Chit Chat Stocks - 2 Software Stocks I Bought This Month (PAYC, SEMR)

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Starting point is 00:00:43 investing. Options are not suitable for all investors and carry significant risk. Full disclosures are in the podcast description. Welcome to Chitchat Stocks. On this show, hosts Ryan Henderson and Brett Schaefer analyze businesses and riff on the world of investing. As a quick reminder, Chitchat Stocks is a CCM Media Group podcast. Anything discussed on Chitchat Stocks by Ryan, Brett, or any other podcast guest is not formal advice or recommendation. Now, please enjoy this episode. All right. Welcome into Chit Chat Stocks. My name is Brett Schaefer, and as always, joined by Ryan Henderson. This is one of our stock research episodes, and we actually have a twofer

Starting point is 00:01:34 for the audience today. It is two software stocks that Ryan is planning to buy, as probably bought as this is getting released for you. Although we do follow the guidelines, We're definitely not someone that wants to buy in anticipation of an episode, but we're going to get right into it. I think I should just say as one quick disclaimer for the listeners, when we do these episodes, we want to go through essentially a full research report on the stocks we're doing, and we want them to be in-depth, very good analysis, and we're essentially just doing them in audio video format.

Starting point is 00:02:12 There will be some shared charts and stuff that we will include on the YouTube and Spotify video feeds. But besides that, we usually just choose one of these each month. We do the research reports. Ryan is doing the one this time. Next time it'll be me. And that's about it. We'll also have some free newsletter stuff on our sub stack as well. So Ryan, we're going to get to the first one. What is the first software stock that has you interested? Yeah, the first one, the way I'm to go about this is we've got two for this month today on the show. And I really couldn't pick one, which one to do. I was interested in both. And after the research, I think I'm going to ultimately end up buying both, maybe have bought both. We're recording this about a week in advance,

Starting point is 00:03:00 so things may have changed, but we're still following our guidelines. Anyway, the first one we're looking at, this one's been around a little while longer. It's less of a, it's more of a household name, you'd say, as compared to the second one I'm going to talk about. And it is Paycom. Paycom, for those that don't know, is a human capital management software provider. So that's a little broad, and I'll try to narrow things down a little bit. But the old version of Paycom, which is still used by some customers, is just a software as a service platform that allows companies to manage and administer their payroll. So that includes things like direct deposit, expense management, time and attendance, scheduling, as well as

Starting point is 00:03:46 if you look through the product suite here, it's a lot of broad solutions. Basically, they're trying to consolidate a whole bunch of the HR functions into one thing. So it's got some other HR tools as well. So things like talent acquisition, new employee onboarding, like HR report center, if there's like HR tickets, that kind of thing. Anyway, it has a ton of different tools and they were kind of selling that as a package. However, in 2021, Paycom launched Betty, which is short for Better Employee Transaction Interface. and that's really been like the hit product for them. And I remember reading the conference calls and hearing them, you know, people talk, management teams always talk about new products and stuff

Starting point is 00:04:33 like that. And I kind of thought this was just another solution in their bucket of tools. And it really isn't. This has cannibalized their existing business in a big way. So 65% of their existing customers already use Betty. So within three years of launch, Betty has already the majority of their customers are relying on this. And the way it's different is that Betty just allows employees to manage their own timesheets and payroll. It's a way for them to manage their sick days, measure their time on the job, immediately get paid. It's really quite convenient. So previously, HR would submit the timesheets and you would vet them, check them, there'd be like mistakes constantly this is just allows employees to do it themselves obviously

Starting point is 00:05:24 they don't you know pick their own pay but they're able to do basically everything else around that so um yeah it's been super successful and employees really ultimately like this it's a pretty i won't i won't go too long on the business because it's pretty simple to understand they charge a subscription price on a per paycheck basis so typically that's about anywhere from $25 to $35 per employee per month. So it's a premium product, but they've been able to grow despite having kind of a premium price because the platform has been so good. As for other aspects of the business model, the sales cycles are a little bit longer since it's you're kind of coming in, you're disrupting the payroll for an existing business. It can take a

Starting point is 00:06:13 while. So two to three months sales cycle. And once a customer is on your software, it's pretty sticky. So they tend to have low churn from logos or companies that stick around. However, like I said, they target a lot of small and medium-sized businesses. So there'll be businesses that just go under. They're not going to stick around. So there is some level of just natural churn in the business. All right. That all makes sense. Yeah. It's not a super complicated software program like some of those enterprise ones that might be for the IT department, right? This is for HR. This is something that most people can understand. And I think it makes sense why someone would pay for this product. And we'll see in the numbers as we get in here, the revenue growth has

Starting point is 00:07:02 been very steady over the last 10 to 15 years. So we have essentially, for example, you have a hundred person company. And instead of having three HR employees, if you use Paycom, you might only need one. So you can, you know, pay a little bit more for the software, but instead of three salaries, you don't have to pay one salary. You can pay that person even more. It's going to really supercharge them and make things even better for them and then all the employees that they manage. So as we get into things, Ryan, who do they compete with? Because I think all the astute listeners are going to think of those graphics that have all the hundreds of different software programs out there, especially in the modern SaaS solutions. So who are their competitors

Starting point is 00:07:45 and why have they been so successful despite such large competition? Yeah, Paycom. Yeah, you're probably guessing. You see those software graphics where it's literally just a million logos. And human capital management software broadly is one of those categories that has tons of upstarts, tons of competitors. It's a highly competitive industry. But really, it's actually fairly consolidated at the top. So Paycom themselves, they describe themselves as serving the mid-market. And I kind of think of that as they specialize in SMBs or small and medium-sized businesses, but they're also willing to take the occasional fortune 500 company because basically they'll take any customer um

Starting point is 00:08:39 but it just so happens that it's mostly adopted by small and medium-sized businesses that's how i think of it but in terms of competition paycom is actually still kind of the new kid on the block in terms of like they are a market share taker from the legacy ones in this case which are paychecks and ADP are the ones they primarily compete with. So, and what's funny about ADP is that we, I think you're reading the one up on Wall Stream for Peter Lynch as well as me, because we're about to record a podcast covering Peter Lynch. ADP has been one of the, well, it's one of the ones he mentions in the book as a long-term

