Paycom Stock: BETI Continues To Cannibalise And FY24 Is Expected To Be Weak (NYSE:PAYC)

Summary

Readers may find my previous coverage via this link. My previous rating was a hold for Paycom (NYSE:PAYC), as I became uncertain about the near-term future of the business, given that the growing adoption of BETI is expected to cannibalize growth. I am reiterating my hold rating as various headwinds are still present in PAYC fundamentals. Notably, BETI continues to cannibalize on growth, and I don’t see any reason for it to stop (because it is for the long-term good of the company). Management FY24 guidance also painted a grim outlook, which reinforces my conservative view.

Financials / Valuation

PAYC reported 4Q23 revenue growth of 17.3%, with recurring revenue up 17.4% and implementation and other revenue up 11%. However, adjusting for interest income growth saw another quarter of deceleration to 16%. Profitability on both a gross and adj EBIT basis did poorly because of the ramp up in investments, with a gross margin of 83.3% vs. 84.3% in 4Q22 and an adj EBIT margin of 32.2% vs. 35.1% in 4Q22. That said, the rather strong growth in total revenue did drive positive EPS performance against 4Q22 ($1.93 vs. $1.73).

Based on my view of the business, PAYC is going to continue to see weak growth in the near term (which management has guided as well) because of the continuous contraction from BETI utilization and the eventual rate cut (which is a headwind to interest income growth). As such, I assumed PAYC to grow 10.6% in FY24 and 10% in FY25. The continuous focus on investments (e.g., expanding overseas) should weigh on margins as well, which again is guided by management for FY24. As such, I assumed the margin to be 39% in FY24, followed by a modest recovery in FY25 as PAYC reaps the benefits from the investment made in FY24. Putting it together, the near-term outlook remains weak, and I think the market is going to continue discounting PAYC valuation in the near term (relative to its average) because of this. Hence, I expect valuations to hover around this 14x forward EBITDA range.

Comments

My view on the business continues to be cautious despite the headline revenue outperformance (to be fair, it was mainly due to interest income that is susceptible to rate movements). Digging deeper, headwinds continue to be present. Firstly, on BETI penetration, my previous take was right that it was going to cannibalize growth as customer relationship representatives [CRR] become less productive as they see more BETI utilization. I would note again that, on a standalone basis, BETI is a great product that offers a huge value proposition to customers, and it is good for PAYC long-term growth. Hence, while management commented they may be shifting slightly the sales pitch on BETI to a more consultative approach, I believe they will (and should) continue to maximize BETI penetration.

My bullishness on BETI was that it makes payroll runs more accurate, which is a strong value proposition that will drive a high adoption rate as it helps businesses save money. This turns out to be a weakness that cannibalises PAYC growth. Because of fewer charges for errors and extra payroll runs, customers are not using as much service revenue with the BETI solution. 3Q23 update

Secondly, pre-employment services revenue, while still growing, remains an overall headwind to growth as the macro conditions remain uncertain, and I think this is leading to fewer people changing jobs either because there are fewer opportunities or the salary does not justify a jump. Until the macro situation recovers, I don’t think this segment is going to see any form of recovery. Thirdly, the growth of total client count slowed drastically to 1% for FY23 (exiting FY23 with 36,820 customers) from the 8% seen in FY22. Viewed from another angle, on an absolute basis, FY23 only added 259 net customers vs. 2.7k in FY22. Lastly, while management noted that client count for companies with more than 500 employees was up 11% y/y and up 18% y/y for companies with more than 2K employees, it is weird that the total stored data for PAYC clients was only up 5%, decelerating from the 14% seen in 4Q22. My inference from here is that there was a lot of churn in the <500 employee customers, which was implicitly reflected in the weak net customer addition for FY23. This is not a good situation, as a large part of the PAYC customer base are SMB clients, and if a large chunk of them continue to churn, it would lead to further deceleration in growth (as already seen in the ex-interest income growth). This weakness is further evidenced by the fact that the revenue retention rate slowed by 100 bps in FY23 (from 91% to 90% compared to FY22). Management explained that this slowdown was concentrated at the bottom of the market, which is likely to be the hardest hit by macro factors like rising interest rates and inflation.

The forward-looking guidance was nothing great, either. For FY24, management guided total revenue of $1.873 billion at the midpoint, implying 10.6% y/y growth, which is another quarter of deceleration and is below the midpoint of its prior guidance of 10 to 12% after the 3Q23 guide. FY24 adj EBITDA guidance was also light, expecting $725 million at the midpoint, implying a 38.7% margin, which implies ~370bps of deceleration vs. FY23.

Although I am pessimistic about the short-term outlook, I am optimistic about the company’s long-term strategy to grow internationally through its Global HCM product. So far, in 2023, they have introduced native payroll processing to Mexico and Canada. In 2024, they will expand to the UK. As of FY23, 100% of PAYC revenues are from the US. As it diversifies its revenue base, the business will become more resilient to economic cycles.

Conclusion

In conclusion, I maintain a hold rating for PAYC due to ongoing challenges in its fundamentals. The continued cannibalization of growth by the BETI platform, as I mentioned previously persists. Despite a 17.3% growth in 4Q23 revenue, a closer look reveals deceleration and margin contraction due to increased investments. The FY24 outlook was also weak with an expected growth rate of 10.6% and a decline in EBITDA margin to 38.7%. An emerging concern is the sluggish client count growth. While I acknowledge PAYC’s international expansion strategy, the short-term outlook remains challenging, hence I am sticking to a conservative stance.