You should always be fine-tuning your list of stocks to buy. Part of the process should be to consider the big picture trends that will help your choices lead the market higher. I have one suggestion: consider cloud software stocks that are benefiting from low unemployment in the U.S.
Unemployment Remains at Historical Lows
The market’s advance in recent years has been firmly supported, in part, by low unemployment. When that’s combined with low inflation, low interest rates and slow GDP growth, we tend to see a long and drawn out economic expansion. That’s what we’re seeing now. Given this, it stands to reason that it’s a good time to own cloud software stocks that power human resources departments.
After all, these are the companies that are helping business meet all their hiring, payroll processing, benefits management and talent management needs. There is a heck of a lot of activity being run through their software. It only makes sense that they should be growing.
And they have been! Revenue growth for the three small-cap and mid-cap cloud software stocks with human capital management (HCM) solutions that I’ll discuss today averaged 32% in 2018. But the stocks haven’t gone up in recent months, and two of them have come down significantly.
Given that the unemployment is holding steady at 3.7%, it’s possible one or more of these cloud software stocks is worth adding to your potential buy list.
Before we get into details, let’s briefly talk about what’s going on in the HCM industry, and how this should play into the hands of industry software providers.
HCM software helps enterprises handle all elements of HR, payroll, benefits and talent management, while also helping employees navigate through the web of confusion.
HCM is a massive global market that surpasses $12 billion today and is estimated to be growing north of 8% annually.
It’s also an extremely fragmented market, with an estimated 40% of companies relying on very small and limited solutions (versus enterprise-wide solutions). That means there is a lot of room for new providers to grow.
As I mentioned, the three market leaders I’ll soon discuss grew revenue by an average of 32% last year. Yet, shares haven’t been very strong lately.
The reasons are varied, ranging from tough market conditions for growth stocks to concerns over growth in the U.S. to worries over the trade war with China.
But stepping back the main issue is likely that valuations for cloud software stocks had become quite high. After a pullback, they’re no longer so extended. Potential values are starting to open up.
Here are three HCM stocks that might be worth a look.
3 Cloud Software Stocks to Play the Trend
Cornerstone OnDemand (CSOD)
Cornerstone OnDemand is a $3.3 billion market cap company with an HCM platform that is tailored toward recruiting, training and managing people. The stock underperformed from 2014 through 2017 due to leadership challenges and uneven financial performance.
It’s not that there isn’t potential – deals with large customers, including the U.S. Postal Service, and momentum in European markets, illustrate that the business is solid, just underperforming. Cornerstone OnDemand has 3,600 clients around the globe, and 40 million users.
Acquisition rumors have swirled around the company for years. Then in 2017 the company began a review of strategic alternatives. Then Silver Lake (a well-regarded private equity firm) and Microsoft (MSFT) stepped up with a $300 million convertible note investment.
At about the same time, Cornerstone’s management announced the company would reduce its focus on lower-margin enterprise services revenue and prioritize higher-margin subscription revenue. It also began a share buyback program.
The change has been ongoing and things appear to be progressing well. In Q2 2019 revenue was up 7%, subscription revenue grew by 16% and adjusted EPS grew 58% to $0.19. Cornerstone OnDemand is focused on creating new recurring revenue streams, including entering the content market, and signed a multi-million-dollar Content Anytime deal.
Analysts now see 2019 revenue growing modestly, by 6%, but EPS jumping 41% to $1.04. In 2020 revenue growth should accelerate to 14% and EPS should be up 40%+ again.
With that backdrop of improving fundamentals and a transition that’s closer to the middle innings than the early ones, shares of CSOD have moved higher since the end of 2017. The stock isn’t a rocket ship just yet! But provided the transition continues to go well shares should have considerable upside potential.
Upland Software (UPLD)
Upland Software (UPLD) is a $926 million market cap company that provides cloud-based Enterprise Work Management (EWM) software to companies where collaboration and teamwork are critical to their operations. HCM solutions are just a portion of the types of solutions it offers, which span project management, information technology, business operations, sales and marketing and human resources.
One of the big selling points of Upland’s solutions is the UplandOne unified operating platform. Users simply log in to access all solutions, which run on a common user-interface, with one set of credentials (this is called single sign-on), from any device of their choosing. This is the inherent benefit of the cloud and is made possible because Upland has moved all solutions to Amazon Web Services (AWS), which also allows for integration with other third-party app providers.
Upland has a history of buying purpose-built cloud-based EWM applications then restructuring and integrating them to help grow overall company revenue, profitability and customer count. Its target is to add over $25 million in revenue per year by snatching up companies with $5 million to $25 million in annual revenue and with renewal rates of 90% or more. Target companies must have EWM solutions that fit within Upland’s three product families and have operations in the U.S., Canada and/or E.U. Each acquired solution is intended to be migrated to the UplandOne model within three months.
In addition to acquisition-led growth, Upland is also generating modest organic growth in the mid-single digits. Faster would be better, which is part of why the stock has pulled back over the last three months. In time, as the business matures, it’s possible that organic growth could accelerate. But management has tried to temper market expectations here.
Stepping back, revenue growth in 2018 was 40% and adjusted EPS grew by 45%, to $2.75. Analysts currently expect revenue to climb around 14% in 2019, but given the M&A strategy that number is likely conservative. Adjusted EPS is estimated to be flat in 2020. But again, that will change if and when acquisitions are announced.
Shares of Upland Software tend to go on nice runs, then pull back to around, or slightly below, the 200-day line, as they have recently. If you can stomach these pullbacks and hold over the long term the stock could do well.
Full disclosure: Upland Software was recently held in the Cabot Small-Cap Confidential portfolio. We stepped aside from the position to protect a gain in the event the stock fell further. It’s currently on my watch list for potential inclusion in that investment advisory service in the future.
Paycom Software (PAYC)
Paycom’s cloud-based HCM software helps employers manage payroll, human resources, talent acquisition and time and labor. While expectations of 28% revenue growth in 2019 won’t hit 30 – 40% as in years past (the revenue base is much larger now), this is still a high-quality, rapid-growth company. And expected revenue and EPS growth around 28% in 2019 and 24% in 2020 shows it’s not exactly turning into a slow growth story! The company has a market cap of $12 billion.
Paycom has been beating analyst expectations for years now, which partially explains why it is the best-performing stock from today’s list over the long-haul, even after a sharp correction in early September.
While some analysts are saying it is time to start locking in profits, it’s hard to argue with a stock that keeps going up.
Trends to watch with Paycom are more about the company illustrating that it hasn’t lost its competitive edge then that it can get growth to accelerate again (not likely). On that note, look for recurring revenue to keep growing, gross margins to expand (or at least stay steady), and cash flows to pick up.
These are the metrics Paycom will need to keep making progress on to validate its premium valuation. Assuming favorable tailwinds persist, this could be an excellent time to pick up a few shares at a discount.
*This post has been updated from an original version, published in 2017.