Chit Chat Stocks - Paylocity (Ticker: PCTY) with Andrew Marshall

Episode Date: August 24, 2023

Paylocity Holding Corporation (PCTY) provides cloud-based payroll and HR software, streamlining workforce management for businesses in a competitive market. Listen as Brett and Ryan ask questions about the company, its business model, and valuation. Enjoy the show! ***************************** Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney  Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Interested to see more of Andrew's work? Find their YouTube here: https://www.youtube.com/c/CapitalMindset Contact us: [e-mail] Timestamps Paylocity | (2:00) Revenue Growth | (14:27) Management | (17:58) 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

Welcome to Chit Chat Money. This is our Thursday deep dive episode where we interview an analyst to discuss a single stock or industry. And today we're talking with Andrew Marshall. He is an analyst at Capital Mindset. And the company we're talking about is Paylocity, but he has kind of a unique perspective on it because he's been a customer, he's explored alternatives. He understands the human capital management software industry really well in terms of all the alternatives. It just has kind of a unique perspective on the business in general. So lots to like here. The business has also grown revenues basically 10X over the last eight years. So it's been a high growth business. I know we haven't done as much

software businesses lately, but hopefully this one is exciting for you guys. I don't think we have any other things I should mention here in the intro. So without further ado, here's our interview with Andrew Marshall. Welcome to Chit Chat Money. On this show, hosts 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. All right. Welcome in. Today, we are joined by first-time guest, Andrew Marshall. He is an analyst at Capital Mindset and someone Brett connected with via Twitter. We're talking about a company maybe some people have heard of. It's Paylocity Software Business. I guess, Andrew, you kind of have an interesting story in terms of, well, I don't know if this is exactly how you found the stock, but how did you come across the business to begin with? Yeah. So I work for a company as a finance officer, and we were very unhappy with the HCM, which is human capital management, is what they call themselves. So I think payroll, uh, HR management, stuff like that, uh, company, um, they just had a lot of issues with processing taxes, getting things done in a timely manner.

So we started to, um, you know, look at taking bids and that's kind of how I ran into Pay Loss City. They're an, an HTM company. Think of like ADP, um, somewhat kind of similar to Workday, although they don't exactly play in the same field or Paycom. um so that that's the field they play in that's kind of how we got introduced yeah let's go through i guess the business basics to start human capital management software kind of a broad category what exactly does paylocity do and what intrigued you about the

business yeah so um think about anything that your hr department does that's what they're going to deal with so think about onboarding think about um client files think about benefits administration so if you have a 401k you have uh medical um insurance things like that they'll do that obviously payroll processing so they're the ones that will process payroll for you um even off-boarding performance reviews um and and now they're kind of even they have a part where they just kind of i guess informational stuff like pushing out notices to employees anything like that you know general announcements so they kind of do anything that your hr department will do they're not a um things called a pel like they don't replace your hr department but they'd be

the software your hr department uses for everything within their sphere um as far as what intrigues me about the business just looking at it when they're going through these pitches i said one, this is super asset light and margins are going to be really good. I mean, it's pretty simple. You set up the software, there's some management on the side of pay loss that they have to do, but for the most part, you're going to have high gross margins and it should mostly flow to the bottom line. Yeah. Let's dive deeper on the unit economics here. What are some of the numbers behind the margins, as you mentioned, and as a software business, what are the major costs here i'll be looking at just employee stuff and then today like what margins are they earning

from maybe a gross and a bottom line basis yeah sure so really their their main costs to your point it's just i mean employees so you know they have roughly i think right now it's 72 like 70 to 75 gross margins um and most of that within their cost of sales is just paying the employees to process payroll, paying for the cloud infrastructure that they use. And then if you look at their expenses, it's primarily SG&A. There's some R&D that they do as well, developing new modules,

