The S&P 500 (^GSPC 0.24%) has added 19% year to date as signs of economic resilience helped quell recession fears to some degree. Despite that momentum in the broader market, Etsy (ETSY +3.70%) and Paycom Software (PAYC +4.81%) have seen their share prices slip 37% and 43%, respectively, over the same timeframe.
In both cases, disappointing financial results and weak guidance were the driving forces behind the declines. However, certain Wall Street analysts believe the stocks are significantly oversold, creating a buying opportunity for investors. Let's take a closer look at these two undervalued growth stocks.
NYSE: ETSY
Key Data Points
1. Etsy: 93% implied upside
Etsy runs multiple online marketplaces, including Depop for fashion resale and Reverb for musical instruments. But the best known is the namesake Etsy marketplace, which specializes in vintage, artisanal, and handmade goods. Morningstar analyst Sean Dunlop has a 12-month price target of $145 per share on Etsy, implying a 93% upside from its current price.
The bull case for Etsy centers on its unique position in the e-commerce industry. As the sixth most visited online marketplace, Etsy blends impressive scale with non-commoditized and often customizable inventory from millions of small sellers. The end result is a shopping experience that buyers are unlikely to find anywhere else, certainly not at big-box retailers.
Etsy reported disappointing financial results in the third quarter. Gross merchandise sales (GMS) climbed just one percentage point, while revenue rose 7% to $636 million, and non-GAAP earnings before interest, taxes, depreciation, and amortization (EBITDA) increased 9% to $182 million. Management also gave downbeat guidance that calls for GMS to decline slightly during the holiday quarter. But investors still have reason to be cautiously optimistic.
Weak GMS growth is likely due to inflationary pressure on consumer spending rather than a failure to engage buyers. CFO Rachel Glaser offered insight on the earnings call supporting that idea: "We estimate that GMS from our buyers in the top decile of household income increased over 20% year-over-year in the third quarter, a positive indicator that Etsy's overall growth can improve as macro conditions stabilize over time."
To that end, Sean Dunlop of Morningstar expects GMS growth to reaccelerate in the next few years, pushing revenue growth above 16% by 2025. That seems reasonable given that Etsy has been obsessive about boosting buyer engagement. The company is using artificial intelligence to not only personalize search results but also to selectively surface high-quality products. Etsy has also made strides in delivery-time transparency and purchase protection, both of which should build trust with buyers.
Investors should monitor GMS and revenue closely, but if Etsy can get those metrics back into double-digit territory for a sustained period, its current valuation of 3.8 times sales is a steal. There is no guarantee that shareholders will see 93% returns any time soon, but patient investors who buy this undervalued growth stock today could be well rewarded five years down the road.
NYSE: PAYC
Key Data Points
2. Paycom Software: 68% implied upside
Paycom Software specializes in human capital management (HCM). Its core product is payroll software, but its platform also includes applications for talent acquisition, training, scheduling, and human resources (HR) management. Morningstar analyst Emma Williams has a 12-month price target of $295 per share on Paycom, implying a 68% upside from its current price.
The bull case for Paycom centers on the comprehensive nature and self-service functionality of its HCM platform, both of which reduce operational costs and complexity for clients. Most companies currently rely on a patchwork of point products to meet their HCM needs, but Paycom allows businesses to manage the full employee lifecycle (from hiring through retirement) with a single, integrated suite of software.
Paycom also introduced a self-service payroll software product called Beti (Better Employee Transaction Interface) two years ago. Beti was the first self-service payroll technology in the HCM industry, and it won Paycom a spot on Fast Company's list of the world's most innovative companies last year. Beti automates payroll by requiring employees to review and approve their paychecks prior to processing. That reduces payroll errors, which frees HR and accounting teams to spend their time on other tasks.
Paycom reported solid financial results in Q3. Revenue increased 22% to $406 million and generally accepted accounting principles (GAAP) net income soared 44% to $75 million. But management gave guidance that fell short of expectations, projecting revenue growth of 14% in Q4 and 11% next year. Wall Street expected 21% growth in both cases.
In a somewhat surprising twist, the driving force behind that weak guidance is Beti. The product is working so well that it has cut into other sources of revenue. To quote CFO Craig Boelte, "Beti adoption and usage creates tremendous value to clients as they experience perfect payrolls and eliminate errors, corrections, and unscheduled payrolls, which would otherwise be billable items."
Paycom has shown itself to be an innovative company, and it has grown nearly three times as fast as the broader HCM and payroll software market over the last five years. Yet Paycom accounts for less than 5% of global HCM spend today, leaving a long runway for growth.
Emma Williams of Morningstar expects Paycom to grow revenue at 15% annually through 2027. That forecast makes its current valuation of 6.3 times sales look relatively inexpensive, especially when the three-year average is 18.6 times sales. Returns of 68% are by no means guaranteed over the next year, but patient investors willing to hold this stock for the next five years should consider buying a small position today.
