Chit Chat Stocks - Paycom Software (PAYC) | Not So Deep Dive

Episode Date: July 29, 2021

Paycom operates a comprehensive set of solutions for human capital management. The company's offerings provide data analytics for the employment life-cycle, from recruitment to retirement. Listen in as Ian, Brett, and Ryan go through the history, financials, and future prospects of Paycom. Enjoy the show! Our Thursday Deep Dives are sponsored by Quartr, the new way of doing company research. Access conference calls, presentations, transcripts, and more for FREE on your mobile device. Download Quartr on the App Store here: https://apps.apple.com/us/app/quartr-investor-relations/id1552412128  Download Quartr on the Google Play Store here: https://play.google.com/store/apps/details?id=se.quartr.android  Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Interested in more of Ian’s work? Follow him on Twitter: https://twitter.com/IanGrayLive  Rather watch us on video? Subscribe to our YouTube channel: https://www.youtube.com/channel/UCG5Ni-SI-jyrEsoNUhqftNQ  Contact us: [e-mail]  Timestamps Company Background | (3:14) Industry | (6:53) Management & Ownership | (8:38) Valuation | (16:18) Earnings | (17:40) Balance Sheet | (20:08) Our Analysis | (21:38) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome in. This is the Not So Deep Dive, our Thursday episode with Ian Gray. If you didn't know, we changed the name to Not So Deep Dive just because the only... After some public

criticism. Yes. The only complaints we're getting from listeners is that they're not deep enough. Uh, so we're going to, uh, go ahead, Ryan. Yeah. And I will, uh, caveat that by saying they're probably right. The point of this show is to turn over rocks. So basically just to look at as many companies as we can and give you sort of, uh, our learn the basics, learn the basics along with us. Yeah, exactly. So if you're looking for something else, I'm sorry, we're not going to provide that to you. If you want to learn every inch of a company, you can read the SEC filings for 10 hours, but it's probably not going to happen in a 30 minute podcast. It will not happen in a 30 to 40 minute show. So please do not expect that going forward, but I think we'll set things

up. We'll do it as the not so deep dive going forward. Show format is going to be the exact same, but we're talking Paycom software today. Ian, you recommended this for, or you chose this as your pick. You've owned this for a while. Anything starting off people should know about Paytm? Well, I think one of the things people should know about, we'll dig deeper into it, but it's got a pretty incredible origin story and just a good, if you're into entrepreneurship and business, it's a good story to go catch up on. And I'll share a little bit of it later on. All right. All right. That's good. And then Ryan, you want to get into what the company does and then first talk about our flagship sponsor for Thursday, Quarter.

yep quarter i actually have been using the app quite frequently i used it for paycom's conference call skip right to the q a it was great uh i listened to it on like 1.5 times speed you know no big deal i can go a little faster than everyone else wow you're since that synthesizing so much information but there's i mean it's honestly the best conference call investor relations app that's out there uh you can go download it if you have iphone i think you can do it on the android now too if i'm not mistaken correct yeah yeah uh it's 100 free they have companies from pretty much every market if not you can recommend it and they'll basically add it uh it's apparently 12 markets around the world and they have a lot more in store for the back half of the year apparently

but it's quarter q u a r t r uh follow them on twitter quarter underscore app uh go download the app, use it yourself. I think you'll love it after you listen to a conference call in that format. But I will get right into the show then. So Paycom, I'm going to go through the different parts of their business. But basically, and Ian can correct me because he's more the expert on Paycom, it's software for the HR department. They call it human capital management software. And so they provide a comprehensive set of solutions that they usually bundle together and sell as one. So I'll go through each one. The first sort of category that they're breaking into is called talent acquisition. And so this is applicant tracking, onboarding employees, tax credits, background checks, and then e-verify, which is a smaller part of their business.

But that's kind of the actual acquiring and onboarding employees. And then time and labor management is another category they cite. And so this is like tracking time and attendance, scheduling, time clocks and terminals, and then allocating your labor resources, essentially. And then the third is payroll. And this is the majority of their revenue, and it covers a lot of different spaces. But it's basically the entire process of companies paying employees, including Betty, which is new mobile app, which Brett will talk about on the second half. And that is, there is not only

a recurring revenue element to that, but I believe there's a cost per form, which is kind of like... Yeah, they're sending in W2s and stuff like that on behalf of companies and they pay a small fee when they do that. Right. And that is included with every package. So if you are signing up for the talent acquisition offering that they have, you'll get payroll as well. That's really what the entire company was built on initially. And then the fourth category they have is talent management. So that's managing the workforce performance, compensation budgeting, and then like organizational charts or position management. And then the fifth one is HR management. This is kind of like a workflow software or workflow tool for the HR department.