Starting point is 00:09:20 compounder, and it's still been a long-term compounder today, and I think it's a thousand beggar. And I guess that's just an example of the industry can be quite profitable if you manage it pretty well and consistently, like someone like ADP or Paycom has. Yeah. ADP, it still grows, which is, if I'm not mistaken, I haven't looked at their financials, but I remember just being blown away that something that big and something that's been around for so long continues to grow. Both of those businesses, Paychex and ADP, have been around for more than 50 years. And those two combined have nearly 50% market share. ADP is the largest. I think they've got like 32% roughly, and Paychex is around 14%. For reference, Paycom

Starting point is 00:10:05 sits at about 4%. So still kind of the smaller player in the industry. And the reason I chose Paychex and ADP is just because they serve similar customers, primarily small and medium-sized businesses. There are other providers, Microsoft, there's some other ones I'm blanking on that are really catered towards enterprises. And I don't really think of those particularly as customers. But anyway, Paycom has been taking share from those two companies for a long time. But it seems like people have become more and more worried lately about the startup type competition. And one analyst actually asked that on the latest conference call. He says, I just wanted to ask in terms of new client wins, has there been any change from a mixed perspective

Starting point is 00:10:57 of where you were seeing those wins come from, whether it's competitive takeaways or in-house or regional, just any context there on the competitive side? Chad Richardson, the CEO says, no. I mean, we've been in a very competitive industry for 26 years. This is our 26th year, arguably with the new guys from specifically who we really compete with. And so it's the usual suspects that we continue to compete against. So they're really trying to win customers over from paychecks and ADP still. What's driven the success? Early days, it was just like, okay, you can do payroll on the internet. That was what kind of drove success early because those customers, a lot of them... I remember there's interviews with Chad Richardson where

Starting point is 00:11:40 I was literally just convincing customers to use the internet and not do timesheets in person or manually, physically, I guess. So that was one of them. But today, what's really driven it? They have constantly, from what I understand, and there's no secret recipe here, they've constantly had one of, if not the best products in the space. It's a great platform, saves customers time and money. And now today with Betty, it really is kind of a differentiated product. And then two, they've done a phenomenal job with sales. Today, they have 55 different sales teams across 28 states that go out and meet with business customers every day. Each of these teams typically consists of one sort of regional leader and eight customer relationship representatives,

Starting point is 00:12:26 just sales reps, basically. And they incentivize them well. These are typically like recent graduates that are kind of young, hungry, work a lot of hours and are willing to go out there and try to generate as much sales as they can. And it seems to work for them. They've really kind of just refined that sales process over the years. When we look at the actual financials, Brett just shared it there for anyone that's watching, but the results have been remarkable over the last decade, their total revenue has compounded at more than 30% a year since 2012. And their operating margins have gone from 8% to 33% over that same time period. So not bad. Great growth, highly profitable business. The one caveat I will add here is we talked with

Starting point is 00:13:18 Braden Dennis a couple of weeks ago about B2B software and how people often overlook the commission side of things. I don't know the specific structure with Paycom. I don't know how long the commissions persist, but I would guess that that does somewhat cap their operating leverage, that this is very much a sales-driven business. It's not product-led growth necessarily. It's not like tons. And I would guess that a lot of the customer wins are coming from outbound sales. So that's just to say, I don't think operating margins can grow to the sky. So kind of factor that in as you're modeling it out. Yeah, that makes sense. But unlike a lot of the other SaaS companies, which claim 80% gross margins, but say have

Starting point is 00:14:05 negative 10% operating margins, Paycom checks that box. They've been profitable for a long time. And as that chart shows, I think over the last 12 months, yep, they're at an all-time high operating margin. So they've been able to grow and do so efficiently, which is really, really quite rare in the SaaS space. Now, when you talk about the history of the business, as well as the management team, there's been a lot of... I'd say the narrative around the stock has gotten negative because of this management team and what they're doing. And Ryan, you can correct me if I'm wrong there, but what is the history of the business and what do you think of the management team and the recent developments? So Paycom was founded in 1998 by Chad Richeson.

Starting point is 00:14:51 Chad, or Chad Richardson is still the CEO today. He worked at ADP actually out of college and then spent some time at another small payroll provider in Denver before eventually returning home to Oklahoma where he built Paycom. I will also say it's kind of refreshing just to see this. Like he went to a, I believe it might not have been a community college, but a small college in oklahoma went out built his own business has done incredibly well there's nothing you know i don't know it's just kind of a nice success story to watch and they've actually been at the forefront um in terms of product evolution for this industry despite having most of their employees i believe in tulsa so um yeah and just goes to show i have a bio here born in tuttle

Starting point is 00:15:41 Central Oklahoma Education University of Central Oklahoma, net worth $1.5 billion. So you don't have to go Harvard-McKinsey route to become a billionaire. I think that's a good example of that. But if you are from Harvard and you listen to the show, we still have love for your school as well. I don't know if we do, but anyway. So Paycom gained traction earlier, like I said, because it was just a pioneer in the online payroll space.

Starting point is 00:16:07 They offered a SaaS payroll product at a time when most businesses were still doing physical timesheets. So the value proposition was pretty clear. And the biggest hurdle was just convincing people that it's better to do it online. But I was hoping to find some long business biography about how Paycom evolved and the different pivots they had, but it's really kind of boring. They've just refined their sales process over two decades, constantly added new customers. And those customers, as long as they stay in business, tend to stick around as long as your product is still serving their needs. So that's basically been the evolution for this business. The only sort of other big monumental change has been Betty. And I mentioned it earlier,

Starting point is 00:16:53 but Betty was rolled out in 2021. And today, already 65% of their customers use it. As for Chad Richardson, I don't quite know what to think. He's obviously done a very good job, But he's a consistent seller of stock. He basically sells half a million dollars worth of stock every day, which, wow, that's a nice life, I guess. These are, what do you call them, predetermined. He's set them to automatic, automated sales. But yeah, anyway, just seller of stock. Do you have anything to say there, Brett?

