Did you know that more than 40 percent of SMBs are fined every year for payroll errors? Small businesses often have difficulties because paychecks are manually processed, or they use software that’s too complex. Smaller companies operating without the infrastructure or expertise of larger enterprises are uniquely pressured to manage their human capital effectively. Enter Paylocity Holding Corporation (PCTY), a cloud-based provider of payroll and human capital management software solutions for small and mid-sized organizations, specifically targeting companies having between 20 and 1,000 employees.
In today’s financial markets, most software companies have outrageous stock market valuations. Paylocity is an exception as I find that it is reasonably priced in terms of relative valuation (more on this later). The company also had consistent YoY revenue growth rate of 22%, great free cash flow margin of 20%, and meets the criteria for the software Rule of 40.
The company scores high on several G2 Crowd Grid® Reports on six HCM software-focused reports for customer satisfaction. Company management is committed to 20-25% growth for the next few years, and I believe that is possible based on past performance and growth plans. For these reasons, I give Paylocity a Buy rating.
Paylocity was founded in 1997 and went public in March 2014. Services are provided in a Software-as-a-Service (SaaS) delivery model utilizing the Company’s cloud-based platform. The Company derives its revenue from contracts predominantly from recurring and non-recurring service fees.
Recurring fees are derived from payroll, timekeeping, and HR-related cloud-based computing services as follows:
- Payroll processing and related services, including payroll reporting and tax filing services, are delivered on a weekly, biweekly, semi-monthly, or monthly basis depending upon the payroll frequency of the client and on an annual basis if a client selects W-2 preparation and processing services,
- Time and attendance reporting services, including time clock rentals, are delivered on a monthly basis, and
- Cloud-based HR software solutions, including employee administration and benefits enrollment and administration, are delivered on a monthly basis.
Non-recurring service fees consist mainly of non-refundable implementation fees, which involve setting the client up in, and loading data into, the Company’s cloud-based applications. These implementation activities are considered set-up activities.”
Employers can preview, verify, and correct employee paychecks prior to processing payroll. Payroll templates for new hires and data integration with third-party vendors are also available. The payroll module includes custom reports and evaluation of compliance with the Affordable Care Act (ACA).
Paylocity provides a self-service portal for employees, where they can access personal and company information. The portal has more than 500,000 daily users. The company has made a significant investment in its mobile app, boosting the number of features, and now, attracts more than 300,000 daily users.
Paylocity targets businesses that have a few employees in order to get them on the platform for doing payroll. Their sweet spot is organizations with 50 to 100 employees. Then, as with all SaaS businesses, the goal is to cross and up-sell their suite of applications.
Paylocity revenues have grown annually at 25% for the last two years, and company management is committed to continuing growing at this pace:
We believe there is a significant opportunity to grow our business by increasing our number of clients, and we intend to invest in our business to achieve this purpose. We market and sell our solutions primarily through our direct sales force. We have increased our sales and marketing expenses as we have added sales representatives and related sales and marketing personnel. We intend to continue to grow our sales and marketing organization across new and existing geographic territories. In addition to growing our number of clients, we intend to grow our revenue over the long term by increasing the number and quality of products that clients purchase from us. To do so, we must continue to enhance and grow the number of solutions we offer to advance our platform.”
In January, Paylocity launched new benefits-focused solutions covering third-party administrative (TPA) services. This includes health savings and reimbursement accounts and flexible spending accounts. Employees are now able to manage their flexible benefits accounts, view their paychecks, submit expenses, and request time off all the same place. The TPA solutions have raised the total per-employee revenue opportunity from $320 to $360 a year for customers taking the full suite.
Paylocity is also in the early stages of building a learning module that will again raise the total employee revenue opportunity, but that is further off in the future.
…we have some learning components in our application. We mostly focus those on compliance courses, which is most applicable to our segment. So think about stuff sexual harassment training, which is mandated in certain states in certain sizes. So we’ve had that available for our customers for a while. We talked about potentially building a learning module. We’ve not launched a learning module yet. Our program typically involves early adopters, client feedback, usage, I would say we are very much in that stage right now, and when we are ready to be able to launch that, you know, obviously we will make that announcement and we will add that to TPI opportunity, but that’s probably next up on our list of product initiative tip market.”
G2 Crowd Grid Reports
G2 Crowd is a review platform that brings transparency to B2B buying by reaching out to users via email and advertisements to deliver unbiased reviews. Before a review appears on G2 Crowd, it must pass through an algorithm, be read and authenticated by a person, and have a validated LinkedIn profile or business email address associated with it.
