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Workday (NYSE:WDAY)

F3Q 2013 Earnings Call

November 28, 2012 5:00 p.m. EST

Executives

Mike Haase – VP, Finance, Treasurer and IR

Mark Peek – CFO

Aneel Bhusri – Chairman, Co-Founder and Co-CEO

Analysts

Adam Holt – Morgan Stanley

Heather Bellini – Goldman Sachs

John DiFucci – JP Morgan

Jason Maynard – Wells Fargo

Brendan Barnicle – Pacific Crest Securities

Richard Davis – Canaccord Genuity

Pat Walravens – JMP Securities

Peter Goldmacher – Cowen & Co.

Brent Thill – UBS

Laura Letterman – William Blair

Mark Murphy – Piper Jaffray

Operator

Welcome to Workday's third quarter earnings call.

At this time all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of the conference.

With that, I will hand the call over to Mike Haase. Please proceed.

Mike Haase

Welcome to Workday's third quarter fiscal 2013 earnings conference call.

On the call we have Aneel Bhusri, our Chairman and Co-CEO, and Mark Peek, our Chief Financial Officer. Following their prepared remarks, we will take questions.

Our press release was issued after close of market and is posted on our website where this call is being simultaneously webcast.

Statements made on this call include forward-looking statements such as those with the words will, believe, expect, anticipate and similar phrases that denote future expectation or intent regarding our financial results, applications, customer demand, operations and other matters. These statements are subject to risks, uncertainties and assumptions. Please refer to the press release and the risk factors in documents filed with the Securities and Exchange Commission, including our registration statement on form S-1 for information on risks and uncertainties that may cause actual results to differ materially from those set forth in such statements.

In addition, during today's call we will discuss non-GAAP financial measures. These non-GAAP financial measures, which are used as measures of Workday's performance, should be considered in addition to, not as a substitute for or an isolation from, GAAP results. Our non-GAAP measures exclude the effect on our GAAP results of stock-based compensation and an equity grant to the Workday Foundation. You can find additional disclosures regarding these non-GAAP measures including reconciliations with comparable GAAP results in our earnings press release which is posted on the Investor Relations page of our website.

Webcast replay of this call will be available for the next 45 days on our company website under the Investor Relations link. Our fourth quarter quiet period begins at the close of business January 17, 2013. Finally, unless otherwise stated, all financial comparisons in this call will be to our results for the comparable period of our fiscal 2012.

With that, let me hand it over to Mark.

Mark Peek

Thanks, Mike, and good afternoon everyone. Welcome to our first investor and analyst earnings call as a public company.

We are very pleased with our results during the fiscal third quarter ended October 31 which included the addition of 31 new customers including Hewlett-Packard for HCM and J.B. Hunt for Financials. At the end of the third quarter we had a total of 356 customers.

Just three weeks after our IPO on the New York Stock Exchange, we kicked off our annual user conference Workday Rising. The event was a big success with more than 2,500 attendees compared to 1,400 last year. We had over 170 prospect companies in attendance and are very enthusiastic about the future and our competitive position. It is clear that we can now serve the largest and most complex companies in the world for HCM, and with a superior user experience and ROI. Our progress and confidence in achieving a similar position for our Financials products remain strong. Aneel will cover Rising and some of our recent product announcements in more detail.

Total third quarter revenues increased 99% to $73 million and our subscription revenue, which is the growth driver of our business, increased 116% compared to the same period last year. Our non-GAAP operating loss was $23.5 million or 32.3% of revenue in the fiscal third quarter compared to a non-GAAP loss of 38% of revenue in our second quarter. Trailing 12-month operating cash flows for the third quarter were again near the breakeven mark at a negative $1.4 million. Our balance sheet is strong with cash and investments of $797 million, including $685 million of net proceeds received from our IPO and unearned revenue of $252 million.

As I know some of you are new to Workday, I want to briefly review how our software-as-a-service business model works. Our customers pay us subscription fees that are typically based on the total number of workers within the organization and the number of Workday applications to which they have subscribed. We start recognizing revenue upon delivery of the first software tenant, usually about a week after contract signing. Most of our customer agreements are for three years and are non-cancellable.

In a typical contract, the first year of a multiyear contract is billed and recorded on our balance sheet as unearned revenue. The unbilled portion of the contract remains off our balance sheet as backlog until billed. We plan to provide total backlog information once a year during our yearend earnings call.

As a reminder, backlog as disclosed in our IPO prospectus was $325 million as of the end of our second quarter. Unearned revenue plus backlog at the end of July totaled $572 million.

Subscription renewals of existing customer contracts are currently not a material component of our business as we have had relatively small number of contracts up for renewal. However, as our human capital management and financial applications are typically implemented as platform decisions and our core systems of record for our customers' operations, we anticipate high customer retention.

With this background, I'll now walk you through the financial results. Total revenues for the third quarter were $73 million, an increase of 99% from a year ago. The vast majority of our sales are currently in US dollars, so there is minimal impact from exchange rates. Subscription revenues for our cloud applications were $52 million, up 116% from last year. As subscription revenues are recognized ratably, our revenue growth represents the service we have provided to all of our 350-plus customers.

The weighted average duration of contracts signed in recent quarters has been within a range of three-and-a-half to four years. The third quarter was consistent with this range at approximately 3.6 years. Our services revenue was $21 million, an increase of 67% compared to last year. Our primary objective with our services business is to maximize customer satisfaction and is therefore not a revenue growth driver. Three years ago our systems integrator partners provided about 50% of our customer deployments. