Why Paycom Should Be on Your Investing Radar

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You may have heard of Paycom (NYSE: PAYC) or seen their tag on your paycheck. Paycom is a disruptor in the human resources and paycheck management industry, and it's growing at a significant clip.

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In this clip from Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Todd Campbell go over some of the most exciting prospects and the biggest risks facing Paycom today. Find out how the company makes its money, why Paycom's fee-per-head model is such a good sign for long-term investors, and how it's been growing over the past few years. They also discuss why competition could be such a massive threat in the industry and much more.

A full transcript follows the video.

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This video was recorded on Sept. 22, 2017.

Dylan Lewis: We have one more stock that people maybe should have on their radar. And this one kind of involves us taking some liberties with the term "small-cap." This is a company that, when you started following them, Todd, was a small-cap company. They have kind of moved into the $4 [billion]$-5 billion market cap territory, which makes them a midcap stock. Why don't we talk about Paycom? This is actually a company that some Fools might be a little familiar with.

Todd Campbell: If you're getting a paycheck. [laughs] If you're employed by an employer that has dozens to hundreds of employees, then that employer may actually be using Paycom's services. You know what's funny, Dylan, we were talking about the previous two, these companies that were reimagining different industries. You've got Alarm reimagining home security, we've got Impinj reimagining inventory management, and now we've got the stodgy, boring human resources industry, and Paycom is blowing that up.

Lewis: Yeah. It's an industry that's been around for a long time. One of of their main competitors, ADP, was a favorite stock of Peter Lynch back in the '80s. So this is an industry that has been around forever and treated investors fairly well. What exactly are they doing to try to unseat some of the established players in the market?

Campbell: I think it's helpful for investors to understand is where human resources was in the past, and where it is now, and maybe where it's going. Dylan, a little fun fact between you and me, a lot of people don't know, in a past life I actually worked in human resources.

Lewis: I didn't know that.

Campbell: Yeah. So back then, in the day, the way that human resources worked, it was very siloed. You had recruitment, you had training, you had payroll, tax reporting, you had evaluation. You had all of these different pieces of the human resource puzzle, and oftentimes different vendors and different databases for each one of those things. Obviously, that's not an efficient way to manage and get the most out of your workforce.

Lewis: Absolutely.

Campbell: We can both agree on that. Obviously, one of the things that leads us to naturally assume is, wouldn't it be more useful if you could break down all those barriers between each one of those different parts of HR to be able to gain greater insight and enable a better relationship between the workers and the employer? And yes, that's exactly what's happening now, and what's happening at a company like Paycom. What they realized early on was, if we build a cloud-based system that centers around one singular database, and then build out functionality across benefits and recruitment and time and attendance, all of those different parts of the HR function, then wow, we could be on to something big here, and we could disrupt the market and maybe win away business from ADP and Paychex and some of these older legacy players, and that's exactly what's happened.

Lewis: And I can't help but notice that what they're doing here isn't all that different from what Impinj is doing and what Alarm.com is doing, where they're basically providing this central hub where you can manage a whole bunch of different things in one place. It's being able to oversee a whole bunch of different functions from one dash.

Campbell: Right, it's all about being able to get more information together in one place so that you can gain greater insight from that information. And in human resources, that's incredibly important, especially since more and more employees are working from home or in remote offices. They're not as centralized anymore. So if you can allow employees to have greater self-service control over their human resources experience, be it training or benefit choice or whatever, that's a good thing. And if you can have all of this information in one spot, then as an employer, you're much more likely to find trouble spots early on that you can address or whatever, whatever it happens to be, the insight that you're going to get from having all of this information compiled in one place. And that, Dylan, is resonating with employers. And as a result, this company is growing and has grown pretty quickly.

Lewis: And what exactly does that look like? It sounds like they're offering something that employers can get behind, employees can get behind. Do the growth numbers bear that out?

