Stocks Investment

Short Paycom: Market Underestimating Cyclicality And Operating Leverage With ~30-50% Downside

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Short Paycom (NYSE:PAYC) at $290. With high expectations embedded in Paycom’s valuation, investors are underestimating the business model’s cyclicality and operating leverage. Street estimates still too high even after being reduced by 66c in 2020, by 75c in 2021 and by $1.08 in 2022. Paychex’s recent quarter provided a preview of what to expect from PAYC’s Q2 on 8/4/20. I expect Q2 to be the catalyst for further estimate cuts and multiple compression (growth deceleration, earnings downside, realization investors are paying >70X multiple for cyclical growth and a portion of earnings coming from float). Large> $225m, broad based insider selling. Weak technically. Last time the stock broke $300, it took the elevator down below to break $200.

Target price $160-200 (31%)-(45%) based on 10X revenues, 25-30X 21/22 ebitda, 40-50X P/E on my lower than consensus 2021/22 $3.94/$4.45 eps estimates. This is the range where I covered both in October 2019 when Q3 missed expectations on margin deleverage and in March/April 2020 with lowering numbers due to Covid macroeconomic concerns about employment and interest rates. This is also where the company is a buyer under its buyback plan (40k at avg $204.04 during the volatile trading of Q1).

Valuation: Enterprise Value $16.6B ($286.97, FD shares 58.44m, $150m net cash). EV/Revenues: 20.4X 2020, 18.5X 2021, 16.8X 2022. EV/Ebitda: 52.8X 2020, 45.8X 2021, 40.7X 2022. P/E: 85.4X 2020, 72.8X 2021, 64.4X 2022, 0.9% FCF yield. Mature payroll comps ADP ($63B, 4.3X sales, 17.4X ebitda, 26/24X P/E, 4.3% FCF yield) and Paychex ($26B, 6.6X sales, 16.5X ebitda, 26/25X P/E, 4.5% FCF yield). Paylocity (NASDAQ:PCTY) is a smaller growth payroll provider with similar high expectations, high multiples ($7.4B, 12.9X sales, 48.6X ebitda, 82/86X p/e, 1% FCF yield).

Investors Underestimating Cyclicality and Operating Leverage.

Cyclicality: Going into 2020, Wall Street analysts were extrapolating PAYC estimates off a base with a cyclically low 3.5% unemployment rate. While no one predicted Covid at the time, it was reasonable to assume a recession would occur when projecting financials over 5-10 years for DCF or earnings power. With the Covid shutdowns, staggered reopenings and the reintroduction of restrictions in certain industries (bars, restaurants, gyms, etc.) in some states, the employment picture will be choppy over the next few quarters. Even with the 7.5m jobs recovered in May and June, employment is still down 15m jobs since February. The current 11.1% unemployment rate is higher than the 10% peak in the Global Financial Crisis. New claims have been >1m for 18 straight weeks where 665k was the GFC peak. A Homebase study baselined to January 2020 has 80% of businesses reopened at staffing levels of 80% of employees (ticked down slightly in July). With the covid increase July has shown reversals. The National Federation of Independent Business, a trade association for small businesses, found that 22 percent of PPP recipients surveyed have laid off or expect to lay off employees after using up their PPP loan. Job postings have declined 35-45% from mid June (Burning Glass) in finance, food services, construction, mining and management. OpenTable restaurant bookings are down (60%) yoy. TSA air travelers are down (70%) yoy. Hotel occupancy is down (30%) yoy. All signs are that the recovery will be slower and not the V priced into Paycom’s valuation. Since Paycom receives a base fee and then a per employee charge, the lower # of employee paychecks processed will lead to revenue downside. Q1 was barely impacted by the start of shutdowns. Q2 revenues will be dramatically impacted by business closings, furloughs, unemployment, etc.

New business formations vs. closures in recessions: Paycom’s core small businesses customers have less financial stability than large companies. While government programs such as PPP have helped many businesses during covid shutdowns, profitability under covid demand/restrictions in service driven industries (restaurants, hotels, airlines, etc.) is not at levels which support the same staffing levels and in some cases will lead to decisions to close the business. Given union requirements, airlines have given notice to over 100k employees of potential layoffs October 1 when government financing employment requirements end. I am a part owner of a bar with 50 employees in Nashville. After having to shutdown a second time, we are having discussions on whether it is worth the long slog, probably unprofitable for a few years, or to close. Many other businesses will have similar conversations. During recessions, new business formation slows. With its small business core customer, Paycom has greater exposure to customers at risk of not making it through the covid recession. As of mid-July, 55 percent of the 132,500 pandemic-era closures on Yelp are now permanent.