as far as pricing goes it's somewhat discreet so if you want to be a customer you have to set up a tutorial or like a one-on-one call and then you get quoted a price someone said that their 11 employees small business was quoted at 318 a month apparently it's on the higher end as far as pricing goes for some of these human capital management solutions that's what i saw in some reviews but it's more holistic it's more comprehensive and it sounds like it's pretty intuitive and easy to use. And then a little bit about the history, I'll let Ian kind of tell his origin story that he has. But as far as I know, Paycom was founded in 1998 by Chad Richeson, who is still the CEO. And prior to founding the company, Chad worked in the payroll processing

industry, and then eventually broke off and started Paycom as an online payroll service. But then it's kind of a typical B2B software story. It looks like so they started to add customers customers say hey we kind of have this bottleneck or this problem uh like could you automate a solution for that and they just started to add on different automated solutions to build out what is now an entire suite of software tools uh for the entire hr department uh in 2011 they moved their headquarters to a 90 000 square foot office building in oklahoma city they were originally from there but they kind of that's when they got bigger i guess the silicon valley of the the great midwest yeah the great plains uh and then they went public in 2014 and since that

point the stock is up more than two thousand percent ian do you want to kind of add anything to that i think that's that's a good place to start for now mine's more kind of related to the management so i'll get into it there all right i'll hit industry landscape competition according to some third-party research the human capital management market which we may uh condense down to HCM is $17 billion worldwide and estimated to be about $24 billion by 2025. It is a crowded market. There are tons of competitors, including Paylocity, which is another public company you can check out to see how the competition is doing, UKJ Pro, Ceridian Day Forest, SAP, everyone knows

SAP, Workday, but Workday is actually focused on much larger companies. So they're sort of a competitor, but sort of not in Paycom and Workday do slightly different things. There's also Oracle, ADP, many more. Paylocity actually has stronger reviews than Paycom on G2. They have 1,700 reviews and 4.5 stars versus Paycom, which only has 816 reviews and 4.2 stars. Not sure what that means. They both have pretty solid reviews, but the competitors are not slouches here. They're pretty solid.

and it's a big market but you know the competition is there uh one question i had though how much money do you think they're saving by being in oklahoma city versus silicon valley or seattle or something like that if i'm well they have apparently they have offices like everywhere but as far as headquarters go i imagine they're saving a lot of money but they've built out like massive facilities which surprises me i wouldn't think they need uh too much space pre-covid people people were doing that so 90 like a i think they have like 180 000 square feet in oklahoma city i wonder how much that'd be pricing them in silicon valley oh i mean yeah they've been probably hardly even find something that big in silicon valley but yeah for sure uh me and you

want to have management ownership yep so as ryan was mentioning chad richardson is the founder and ceo he's been around since the beginning like like we've said it was founded in 1998 so it's it's been around for a long time and it's kind of funny to think about like how much the business has probably changed over that amount of time and what innovation meant from 1998 to 2021 but i'll get into a little bit of his story here so as ryan mentioned he worked for a payroll processor um it was actually adp which is the big guy and he worked there for about two and a half years but he talks about how he was kind of um he was kind of frustrated with the platform he was working I believe he was working in sales and was kind of frustrated with the

platform and just saw how many customers were kind of having trouble with it and things weren't being customized and made to be simple for the customers. And so then after a couple of years, he moved to like more of a regional provider, I believe out of Colorado. And when he was there kind of was there for a couple of years and had the same experience that it was not really the best product for the customers. the customers were frustrated um it just wasn't doing the job he wanted and so he said you know what i'm going to start my own thing and basically designed the first version of it himself um

then he went and just started selling to the companies that he could and he said that the companies that were closest to him um it was he was in a little bit of a bigger city at that point and uh the cities that were close or the companies that were closest to him didn't really want to try it out but then he started going out into places where he was actually having to teach people how to use the internet. And then they would use Paycom because he was teaching them how to use the internet and giving them his service. So pretty kind of interesting story went into some credit card debt to kind of get it going. And it's just kind of been a scrapper and a fighter ever since then. Another cool thing about this team, and there's more to that story,

if you want to dig deeper into it, but, but pretty, pretty cool story. This, the CFO has also been there a long time. The CFO has been there since 2006, which is fairly rare at one of these companies for a CEO or CFO to just be around that much before the IPO and still be here after the IPO, especially with how much they've grown. So a pretty solid management team at the top. Insiders own about 17% of the company and Chad owns nearly 15%. He's the largest shareholder by far. And that's paid off for him in the past. He kind of protected it from becoming part of a roll-up before they went public and a couple of other activities. He's kind of tried to be a major shareholder for a long time. One thing you'll see is, and you'll find this if you look up his name,