new things for their customers. But really at all, about 75% gross margins. And right now, they're about 20% free cash flow margins, or maybe it's 18%. But they even just announced, you know, those are continuing to go up and their long term targets closer to 25% free cash flow margin. So in my opinion, really solid on that front. And they can do that at scale. As they get more scale, it'll become better. Right, right. And maybe you don't have this in front of me, but how I know a lot of people, a lot of listeners to our show are going to hear, because we harp on it all the time, oh, free cashflow margins for a software

company. What's the SBC? What's the stock-based compensation? How efficient or inefficient are they with that? Do you have those numbers in front of you? Is that a highlight or a low light for you for this one? So I don't have the numbers in front of me, but I believe last year it was about 145 million in sbc um that's off of about 1.1 billion in revenues so it's a pretty high amount of percentage of revenues um i i would say it's closer to a low light than a highlight for me i think the one question and we'll get into a little bit deeper maybe about this business the one question or low light in particular how this business is run in my opinion would be sbc or just the sbc and also the how would i say this what's happening so i'll give a quick sidebar

the founder because the current ceo he's been there since 2007 you know he's you know still going to be there for a long time but the founder who found the company back and i think it was 98 97 when they ipo'd he had 49 of the shares now he's down to 18 and he's kind of a um he sells no matter what what's the indiscriminate seller and so you will have some selling pressure on you no matter what you know that that's one thing that i noticed is kind of a negative for me it's not enough to turn me away from the business but i think the sbc and that indiscriminate seller from the founder is something to be aware of for sure right and the context you're giving it seems like pay velocity is still fairly you know it's a sizable

business over a billion dollars in revenue, but it's still fairly in its early days. It's still investing a lot for growth. And we know what revenue they're doing right now, again, just over a billion dollars, but what is the size of the market that Paylocity operates in? As I saw, or maybe I saw you mentioned, they operate in kind of the smaller, like small to medium-sized businesses. But again, correct me if I'm wrong there. Nope. You're totally right. So, I mean, Paylocity can supply larger companies. There are larger companies that use them, but they're primarily going to operate in that small to medium business.

You're looking at probably somewhere between under 1,000 employees is probably their sweet spot. And it is a very large market. And in my opinion, the trends from COVID, But one of the things I noticed is that tax and payroll tax, especially, and having these things done correctly is very important. So one of the things that PayLossity really helped with was, I'm not sure if you're aware what the employee retention tax credit was, but it was basically more or less a grant done by the government that was run through payroll taxes. So basically said, if you had employees that you paid through COVID, we're going to give you up to $5,000 per employee per quarter through 2020 and 2021.

Like that's the, well, Paylocity, you know, for us, we had some issues getting some of the documents, some of the things we needed, like 941s from our HCM. I talked to Paylocity about this, you know, they literally told us every single one of our um our customers they had all the documents they needed same day like they had everything ready they send it out and i think as the tax code becomes more um complex i don't think it's going to become more simple you're having a lot of these companies that run payroll themselves that are small to medium or they're using maybe more smaller regional players that aren't as complex and they're going to move towards towards a paylocity um you know they have a few people

they they compete with uh like adp is one that comes off adp plays in all segments and even you know adp i think they've called out that they're only have a penetration of like i think it was something like five to seven percent in the market so it's very segmented which is, you could argue a good and a bad, but I don't know if that answered your question or if that. No, yeah, I think that covered it. And maybe can you talk about some of the other competitors? You mentioned ADP, who else does Paylocity compete with? We were talking about this before we hit record, but why did you choose Paylocity over some of these other providers? Sure. So the primary competitors for them are going to be ADP because ADP competes in

all parts of the market. And then you have Paychex, which is another pretty large player, but they also focus more on SMB. And then you have Paycom, which I know a lot of people are familiar with, I think, or it's one of the more common ones if you're investing in HTM, as well as pay core so and i i'll just say this pay core is the one we're moving off of um and so that was one we're moving off of and then paycom was one along with adp that we are taking bids from um really and i didn't go into this beforehand but one of the things that i think makes pay loss successful is they focus on customer satisfaction more than the other players like everyone says they focus on customer satisfaction but actually i mean paylocity gets 25 to 30 percent