Is the covid pandemic the time to switch payroll vendors? During its Q1 conference call, Paycom stated that after minor disruption with the move to working from home, its order book was back to pre-covid levels. On its call, Paychex commented that it had its highest retention quarter since customers valued its services during the crisis and weren’t going to move over a few bucks. With businesses focused on the shift to working from home, client retention, employee safety, reopening protocols, etc., shifting payroll vendors seems to be a low priority.

Net/net: there are a wide range of scenarios in both the reduction in core employee paychecks processed as well as the timing and slope of recovery in employment impacting Paycom’s revenues. With lower revenues from lower interest rates causing a ($13.5m) (7.6%) growth headwind and the loss of employment at customers, Paycom’s revenue growth will slow with scenarios ranging from growth deceleration +10-15% to flat and negative 2020/21 scenarios. With a lower base and slower growth rate, future revenues, earnings and cash flow used for valuation including terminal values in DCF will be much lower than the 20% growth, holding margins baked into estimates when 2020 started and its current V scenario valuation.

Margins/Negative Operating Leverage: With expenses growing faster than revenues, margin compression was occurring before Covid impacted its clients. Q1 ebitda and operating margins were down (300bps) due to deleveraging from increased marketing spend (28.4%, 1000bps>yoy), R&D (28bps>) and G&A (140bps>). The company plans to continue its aggressive marketing spend including TV advertising, R&D investments to improve functionality and G&A. With the lower employment and interest hit to revenues, this will lead to further deleveraging of margins. My forecast expects marketing (200bps) and G&A (130bps) in 2020. Paycom ($67.6m in 2019, 9.2% sales) significantly underinvests in R&D and is at a scale disadvantage vs. competitors (ADP’s R&D is $636m only 4.5% of ADP’s revenues but equivalent to 77% of PAYC’s sales). If it wants to add the functionality to compete for larger customers, it must invest more aggressively in R&D causing further margin erosion (over the last few years R&D has increased from 6.6% in 2017 to 7.6% in 2018 to 9.2% in 2019). How the company responds to slower revenue growth and deteriorating margins will impact growth rates and earnings power driving its valuation. If it pulls back on the marketing and R&D investments, it helps eps but slows growth rates leading to multiple compression.

Multiple compression: Growth deceleration is typically the catalyst for multiple rerating in high growth stocks. The ($13.5m) lower float income is causing a (7.5%) revenue growth headwind in 2020. Management has not quantified the unemployment impact but the covid recessionary impact on the US will lead to businesses going out of business, a slowdown in formations and reduced employment at continuing customers which reduce revenue. With the headwinds from lower interest rates and employment, Paycom will see a significant revenue and earnings deceleration in Q2 (My estimates are Q2 +5-10% vs. +21% Q1 and +31.5% last Q2) and 2020 +11-14% vs. +30.3% and +30.8%). Depending on how long the Covid recession lasts, the slower growth and lower margins potentially for years will significantly reduce long term earnings power and terminal values in DCF valuations.

The current crisis has exposed some business model flaws that were hidden by a 3.5% unemployment rate and high growth rates. With the Fed cutting interest rates close to zero, the 150 bp reduction in interest rates has reduced Paycom’s float revenues by $4.5m per quarter =6c quarterly eps. The bigger question is why were investors paying >20X sales and 70X P/E for float revenue/eps which is effectively what you get at banks for 10X and insurance companies for 8X. Paycom has aggressive growth embedded in its valuation. As it matures multiples will compress to valuations like mature industry leaders ADP and PAYX at 25X P/E’s which suggests $12 earnings power is already embedded in its valuation (2025 eps if growth > 20%, ebitda margins expand 320bps to 51.8%).

Paychex Tell: We received a preview of Paycom’s Q2 from Paychex’s recently reported May quarter (PAYX’s April/May overlap with PAYC’s Q2 plus weak outlook for Q1 (June/July/August) overlaps with PAYC’s Q3). Paycom and Paychex provide payroll and human capital solutions to small/midsized clients (50-5,000 employees). They are also similar in market cap PAYC $16.6B vs. PAYX’s $26.5B. PAYX is a broader lens into the economy with 55,000 clients +7% and 1.43m (4%) employees covered. Paychex earns more in revenue $915m and ebitda $351m in a quarter than Paycom does in a year ($738m/$318m). Paychex’s $1.3B free cash flow is 1.5X Paycom’s revenues. Paychex is basically what Paycom will look like when Paycom grows up in a few years.