Starting point is 00:17:27 I'm seeing you grin here. He said that he might be funding University of Central Oklahoma's NIL, or, you know, the new student payment stuff that they do, but probably not that. I think on a serious note, Peter Lynch is on the mind because we just read his book in preparation for making some notes for a podcast on him. and he said many other people have said that there are many reasons why an executive sells a stock you really don't know why but there's only one reason that they buy is because they're bullish on it so i don't know if there's the narrative has been out there that he's selling a stock and there's there's i think it's driven at least from what i'm seeing and reading that that's driven the stock down um just because people's perception of that is really negative but if we look at the historical evidence. It seems like it's a crapshoot predicting whether this has any

Starting point is 00:18:19 sort of significance. Yeah. And I'll go more into it here, but I would not read into the sales too much and I'll talk about why that is. But the other thing is he still owns a ton of stock. There's no dual class share structure, super voting or anything like that. He just outright owns 12% of the company, 12% of the shares. And then the other part that's interesting as well is he's got one of those crazy long-term equity compensation packages where if the stock soars, he makes a ton of money. Here's how it would work in his case. If the stock – and keep in mind, the stock is at $157 as of this recording. If the stock is above $1,000 in 2026, he would get $800 million worth of stock. That's, I don't know, probably a seven

Starting point is 00:19:11 bagger in two years, three years. If the stock is above $1,750 a share, so 10 bagger, more than a 10 bagger from here, by 2030, he would get $1.4 billion worth of stock. That would be a ton of value created. We'd be looking at probably $100 billion market cap business here. So he would be getting some of the value that he created, but I think it's, I don't know, kind of interesting incentives. And I don't mind that, actually. For a business like this, there's really no way to get to that level of a stock price without growing your earnings and growing your revenue. So the incentives are in place, I think, in this case. Yeah. Better than adjusted EBITDA, that's for sure. We're not the giant Elon Musk fanboys on this podcast, but this is the type of comp plan

Starting point is 00:20:02 that has been inspired that he used that's been inspired by many companies looks like paycom as well and i i really don't hate these plans as long as they have good enough hurdles and these are might even be too extreme honestly they're ambitious they're very ambitious these were instituted in 2020 as well so the stock we'll talk about it here in a second but the stock was at a much higher price then okay yeah that makes more sense and hey look that's the beauty of these plans if shareholders aren't winning like they haven't over the last few years well they're not going to just pay the executive team a boatload of stock now i'm seeing another quote here about a leak ryan uh from a development meeting what did uh you find out about this and what'd you think

Starting point is 00:20:49 about it any any insights from this and where was it reported i guess has it been broadly reported or i don't i i saw it in a write-up uh write-up about paycom but the um it's yeah so basically there's this leaked audio tape of him talking to i think the development team and it's on youtube you can look it up just like paycom leaked audio tape um and it's 20 minutes long it's worth listening to the whole thing i think if you're a shareholder because you get a pretty good sense of how this guy runs the company. But I didn't find him particularly inspiring. So this was from a meeting heading into 2024. And he's talking to the development team. He said, I will tell you that last year, the more I dug into the product, the more embarrassed I was about it. It's not

Starting point is 00:21:41 your fault. It's just where we were as a company. He said, with 2024, all I want to do is fix our product. I don't want to go skiing. I don't want to go on vacation. I don't want to go on a sales call. I don't want to talk to any investors. I don't want to have any board meetings, to be honest with you. All I want to do is fix this product. Like I said, it's about a 20-minute leak. I think in general, it was all right. He's clearly very demanding. And there are parts where he sounded like kind of an intimidator in a way. But I don't think that necessarily means they're going to be unable to produce good business outcomes. Some people lead well that way. And I imagine that if you're an employee there, you probably knew who this guy was when you signed

Starting point is 00:22:28 up or you at least got some idea along the way. The concern for me is the fact that someone felt compelled to record and leak this meeting kind of goes to show where he stands with his employees. It's known as a high turnover place. And you can tell that it kind of lacks trust. And throughout that meeting, you kind of got the sense that this guy, I mean, he's in it for the money. It's not like this is some passion project where he loves payroll. Maybe he does. But he's like, I don't want to do any more skiing or going on vacation. Just fix the product.

Starting point is 00:23:04 So anyway, yeah, it's worth going and listening to that if you're thinking about being a shareholder. Yeah, and it's interesting he talked about – So on the one hand, it's good that they're focused on the product. because that's where everything begins. It's the most important thing. You always have to be doing that. But on the other hand, it seems like they may have under-invested in product development, which is possibly why the operating margins have been so high. Are they over-earning? Did they over-earn? Let me see. What do we have here? Say back in 2016, 2017, 2018, profit margins were still at 30%. And now today, some of the product development, you know, falling behind on that,

Starting point is 00:23:49 that might be showing up possibly. But as you said here, Ryan, he also just might be someone that's kind of an intimidator when he tries to lead football coach mentality. Yeah. Yeah. And he, yeah, it did kind of remind me of like football coach mentality there. the other part is he at one point he's like yeah you know we almost let our competitors get back to product parity with us it's like we didn't though then thankfully because of betty and there's another app that they did or another product that they have called gone which is i think for like time absences and uh planning trips or planning time away stuff like that And so they, I think the core product has lacked innovation, but they've still survived as a

Starting point is 00:24:40 business because I think largely of Betty. Yeah. Makes sense. All right. What has happened to the stock? I'm seeing a big drawdown. Valuation's getting lower. We're going to get into that here. What do you think? Why is the stock falling? So yeah, Paycom is down 72% from its highs and has been one of the biggest losers in the S&P 500 over the last year. And I think there are a couple of reasons why. So for starters, Betty, as I mentioned, it's been a big success, but it's actually a headwind to the top line. And so I recommend Ryan Reeves, friend of the show, author of the Investing City blog, wrote a good piece on Paycom recently. He says, in the past, if an HR employee made a mistake

Starting point is 00:25:28 and had to rerun payroll, there'd be an extra charge for that. However, since Betty can be accessed by employees anywhere at any time, the software also prompts employees if there seems to be a mistake. This is a biased study commissioned by Paycom, but apparently this has decreased payroll-related errors by up to 80%. This is obviously a good thing for customers, but error-related charges are down, which is hurting revenue growth. So kind of cannibalizing their own business in a way, but I think it serves them better for the long run. Either way, it's led them to misestimates on the top line. And then the second one that I think is important is Paycom. As I mentioned, they sell to S&Bs. And the employment numbers that have been coming out have been concerning. And if their customers are employing less people, it's a headwind for Paycom because of their pricing model. Is that some of the narrative you're seeing from reading other write-ups and headlines and reports on the company? Yeah.

