Paycom: An Inevitable Business Taking Market Share For 20 Years

It has been said that nothing is certain in life - except for death and taxes.

For business owners, you can add a third: payroll!

At many of the enterprise scale businesses in the U.S., payroll is managed by one of two companies: Automatic Data Processing (ADP) or Paychex (PAYX). Between them, these two firms have almost 20% market share in payroll and service nearly 1.8 million clients.

But what about the 33 million small-to-medium size (SMB) businesses operating in the U.S.?

That's where today's stock, Paycom (PAYC), comes in! Let's take a look at this interesting business.

What Paycom Does

Paycom offers payroll management, benefits management, time tracking, onboarding and termination, compliance tracking, performance management, and other HR-based software solutions.

The firm's target clients are small-to-medium size businesses, specifically with an employee count ranging between 50 and 5,000.

Paycom's software is fully cloud-delivered. There is no complex IT needed to set up and maintain an on-premises deployment. Updates are delivered constantly and automatically. Clients pay subscription fees on a "number of users" basis.

And... that's really it! This is a pretty straightforward business model that's easy to understand. Anyone who has been a corporate employee should be pretty familiar with this kind of software. Paycom's offering is similar in many ways to the Workday (WDAY) or SAP deployments you might have encountered in the corporate world - just tailored for small businesses.

The Revenue Opportunity

Paycom has been a rapidly growing company. Its 3 year compound annual revenue growth rate is over 23%, and that includes a weak 2020 that saw a lot of SMBs close due to COVID lockdowns. Outside of 2020, annual growth rates have been closer to 30%, and 2022 looks to come in close to that figure.

Management estimates the addressable market for what the company provides to be $24 billion, growing between 9-10% annually. That represents tremendous revenue growth runway from a current run rate of $1.4 billion. That's just 5% of the current addressable market.

Another way to visualize the growth potential is to consider the client base. There are nearly 33 million SMBs in the United States. Paycom's client base is 34,000. That's less than 1% penetration! Even if a lot of those are too small for the company, there is still a lot of potential here to add new clients.

Paycom continues to steadily pursue its growth avenues. Although it has recently sped up its opening of new sales offices, it still only has a direct sales presence in 28 states. Continued sales force expansion through the U.S., and eventually internationally, should help drive industry leading growth rates for the next 5+ years (at least).

As a subscription-based cloud software provider, Paycom exhibits one of the classic recurring revenue models. Its clients continue to pay, month after month, as long as they continue to use its services. That's exactly what we like to see!

Competition and Moats

There's no question the payroll and HR software space is pretty crowded. We've already mentioned ADP and Paychex. In the SMB space, Intuit (INTU) has long dominated the *really* small business end with its Quickbooks product. Additional competitors include Paylocity (PCTY) (another Green Screen stock), SAP, Paycor, and many others.

With so much competition, how can Paycom continue to succeed?

The primary structural moat characteristic in the business is HIGH SWITCHING COSTS. Payroll is business critical, the "first bill you have to pay". It is not a service most companies are interested in disrupting unless absolutely necessary. Paycom keeps over 94% of its customers annually, an excellent figure in the SMB world where firms close shop or get acquired frequently. This has been rising as clients add more and more of its HR service modules.

This protects the firm against losing existing clients, but what about gaining new ones?

Paycom has been grabbing market share for over 20 years now by simply offering a better product. While ADP and Paychex have built out their HR software suites by offering bolted-on acquisitions that are not well integrated, Paycom's software is single-platform, developed in house, and carefully integrated.

This creates a much better user experience. Any new modules added can automatically import and use existing employee data with zero intervention. The company recently launched a platform called BETI to market, which tasks employees with entering or confirming their own payroll info (hours, time off, benefits elections, etc.). The result has been high customer satisfaction, with fewer errors in payroll and less time spent by HR professionals on the task. A win-win all around.

This is a competitive space but with switching costs and a superior product, Paycom has shown the ability to win. I expect that to continue.

Leadership and Financials

If it is a "green dot" stock, chances are there's a founder CEO at the helm!

That is certainly the case with Paycom. Chad Richison co-founded the firm in 1998 after a stint with ADP, and has led it ever since. He has been a visionary, bringing payroll solutions to the underserved SMB market and a leader in moving to a cloud-based subscription solution.

What impresses me most is the efficient way Richison has grown the company. The balance sheet is nearly debt-free and goodwill is a minimal $50 million, meaning virtually all of Paycom's growth has come organically (matching the internally-developed product strategy). This allows some impressive returns on invested capital, which have stood at over 25% for many years.

Over the long term, this kind of efficiency delivers big investment returns. Since going public in 2014, Paycom has delivered investors a return of over 1,800%, or 43% annually. Is that good?!

There's no reason to think Richison is going anywhere soon. At 51, he is relatively young as CEOs go. He owns a large 14% stake in the company, a $2.5 billion nest egg that puts him in the Forbes 400 wealthiest people. In 2020, he received a massive 1.6 million in restricted stock units that could be worth over $2 billion if Paycom's stock increases 5x over the next 7 years. That's quite a bit of incentive not only to stay, but to focus on investment success for all stakeholders.

Simply put, management and financial strength are both big plusses.

Risks

Near-term, the risk of a widely predicted recession in 2023 would certainly ding Paycom's results. Any recession that leads to an increase in unemployment is going to hit all payroll firms. While the market will sell down the stock if this happens, I'm not too concerned about it. It will provide a better entry into the stock, and there's not much Paycom can do about it anyway.

Longer-term, competition clearly looks like the biggest risk. Particularly in the SMB market, where price sensitivity is high and switching is less onerous, the prospect of losing clients is real. Paycom's retention rate is the single most important business metric here. As long as it remains in the mid-90% range, I don't have any major concerns. If it falls below 90%, or the firm stops reporting it, there may be reason to review the thesis.

I also would be concerned if Paycom's traditional "in-house" strategy starts to shift. A move towards growth-by-acquisition would be completely out of character for the firm, and probably indicates trouble adding new customers.

Conclusion

Paycom is a really attractive company with all of the key points we look for: growth potential, recurring revenues, a structural moat, excellent financial metrics, and strong leadership. It easily gets the nod as a "Green Dot" stock and will be added to the Watch List today.

Check out the PAYC stock page for more thoughts on valuation and a good price for investors to buy (subscribe today!).