of their new um customers from client referral like they have a whole client referral program that's how they get a large chunk of their new customers um and even uh like quickest another quick aside we'll get is when i was going through this process i actually got like a personalized video sent from the ceo just being like like that's to me showed they're very committed to like at all levels trying to get people in keep them happy and and listen to them is what i i heard constantly paycom is a a company that's also great but one of the things was they they just priced us out i think they were about four and a half times as expensive as paylocity um and was there any sorry to cut you off was there any functionality that

warranted the higher price that is there anything that like pay loss pay loss that you lacked yeah betty is a really cool product so i don't know if if you guys talked about betty i think it was kind of nascent um i don't think it was launched yet or maybe it was like just haven't been launched super cool product especially if you have a lot of people that are working on shifts so those every every employee on their phone they're just going to pull it up and approve their payroll so it really expedites the process for um the hr administrators the other thing is um within my company and i don't i still don't know if this is worth it maybe for some organizations is um paycom from what they were telling me was

so we have a lot of eins within our organization we have about 55 eins sub sub organization like so the structure is very complex um paycom said that and i in reviewing i don't think it'll be an issue for us but they're transitioning between like uh intercompany transitioning so if someone's moving from one company to another they do that very smoothly with paylocity it's a little less smooth. But for us, that wasn't an issue. So depending on the company, I can see the reason for Paycom. But I actually think that this move to Betty is actually pushing them more up to larger businesses. I think they're going upmarket with this product. And it's actually going to leave, I don't want to say a vacuum, but more opportunity for Paylocity in the SMB space.

Interesting. So you're saying that Paycom is actually less and less of a direct competitor with Paylocity, even though they're both generally benefiting from the cloud HCM tailwind. Today's episode is presented by the Science of Hitting Investment Research Service. The Science of Hitting was founded by Alex Morris, who spent a decade working as a buy-side equities analyst before launching his own service in early 2021. You've heard him here on the show a number of times, but Alex produces really, really high quality equity research. And in addition, he provides 100% transparency into all his portfolio decision-making. We were early subscribers to the Science of Hitting Research Service, and we genuinely believe that Alex

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paylocity and again these are all confusing because they all start with pay but they've 10x their revenue over the last decade give or take is there any reason they've done this besides just the tailwind of the overall market is there anything that makes them special is because they're cloud-based is it because of anything that you think makes them stand out from the competition you know i looked into this and like i can give an opinion on why i think they're they stand out now but that's not answering the question which is why they've what's structural what's been put in place by the ceo that's worked you know i even listened to the ceo kind of talk about this and basically what he said was the two things that really made him

because someone asked him this question directly like two three years ago and he said um we listen to customers and we're agile like we have no problem pivoting and making a change if it if it helps our customers and really if you think about this industry okay processing payroll bringing on people processing taxes all this stuff anyone can in theory do it it's not like something that's it's not an aws or something like that the question becomes how reactive are to your customers and that's kind of what the ceo hit on um and it sounds very simple but i think it's harder to do than people actually think and then to your point being cloud-based uh fairly early on i think has helped for sure um and i think it could just be as simple as having you

know early on a better sales team i mean i can tell you what what they do better now than because we also had we took you know six seven bids and there are some smaller players that just don't have the functionality they do now and i think it's going to really help them hit this space you know moving forward but i think that's been really what's helped them in the past was uh the current ceo ceo steven bochamp listening to people pivoting and really uh like i said it shows if you're having 25 30 coming from customers i think that really speaks to how well of a product you're putting out there okay so you talked about the ceo briefly what are your thoughts on him a little more broadly as a capital allocator is he somebody

you trust um i guess what gives you the sense that he's kind of worth investing in and is he important to the thesis here um yeah yes and no so like i think he's a really good ceo i generally don't like trying to invest on a company based solely on a ceo i think that's a if you do that then anything can happen he gets hit by a bus you know it's proverbial then you you know uh historically he's been a great capital allocator so one of the things that you're doing in the payroll space is trying to say what's the next thing that our clients are going to need and how do we invest in either research and development or m&a to get that right so personally looking at the last few moves that