Starting point is 00:26:24 I mean, when the employee numbers come out or the – what do they call them? Unemployment numbers come out. Employment figures, job ad, job losses, yeah. You see pay comp trade a little bit based on it just because it can affect them. And it also affects their guidance. Third is just concerns over competition. Even Richeson said this in that leaked meeting, but competitors have closed the gap on Paycom's product advantage. I think Betty is differentiated enough to save them from it.

Starting point is 00:26:57 But it just raises the concern that people can innovate. Software moves fast. Software changes quickly. So even though you have sticky customers, it might be harder to win that next potential customer when it's so competitive and there are a lot of upstarts and stuff like that. So kind of those big three things. I mean, ultimately, these things have driven revisions in earnings per share estimates, which that's ultimately what's going to drive the stock down. And I also think Paycom had been growing 30% for a decade and people were kind of expecting this to just cannibalize or win the whole market, it seemed like, in 2020. So maybe it's just comping off quite a big high.

Starting point is 00:27:47 Yep. It's a revenue deceleration. And I think it's one of those classic situations where you're betting or trying to think about when is the revenue either going to, or excuse me, the revenue growth, when is it going to stabilize or re-accelerate? And that's where we can get some good returns. Let's move into the valuation though. Ryan, it seems like you have some interesting things here. How are you valuing the stock? What does it look like?

Starting point is 00:28:13 And I guess we'll get to the buy question after that. Yeah. So a common mistake that I've been making until you kind of dig in a little bit here is if you're just screening on like an EV to EBIT basis or even a net income basis, this looks super cheap. And so I'll say it right now, don't value this based on that because they do something that's a little irregular here, which is instead of using cloud providers, they run their own data center. So if you're looking at their financial statements, you're probably thinking, wow, they've got a lot of CapEx. Yes, they do. And that is why. And Richardson has come out before. I guess he just doesn't necessarily trust or he didn't trust initially the big cloud providers to be up all the time, which if you're a payroll company, you've got to stay up because it's pretty critical for a lot of these businesses. So he wanted to run his own data centers. Yeah, I think that's kind of a low light for those businesses that their costs would likely be lower at one of the big three, I would guess. Or an opportunity, Brett. Maybe it could be an opportunity, yeah. They haven't pointed to moving to the cloud, but if they do, yeah, it would reduce their CapEx.

Starting point is 00:29:28 But just all this is to say free cash flow margins tend to be about 10% lower than operating margins for Paycom. And keep in mind, this difference is going to be persistent as long as they continue to maintain their own data center. So you'll really want to value this on a free cash flow basis. If you're looking at this EV to EBIT, you're probably thinking, holy smokes, this is like the cheapest thing I've ever seen. 30% annual growth for a decade, trades at like, I don't know, low teens, EBIT multiple. the current evito free cash flow which i think is the most important here is around 23 times so still relatively cheap especially given the historic growth right here but yeah not quite as cheap as it might look when you're looking at those gap figures yeah i mean if you think free cash flow margins can be steady and then revenue can grow at 10 to 15 percent for a long while as you mentioned only four percent market share and there's still a lot of quote pen and paper or legacy solutions to go after, hey, the stock will work. I think as a side note,

Starting point is 00:30:31 companies and accounting auditors and all that stuff really need to evaluate. If your free cashflow never converges with net income, you are not accounting correctly. So maybe they need to do a reevaluation there, but that's a whole nother topic. For listeners, for investors, free cashflow again is what's going to matter for a company like this all right yeah exactly we're getting to the final question maybe the roaring kitty question why do i like the stock uh what's going to take it to do well here what numbers are you looking at what are your estimates why do you own this thing yeah i think i guess some of the things i like i think betty's seems like an easy sell for most customers it seems differentiated i imagine they will continue to be a market share taker

Starting point is 00:31:22 because of that as for the actual numbers it's hard to shake out because you know there's some customer sensitivity just around like employment and stuff like that and you know they could raise prices or something and it might affect the actual growth rate on a year-to-year basis sorry go ahead we could be in a recession you never know yeah and then three years from now we might not be. Yeah. So I don't know. A little hard to put specific numbers down and feel too confident about it, but let's just throw some assumptions in there, see what we get to. So if they grew revenue by 15% a year for the next six years, I know that's a long ways out, free cashflow margins jump back up to 20%, which is about where they've been,

Starting point is 00:32:06 dipped a little bit last year, but I think it could be their steady state free cashflow margins. And they trade at 25 times free cash flow. Obviously, some of those numbers are a little bit optimistic. That would be around a $22 billion market cap by 2030. So that's – today, I think it's an $8.9 billion market cap, a little over a double. Share count coming down or no? Honestly, did not check and I didn't check it. I'll check right now.

Starting point is 00:32:36 But maybe you can pull it up on FinChat. I don't remember it being a huge part of the story, but I could be wrong. Yeah. I assume they're doing something with that cash that they're generating. So hopefully buying back stock. Anyway, probably a double. I would guess in that scenario, you get those growth rates, you're going to be doing better than the market.

