Yahoo Finance Paycom: A High-Quality, Fast-Growing Company
"I saw an opportunity for people to have something easier to use but also to generate efficiencies to improve their business." - Chad Richison, founder of Paycom
The tech sector has been filled with fantastic growth stories across different industries, verticals and business models. Meanwhile, from an owner's perspective, not all growth is created equal. A superior return on capital is necessary to create shareholder value. In this regard, it would be quite challenging to find a technology business delivering both high growth and high returns consistently. Oklahoma-based Paycom Software Inc. (NYSE:PAYC) is a rare species in our view. The company develops comprehensive human resources and payroll software and claims to be one of the first companies to process payroll entirely online. Chad Richison, a former senior manager at entrenched ADP (NASDAQ:ADP), founded Paycom in 1998 after noticing the inefficient, error-prone access to HR information among employers and employees. He currently serves as the company's CEO and chairman with a 12.7% equity stake in the company.
Paycom employs a one-stop shop design for its human capital management solution to cover a comprehensive range of HR-related functions, from recruitment to retirement. According to Ernst & Young, the average cost of each employee-made entry in the HR-related database is estimated to be $4.39. Rishison's vision was to streamline the HR processes with accuracy, promote efficiency and, as a result, increase the bottom line for the client.
During the early years, Rishison and his team had to overcome the skepticism of customers to trust such a critical function to a new company with a young CEO. But once the customer was convinced, it would be difficult for it to depart thanks to the high switching cost. Paycom consistently invests in product development and customer service to widen its moat. The revenue retention rate increased steadily from 91% to 93% over the past three years, as the company enjoys high client satisfaction. At the same time, 98% of the sales are recurring through a software-as-a-service model.
As displayed below, Paycom appears to have achieved a decent balance between growth and return compared to its peers in the space. The business has steadily improved its return on assets to around 9% since its initial public offering, driven by both margin and asset turnover. The industry leader, ADP, and another fast-grower Paylocity (NASDAQ:PCTY) earn only 5.7% and 3.3%.
Paychex (NASDAQ:PAYX), which differentiates itself by focusing on small- and medium-sized enterprises, is the top performer in terms of this crucial return metric (with a 12% return on assets). But it underperformed Paycom with regards to top-line growth by a wide margin, as indicated below - a three-year average growth rate of 9% versus 31%.
Paycom has increased the average size of its clients significantly over the years, leading to higher revenue per client. We expect the organic growth trend to continue and considerably benefit the bottom line, thanks to the superior quality and scalability of service and products offered by the company. The CEO once mentioned that employee referral represents a respectable portion of new customer acquisition, signaling a decent industry-wide reputation. At the same time, management believes the challenges of managing the ever-changing complexity of payroll and human resources (e.g., COBRA, ACA) will continue to drive companies to turn to outsourced providers for help with their human capital management needs.
On the risk side, our slight concern with Paycom is its capability to reinvest. Based on our calculation, Paycom generates a 32% incremental return on equity capital for the last three years, compared to 33% at Paylocity, 38% at Paychex and 108% at ADP. Over the past five years, the company earned a 45% return on retained earnings, outperforming ADP (38%) but underperforming Paylocity (272%) and Paychex (54%).
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Paychex.
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This article first appeared on GuruFocus.
