It’s time to short Paycom
This payroll firm has performed well, but faces two headwinds
One of the big trends in technology in recent years has been software as a service (SaaS). The big idea is that instead of selling people a piece of software that they might not replace for several years, companies can make much more money if they sell an annual subscription, forcing users to pay again every year. Payroll company Paycom (NYSE: PAYC) has done well from this shift and its shares have risen by around 1,900% since it floated in 2014. Today, it is valued at almost $18bn. Yet all good things must come to an end and Paycom is facing two sets of headwinds.
In the short run it faces challenges from the current state of the US economy. While America seems to have outperformed the gloomiest forecasts so far, all the indications are that it will either have a recession, or at best a period of very slow growth of less than 1%, this year. As a result, demand is set to slacken in the labour market, causing the recent surge in jobs to go sharply into reverse. This is bad news for a company whose business depends on high employment rates.
Running out of room
In the longer run, the risk is that Paycom is running out of room to grow. The company says that it has only tapped into around 5% of the potential market, but short-seller Sahm Adrangi of Kerrisdale Capital argued in a report last year that nearly half of all small and medium-sized US firms now subscribe to some sort of payroll software package. This implies that the market for payroll software is much closer to reaching saturation point.
At the same time, Paycom faces an increasing challenge from competitors at both ends of the market. That includes both new startups, such as Gusto, and incumbents, such as ADP, the $95bn marketcap heavyweight of the payroll sector, which are looking to broaden their market beyond the larger corporations they currently serve.
Increased competition is likely to force all companies in the payroll software market, including Paycom, to cut their prices, and therefore margins, in the future, making it even harder to them to keep growing earnings at such a fast rate. This might not be such a big problem if it wasn’t so highly valued. However, at the moment Paycom trades at 40 times estimated 2023 earnings, significantly more than competitors such as ADP, which trades at 28 times.
Paycom’s shares have been very volatile over the past year, swinging between $255 and $402. However, it looks like that the market sentiment has been cooling in the past few weeks. The price has fallen by around 7% over the last month, and it is now trading below both its 50-day and 200-day moving averages. As a result, I’d suggest that you go short at the current price of around $303 at £5 per $1. I’d suggest that you cover your position if it goes above $453, which will give you a total downside of £750.
“Paycom trades at 40 times 2023 earnings, significantly more than competitors”