Sometimes, the best stock for you to buy is the one you already own. Such is the case this February -- I'm headed back to a company that I called out less than two months ago. That company is paycheck and HR specialist Paycom Solutions (NYSE: PAYC).
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What's changed since then? The price recently dropped 16% in a matter of six trading days on virtually no news. That offers a compelling opportunity for investors to purchase an initial lot at a much better entry point. Here's what I mean...
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All of the signs of a great investment
In December, I outlined all of the reasons I'm so excited about owning this stock. You can read the article if you want to dig deeper, but here's a quick review of the major points.
- A strong moat: Once businesses sign on with Paycom, their HR departments becomes heavily reliant upon it to complete critical tasks, including processing paychecks, scheduling time off, tracking potential hires, and regulatory compliance. It would create huge headaches to switch -- evidenced by the company's 91% retention rate.
- Under-appreciated optionality: The company's mission is to further the "ongoing
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development of a single application to lower labor costs, drive employee engagement, and reduce exposure." Most people under-appreciate the "ongoing development" part, which means that further functionality will be added to Paycom's cloud for customers. That's why R&D spending quadrupled between 2013 and 2015, and has essentially doubled over the first three quarters of 2016 alone.
- Skin in the game: If you invest with Paycom, you'll not only own a small slice of a company that's doing well by its employees -- as evidenced by Glassdoor reviews -- but you'll also be investing alongside a founder/CEO in Chad Richardson. He owns 13.2% of shares outstanding, currently worth almost $350 million.
- A very strong balance sheet: One of the great things about Paycom is that it's a Software-as-a-Service (SaaS) company. That means that all of its solutions are offered up on the cloud, and the business as a whole is very capital-light. The company currently has $75 million in cash on hand, versus just $29 million in long-term debt. It also is free cash flow positive, bringing in $45 million over the past twelve months.
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Combine these factors and I believe you have a compelling stock to own.
About that valuation...
There's no doubt that this is still an "expensive" stock. As of this past week's low of $42.50, shares were still trading for 54 times non-GAAP earnings. But that's a much better entry point than the 67 it traded for in December.
Just as relevant, the company is trading for only 42 times expected 2017 earnings. If recent history is any guide, those estimates might be artificially low as well. Over the past ten quarters, the company has exceeded analyst expectations by an average of 42%! Even if we adjusted expected 2017 earnings up to account for a more modest 15% beat, we still get a notably more reasonable ratio of 36 times expected earnings.
Here's what to really focus on
To be honest, though, I'm not much for haggling on price. I include the section above because the recent drop is what encouraged me to buy more shares of Paycom in February, but what's really important is the company strengthening its moat.
There are two big risks that an investment in Paycom faces. The first is execution problems: Paycom relies heavily on its sales force to convince companies to switch from their usual paycheck processor. Here, high switching costs -- which provide substantially Paycom's entire moat -- work against the company. They have to convince companies that making the change is worth the headache. I'll be watching the company's Glassdoor ratings closely to see if the sales force remains motivated.
Just as important, it has to beat a host of rivals to gain market share. Because of high switching costs, once companies are signed in to the new wave of HR SaaS providers, they usually stay locked in. While there are a host of larger rivals focused on big names, Paycom has to compete against similarly small start-ups like Workday (NYSE: WDAY) and Namely.
That's why I'll be monitoring the client count closely when annual results are released. Here's a look at the growth the company has recently experienced on that front.
Data source: SEC filings
I expect that the customer count will come in above 18,000 for 2016, especially considering the company's geographic expansion of its sales force.
Combine all of these facts -- powerful company forces and a better entry point -- and you can see why I recently added shares of Paycom. It's important to note that there's still a fair amount risk involved with the company. That's why it only accounts for less than 2% of my family's real-life holdings. But if you're like me, you see a growth story that you can continue to add to over time as it becomes more and more relevant for American HR departments.
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