he was technically the highest paid CEO in 2020, according to the SEC, due to some fairly significant stock grants he got. But these stock grants came into in two tranches, they're restricted stock units, and half, he gets half of them if the stock hits $1,000 within six years, which it's currently at about $400. Um, so that's kind of a two or one and a half X within six years. And then the other half of this, he gets the other half if the stock hits $1,750 within 10 years. So that's a little bit over a four X. Um, it would be about one and a half percent of current shares outstanding. So it's a pretty big, pretty big tranche. Um, but it seems like he's in this for the long haul. If, if he's going to have the vast majority of the compensation tied to the

stock tranches that don't hit for six or 10 years, he's 51 years old now. So definitely has, or it should have time to, to make that happen. Um, and, uh, yeah, they're just super focused on simplicity. You know, it's hard to argue with him when the stock is up 25 times since it's IPO in 2014. But I wanted to throw a question back to you guys. Um, what do you guys think of some of these like really significant equity grants like this that just put a stock price target and say hey if you hit this for a little while like elon musk famously had some um that he's basically hit all those targets but um i don't know these seem to be getting more popular do you guys have any opinion on them uh okay it's not i don't think it's black or white

just if like someone has them and someone doesn't if it's a new ceo with no ownership and they have these grants based on long-term stock price, I think that's okay. But I do not like it in this scenario when he already owns 15%. I know comparing everyone to Warren Buffett is kind of lazy and you can't expect every CEO to act like Warren Buffett. But when you already own 15% of the company, I think getting grants like this is greedy. And I don't like it. I'm just going to be honest.

I think you could just spin it the other way. Don't dilute your shares outstanding and you'll maintain your ownership. I'll talk about it. They have a sizeable stock-based compensation expense. If you have to offset that dilution by giving yourself your own equity grants, that's probably not great. But at the same time, the stock, it also depends on management integrity because sometimes management will do things to pump the stock up to get their equity grants but it seems like richardson uh it seems he seems competent and he's in this business for the long haul uh based off his prior performance yeah and it sounds yeah i mean i like the the way they've set up this grant versus like an adjusted ebitda target on adjusted earnings per share thing

and and with it like people are like well the stock price whatever but like on a long-term time horizon you know the stock price is it's not like a two-year thing if it's like a 10-year thing on a stock price that makes sense to me and i like that but i for someone that's the founder i mean i i don't like that yeah i i hear what you're saying i do prefer performance related incentives where it's tied to actual operating performance because i just think it's better once you get to judgment day you're gonna do things to hit that stock uh price yeah i like yeah i just i just don't have much confidence that the the ceo can can move the stock price enough like if he's within if he's within five percent of this thing and he figures out a way

bump it over the last five percent at the before is you know before the bomb goes off and time expires um depends on the CEO there's rare there's rare CEOs that can do that besides that most right and and all the thing I like about this I've thought about this a lot and I think I like these types of grants is it's just really simple right and it's clearly aligned with shareholders because shareholders at the end of the day the thing we're going to care most about is the stock price especially over the long term like this over six or ten years so um i just like the simplicity of it i'm fine if my ceo if my ceo even if he already owns a big chunk of the company and this is the thing i always say if if he if he you know gets my stock

to go up four and a half times over the next 10 years and he wants to take another one and a half percent of the company go for it that's all it's that's all good with me it's like the bobby it's like the bobby kodak or bobby kodak yeah everyone complains about his compensation but it's not a reason to not invest if everything else checks out and you have this it's not like well i'm not going to invest well the guys and the guy has a track record right cash you do well you generate profits we pay you a lot of cash pretty damn simple um i'll have valuation sorry sorry but i'll have valuation enterprise value is about 22.4 billion dollars tickers p-a-y-c trailing EV to sales 25.7 trailing EV to gross profit of 29.1 so really strong gross margins

trailing EV to free cash flow north of 150 however that is a bit depressed earnings have flatlined last year so if you look through and assume that their mark we'll talk about this probably in earnings with Ryan but if you assume earnings are going to revert and that their growth is going to revert back to the 20 to 30 percent range like they've said the forward EV to free cash flow is going to look a lot better than the trailing EV to free cash flow. Just as another note here, 2.5 million in options outstanding versus, and that's options, RSUs, PSUs, I put them all in one bucket. That is versus 57.8 million shares outstanding. They do have some restricted stock. If you're looking at some of their SEC filings, where it's going to make it

seem like the share count is in the 60 million range, but the true one, according to all the sources I was looking at, which I guess is just Coifin, is $57.8M. And then as another note, they've bought back about $100M of stock a year over the past five years. So share count has been fairly flat, even with these option grants. So that's been balanced out. Whether that's a good or bad thing, we can have a long discussion on that. But Ryan, do you want to hit earnings? Yeah, I'm going to avoid Q1 and I'll just talk about fiscal year 2020 revenue. and then we can mention Q1. They had around $841 million in revenue. That was up 14% year over year. They had 85% gross margins and 27% operating cash flow margins. Adjusted EBITDA margins

