Paylocity (PCTY)
Rating: BUY
Current Price: $29.75
Price Target: $45

Thesis:
Paylocity is a cloud-based provider of payroll and human resource capital management software solutions for mid-sized organizations. They are generally a less expensive solution than ADP which is the payroll processing industry standard suited for large organizations. Paylocity is a smaller market capitalization company (~$1.6 billion), headquartered in Arlington Heights, Illinois, that has grown its revenues at an astounding rate in recent years, but has also spent heavily to achieve this growth. We believe Paylocity’s high spending is acceptable for a small organization that is growing to meet market demand. We believe the company will eventually reach a point where the heavy spending on growth will become unnecessary, and the company’s high gross profit margin will make it essentially a “cash cow.”

Valuation:
As a relatively new public company (the initial public offering was March 24, 2014), we value Paylocity using Price-to-Revenue comparables. More traditional valuation metrics such as discounted cash flow analysis and price-to-earnings ratios are less useful for Paylocity because the company is currently spending very heavily on growth. Early stage companies often spend more than they collect to fund future growth opportunities that are expected to result in significant future profitability.

Paylocity has been growing revenues at a pace of approximately 40% per year since 2011, and the company expects continued high growth going forward. During the earning conference call on August 13, 2015, Paylocity forecast 2016 earnings to be $199 to $203 million, representing ~32% growth over fiscal year 2015. Assuming the company can grow revenues at 27.2% for the next five years (this is the average estimate by the six analysts surveyed by Yahoo Finance) gives Paylocity a “price to five-year-forward-revenue” ratio of 3.2 times ($1,620 million market capitalization divided by $508 million revenues). This compares favorably to the same ratio of peers ADP and Paychex of 2.3 and 4.3, respectively. We assumedADP to have a revenue growth rate of 8.15% and Paychex to have a revenue growth rate of 7.15% using the average revenue growth estimates of the analysts (20 and 19, respectively) surveyed by Yahoo Finance.

We believe Paylocity should trade in a price to fiscal year 5 revenue range of 4 to 5 times, given its size and future growth opportunities. This gives us a target price range of $40 to $50 per share, well above its current price of $29.75.

What makes the Paylocity valuation even more compelling is the fact that the company has clear opportunities to grow its revenues significantly beyond the $508 million estimate for 2020. In fact, Paylocity estimates their market opportunity to be closer to $9 billion. The following passage from the firm’s most recent annual report gives some flavor for how they view the market opportunity:

According to market analyses published by International Data Corporation, or IDC, titled Worldwide and U.S. Human Capital Management Applications 2015 – 2019 Forecast (June 2015) and U.S. Payroll Outsourcing Services 2013 – 2017 Forecast and Analysis (October 2013), the U.S. Market for HCM applications and payroll outsourcing services is estimated to be $24 billion in 2015. The market opportunity is driven by the importance of payroll and HCM solutions to the successful management of organizations.
To estimate our addressable market, we focus our analysis on the number of U.S. medium-sized organizations and the number of their employees.ccAccording to the U.S. Census Bureau, there were over 565,000 firms with 20 to 999 employees in the U.S. in 2010, employing over 40 million persons.

We estimate that if clients were to buy our entire suite of existing solutions at list prices, they would spend approximately $230 per employee annually. Based on this analysis, we believe our current target addressable market is approximately $9.0 billion. Our existing clients do not typically buy our entire suite of solutions, and as we continue to expand our product offerings, we believe that we have an opportunity to increase the amount clients spend on payroll and HCM solutions per employee and to expand our addressable market.

And if Paylocity is able to continue to grow beyond the next five years, then the stock’s valuation is even more compelling. Unlike the large and more mature ADP, Paylocity has much more significant growth opportunities ahead.

Competitive Advantages:
Cloud-based solutions: Paylocity’s solutions are cloud-based and offered on a subscription basis, making them easier and more affordable to implement, operate and update. They enable clients to focus less on their IT infrastructure and more on their core businesses.

Underserved market: Paylocity serves small and mid-sized companies (defined by Paylocity as 20 to 1,000 employees) that often don’t need all the expensive bells and whistles, and are also often ignored by bigger competitors that prefer to focus on bigger clients. Paylocity serves the unique challenges faced by this group, noting that employees in these medium-sized organizations often perform multiple job functions, and many medium-sized organizations have limited financial, technical and other resources needed to effectively manage their critical business requirements and to build and maintain the systems required to do so.