Starting point is 00:32:59 Yeah, all right. Let's pull it down. It looks like, okay, I probably won't share it, but you can find these on FinChat. And hey, look, it took me about 10 seconds to log up, so go check out FinChat. It's great. September 2021, 58 million shares outstanding. June 2024, 54.7 million. So it's declining at

Starting point is 00:33:17 about 2% a year. Sounds about right. They probably got some SBC headwinds, but stock's cheap enough. And hey, it's gotten cheaper. So maybe that can start going down at a quicker rate. Yeah. Yeah. I mean, when I think about why do I actually like the stock? for starters the incentives i think are pretty powerful here i would be a little worried that richison is like thinks he's just has no chance of hitting his equity package so he doesn't care but maybe it'd be better if he left because you know they might need a fresh face could be they'd probably need to compound if they were to hit that incentive package they'd probably need

Starting point is 00:33:59 to compound revenue in the mid to high 20% range until 2030. And that would obviously be a great outcome from here. My assumptions in that case would be way too conservative. Also, I think there's a bit of a floor just because the software itself is really sticky. The headwind of Betty disrupting their own business will start to roll off. So it won't impact the top line growth quite as much. And it's one where you can kind of monitor the competitive landscape pretty easily, fortunately, because a lot of the providers here are actually public. Sometimes you'll see companies getting disrupted by a private company and you just maybe aren't able to see it tangibly in the numbers. In this case, you're going to be able to see it. You can visualize a lot of

Starting point is 00:34:45 the market share by looking at the actual revenue growth of competitors and how they're doing. So my kind of game plan here is probably a small position. Watch the competitive landscape. It seems like a good business. It's not the no-brainer that it looks like, or maybe I thought it was when I saw that EV to EBIT chart. But I think they have a really good sales organization and a good product, and they should be able to continue growing the top line north of 10%. Yep. Another reminder, cash flow is superior to earnings, at least for non-banks. Maybe banks are the one exception to the rule there. Yeah, I think the software, without using it, actually, I think for an internship, I did use it once, but that was just getting payroll stuff. If you work in an office environment, if you work in anything remotely that would use some sort of paycom system or competitor, you know that when this gets embedded, especially in medium-sized businesses that aren't smaller, I mean, even with our tiny company, when we switch to something else, it's a bit of a headache. even though if we think it's going to be better but switching off to something else would be quite a it's just annoying and it's a headache and you know that's why it's sticky and yes that makes it harder for paycom to make inroads but if their product is better if it's modern and if it's not on one of the big cloud providers it'll hopefully still be a sas like platform

Starting point is 00:36:17 that can be better and that's probably why they've been getting market share and steadily growing for for so many years. All right. Want to hit the next one, Ryan? This one you actually have, I don't know if you've used Paycom in your personal life, but this one you have used and the anecdotal evidence is what got you inspired to look at the stock. So what is it and what do they do? All right. New sponsor alert. This episode is brought to you by our friends at Yellow Brick Investing. Yellow Brick is an aggregator of the best stock pitches across the internet. By tracking thousands of blogs, newsletters, fun letters, podcasts, and more, they collect and summarize the best stock pitches and bring

Starting point is 00:37:00 them to you in a single place. Think of it like a modern value investors club. I genuinely use Yellowbrick every single week here to try and discover new small cap ideas for the weekly power hour episodes that we do. And the best part is you get tons of features for free. Try it for yourself. Simply go to joinyellowbrick.com and search a company or ticker that you're interested in. You are bound to find a great report on just about any company. That is joinyellowbrick.com. Earlier in the show, you heard us talk about the investing platform public.com. That's where you can trade options with no commissions or per contract fees, and you get a rebate of up to 18 cents per contract traded. NerdWallet recently

Starting point is 00:37:42 gave public five out of five stars for options trading. If you want to see why, go to public.com and start getting a rebate of up to 18 cents per contract traded, paid for by public investing options not suitable for all investors and carry significant risk. Full disclosures in podcast description, US members only. The company here is company number two is SEMrush. So maybe people have heard of this if you work in marketing you probably have um but semrush describes themselves as an online visibility management platform which they love describing stuff by not by making you more confused all these companies do a little yeah yeah if i had read that and not looked at the product i'd be like okay what does that mean but it's actually a fairly good description because

Starting point is 00:38:33 the line after it just says we enable companies globally to identify and reach the right audience for their content in the right context and through the right channels. Essentially, if you're running a website and you want to figure out how your website is performing, and by performing, I mean where it's ranking in search, what pages on your website are performing the best, what keywords you're ranking really well on, how your competitors are performing, where they're getting a lot of traffic, and lots more, you come to SEMrush or Google Search Console as well. But Google Search Console is – obviously, they are the dominant search provider, but there are some other search providers, so there can be some limitations there. But yeah, SEMrush, if you just look up best SEO tools on Google, pretty much every single page is going to mention SEMrush.

Starting point is 00:39:22 They are a leader here. And if you work in the SEO or even just marketing space broadly, it's – you have probably checked out the platform. It's pretty much critical to use. and as you mentioned brett kind of a tangent here or anecdotal evidence i first came across this i actually very first time i came across this was in a screener and i was like wow it's it looks cheap it was some like revenue growth valuation screener and it looked kind of cheap didn't really know what they did second time i came across it was in my job i do um i help out a lot with marketing for FinChat, which shameless plug, finchat.io slash chitchat. We've been using it all day.

Starting point is 00:40:08 I used it for this episode. Go ahead, check it out. In my marketing work there, I've been spending more and more time working on SEO, trying to figure out what pages work well for us, what blog posts perform well, that kind of thing, because it's super helpful in guiding my future decisions on what to write you know you do contracting for the molly fool it's very nice to know what type of content uh does well because then i'm sure they're a customer yeah yeah then you're not just shooting into the dark so um anyways that's side note i love when i discover businesses that way where i instantly understand the customer value prop it's like okay this is really valuable. I don't have to sit there and try to figure out whether or not it's something

Starting point is 00:40:57 that matters to customers. But one of the first questions I had when I saw SEMrush was how on earth do they get this data? Because the insights they're able to provide are impressive. And I would think, why can't other people do this? It's obviously not first-party data, right? They don't run the search browser. So it's not like Google search console. So here's what they say in their 10K. I'm not going to go through all of it, but it says, we obtain data through a mix of proprietary and third-party data sources. Our data sources include collecting data from websites algorithmically, basically through web crawling of third-party websites, data purchased from independent third-party data providers. So that includes clickstream data, search engine

Starting point is 00:41:40 data, this case, probably Google search console provides it to them, online advertising data, data from social media sources, and reference data that our customers grant us access to, which includes like customers' websites, social media data, a bunch of other stuff. So they have built kind of this – they've kind of triangulated a bunch of different sources to pull in the numbers you need to know if you are running your own website. So positive on the data advantage, but definitely something that's going to be – unlike other software companies, will be included in that cost of revenue or an additional piece of that cost of revenue. Yeah, and it wasn't as expensive as I would have expected. They're getting to larger scale. Like a startup, it's probably really expensive to get, say, Twitter's data.

