
To explain what it is, I quote from an article I wrote for my subscribers in April of 2022 already.
"Chad Richison, Paycom's founder and CEO, phrased it very succinctly on the conference call :
"For years, I have been predicting the end of the old model whereby HR and payroll personnel's routine of inputting data for employees is replaced by a self-service model that provides employees direct access to the database.
The old model is dying and that is good for both the business and the employee. Paycom is leading this transformation. We will continue to automate the processes that generate maximum ROI for our clients."
Beti, which enables employees to do their own payroll, was only rolled out in 2021, but already saw very strong adoption. And that won't stop anytime soon."
Prophetic words, that last sentence. So, in short, Beti is a system in which employees can do their own HR and payroll through an app on their phone.
That is great for companies and employees. Companies can make huge savings on HR. And while you may think employees don't benefit, they do. Employees have the power to review and update payroll errors prior to payday, which gives them much more confidence their wages are paid in time and correctly. If you can check if everything is in order before you are paid, that will reduce the number of mistakes dramatically.
Now, this year, Beti has been a big success. And indeed, it works very well. What that means is that employees use it and mistakes are reduced by a huge amount.
Over the short term, Beti is bad for Paycom, as it impacts the company in two ways:
- unscheduled runs to correct payroll s: all manual work that has to be done to correct payrolls costs money for businesses and it means revenue for Paycom. Now that there are so many fewer mistakes because of Beti, this impacts Paycom's revenue.
Usually, the fourth quarter is the one in which there are the most payrolls to correct, hence the guidance that's quite a bit lower than previously expected.
- service revenues: Paycom also earns money from implementing its software throughout companies. With Beti, this is not really necessary anymore, as most employees install it on their phones and HR professionals get in the data.
Now, how successful is Beti? Founder and CEO Chad Richison on the conference call:
The clients have deployed Betty... 50% of their employees are now doing their own payroll. So you know that eventually goes to 100.
That's why Paycom decided to go all-in on Beti. They see customers and employees love it and they think they have a big winner in their hands. And I believe them. This is long-term thinking and Paycom even said so explicitly. CFO Craig Boelte on the conference call:
As we look out to 2024, we have a number of strategic initiatives that we believe will further strengthen the value clients receive from our offering. We are making strategic performance and client value decisions that we feel are best for our long-term relationship with our clients. Our mission is to ensure and achieve client value and that is our focus.
The strategic initiatives management talks about is letting their CRRs or customer relations representatives, an alternative name for salespeople, focus even more on selling customers on Beti. This also means that Paycom expects cross-selling to be lower.
Why Is Paycom Doing This?
If you have followed what I have written so far, you may wonder why Paycom is doing this. After all, this looks like a self-inflicted wound, no?
Well, to a certain extent, it is. Paycom gives up short-term gains for long-term gains and often, the market is not happy with such initiatives.
But in an age of technological disruption, it's better to disrupt yourself than to be disrupted. That's the basic philosophy of Amazon, for example. There is a reason the main building of its headquarters is called Day One. And Jeff Bezos has always said: "Your profit margin is my opportunity."
Founder and CEO Richison referred to the very start of Paycom, 25 years ago now, and he sees Beti as the most significant shift in the company's history (my emphasis):
Throughout our 25-year history, Paycom's innovations have been transforming the payroll and HCM industry. Now, we have fundamentally shifted our businesses' use of HR and Payroll products.
We started transforming the industry in 1998 by moving payroll to the web. We have made many innovations in those 25 years, but none more important, than do-it-yourself payroll for employees. This is a paradigm shift for our industry and delivers tremendous value to our clients.
Along with our focus on automating and innovating all of our current products. We're continuing to enhance global HCM and payroll products for international enterprises .
Two very important things in that quote and I made sure they stood out by putting them in bold. First, yes, this is a paradigm shift, and second, international enterprises. Don't forget that up to now, Paycom has only served SMBs in the US. So, for the company to talk about international enterprises, that takes it to a whole new level in two ways: international and enterprises.
