Like many other high-growth cloud companies, Paycom Software (PAYC 1.24%) stock fell off a cliff in late 2021 into 2022 due to high inflation and the Federal Reserve pushing interest rates higher at the fastest pace in 40 years.
Many experts believe the economy will dive into recession sometime this year due to the aggressive actions by the Federal Reserve to fight inflation. This is terrible news for Paycom, as it is especially susceptible to producing poor results in a slowing economy. As a result, many investors have lost their enthusiasm for investing in this stock. It's down 2% year to date, compared to the Technology Select Sector SPDR Fund, which is up 22% in 2023.
However, this bear market should only last for a short while. If you are looking for a top-growth stock for the long term, Paycom is worth considering. Here's why.
Paycom has an attractive business
Paycom is a rising payroll and human capital management (HCM) company for small to medium-sized companies. Its platform has two advantages over competitors.
The first advantage is that its developers built its platform from the ground up to run on a single database, unlike many competitors that use third-party technology and multiple databases. So, Paycom's simple platform outperforms competitors' complex patchwork systems that require redundant data entry and contain more security risks.
The second advantage is that it created a tool named BETI that enables employees to do their own payroll. BETI ensures accuracy in payroll processing and increases efficiency. The company believes BETI is the future of payroll.
Paycom's target market must find the advantages of its platform very appealing, as the company is growing revenue and profits like a weed. It has delivered outstanding results quarter after quarter and beaten analysts' revenue and earnings estimates for the past four quarters.
Moreover, in its fourth-quarter 2022 earnings report on Feb. 7, 2023, it produced quarterly revenue growth of 30% year over year, its seventh straight quarter of 30% growth and above -- impressive in this economy.
It also produced a generally accepted accounting principles (GAAP) fourth-quarter 2022 net income of $80 million, up from $48.7 million in the previous year's comparable period.
However, management prefers using adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) rather than net income to measure bottom-line profits. EBITDA excludes a company's depreciation assumptions, financing choices, and tax situation. Thus, EBITDA is a better measure of a company's core profitability, and Paycom's core profitability is rising in this challenging economy. For example, the company's EBITDA margins increased from 38.4% in Q4 2021 to 44.2% in Q4 2022.
Once clients embed Paycom's solutions into their operations, the time and effort to switch to another provider become untenable, locking them into its platform from which it can sell those clients additional modules or services. Additionally, these high switching costs give it pricing power and make it difficult for competitors to steal market share.
You can measure Paycom's high switching cost by observing its annual revenue retention rate, which was 93% in 2022. This is consistent with its average from 2019 of 93% -- an incredible number. If you see the number increase, its switching cost competitive advantage is strengthening. Conversely, the company could risk shrinking margins or losing market share if the number starts decreasing.
Why Paycom shareholders fear a hard landing
Paycom charges its clients monthly on a per-employee or transaction-processed basis for services like payroll, which helps it generate much of its recurring revenue. That's a great business model in a growing economy where businesses are hiring heavily. But in a recession with many smaller enterprises either going out of business or laying off workers, getting paid on a per-employee basis can hurt revenue growth.
An extreme example of what could happen to Paycom's revenue growth during a recession occurred in the second quarter of 2020, the worst portion of the pandemic, when the U.S. gross domestic product shrank at an annual rate of 32.9%. In addition, unemployment jumped from 3.6% in Q4 2019 to 13% in the second quarter of 2020 -- the U.S.'s highest quarterly unemployment rate ever. As a result of the fall in employment, the company's quarterly year-over-year revenue growth fell to just 7%, as shown in the chart below.
PAYC Revenue (Quarterly YoY Growth) data by YCharts
While no one expects unemployment to worsen to the levels seen during the pandemic's height, a recession could stunt Paycom's growth. The stock has recently performed in lock-step with consensus opinions about whether the U.S. will have a hard or soft landing, and right now, many believe there will be a hard landing. The uncertainty about whether a recession will occur and whether it will be mild or severe has held the stock back into a tight trading range.
Now is a great time for long-term investors to buy
Even if a recession occurs, Paycom is built to survive. As of the end of 2022, it had $400 million in cash against only $29 million in long-term debt -- a solid balance sheet. Additionally, it produced $228 million in free cash flow (FCF) in 2022. As a result, the company is likely to withstand a recession without its balance sheet becoming overly stressed.
Paycom is one of the best cloud companies in the market today. If you can withstand short-term downdrafts in stock price, this investment should be one of the better performers over the next 10 years.