Starting point is 00:42:29 But for someone of their size, not so much. Yeah, in terms of the business model, they have a lot of these companies, like various subscription pricing tiers where you're able to unlock more and more features. It's mostly product-led growth, though, it appears. So there doesn't need to be, even though they have a lot of sales employees, and we're going to talk about that here in a second, it's not like Paycom where oftentimes it's very outbound first model. In this case, a lot of people come to SEMrush. So that is important. They've generated a lot of free users that way.

Starting point is 00:43:07 But the other part that's really important for just understanding the industry in general is that marketing and SEO have a big partner ecosystem. So if you've ever run your own website, especially if it's on like Wix or Shopify or anything like that, you've probably gotten messages from freelancers. There are lots of SEO freelancers. There are lots of marketing agencies that big companies work with. And that's actually a big growth driver for SEMrush. So there was at a recent sell-side conference, there was an analyst talking about ad agencies. He says, how do they factor into your go-to-market strategy? The CFO said, it's a huge part of it.

Starting point is 00:43:44 So we have, I'd say pretty much every single marketing agency in the world is using our products and advocating for our platform. They're using it for, in certain cases, for consulting engagements where they're working with their clients to optimize their online awareness. And in many cases, we then become a supplier for that account after that engagement is over. So this is actually very similar to my experience. We brought in someone who specializes in SEO and they raised awareness, in my case, they

Starting point is 00:44:14 showed me SEMrush for the first time, the platform side, and saw the valuable insights that you can actually extract from it. And suddenly I'm using it more and more. And so part of it is just like, I like businesses where customers end up becoming kind of your sales force and SEMrush seems like one of those products. They recently crossed more than 100,000 paying customers, but they also have more than 1 million free users. So as they start to try and maybe leverage the monetization side a little more, you probably will see revenue growth outpace user growth. Okay, let me give you a breather here.

Starting point is 00:44:54 We're going to talk about the history, but maybe a quick question. Would Chitchat Stocks be a free user of SEMrush? Is that something that we could find use of, especially because we do have a Substack newsletter, which is also a website, or is it more for larger businesses? Because from my thinking is that a lot of these smaller players, you mentioned only 1 million free users, there could be a long runway to grow if not everyone's discovered SEMrush yet. Could Chitchat Stocks be one? Not a paid user, probably. We're too small. But free user, yes or no?

Starting point is 00:45:30 Because I'm thinking podcasts, it's very hard to get analytics, but maybe that's a different ballgame. I'm not sure on their podcast analytics, so maybe not the actual podcast itself. If we were talking about the blog, yeah, you could see what articles did well. You could see what posted well, where people are finding you, all that stuff. You could look at your competitors and see, okay, here's where that sub stack is performing well. So yeah, I think there'd probably be some value out of that. I'm not sure if those are all free features. So there might be some limitations, but it's probably worth checking out.

Starting point is 00:46:12 So as you, the man that runs the Substack, feel free to give it a look. I was thinking of checking it out and becoming a free user. I think that's the beauty of the freemium tier, especially when you're a product-led software company like SEMrush is. Well, let's get into the history. We got to move forward here on the podcast and not go too long. How were they founded? What is the relevant history for any potential investor? Okay. I think, yeah, people get the business. Let's talk about the history and the founding. So what has now become SEMrush began taking shape around 2006, 2007, and it was two childhood

Starting point is 00:46:49 friends. I'm going to try to get these names right. Oleg Shigalov and Dmitry Melnikov. They were trying to put together a tool to help. Well, they were kind of just exploring. They seemed like SEO and IT, like passion project type people. And they were helping some of their friends with this tool. They were also helping their own websites with this tool. And it was gradual success. Initially, they named it SEO Digger. And a year later, they renamed it SEO Quake. I think the platform, there isn't that much documented about the early days. The platform was mostly used by friends at the start, from what I understand. It seemed like gradual growth. It doesn't seem like it was explosive from day one. The two founders here were in their early

Starting point is 00:47:43 20s. They were passionate about SEO, but from the outside looking in, it doesn't seem like either of them were particularly ready to start running a business. I'll talk about it here in a second, but they are maybe more product type executives than real business leaders. However, it grew. It provided value to customers. So more and more customers begin finding it and probably word of mouth marketing along with maybe traditional marketing. Plus one good thing about SEMrush and being so good at SEO is that they themselves can win on SEO. So it makes for nice organic growth. But these guys bootstrapped SEMrush pretty much the entire way. They didn't receive any outside funding until 2018. And a lot of that, I would

Starting point is 00:48:34 guess probably has to do with oleg so oleg how do i'm trying to think of a nice way to describe it so first of all he's kind of got this thick russian accent he clearly has this chip on his shoulder and frankly in reading some of his like interviews that he did he comes off as pretty abrasive. So I think that's probably just, you know, the Russian culture, right? Yeah. I mean, that might be part of it, but the other, here's a quote from an interview he did in 2023. He says, uh, people like the interviewer here asked him about his, uh, it's worth just reading the interview. They asked him about like challenges in running the business. And at one point he says, anyway, there had always been a bunch of quote unquote experts who kept telling

Starting point is 00:49:24 us that we were going to fail that we needed to attract more external investments and who kept giving other advice i couldn't care less about i guess these experts are now quite satisfied with their nine-to-five work with it that they do for pennies i would consider donating to them if i knew their contacts um he also sometimes spike can work and make you quite motivated right yeah this guy is motivated uh in his like literal business bio on sam rush's website it's like Like, I can't remember the exact words, but it's like, I don't only want to do well in SEO. I want to conquer the industry. It's like, all right, he's motivated.

Starting point is 00:50:05 But it also seems like now as a public company, they tend to limit him a little bit in how much he's able to speak to investors publicly. And that might just be he just doesn't have interest in it. So like the sell-side conferences, he wasn't there. the, or at least I didn't hear him answer any questions on the quarterly conference calls. He mostly answers questions about the product, but nothing really finance related, I guess. So they really defer that to the CFO. So from everything I can gauge, he's really a product guy, but he does run the ship. Him and Oleg and Dimitri own 49% of the shares. Oleg owns the majority in that case and 80% of the voting power. So they own a ton of this business.