Paylocity has been recognized on several G2 Crowd Grid Reports, including ranking #1 in Satisfaction on six HCM software-focused reports. The six reports Paylocity leads in Satisfaction are:
As I explained in a recent article on Splunk (SPLK), high-growth companies generally don’t measure up based on traditional value metrics. In fact, they often confound analysts, with the result being a lost investment opportunity. In place of traditional value factors, I generally focus on other measures, such as revenue growth, free cash flow margin, and the software company „Rule of 40“.
Paylocity had a good year with trailing-twelve-month (TTM) revenue growth of 22%. The company’s 5-year annual growth rate of 37% is also extremely good.
Free Cash Flow Margin
Paylocity’s free cash flow margin TTM has been positive since mid-2015 and is currently sitting at a very healthy 20% of revenues.
Paylocity’s gross profit margin has been steadily increasing since the company went public and now sits at almost 72%. The best SaaS companies have a gross margin in the neighborhood of 85-90%, but Paylocity’s GM is not bad. The lower GM is a result of non-recurring service fees.
Paylocity has good control of SG&A expenses which are about 57% of revenues, typical for a mature software company.
The Rule of 40
One industry metric that is often used for software companies is the „Rule of 40.“ It is an industry rule of thumb that attempts to help software companies ascertain how to balance growth and profitability. There are different ways of calculating the Rule of 40; some analysts use EBITDA, and others use the free cash flow margin. I use the free cash flow margin, as the figure is useful in a later part of my analysis.
The Rule of 40 is interpreted as follows: If a company’s growth rate plus free cash flow margin adds up to 40% or more, then the SaaS company has growth and cash flow in balance and is considered financially healthy. In Paylocity’s case:
Revenue Growth + FCF margin = 22% + 20% = 42%
Since the calculation comes out at 42%, I conclude that Paylocity is financially healthy.
Revenue growth plus FCF margin is sometimes referred to as the „Efficiency Score.“ It has been determined that Efficiency Score has a greater than 70 percent correlation to a public SaaS company’s revenue multiple, which is the valuation divided by revenue.
In order to demonstrate this, I have plotted the EV/Sales multiple versus the Efficiency Score in MS Excel for 48 software stocks from my digital transformation stock list. A linear trendline is plotted through the scatter plot that represents the best-fit valuation multiple for a given Efficiency Score.
(Source: Portfolio123 /MS Excel)
As can be seen from the above graph, Paylocity sits slightly below the best-fit line through the data points.
The rest of this analysis is somewhat controversial. For me, at least, it seems logical to assume higher valuation for higher-growth companies, and I use the best-fit line to gauge a company’s valuation relative to the rest of the stocks in the custom universe. This is a relative valuation, not absolute as one would attempt to get using a DCF calculation.
Based on the above chart, I conclude that Paylocity’s stock price is fairly valued relative to the rest of the digital transformation stocks in my custom universe. Based on my relative valuation calculation, good growth, FCF margin, and SG&A expense, I believe that Paylocity is a good investment candidate as a “Growth at a Reasonable Price” stock, and I assign a Buy rating for Paylocity.
An investment in Paylocity comes with several risks. For starters, the bull market is long in the tooth, and we could enter a bear market in the not-too-distant future based on a slowing economy or a resurgence in trade tensions between the USA and China.
In addition, SaaS stocks are on a tear, and many of them are reaching all-time highs. Some analysts believe that we are in for a second „dot-com“ crash due to lofty valuation.
The market for payroll and HCM solutions is fragmented, highly competitive, and rapidly changing. Paylocity’s competitors vary for each of solution and include enterprise-focused software providers, such as Ultimate Software Group, Workday (WDAY), SAP (SAP), Oracle (ORCL), and Ceridian (CDAY), payroll service providers, such as Automatic Data Processing (ADP), Paychex (PAYX), Paycom (PAYC), Paycor, and other regional providers, and HCM point solutions, such as Cornerstone OnDemand (CSOD).
Changes in tax, benefit, and other laws and regulations could require Paylocity to make significant modifications to their products or delay or cease sales of certain products.
Paylocity is a cloud-based provider of payroll and human capital management software solutions for small and mid-sized organizations, specifically targeting companies having between 20 and 1,000 employees. Paylocity targets smaller organizations, and their sweet spot is companies with 50 to 100 employees.
Company management is focused on company growth of approximately 25% per annum, and from what I can see, this is plausible, assuming that the economy remains bullish.
The company scores quite well on the Rule of 40, and I believe that the company is fairly valued relative to other software stocks.
This investment comes with significant risks, however. All digital transformation stocks have lofty values. At some point in time, these companies may come down to earth. There is also intense competition in the payroll/HCM market.
I believe that Paylocity, with its more reasonable valuation and profitability, is a buying opportunity, and investors should not miss out. Therefore, I assign a Buy rating to Paylocity.
Keep an eye out for my soon-to-be-launched Digital Transformation marketplace service!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.