2023-11-01 12:10:46 ET
Summary
- Paycom stock plummeted after the company released earnings, despite solid revenue growth and profitability.
- The company's automated Beti product appears to be cannibalizing its business and the case of the deteriorating growth outlook.
- The company is GAAP profitable, has a net cash balance sheet, and is buying back stock.
- I'm upgrading the stock to "strong buy" given the attractive valuation.
Shares of Paycom Software ( PAYC ) were crushed on Wednesday trading after the company released earnings after Tuesday’s close. While the company reported a solid quarter highlighted by more than 20% revenue growth and typically high profit margins, management’s guidance for the next quarter and next year spooked investors. The company’s automated Beti product is cannibalizing the business which explains the deteriorating growth outlook. A valuation reset makes sense, but the magnitude of the crash looks overdone given the company’s secular growth profile (albeit slower), net cash balance sheet, and GAAP profitability. I'm upgrading the stock to “strong buy” due to valuation.
Paycom Software Stock Price
PAYC has been one of the worst performing stocks in the tech sector over the past year, and today’s crash adds more pain to that suffering.
I last covered PAYC in August where I rated the stock a buy but noted that “downside surprises to revenue growth may heavily impact the stock price.” The stock is down 50% since then and I take no credit for predicting this decline as I did not anticipate growth to decelerate so meaningfully in the absence of macro changes. It's time for another look.
Paycom Stock Key Metrics
In its most recent quarter, PAYC delivered 21.6% YoY revenue growth to $406.3 million, slightly below guidance for $411 million. PAYC remained highly profitable with $165.6 million of adjusted EBITDA, representing 31% YoY growth, and $102.4 million of non-GAAP net income, representing 39.5% YoY growth. The company also was profitable on a GAAP basis, generating $75.2 million in GAAP net income.
The company’s strong profitability profile enabled it to generously return cash to shareholders, paying $21.6 million in dividends and repurchasing $76.5 million of stock in the quarter. PAYC ended the quarter with $484 million of cash vs. $29 million of debt, representing a strong net cash balance sheet. I note that this cash balance excludes $2.1 billion of funds held on behalf of clients.
Looking ahead, management has guided for up to $425 million in revenues in the fourth quarter, representing just around 14% YoY growth, and lower full-year guidance to $1.684 billion in revenues (vs. prior guidance of $1.715 billion) and $717 million in adjusted EBITDA (down from prior guidance of $724 million). This drop in guidance is concerning given that it was just in the prior quarter that management was highly confident about being able to sustain at least 20% revenue growth in the near term.
2023 Q3 Press Release
On the conference call , management delivered even more bad news, guiding for 2024 to see revenue growth decline to the 10% to 12% range. What happened?
Management blamed the failures on the successes of their Beti automated software. Beti allows customer’s employees to initiate payrolls by themselves. Because Beti has been so effective and accurate, it has reduced the need to further use Paycom’s other software to correct payrolls, which is eliminating “certain billable items.” Management gave an example where a customer was previously running 19 payrolls in a quarter but has reduced that number to 13 due to the effectiveness of Beti. While it may be too early to find silver linings, management emphasized that they are “focused on the client value and the differential between what they're paying and what they're actually achieving.” That might suggest some pricing power at some point in the future, but it's little solace given the poor guidance for the upcoming year.
Is PAYC Stock A Buy, Sell, or Hold?
PAYC is a payroll and HCM solution, helping its customers manage the employee lifecycle.
Paycom
That means it's earning recurring revenues just like many of the other well-known enterprise tech names like Salesforce ( CRM ), but this reduction in guidance (and loss of trust) is weighing on valuations. At recent prices, PAYC was trading at around 20x this year’s earnings.
Seeking Alpha
The stock was trading at just around 5.2x sales (I note that consensus estimates have not yet incorporated the new guidance).
Seeking Alpha
As I stated in my prior report, a valuation reset would be likely if the growth outlook were to deteriorate. Yet I had expected the strong profitability to offer downside support. At these valuations, PAYC is now trading neck to neck with CRM on a price to sales basis but arguably has a stronger growth outlook and stronger profit margins. Based on 12% forward revenue growth, 35% long-term net margins and a 1.5x price to earnings growth ratio (PEG ratio), I see the stock trading at around 6.3x sales, implying multiple expansion upside to go alongside annual growth. Together with the earnings yield, I could see the stock delivering around 15% annual return potential which is a satisfactory value proposition given the high quality financial profile (GAAP profitability, net cash balance sheet) and reasonable assumptions. I expect the catalyst to be old fashioned: Just consistently executed share buybacks.
What are the key risks? It's possible that the macro environment worsens and causes the growth outlook to deteriorate further. I have seldom seen management outperform after issuing such pessimistic outlooks, but it's possible that a worsening macro environment may add additional weight. Given that management was guiding for around 20% growth just three months back, it's reasonable to wonder if management can be trusted to be issuing guidance anymore, at least in the near term. PAYC does not break out how much of its revenues are earned from interest income from funds held on behalf of clients though I estimate it to be around 25% of GAAP net income at the most. This risk might not be so concerning given that the company may earn higher interest income in the event of persistently high interest rates, or experience multiple expansion in the event of a decline in interest rates. Competition risk should not be ignored. The payroll and HCM space has formidable competitors and the market may eventually become saturated.
I'm of the view that the Beti cannibalization has increased the quality of earnings given the potential for future pricing power. I'm upgrading my rating of PAYC stock to “strong buy” given the attractive valuation.
For further details see:
Paycom Stock Tumbles: Upgrade To Strong Buy, $400 Million Net Cash, GAAP Profitability