Paychex discussed the low visibility for a business model that traditionally receives a premium for visibility. PAYX’s Q4 revenue experienced (7%) volume declines. Their outlook is for a weak 1H (most impacted Q1 Aug which overlaps with PAYC’s Q3) down mid to upper single digits, recovery 2H especially Q4 May 21 (PAYC’s Q1/2 21). Q1 operating margins declining to 30%, below 1H 32%, with the 2H ramping to 37%, (100bps) below last year’s 38%. Paychex doesn’t see the full recovery until Q4 returning to pre covid levels. Expect annual revenues (2-5%), eps (6-10%). Record 83% retention. Key metrics: Client suspensions going down (less than half, are they suspended or going out of business permanently?), number of checks up, sales improving but not at precovid levels. Losses to competitors have remarkably improved. Management stated “customers were not moving to pick up an extra discount at a time when they needed our help”. Don’t expect to be at precovid levels until Q4FY21. Modest gradual improvement Q1-3.

Weakening technicals: PAYC has been in distribution mode with the stock down on many up days for the market indices. It recently broke through the key $300 support level. When that happened in February, the elevator quickly went down to $200 before bottoming at $161 in April.

Watch what they do, not what they say. Large>$225m, broad based insider sales. They’ll say the window was open post earnings, diversification, options related but $225m in sales is significant. Chairman Richison sold 650k for $174m. CFO Boelte sold 10k for $2.8m. COO Evans sold 3k for $770k. Director Levenson sold 82k for $24.78m. Jeffrey York sold 50k for $16.4m. Brad Smith sold 10k for $3m.

Financial projections: There are a wide range of estimates based on the severity, duration, timing and slope of the recovery. Wall Street consensus is $3.54/$4.49/$5.76 after being cut by 66c in 2020, 75c in 2021 and $1.08 in 2022. It is interesting that after the cuts, the Street still assumes the average $1 per year earnings growth they had previously assumed. My 2020 base case $3.36 assumes 11% revenue growth (key seasonal Q1 before covid shutdowns), ebitda margins declining (440bps) from operating deleverage. Despite the historic visibility of the payroll processors, 2021 has a wide range of outcomes from down yoy to slowly starting a recovery to a sharp acceleration post vaccine. The key variable is employment rates which will correlate to the vaccine since GDP recovery requires a return to some level of normalcy in significantly impacted industries like travel and entertainment. As we saw in the Global Financial Crisis, employment recovery is not a light switch. Given the magnitude of the impact across industries and geographies, the recovery will probably be slower than the V priced into PAYC’s valuation (when the stock went back into the $300’s, investors were pricing in returning to 3.5% unemployment. If 2021 is 5% or 7% unemployment, significant downside to expectations and estimates). In the slower growth scenarios, Paycom is only earning $4-$5 in 2025. It is more likely to assume that Paycom adjusts its marketing and G&A spending to the new job environment leading to less deleveraging in future years which leads to $5-$6 in 2025. Not only do I believe the Street number’s are too high for the next two years, I believe the market is underestimating how much this impact long term earnings power and DCF terminal values. To get to the consensus numbers’s, you have to assume the Covid recession is over by year end 2020 with growth accelerating in 21/22 so that Paycom is back to the 20% growth rates while having expense control to get operating leverage for ebitda margins in the mid 50’s to get to $10-12 eps power. Even then, multiples should compress towards more mature payroll processor multiples of 25X for $250-300 stock in 5 years.

Other considerations:

Brand and financial risk from SEC inquiry: SEC subpoena 2/19, ongoing inquiry into books, records, and internal controls. Refunded $2.5m to 250 clients charged multiple applications between 2011-19. From the q1 10Q: “Note 12. COMMITMENTS AND CONTINGENCIES “As previously disclosed, since February 2019, we have received subpoenas and requests from the SEC focused on whether certain of our clients were charged, and paid, an additional amount for one or more applications for which the clients were already being charged. In connection with this matter, we identified less than 250 affected clients, representing approximately 0.5% of our client base as of December 31, 2019. Since December 2019, we have been notifying clients affected by such charges between approximately 2011 and 2019 and have refunded approximately $2.5 million, in the aggregate, to such clients. This issue did not have a material impact on our financial results for any prior period. The SEC staff has informed our legal counsel that its inquiry concerns our books and records and internal controls. We cannot predict the timing, scope or outcome of this matter.”

Compensation: Paycom is a company with significant options compensation dilution overhang. Interesting details in the CEO’s compensation agreement. When you are worth a few billions, do you really need shareholders to pay for your golf membership, car, and 75 hours of NetJets? Management leads the Street to use adjusted numbers which add back noncash stock compensation to get to adjusted ebitda/eps. 10Q highlights the magnitude of compensation costs: $143m unrecognized compensation costs over next 2 yrs. To reduce the dilution effect, the company is buying back stock. So basically they use free cash flow to buy back the stock they issued for compensation but since Wall Street analysts add the stock compensation expense back, they inflate margins and earnings which inflates the valuation.

Catalyst: Weak Q2 #’s/Q3 outlook leads to Street further lowering future estimates and price target reductions.

Disclosure: I am/we are short PAYC. 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.

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