Paycom is the first to have a fully developed DIY payroll solution, or at least one of the big players in this space. All the others are even relying on manual work much more than Paycom, where it has been just a small part of overall revenue.
Suppose you are the CFO, who is also ultimately responsible for Payroll at an enterprise. You can choose between payroll software ABC, where HR people have to type in everything before it's automated. That's hours, days, months and years of work and costs a ton of money.
Or you can choose a software solution in which your employees can do most of these things themselves. It costs millions of dollars less than the manual solution and on top of that, you don't have to pay the vendor a second time for errors to be solved manually, as the percentage of mistakes is dramatically lower than the one where everything happens automatically. What would you choose? I think I would know.
This is disruption, this is a paradigm shift, as Chad Richison says. And Paycom knows it can break into the enterprise market with this, as the product is so much better and most of the competition, if not all, will not be willing to sacrifice their fat margins for a new solution like this.
That's also why Paycom wants to move fast with international expansion. In August, they launched Beti in Canada and it's about to be launched in Mexico.
If this strategy succeeds, and that remains to be seen, this can catapult Paycom from a fairly big SMB player in the US only to a global leader in enterprise payroll management.
Of course, between point A, where we are now, and point B, Paycom becoming that global leader, there is a long road full of dangers. The company will have to execute flawlessly, but it has an outstanding track record. There will be stumbles along the way, as no transition ever goes smoothly, but I believe Paycom has a chance of attaining its goal.
Like Adobe?
This company is still widely profitable, on a GAAP basis too, has a very strong balance sheet, and looks to innovate a whole industry in a way that deserves all praise, in my opinion.
As an investor, you will probably have to be patient. Beti brought Paycom from a rather unremarkable but greatly performing company to the front row. The risks have grown substantially, especially execution risk. But the fact that this decision is taken and Paycom chooses the long-term big audacious goal and not the short-term easy goal of continuing to do the same, should not be taken against them, in my opinion.
Before Paycom, many companies went through painful transition periods. Think of Adobe, for example, when it switched to a subscription model. That also looked like a self-inflicted wound. In 2013, revenue growth even went negative.
Y Charts
But suppose you invested in the stock then. This would be your return with $10K.
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Valuation
To me, valuations remain very subjective, although they look as if they are objective. Gross margins are a part of the story because they often show how profitable a company could become when it scales. Paycom has gross margins of 83%, which is outstanding.
Let's look at a few other ratios.
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As you can see, the valuation is historically low now. With a forward PE of 19.7, for a company that has always executed this well. This is based on non-GAAP numbers, just make sure.
Yes, Paycom is seeing a headwind, as Beti cannibalizes its own revenue from recalculations of payroll mistakes, but this should be a temporary headwind. Temporary as in probably for a year or so.
Now, just like in every transition, there is uncertainty. That's why I wouldn't go all-in. I personally never do that. I scale into stocks over years, as I add money to my portfolio every two weeks. The stock will probably need a while to turn, so there will be quite a bit of time to see the stock rise substantially again. So, if you want to time the market, I would wait. My approach is to hold stocks for decades if possible. I will add to my Paycom position at this price, but there is always more downside possible over the short and long term. Paycom will have to be able to execute its plans and break into the enterprise market. If that doesn't work, things don't look great.
Conclusion
I understand the shock the paradigm shift gave the market and the earnings guidance for Q4 is a miss. The most shocking element was management guiding for 10% to 12% revenue growth next year.
With the background of this conference call, I also understand what management wants to do and giving up short-term gains for long-term gains is precisely how you want management to think if you are a long-term investor. Nevertheless, we shouldn't ignore the fact that while the potential for Paycom has shot up together with its total addressable market, execution risk has also increased.
In the meantime, keep growing!
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For further details see:
Paycom Stock: A Slow Buy Is A Good Bet On Beti