reached about 40%. Take that with what you will. Then shares outstanding slightly decreased year over year. I put surprisingly high stock-based compensation. It's about 11% revenue. That might be a one-time recognition of something because that doubled year over year yeah that's going to be related to that stock grant that they just gave him yeah and then i mean but i mean even if you look at it from last year five percent of revenue isn't huge but yeah i expected it i guess to be less um and i just found that a little surprising but uh annual revenue retention rate was 93 that includes businesses that cease operation so pretty i don't think that's revenue retention rate. That is a standard retention rate, if I'm not mistaken, unless

I read that wrong. No, I think it's revenue retention. It's not net. It's not net though. Oh, okay. Okay. That makes sense. Right. And so that also includes businesses that not necessarily churn, but they fail. And remember, they're selling to a lot of small and medium-sized businesses. So failure is a little more common than, say, workday's customers. But that was able to hold strong even during COVID, which is kind of a testament to the service. And then client count reached 31,000. That was up 17% year over year. Revenue and cash flow, as we kind of talked about, though, were both lumpy last year. And a lot of that is due to less form filing. So as we mentioned earlier, they pay a fee basically to pay com for every

form filing or every W-2. And with less of those last year, it kind of halted or slowed revenue. So I was just paying mostly attention to guidance. And this is because unemployment is higher. And then also interest rates actually affected them. They hold like two or something billion in cash and you maybe call it escrow or just on behalf of clients and they earn interest income on that. So if interest rates depressed, they lost some of that revenue as well. All right, Ian, you want to hit balance sheet, wrap up the first half. Yep. So they've got $215 million in cash approximately. What you were just talking about is, you'll see on their balance sheet, it's called funds held for clients and it's a really big number. And that's, it's like you said, about

$2 billion, but then there's a corresponding liability of client funds obligation, and those will equal each other. And so they both hold that on their balance sheet because they do generate a little bit of interest on it and kind of transit. But then it's owed to clients still. And so it's not really cash that they can use. They just earn a little bit of interest, like you said, while it's an escrow or while it's in transit. They've got about $30 million in long-term debt. So really small debt, um, debt total. Um, and basically the rate on that is live or plus one and a half percent. So, so pretty low. Um, and then they have an untapped line of credit if they had to generate, if they had to draw on that a little bit, they could, um, about another $17

million in leases. So a strong net cash position, pretty straightforward balance sheet looks in good shape to me. Um, yeah, very simple, very simple. Uh, I wonder why they still have the debt. Like, why not? I mean, why not not pay it back? But why not pay it back, if you get what I mean? Right. It's cheap. It's cheap money, right?

So you're in a good relationship with your lender. I guess, yeah. That's all important, I guess. It's surprising when a company is in this strong financial position and they hold just this tiny amount of debt. We see that quite a bit. But who knows? All right, let's take the ad break,

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Tonight, La Quinta. Tomorrow, you triumph. Book your stay at LQ.com. this episode is brought to you by kpmg as a business leader how can you innovate build trust and move forward in a digital era kpmg can help by bringing together the right talent and technologies generating insights that spark opportunities to explore their thinking visit read.kpmg.us opportunities all right welcome back in next up we're going to have any anecdotal evidence. Ian, looks like you got some for us. What do you got?

Yep. So this was a, as we were kind of talking about at the top, this was one of my first investments ever. And it was one of the ones that, you know, Peter Lynch talks about following his daughters around. This is one I actually followed my dad around to find. He was, my dad was working in a small organization with about 50 to a hundred employees, and they'd been doing a lot of manual processes. And he kind of found Paycom and said, Hey, if we transition to Paycom, I think we can save a lot of time and sure enough they did um saved a lot of time saved a lot of man hours um and it was really impressed with the way that paycom worked with them to implement and make sure that everything was working well because they were a little bit of a unique situation had some kind

of interesting things but paycom you know had people out to their office and were just ensuring that it was all running smoothly and so um when i was looking to invest a little a couple months later i was like huh i wonder if they're a stock and sure enough they were and um i uh i bought a of shares but that was kind of my my anecdotal evidence nice nice no i mean that's that's worked out well just a little just a little tidbit this one anecdotal evidence where like i'm buying that that could work sometimes um that's interesting though that you know it seems like people might complain sometimes that the software is expensive but from what you're reading about it can save you hours upon hours of time that was wasted so the value might be there yeah right and especially