Starting point is 00:50:50 Think they control it. Yep. Yeah, they're not. They might sell here and there, but they're not selling a lot. All right. That makes sense. Now, what do the numbers look like? What are the recent financials look like? And I'm seeing that they give out, which I think will be interesting, is their long-term operating model for the income statement. I love these because companies, I think a lot of the stagnating software companies tend to put these out and then they just re-update and say, oh no, actually three years from now we'll be hitting these targets, not three years ago. But what does it look like for SEMRush? What do you think is important for the listeners?

Starting point is 00:51:33 Yeah. Sometimes I get a little, I don't know, wary when I see them put out their own financial targets because it takes me back to the SPAC bubble. But this has been a high growth business. they've done a really good job. At the start of 2019, SEMrush was doing basically $100 million in annual recurring revenue. And as of last quarter, so four and a half years later, they're generating $378 million. So 34% annual growth on the top line. In terms of serving that revenue, it really isn't too costly for them. I was mentioning this earlier, but their cost of goods sold line items are kind of the typical ones you'll see for a software companies. So cloud hosting costs, transaction processing fees, customer support, stuff like

Starting point is 00:52:18 that. But also getting the data from those third-party providers. In total though, they've got 83% gross margin. So they've grown that over time as well. I think four years ago, five years ago, they were doing 75% gross margin. So I think just acquiring that data, it's come down as a percentage of sales as they've scaled the business. But as you move down the income statement, I was kind of surprised to see this, but the largest cost for SEMrush is still sales and marketing expenses. They currently spend 41% of revenue on sales and marketing. I believe it might be lower now a little bit, but given how much customers come to them, I would have expected maybe a little more efficiency here. maybe this is marketing, like more marketing rather than sales commissions. But I don't know, I guess this is maybe a low light looking at the business. They do expect this to come down over time. And I guess I'll talk about this now. They're making this push towards enterprise clients. So

Starting point is 00:53:21 they've got a lot of your freelancers, a lot of small businesses, probably even some enterprises that are using it more as like, it's an enterprise customer, but there was no enterprise plan for a long time. So they were just using like a business account. Now they've rolled out an enterprise plan. They say it's going to be 10 to 15 times higher priced. And there's actually this quote, I want to find it here. So he says that they released the product. They started talking with some of the enterprise customers and they said, we actually increased prices a little bit after the initial launch in May. We had some feedback from customers who were saying that sometimes we're a little bit underpriced and we should charge more. So I think customers are certainly

Starting point is 00:54:10 getting a lot of value out of this. All that is to say, commissions might jump in the short term. They said they've changed the sales incentives for a lot of the sales employees to target some of these enterprise clients. I'm not 100% sure what exactly that means, but anyway, I think you can expect sales and marketing to continue to be the largest cost line for them. Yeah, I agree. It makes a lot of sense. And if you look, hey, just listen to their long-term model they have. I'll read it off here. 80% gross margin, 35% sales and marketing as a percentage of revenue. That's compared to 41% today. So a slight decrease. R&D will come down to 15% from 19%. So a slight decrease, but you still got to keep up that R&D and you're going to have staff

Starting point is 00:54:59 there. But the biggest decrease, I was kind of surprised to see this as a huge jump for general and administrative from 25% to 10%. I think that's going to be important to track because a lot of that, and I might be making this too simple and overstating it, a lot of that is a choice as you get bigger? Do you want 30 HR people? Do you want 30 lawyers as you become a multi-billion dollar revenue business? I mean, those are just some examples. There's a lot of other GNA out there. I mean, do you want an elaborate office in the most expensive part of the world? Yeah. Right? I think that's going to be an important number for investors to track.

Starting point is 00:55:40 Yeah. And it's probably the one where software companies misestimate it the most because they end up, Oh, I need, you know, we need personnel for this, this, whatever. Anyway, $30 lunches every day, right? Yeah, exactly. The, the one thing I do like is, you know, they come from a bootstrap background, so they're familiar with grinding on not a lot of, you know, capital to spend. The other part is the R and D line item for, for how powerful the platform is for them to be spending so little on research and development i thought was pretty impressive and i would guess that a big reason for this is the 500 or so product development employees they have are all in europe so mostly prague czechoslovakia um warsaw and uh netherlands is

Starting point is 00:56:36 another one they called out but i don't believe they labeled any product development employees as being in the U.S. Nice. Central Europe, nice little arbitrage. Not a bad arbitrage on those salaries. Finchat.io is the complete stock research platform for fundamental investors. They have all the standard financial data on more than 100,000 stocks globally.

Starting point is 00:57:00 But beyond that, they have company-specific segment and KPI data on 1,800 stocks. Want to see NVIDIA's data set and revenue? Finchat's got it. Like to track Spotify's premium subscribers? they've got that too and they just added etfs to the platform as well the breadth of finchat's data is truly one of a kind we use finchat every day and i've personally been using the ai co-pilot more and more to summarize earnings calls and conference transcripts to get 15 off any paid

Starting point is 00:57:29 plan go to finchat.io slash chitchat that is finchat.io slash chitchat to get 15 off any paid plan today, the link is in the show notes. Yeah. A good example that we've looked at before is Adyen versus Stripe. Adyen is 10 times more profitable because all their employees are based, I believe it's in the Netherlands versus Stripe who has tons of employees in Silicon Valley. And it's just a culture that kind of incentivizes more and more spending. So anyway, I just like that it's a global business. It's not necessarily... Both of these businesses, Paycom and SEMrush. One's in Oklahoma, one's headquartered in Boston, but it has a lot of employees in Europe and has roots there. So I just tend to like that.

Starting point is 00:58:16 The other part, sometimes we see these targets, which I'm putting air quotes there if you're listening, and it just means absolutely squat. In this case, they have gone from at the bottom of 2023, they had negative 12% operating margins. And then that was kind of at its lowest point. To today, it's just gone clear progression upwards over the last five quarters. Last quarter, they generated positive 3% operating margin. So they target 20% of the long-term. I really don't see any reason that they can't get there, assuming the business continues to scale and grow quickly and they maintain some cost discipline, which all seems feasible. Makes sense to me. All right. You have a question here about the moat.