they've made i've very very much liked um one of their recent uh acquisitions in recent being like last one or two years i thought was awesome trying to remember the name of it i always think of it's similar to Jeff Bezos company it's not Blue Origin it's something like that but it's basically the ability now if I have international employees I can actually pay them in their home country in their home currency directly which is a really cool thing because a lot of these even smaller companies now you're going to be having some international employees maybe you're 90 America 10 international and having that is going to really put you give the provider an edge um so i think he's been a great capital allocator i mean he's led

the company since 2007 so i don't think it's like anything to really really from a small business like small revenue base to a over a billion dollars and that shows impressive breadth of not very many people can scale up with the business exactly and i think he's one of the things i like about him and this isn't like something that makes or breaks the ceo but he's kind of maintained in my opinion just by hearing him speak everything a bit of humility which i think is really nice to have um in your ceo like he's he doesn't come off as super slimy or salesy he comes off as kind of like the guy you go watch like a chicago bears game you know with and grill outside seems seems like a good guy and like i said kind of uh got that vibe too when he took

the time to like send us a personalized um you know a sales video you know just saying hey we'd love to have you on we think we'd be great partners things like that nice so yeah i mean it sounds like they're very management team checks out sounds like they're kind of the product checks out it's got good unit economics the one thing that a lot of people get concerned with with software companies now is obviously the valuation a lot of these companies trade at premium valuations. Paylocity is no different. What is the valuation look like today? And maybe a question to lead into this, they 10X the revenue over the last decade to a billion dollars. Do you think that's possible again this decade or give or take 10, 12 years? Can they 10X it again?

10x i doubt grow at a solid clip uh for many years yes so like management has maintained that they feel extremely confident they'll grow 20 plus for the foreseeable future and based on their you know um recent like growth i think that's definitely possible Uh, in my opinion, if you're looking at top line growth of 20%, uh, 20% plus, um, as well as improving margins, I think it's, it's a really, um, actually attractive, uh, company at the current valuation. So this year, software companies have really run up a lot in valuation. So you have some, you know, companies going up to 60, 70, 80 times cashflow or earnings,

depending on which one you like they're only at and i mean it's still a premium but 30 about 34 times um i think uh price to earnings and about roughly the same on a free cash flow basis so oh yeah disregard that ryan's internet's unstable for any listeners that's why uh andrew paused there but continue on the valuation stuff no that's good i mean maybe you talked about the earnings ratio. It's in the thirties, right? Low to mid thirties. Is this one where you say, okay, look, we're betting on the durability of the competitive advantage and the durability of the industry tailwind. We think regardless of where it's 20%, 15%, 25%, the revenue CAGR this decade is going to make up for this seemingly high multiple.

I think if you're buying Paylocity now, you're making the argument that you think the economy will stay roughly okay in the next year or two. So here's, and this kind of maybe even leads into a question on what we think maybe the risks would be to Paylocity. They are going to have a double whammy if there's a recession that's serious. So we didn't talk about this, but all HTM companies do this is every time they make a sale, not only do they get the revenue from the company, they get revenue from the float that they then put into, they then get interest on. so right now it's it's about for every roughly for every dollar of revenue you get three dollars afloat so let's say right now they have um a billion in revenue they'll have probably about

three billion in client funds that they they hold in between you know when i pay them versus it gets deposited into my employees accounts so they're getting interest off that um essentially money market rates, I think last I checked was like four, four and a half, somewhere between four and four and a half percent. So what you're going to have happen is if a recession hits, obviously there's going to be less jobs. So a company that gets paid based on the seats you have and jobs being available is going to get hurt. And then also they're going to lose an interest rate. I think as long as the interest rates don't get caught a ton, which would be the result really of a bad recession.