at this point in my kind of investing life, I try not to rely too much on anecdotal evidence, but one of the things that does stick out to me is when the story that they're telling at the corporate level is what's actually being experienced at the anecdotal level. And so when it not just is both good, but when they actually both align and, and like, you know, pay conflict thing is simplicity. We're going to save you time simplicity. We're going to save you time. And that's exactly what my, my dad experienced at this company. It's like, okay, that's something's working here, right? It's kind of really the company is doing what they say they're going to do. All right, Ryan, you got yours? I guess I don't have any product experience, but they

say they only have 5% market share in their conference calls. So there are alternatives out there, but on the flip side, there's more customers for Paycom to go for. I don't think this market is saturated by any means. I mean, it might be saturated in terms of services that are provided, but they can go ahead and steal customers from SAP. What's the other one? ADP? ADP, Oracle. I mean, there's so many. Paylocity has been growing pretty quickly, but Paycom and probably them as well have been outpacing the overall industry growth. So I mean, there's no reason to think that's going to slow down anytime soon. All right. I have some anecdotal evidence and I was reading some online reviews for looking at the competitors. So I'll just go through some

kind of a standard pro and con that people have. So pro, this is a quote from a customer. They said, the fact that everything is all together on one database, no moving between platforms for information, the same information for payroll is available for HR and vice versa. Also love the phone app. And then con, they say it's a bit costly compared to most payroll software companies. So you might worry about Paycom's pricing power. And then a lot of reviews also indicate it takes a lot of time to set up, but I don't think that's like a low light for the, from an investing perspective, that's kind of what you'd expect. All right. Future growth opportunities, Ian, what do you have for us? So they've already begun executing on this. And for anyone following

Paycom, you'll know that this is a big piece of the story, but they're really attacking large enterprises now instead of only small and medium-sized businesses, which is how it got into the market, both when Chad was first starting, but then also as they grew, they said, hey, there's an opportunity here to go get these kind of more, you know, 10, 50, 100 member businesses. They're really starting to try and attack more of these enterprise scale businesses now as well. And so I think that's a big growth opportunity for them because it just means that entire $24 billion TAM that's cited is available to them. and presumably they're going to be able to keep kind of taking some customers from some of the other incumbents. They say that like, and this was, this was stat was from a little while ago,

but they say one out of every two customers they get was either from paychecks, which is one of the big providers or ADP, which is the biggest provider. And so they are actually being successful in winning business away from customers. And I think that's from competitors. And I think that's going to continue to grow. Now, was I right or wrong in that Workday is competing in this large marketplace as well for the large customers? They are, um, I, you would have to, to figure out the exact market dynamics and I'm not as familiar with Workday, but I believe that Workday does more, um, with like enterprise resource planning. And so they do, um, like even more type of stuff. It's a more holistic solution for like all your data needs rather than just human

capital management is my impression. Um, but I think they have modules that kind of do compete with Paycom is my understanding. Okay. It'll be interesting to see if Paycom can work itself up the market. Ryan, what do you have? Expanding their sales operations into both new and existing markets. So these were the first two growth initiatives. They mentioned them in the 10K. So they already have sales operations in 38 of the 50 largest metropolitan markets, but they believe they can increase the sales staffs they have in those areas. So a lot of these are just offices with one sales team and one manager and like eight people. But if they can, I mean, for these bigger markets, if they can go after more customers, they might need more staff

there. Not to mention, they go through the implementation process with them. So having people in these areas is kind of crucial. And then obviously, they should go after those other 12 markets or metropolitan areas. They said it takes, I think, 24 months for those new sales offices to get up to like what they call maturity uh so expanding into those new markets uh i i guess there's always you could always say international expansion but we should ban that yeah that's like future growth opportunities it's cheating yeah just uh yeah continuing to kind of expand that and then uh be in as many areas as they can so they can help their customers in the surrounding areas yeah and i saw in their conference call or maybe an investor conference that their head

of sales now she was their first intern back like 14 years ago and you may you may have read about that which is another anecdote about their um employee retention which is a great sign they said that she's known the whole evolution of the paycom selling process and i think that's a great sign like you got you know ceo's there since 1998 he founded the business ceo fo is there since 2006 head of sales now has been around for 15 years the culture sounds incredible sounds pretty solid and you're convincing people well maybe not now but yeah i mean doing it in oklahoma city yeah that seems nice as well but maybe maybe you have more spending power there who knows yeah you have the oklahoma city thunder uh all right i'll hit mine it's the

b-e-t-i or betty app uh that was launched this month do you know what's betty or ugly man it's not a great name but um betty is an app that lets employees do payroll themselves and this is a part of their payroll software program. So it is included, but when some employee signs on, it's almost like a pay per use or pay for, there's a fee. They don't give away how much it costs, but it's a fee for every time someone uses it. So it helps them approve paychecks themselves. So the value proposition is that it reduces steps and further simplifies, like Ian said, they're always looking to further simplify stuff and the process for these companies while also improving accuracy so this makes sense because employees are usually the ones that are