Starting point is 00:59:06 Do you think SEMrush has a moat? Maybe we can get SEMrush and then your general confidence on moats in software companies, because I know that's something we've talked about and been a bit hesitant on in the past. Yeah. I don't think SEMrush has a moat. At least I haven't been able to identify one yet. It's definitely a sticky product and it delivers a ton of value to customers. As we can see, it's evident in the net revenue retention figure. Customers tend to spend more and more, so it's sticky. They stick around. The other part is, let's say you're running a blog. For example, this isn't something you want to just look at once. You don't subscribe for a month and say, oh, these pages are doing well, yada, yada. It's ongoing, right? Things in SEO

Starting point is 00:59:57 change and you want to know what's constantly working. So it's a subscription that you're going to want to maintain. But I would be hard pressed to call this really a wide moat business. Their data doesn't really belong to them. They don't have any sort of physical advantages and there's nothing completely locking these customers in other than having the most valuable platform around so i'd say no honestly but i'll talk about this more in a second i'm not sure it really matters all right well it's just because i can't identify one doesn't mean there aren't advantages here or doesn't mean it's going to be a bad investment like right depending on the size of the business where they're at in their life cycle like i don't want to miss it just because

Starting point is 01:00:46 I can't say like, oh, here are the four exact qualitative factors that make them undisruptable. It's just, they're not there yet. Or maybe I'm not there yet as an investor. I haven't found what their big advantages are. Okay. How are you valuing the stock? Yeah, this one's a little tough to do. So as of this recording, SEMrush has a market cap of just under $2 billion and they've got more than $200 million in net cash on the balance sheet. So enterprise value is about $1.75 billion. They've got $378 million in annual recurring revenue. So this gives them an EV to sales. I know people maybe just got the chills. You haven't heard that word since the 2020 bubble, but EV to sales of just under five times. I just wanted to give some

Starting point is 01:01:39 quick numbers. I'm not valuing it solely based on EV to sales. I know you shouldn't do that. But the growth rate from here is a little bit of a crapshoot, I think, because it's a business that grows fast. You don't know what customer adoption is going to be. So it could certainly surpass to the upside, but I'll just take the consensus estimates and see where we get. So consensus estimates right now are that SEMrush grows revenue 20% a year over the next three years. I think that's reasonable. They just officially rolled out their enterprise product, as I mentioned. So adoption on that kind of remains to be seen. But if that goes well, I suspect they're going to get more of a sales lift than analysts are projecting.

Starting point is 01:02:23 Here's a quote from Oleg. I already said the quote about how they raised prices more than they were projecting. I think they had a price increase a year ago. I suspect there's probably room to continue increasing prices for the customers. Not about sign, when your customers tell you that you're pricing it too low. Yeah, exactly. Anyway, let's say they do grow at analyst estimates and they get to 15% operating margins in three years. We are looking at roughly $100 million in annual operating income. So in that scenario, we would be trading at today, the price would be enterprise value roughly 17 times 2027's operating income. So it's not the greatest valuation in the world, but

Starting point is 01:03:10 there's a lot of wiggle room there in terms of the numbers you pick. Like if they get to 20% operating margins faster than projected, or if revenue growth is higher than they expect, all that stuff. It's hard with a business like this where it's growing quickly. Yeah. It's a fairly demanding valuation. I guess those feel reasonable given its historical growth I feel like from that point onwards, there's kind of three questions, or I guess one is kind of from now until then, is revenue going to grow quicker? And then from 2027 onward, will revenue keep growing at a double digit rate and will margins keep marching higher? I mean, that can lead to some really strong returns if that market opportunity is as big as they're saying or as you think. Now, to close out, you said the valuation is not that great.

Starting point is 01:04:01 management's a little prickly and the moat's not that strong so why do you like this stock yeah it is a little weird to be saying there's no moat the valuation isn't great i don't know if management really cares that much about minority shareholders the other thing i should mention this red flag the cfo on the these sell side conferences kept saying we're incredibly profitable they have three percent operating margins last quarter so They are. I look at this and red flags shoot up all over the place. Tons of non-gap metrics, tons of adjustments, tons of, I don't know, management being weird or maybe getting the sense that they are not pristine capital allocators. But to put it simply, I think

Starting point is 01:04:51 there are cases where the product is so good that it doesn't matter that you can't define the moat. It doesn't matter that the P&L isn't perfect. It doesn't matter that management can't speak well or can't articulate the great capital allocation principles that investors love to see. The product's good enough that they are going to grow the top line quickly, and it's at its core profitable, and maybe the P&L costs will maybe grow not the way we want them to, but it's not this unsolvable problem. So I've missed out on opportunities like this where I thought the product was so good. Monday.com is one for me where I think the product is so good that – but I see like, oh, they're not incredibly profitable already. It's like if they were, it wouldn't be trading at five-time sales. It would be trading at 10-time sales or whatever. Yeah, part of the risk. Yeah, I think they can get there.

Starting point is 01:05:49 I think there's a very good chance that because of the value SEMrush provides to customers, they're able to surprise to the upside with growth over the coming years. So not something I'm going to own in huge size. And I gave myself a mandate to anything I buy, I have to own for three years. So I will buy it small to start. And this is one where if it can be as big as they talk about, you can add over time. Yeah. And given the market cap of just, well, enterprise value of just $1.75 billion and given the growth rate, there's a chance this becomes a 10 beggar. So as you mentioned, Ryan, the upside is, you know, there's a lot of potential there, but we just discussed as well, doesn't come without its risks. All right. That's going to do it for this episode. Let me hit the disclosure. We are not financial advisors. Anything we say on the show is not formal advice or recommendation. Ryan, I, or any podcast guests may hold securities discussed in this podcast. They have held them in the past and may buy, sell, or hold them in the future. Thank you everyone for tuning in and we'll see you next time.

Chit Chat Stocks - 2 Software Stocks I Bought This Month (PAYC, SEMR)

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