Campbell: Yeah. Absolutely. You've got sales that are growing very rapidly. They're up 46% last year, $329 million. In the second quarter, sales were up 33% to $98 million. So you're talking about close to a $400 million run rate. And the way that this company makes its money is, it charges either a per-period fee, or a per-period fee plus a fee for each employee. So you can imagine, Dylan, in an environment where you've got low unemployment, you've got a lot of hiring going on, that's actually providing a relatively nice growth stream for the company, to be able to not only go out and open up new offices where they're in markets and be able to win away business from some of their competitors, but to also be able to take their existing client base and say, "Hey, we now have extra functionality. You want to use us for time and attendance, you want to use us for tax form reporting, you want to use us some of this other stuff? It'll cost you a little bit extra. Do you want to do that?" So there's a lot of opportunities for organic growth for this company as well.

At a recent conference, Dylan, the CEO actually outlined what he thinks that market opportunity could be. He said this could be a billion-dollar sales company at some point down the road. Now, take that with a grain of salt. But the market is big enough, theoretically, to support that.

Lewis: Yeah, major grain of salt with that. But something to keep in mind. Something that I really like when I look at this company, Todd, you hit on the idea of there being a pay-per-head pricing model, and the idea that this business scales with the businesses that it supports. It's this kind of symbiotic relationship. You also see that working out with companies like Shopify. Software companies that especially provide services to businesses and grow as the businesses that they support grow, I think that's generally a good sign. It's something that should have investors' ears perk up a little bit.

Campbell: Yeah. And the other thing that's interesting, too, Dylan, you triggered something in my head -- historically payroll and payroll processing have been a very tooth-and-nail kind of market, very price-sensitive, a lot of battling back and forth to win business year over year. High churn. If you can create a system that's very deeply embedded within the company -- again, unified, one database, everything feeding off this one database -- maybe that gives you more stickiness and helps to reduce your churn, and in turn gives you more opportunities to enjoy that symbiotic relationship over time as the companies get bigger.

Lewis: Yeah. There are big costs to switching providers if you're a business. You get used to using something, you use it for a year, maybe two years, your employees become trained on it and very used to using it. Then you switch over to a new provider -- there are months and months of new training, understanding how the software works, getting all your employees on board. So if you can be a good service provider, really cause a frictionless experience for your end users, I think that's going to work pretty well for the business.

Campbell: Right. And Paycom, by their own admission, they're not the lowest cost provider out there in this industry. So, you summed it up beautifully, you're competing not just on price but on functionality and service, what kind of a relationship you can establish with that employer. And if it's a good relationship, you get all sorts of benefits that come from that. Not the least of that would be referral business, right?

Lewis: Yeah, absolutely. If something works for one person, chances are they're going to tell somebody else that works in HR, their buddy across the street, about it. Todd, we mentioned some of the legacy competitors. I think for this industry in particular and this small-cap that we're talking about, out of the three, this might be one that's really good to take a step back and look at the industry and how some of the competitors stack up to Paycom on sales.

Campbell: I think it's important. Dylan, you're hinting me toward that risk area, how might this all play out. I think, from an investor standpoint, you're all excited now because I've been ranting and raving about how great of a company Paycom is. But you need to remember, too, that none of these legacy players are sitting back on their heels. They're all doing these same things. They're trying to create unified solutions. The disadvantage they have is, oftentimes they're trying to make those unified solutions out of legacy products, rather than building them from the ground up to be cloud-based. However, that being said, this is a big market. ADP is the gorilla. They do $12 billion a year in sales. You've also got Paychex out there, they're doing $3 billion a year in sales. So, when you think about the fact that those two companies are doing $15 billion in sales, maybe Paycom's idea of being a $1 billion company isn't so far-fetched. But they are going to have to battle, and as we talked about, not only on price, but they're going to have to battle on service and functionality.

Lewis: Yeah, and they're going to be going up against deeper-pocketed competitors when it comes to the R&D and innovation side of what they do, which is something that you see time and time again with upstarts in the tech space.

Dylan Lewis has no position in any of the stocks mentioned. Todd Campbell owns shares of Impinj, Paycom Software, and Shopify. The Motley Fool owns shares of and recommends Paycom Software and Shopify. The Motley Fool recommends Alarm.com Holdings and Impinj. The Motley Fool has a disclosure policy.