getting their checks after everything's been finalized and then they realize that something's wrong then you have to go back redo taxes you have to redo a lot of stuff it creates probably like 10 more steps for the hr or expenses department but doing this now you can get everything done from the employee standpoint they go through it themselves and then they pass it on to hr with any problems they have really thinks that it's going to help with the efficiency and this is not necessarily going to help them sell more to customers but it's going to help them more probably retain them and it likely will help them build more of a moat because not you know every time they add a product that a customer is going to use it's harder and harder for someone to

replicate this comprehensive solution yeah great yep and i believe i believe they said um and i and I could be wrong about this, but I believe they said they were going to be, be adding, um, it is a, it's a marginal cost, um, increase too, for the, for, Oh, for the subscription thing. I didn't subscription. Yeah. Sometimes they, so a lot of their products, I know they kind of have, you know, you'll have like a base fee to use Paycom, but then like, you'll get charged per head. And then sometimes, um, you can get a little add ons as well per head. So you might get, I think that's how this was set up where you paid an extra, an extra little fee. and it wasn't a huge fee but a little fee to uh to kind of use this as well all right that's what

that's what i meant to say but i think i must have said it in a confusing way so thank you thank you for playing okay thank you for playing that i've been all right highlights and lowlights in what do you like i know you own this just be clear i know you do own this business so you do like it so what do you like what do you what are the lowlights you found yep and and obviously everyone should be taking what i say with a grain of salt but i try i try and be critical of my investments too and um some of the highlights for me is and diving back into it this time i was impressed too is i just i like the founder i like the story um it's really hard to argue with his execution and i think i do like the incentive program even though it is um pretty significant uh if that's

if that's what motivates him to continue building a great company i'm fine with that um they've been profitable since day one uh and a couple of lowlights for me though is it is a crowded market You're always at risk of whether it's an incumbent or a new player like they were to come in and kind of start to take some market share, come out with a new innovation. There's also some macro risk, which we saw in 2020, that it's susceptible to some of these economic swings because of the pricing model based on the number of employees and the number of checks and forms that they're writing. So when the economy contracts and if unemployment rises, there is a direct effect on Paycom's business. That's not something I'm super concerned about, but it is something to keep in mind that this company can get hit by some of those. It's not immune to some of these economic hardships. Right, right.

And also, I would say, sorry, I'll just add one last thing. Unlike some of the other SaaS companies that really saw a lot of growth in 2020 because of more and more people realizing as they were out of the office that we need SaaS solutions to help us out, Paycom, while there probably was some growth driven by that as people try to get more automated processes, because of the decrease in employees and the number of forms they were sending, their revenue growth wasn't as high as it's been traditionally. Yeah, usage was down, even though retention was staying solid. Ryan, what do you like? What did you not like when you looked into Paycom? Strong customer value prop just from making the entire HR, all the processes so intuitive and simplifying it. But obviously there are competitors. The other thing is as far as efficiency goes from a business standpoint, they seem great.

I can't think – honestly, I couldn't think of too many lowlights business-wise. they seem like they're executing exceptionally well uh the only thing i would say is maybe it's just not an area that has that much pricing power or maybe they've already done it if those anecdotes that you had seem like it's quite expensive already yeah i mean it's just especially serving smb there are even if it's a really intuitive solution and it seems like it probably is annoying to switch off of it isn't like uh i can charge any price like maybe an adobe or an Autodesk is just because the nature of an HR department software. Yeah, because there's so many alternatives.

Yeah, because a Paycom, you're what, probably using it once a day, unless you're in the HR expense department. Most employees are probably using it once a day, maybe five minutes, something like that. But with an Adobe or Autodesk or Microsoft, you're in that software all day. That is your job. So it's a bit different from a pricing power perspective. That's kind of how I look at it.

The one thing I will say is, and we haven't talked about this, but it is, I think, pretty sticky because of the long implementation times. And that's kind of true across the industry that it just takes a while to actually do this. And so once you get on a system, it's a real pain to try and get all the data and move it over to a new system and work through it. And it just, it eats up a lot of time in your HR and finance department. So, you know, I think there is some stickiness just because of the implementation cost of doing it. You don't want to be changing providers every every year or two it definitely yeah i mean there has to be 93 revenue retention rate on s b market there's obviously some stickiness it kind of reminds me of like a like content collaboration

platforms like dropbox or google drive something like that where it is uh important people use it it's annoying to switch but you couldn't double your price uh tomorrow and stick around Not sure many businesses could, but that's, I guess, just my only potential low life. Yeah. All right. I'll have mine. I mean, great margins, strong track record. The track record is very impressive and it's not just the revenue growth or the stock price. It's the fact that they've been able to grow at what, like a 20% revenue clip for 10 years after going, well, if you look back from their S1, 10 years since going public and every year they've either been, And I believe positive operating profit, positive net income, and positive free cash flow, they do capitalize some of their software investments.