Lower cost solutions: Mid-sized companies often don’t need all the expensive bells and whistles, and are also often ignored by bigger competitors that prefer to focus on bigger clients. Paylocity offers solutions targeted towards these organizations.

Growth Strategy: According to the firm’s annual report (p.4), Paylocity’s growth strategy includes the following:

Growing the Client Base: We believe that our current client base represents only a small portion of the medium-sized organizations that could benefit from our solutions. While we served approximately 10,350 clients across the U.S. as of June 30, 2015, there were over 565,000 firms with 20 to 999 employees in the United States, employing more than 40 million persons, according to the U.S. Census Bureau in 2010. In order to acquire new clients, we plan to continue to grow our sales organization aggressively across all U.S. geographies.
Expanding Product Offerings: We believe that our leadership position is in significant part the result of our investment and innovation in our product offerings designed for medium-sized organizations. Therefore, we plan to increase investment in software development to continue to advance our platform and expand our product offerings. For example, in June 2015 we announced the release of ACA Enhanced, which will provide compliance and reporting for the Affordable Care Act.
Increasing Average Revenue per Client: Our average revenue per client has consistently increased in each of the last three years as we have broadened our product offerings. We plan to further grow average revenue per client by selling a broader selection of products to new and existing clients.
Extending Technological Leadership: We believe that our organically developed cloud-based multi-tenant software platform, combined with our unified database architecture, enhances the experience and usability of our products, providing what we believe to be a competitive advantage over alternative solutions. Our modern, intuitive user interface utilizes features found on many popular consumer Internet sites, enabling users to use our solutions with limited training. We plan to continue our technology innovation, as we have done with our mobile applications, social features and analytics capabilities.
Further Developing Referral Networks: We have developed a strong network of referral participants, such as 401(k) advisors, benefits administrators, insurance brokers, third-party administrators and HR consultants that recommend our solutions and provide referrals. We believe that our platform’s automated data integration with over 200 related third-party partner systems is valuable to our referral participants, as they are able to access payroll and HR data through a single system which decreases complexity and cost and complements their own product offerings. We plan to increase integration with third-party providers and expand our referral network to grow our client base and lower our client acquisition costs

Risks:
Achieving Profitability: Paylocity faces a variety of risks, and perhaps the greatest and most obvious is noted in their annual report: “we have incurred losses in the past, and we may not be able to achieve or sustain profitability for the foreseeable future.” This is a company that is spending heavily on future growth. If the growth is not achieved then the company and it its stock price will suffer.

Competition is another significant risk. As the company notes in its annual report: “The markets in which we participate are highly competitive, and if we do not compete effectively, our operating results could be adversely affected.” Paylocity goes on to explain that the “market for payroll and HCM solutions is fragmented, highly competitive and rapidly changing. Our competitors vary for each of our solutions, and include enterprise focused software providers, such as Ultimate Software Group, Inc., Workday, Inc., SAP AG, Oracle Corporation and Ceridian Corporation, payroll service providers, such as Automatic Data Processing, Inc., Paychex, Inc., Paycom Software, Inc. and other regional providers, and HCM point solutions, such as Cornerstone OnDemand, Inc.”

Insider control is another risk. According to Paylocity “Insiders have substantial control over us, which may limit Our stockholders’ ability to influence corporate matters and delay or prevent a third party from acquiring control over us.” Said differently, stockholders cannot do much if the directors, officers and affiliates want to make bad decisions. The annual report explains “as of August 7, 2015, our directors, executive officers and holders of more than 5% of our common stock, together with their respective affiliates, beneficially owned, in the aggregate, approximately 64.4% of our outstanding common stock. This significant concentration of ownership may adversely affect the trading price for our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders. In addition, these stockholders will be able to exercise influence over all matters requiring stockholder approval, including the election of directors and approval of corporate transactions, such as a merger or other sale of our company or its assets. This concentration of ownership could limit the ability of our other stockholders to influence corporate matters and may have the effect of delaying or preventing a change in control, including a merger, consolidation, or other business combination involving us, or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control, even if that change in control would benefit our other stockholders.”

Economic growth (or lack thereof) is another risk. If the overall economy fails to grow, or grows at a slow rate, this may impact the ability of Paylocity to grow its business as expected.

Conclusion:
Paylocity is one of the higher risk (and potentially higher rewarding) companies in the Blue Harbinger 15. Based on the market opportunity, this company could turn extremely profitable within the next five years. And any signs of improvement in the near term should cause the stock price to increase towards our price target of $40 to $50 per share. Realistically, this company could greatly exceed our growth targets and continue to grow dramatically for many years to come.