I think pay loss city is extremely attractive here. I think that if a recession hits and rates get cut, then you're going to see quite a dip in the share price because the fundamentals are going to get hurt too. So the nice thing is that the bear case is very much in your face. You know what it is. Interesting. Yeah. So they're going to hit double whammy if it's a recession, But that's something that, yeah, so that's kind of a near-term risk you could have heard

in the short term, could maybe present a buying opportunity. What, so maybe over any time period, you know, you talked a little bit about maybe the one to two to three-year time period for this sort of interest rate risk in the recession. But maybe over the long term, over the near term, why do you think someone, say you're buying Paylocity shares today, why does someone lose money on the investment? What are the biggest risks to the stock? And you're saying more as a structural risk rather than a near term. Gotcha. Yeah. I mean, with any of these B2B businesses that deal directly with providing a service for a business, there's always a possibility for disruption. Now, I think in this space, it's not as much of a risk. I think that Paylocity is actually, you know, more or less providing a little bit of that disruption by going in there and really being a fairly affordable way for people to have all their HR needs met.

um i guess if i were to say like what's going to long term why you would underperform is probably just for whatever reason their products don't end up panning out maybe there's some bad investment by management which none of these have have have been the case in the past but that's what i would see happening um you know maybe there's something like we talked briefly about paycoms betty well maybe if another company sees that replicates it does it at a cheap price you know something like that could potentially have them have muted growth in the future um it's not something that i personally see happening uh but i think if you were to say what's the long-term thing that could really hurt them it'd be that right yeah it seems like with a lot of these software companies you

know right now this market seems to be acting fairly rationally you saw you know pay you said Paycom quotes a very high price, you know, keeps maybe a nice little starting point for everyone else. But I think the big concern is maybe some company comes in and you really never can predict this and goes for a door dash type thing and just blazes, try to, you know, lose money on a bunch of stuff and make it a mother market share over the longterm with a bunch of funding. That's kind of unpredictable, but I think it kind of leads to a different question when facing that threat, facing that maybe quote unquote moat test as we like to talk about in chitchat money what's do maybe closing question here do you think paylocity has high switching costs and if not

why not um you know what i i hear a lot of people say that um hcms are like uh they have they're they're very sticky and they are because but i don't think it's because of high switching costs i think it's because most time people are happy with the product like for me switching was actually fairly easy um so i think it's more of is there their moat i wouldn't actually say that there's like an amazing moat for any of these companies because for me a moat is something like like visa has a moat because visa is the only one that can well them in mastercard they're like the only ones that play in their space this one the closest thing that you'd have to emote is the fact that pay loss has the highest customer satisfaction score out of any of the payroll management

companies um but you know uh customer satisfaction can be fickle you know something so do i think there is a a moat per se honestly like my honest opinion is is no uh nothing like amazing i mean uh maybe maybe the the biggest mode is just like people being lazy and not wanting to switch uh their hr but um i guess yeah it's not like this company where you're going to look at and go like oh that's a company that's structurally set up to monetize off of a structural venture they have over other people. Right. It's not like a Microsoft Excel where everything's just super, super high switching costs. Yeah. It's an interesting one where there's a big market tailwind and the culture seems great, but I think the big concerns many

investors have is, all right, the competitive advantage, the brand, you know, is it really that strong? But I mean, you made a pretty good case here. Before we close, anything else, anything, where can the listeners find you? Maybe give a little 30 second pitch for capital mindset. yeah sure so just uh thanks for that if anyone wants to see me i i went along with fabio and leo uh run capital mindset you can find us on youtube uh just search capital mindset it's got like a brain as the the logo um we're also on twitter we don't have a really big presence there but yeah just we do work there together and if you guys want to find us go look us up on youtube Right.

Yeah. A lot of fundamental analysis there. And it's not the clickbait Doomer stuff. No, it's not. No, we are not. We make fun of the clickbait Doomer, all that stuff. Yeah. That's right.

Yeah. There's too much of that stuff out there. Okay. Well, I'm going to hit the disclosure and then we're going to get out of here. Remember, we are not financial advisors. Ryan and I are general partners at Arch Capital and clients may hold securities discussed in this podcast. Thank you everyone for listening.

Andrew, thank you for joining and we'll see you all next time. We'll be right back.