So that's why net income hasn't – not everything's jammed into the operating expenses line. So that's given them a bit of advantage from a net income perspective. But that, I mean, was really impressive to me, along with the retention of their executives. And then, again, you can see the switching costs as that comprehensive solution. can give them quite an advantage. I think it may not be as strong as some other ones like we just talked about. Lowlights, I had trouble finding any, but crowded market and heavy share dilution, I think investors may be underrating the share dilution coming down the line. If that's going to be a 2%, 3% headwind per year now, that's a lot, and that eats into your returns.

but they are they are i guess it becomes like a break if they're buying back if they're buying back stock that's value is not being provided to shareholders um all right bull case ian what do you think has to go right here for the stock to do well over the long term yep i think if they can continue to pick off especially some of these larger clients for paychecks and adp um and expand margins they're kind of they're guiding for some or they're expecting some higher margins going forward and approaching, you know, 30% free cashflow margins probably in the next couple of years, which is, which I think if they're, that's a recipe for success. If you've got 30% free cashflow margins and you're growing at 20, 25% year over year, you're just going to,

you're going to do pretty well now because of the valuation, it's going to be tough to have outstanding returns, but if they can really hit a 10 year CAGR of, you know, 20 to 25%, this investment doesn't, um, this investment should do all right for you. It always depends on where that multiple ends up. But if that multiple ends up somewhere around, um, where Salesforce is right now at kind of a more mature company, who's growing around that level. And they obviously have the M&A component. You're probably looking at, um, a moderately market beating stock, um, 10 years from now. Um, now that's, that's not something that probably gets a whole lot of people excited, but, but that's kind of the bull case. And if they, you know,

who knows maybe they they continue to hit it out of the park and expand some in some new ways but that's kind of the bull case that i see no for me uh yeah pretty much what and just mentioned if they continue on the same path they've been on this is going to be a solid performer uh historical returns are i don't think forward-looking returns uh are going to be nearly as good as historical returns just well the thing is with the valuation the only way historical forward returns are just as good as historical returns is it growth is better that's yeah yeah it has to be um but if they continue to grow customer count at a double digit rate for the next five years or so or they grow high single digit customer count with bigger contracts and

they start to bolt on these different solutions that the customers want like different layers of functionality um that's gonna lead to strong double digit revenue growth and they've shown that they can keep or they can expand margins incrementally, if they can continue to do that, maybe hit 35% operating cash flow margins, I could see this being a solid performer, I guess. Like Ian said, it's not going to be 2,400% from here. I don't think it'll be a 25%. They'd have to really ramp up that growth rate. And I think one thing you guys both mentioned here is that the bull case, part of it has to be that you think it deserves a premium valuation. Would you guys agree on that? Yeah. Terminally, I think this

trades above 30 times your capital. I get nervous making that assumption though. I just can't think of a B2B software as a service provider with these kind of margins, this kind of stickiness and this kind of endured growth that trades below 30 times for cashflow. I don't know. Are we, I mean, comparisons,

I don't know. Whenever we say this, I think we're like looking at peak valuations, but I do agree with you guys. It is a quality company and probably deserves a premium multiple. My bull case, I think this might sound aggressive, but I think you got expected to hit like 5 billion in sales,

which is about, if you think they're going to hit their forward guidance this year, that's about 5x from their current level. And if you compound a double digit rate, that's doable over the next decade. One question I think if you're an investor, you might want to ask is, at this cost basis, how long is it going to take me to get to a 10% free cash flow yield? And the reason I like using that question nowadays is that once you get to a 10% free cash flow yield on your cost basis, you don't need necessarily, if you have a good capital allocator at the helm, any earnings growth or free cash flow growth to get a 10% return each

year, if that makes sense, where the 10% return comes from the cash actually being generated by this business. Asking that question with Paycom, I think that just makes me a bit nervous. I would also, yeah, it would obviously take some time to get to a 10% free cash flow yield, but unless there was like insane multiple compression tomorrow but it from this i'm assuming buying the stock today i don't think there's any realistic world where it trades at 10 times free cash flow well i mean who's yeah but the only difficult part about playing the this is going to trade at what game is that you're betting on what other people are going to you know it's a bit risky because you're betting that everyone else is going to

