Source: Paycom
Shares of human resource and payroll service provider Paycom (PAYC) continue to reach new highs. A recent earnings report sent the stock shooting higher as the company beat expectations. While its addressable market is rather large, competition is strong and the company would need to continue to grow at current rates for years to come to justify the valuation. I think shares have gotten quite a bit ahead of themselves here and need to pullback before becoming an attractive buy. The growth is great, but sales and earnings would have ways to go before the current valuation makes sense let alone a higher one.
Performance
Paycom just reported second quarter earnings that resulted in a beat in both the top and bottom line.
Source: Seeking Alpha
Top line revenue growth of over 30% continued and earnings are positive which is unlike most software companies. However, Paycom is not just a software company. It is a payroll and human resource provider that uses technology to offer a superior product platform to most competitors. The company benefits from being a one-stop shop for solutions in almost every aspect of hiring, firing, retirement, management, and more.
This has helped it grow to have a tremendous client base of over 13,000 customers. The continued satisfaction and retention of these clients help not only attract new customers but also enhance offerings and cross selling driving revenue higher.
The company saw net income rise for the quarter by over 37%.
Source: 10-Q
This growth in income has allowed the company to expand with little debt and keep investing in expanding its presence. Additionally, the company has been repurchasing shares which is not common practice for a company of its size and in the industry in which it operates in. The company was able to continue to capitalize on its total offerings and obtain gross margins of over 85% which is just huge. This helped the company raise its full year guidance and it now expects adjusted EBITDA in the range of $306 million to $308 million.
The company maintains a strong balance sheet as well, further making it an attractive investment.
Source: 10-Q
With a cash position of over $90 million and debt of $35 million, the company has a net positive cash position. This is, of course, rare to find as well. With limited debt on the balance sheet, investors should be mindful that an increased valuation comes about. Without leverage, there is little risk in the event of a recession that the company will have a hard time. This also leaves the company in a position to make acquisitions that can further bolster its business and add more earnings or technology.
Valuation
Valuing a company like this is somewhat easy but also difficult. It operates in a space that does not see much growth. Typically, the growth comes when the bottom of a cycle has just happened and employment is on the rise. This is because the company is paid for its services by number of employees being covered. So when employees are laid off, there is less revenue, and when hired, there is more. However, Paycom has been winning business from the legacy providers that offer similar services but not the total package. Also, the company has a smart pricing structure.
From the annual report:
“Pricing is determined by employee headcount and the number of applications utilized, enabling our clients to align HCM spending with their evolving HCM needs as compared to traditional HCM products that require clients to migrate to new software as they grow but retain fixed costs even if the client shrinks in size.”
If customers lay off employees, the number of employees being covered by Paycom services decrease, but the customer pricing may rise due to less total headcount. This helps mitigate downside risk.
Below, we can see how competitors are valued compared to Paycom.
Data by YCharts
Trading at more than 70x forward earnings, it is quite a bit ahead of peers. The company also trades at double the P/S ratio of its nearest competitor and doesn’t offer a dividend like other peers. This is typical of growth companies, however. If we presume the following growth metrics for the next few years, we can have an idea of where valuation would lie compared to earnings, presuming no more stock price appreciation.
We start by assuming EPS comes in around $3.95 for 2019. We also assume the company takes a multiple of 30x earnings to find a fair valuation given growth. This helps us find an implied fair price.
| EPS Growth | EPS | Share Price | |
| Year 1 2020 | 35% | $5.33 | $159.90 |
| Year 2 2021 | 30% | $6.93 | $207.90 |
| Year 3 2022 | 25% | $8.66 | $259.80 |
As we can see, shares are trading close to what I would consider fair value based on 2022 earnings. This also presumes pretty lofty continued growth in earnings. As we know, the law of large numbers makes growth in earnings harder. However, I presume the company can increase earnings with less capital expenditures or the use of leverage to make accretive acquisitions. I am not sure there are many acquisition targets that make sense for a company that can essentially design all the solutions it would like to offer in house. However, there may be something that fits within the company or a new strategy it may approach. Additionally, earnings should benefit from continued share repurchases as the company makes use of its free cash flow. However, I prefer to see the company build a cash position at these levels of its stock price.
Lastly, looking at the historical valuation, we can see where the shares currently trade versus their own history.
Source: Morningstar
As we can see, the company is trading at a premium to its own historical valuation levels. This despite the fact the growth is in line with its own history. It trades at a premium to its own P/S, P/CF, and forward P/E. These are all signals the stock has gotten ahead of itself.
Conclusion
While Paycom has certainly disrupted the space it operates in, the shares are trading at a valuation that can’t be justified for me at this time. I prefer to invest in a growth company at a fairer valuation which is usually a P/E close to the growth it is experiencing in this case. This would mean the company would need to see its stock drop to around $160 for me to initiate a position and this is presuming the company can continue to grow at an accelerated pace. For now, I am sitting on the sidelines and will wait until a disappointing earnings report or a general market pullback for an opportunity to enter a position.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
