Small Player in a Big Market

After peaking at 10% in October 2009, the U.S. unemployment rate has been declining fairly steadily to today’s 5.6%. More than 3 million Americans found work last year alone, taking our unemployment rate to its lowest level since June 2008 and marking the best year for employment gains since 1999. With most economists forecasting that the U.S. economy will grow by more than 3% this year, some believe that we could reach a 5% unemployment rate by the time we’re ringing in 2016.

Not only is that terrific news for workers, it’s also good news for companies that provide payroll processing and human resources services. With a raft of regulations dealing with employee payroll, ranging from Internal Revenue Service withholding requirements to legal compliance, a company that actually handles its own payroll is a rare beast these days. Professional payroll services are better equipped to deal with the nuances of actually paying workers, with the added benefit of being on the hook if anything were to go wrong.

There are currently two large payroll processing companies that dominate the field; Automatic Data Processing (NSDQ: ADP) and Paychex (NSDQ: PAYX). Despite the burgeoning size of the American workforce, neither company has managed to grow revenue or earnings much more than mid-single digits over the past five years. With ADP’s nearly $42 billion market capitalization and more than $12 billion in annual revenue, it takes a lot of new hires to move the needle on earnings.

That’s not the case for Paycom Software, though, which since being recommended by our technology-savvy analysts at Smart Tech Investor has seen its shares soar by more than 65%. ADP’s shares, on the other hand, are up just 5.5% over the same period.

Founded in 1998 and having just gone public this past April, Paycom (NSDQ: PAYC) is a relative upstart in the industry. But largely thanks to its diminutive size with a market cap of just $1.4 billion and innovative products, market share is there for its taking.

Focusing primarily on businesses with between 50 and 2,000 employees, its target market employs almost half of all American workers. While it currently has sales offices in 30 of the nation’s largest metropolitan areas, it has more than 10,000 clients in all 50 states. No single client represents more than 0.5% of the company’s total revenue though, so even if a client were to drop Paycom’s services, it wouldn’t be catastrophic. But that’s not much of a concern since it has an average 91% retention rate over the past five years.

Perhaps one of its most attractive features though isn’t its ability to attract new clients. While that’s clearly where a lot of upside lies, Paycom has shown it has the ability to successfully pitch add-on services to its existing clients. In addition to offering payroll services, the company’s software-as-a-service platform also makes modules available which help with tracking potential new-hires, time and labor management systems and human resources management services. According to the team at STI, while Paycom customers used just 5.2 of the 18 available applications on the platform in 2013, that number has since moved up to 6.2.

Paycom is clearly mastering the upsell, and the ease of use of its product is probably helping that along. Customer satisfaction rates with the products tends to be high, with its systems usable across multiple devices such as PCs and smartphones, with an intuitive interface designed to minimize potential errors. It also recently launched a free tool to help its clients comply with new health insurance regulations, so it also clearly adds a lot of value for its customers.

As customers are embracing more of Paycom’s services, it revenue stream is diversifying. While 68% of the company’s revenue came from payroll processing in 2011, that number fell to just 58% of the total in 2013 even as revenue grew. For full-year 2014, the current consensus looks for revenue to hit about $144 million, year-over-year growth of nearly 34%.

To help propel that already rapid growth higher, Paycom announced earlier this month that it was making a secondary offering of 5,585,000 shares of stock, potentially raising an additional $125.6 million for the company’s coffers. That cash will be used to open new sales offices across the country and continue refining its product offerings, which are already generally considered some of the easiest to use in the industry.

Analysts are clearly enthused by the company, even if they are something of Johnny-come-latelies to the story. While Paycom’s initial public offering didn’t generate a lot of initial enthusiasm, with shares hitting a new low just three months after the IPO, analysts forecast earnings of $0.17 per share for full-year 2014. That’s eye-popping earnings growth of 750% year-over-year. While the outlook for 2015 isn’t nearly as high, currently at $0.29 per share, that’s still better than 70% growth.

For a company enjoying a secular tailwind of a growing U.S. labor market and an increasingly popular suite of products, Paycom should continue turning in impressive growth numbers throughout 2015.