so you're saying evaluation didn't move how long would it take i'm saying at your cost basis how long does it take to get a 10 for cash flow yield i think it might take seven years on this you know something like that yeah i would i did some math and i would say probably 10 plus would be like yeah and that's not i mean it's not to say it won't be a bad investment but that's just all right bear case ian what could go wrong here yeah i think it's pretty simple if the growth doesn't pick up to pre-COVID levels that they kind of aren't able to kind of get back to that 20, 25% clip. And then valuation becomes a bigger and bigger deal, the less they grow. I guess I would extend that and say, as a shareholder, what is the

biggest risk you're monitoring? And then what would warrant you to sell? I think, honestly, it's pretty, it would be pretty close to that growth rate, right? Like I expect, And they've been proven in the past that they can grow at 20 to 25%. And I think there's plenty of room left in the market to keep doing that. If they were starting to stumble a little bit, I don't, it would be hard for me to sell this one just because it's been just such a great performer and just such a, just, I trust this management team to find ways to grow and like,

and simplify things. And it just seems like a great business. So it's hard to think about exactly what it'd be, but I think the growth rate would be the big number that would start alerting me. And it wouldn't just be like, you know, we had one down year this year and it would have to be, I'd probably be slow to sell this one. And that would probably be a potential mistake, but that's, it would probably take a couple of another year or two of a bad growth for me

to, for me to think about selling this one. Right. Cause last quarter was what, like 10, 15% revenue growth and they're expecting it back into the 20 to 30% range. Right. Once everything recovers. Yeah, exactly. All right, Ryan, bear case. Bear case, for me, is pretty limited from a business standpoint. They seem efficient. I don't think there's anything they would do or could do that would be business suicide. They're a staple of HR departments' workflow. low. But I think the worst case scenario is that the market stays fragmented or paylocity or ADP

or some of the competitors copy products or have products that are similar enough to them that there is no pricing power or there's limited pricing power because that just kind of caps what they're able to grow at without adding new customers. And then the valuation stays or compresses a little bit, it's not like this is going to result in a long-term 50% decline, but you could easily lag the market in that scenario. Yeah, for me, valuation just comes in.

That's kind of the one risk I'm seeing. I mean, you could argue that the space has been competitive since they've IPO'd. So I don't think you should put a big, think about that as a huge risk, but it's there. and maybe that the market's kind of saturating, they could possibly argue

that we're hitting the maturity of the S-curve and that could be a risk. But really it's valuation for me as the big bear case if you see the multiple compression. All right, more or less interested. Ian, I think we already know your answer here, but what are your thoughts to wrap things up?

Yeah, I'm more interested. Every time I dig into this company, it's just a really well-run company and something that I enjoy holding. Wish the valuation was a little lower so I could buy some more, but it's a, it's a great business. And as a shareholder, I've had no complaints. Yeah. Honestly, the thing, the thing I liked about the business the most, which seems weird

is that they're headquartered in Oklahoma city. Like it's, well, they're not just a cliche. Yeah. It seems like you, you, there's almost ripple effects in the culture from that and being not sort of in the Silicon Valley. The CEO gives a lot of football anecdotes on conference calls. Yeah. And he's like, that's a plus. I would say management feels genuine. But I'm actually going to go less interested. I'm not huge into B2B SaaS providers anyway, that might be to my detriment, but it's crowded. It's a market I don't know that well. And I think sometimes you can assume it's harder to replace than it really is. I do that a lot with business business yeah i mean the same boat i get confused on who is working with what because there's like

and all these companies like 20 different like paycom connects with blank they connect with workday they connect with this and like who's providing the value could they encroach on each other i just get super confused i don't know but maybe that doesn't matter i'm just gonna i'll go less interested i guess it's just not a company where i find an edge yeah uh i'm gonna go more interested definitely a high quality business i mean it's going on the watch list now you know, valuation stuff, but really, really high quality business. Definitely. Yeah. Definitely want to look at, I mean, I don't know. There's kind of what I was reading. I was like, wow, there's probably no reason to sell this now, but you know, like, does this look like the opportune

buying opportunity? I'm not so sure. Yeah. That's if I, if I held shares, if I was in Ian's position right now, I have, there's no incentive to sell, but underwriting at this price, you kind of have to be real. You just have to temper your expectations. Yeah, exactly. I'm in the same boat. All right, that's going to do it for this episode, but we've got stock for next week. It's going to be my choice and I'm going to be choosing a latch. They just de-SPAC, trading on the NASDAQ. De-SPAC, right? That's a proper term, I think. Yeah, I guess. I think that's, yeah, they consummated the marriage between the SPAC. Yeah,

We're going to talk about them, some sort of software for apartments and doors, so it could be fun. All right, that's going to do it for this episode. Thank you all for listening. Remember, we are not financial advisors. Anything we say on this show is not formal advice or recommendation. Ryan and I are general partners at Arch Capital. Arch Capital clients and enabled security is discussed in this podcast. Thank you all for listening. We'll see you next time. This family is on the brink of civil war.

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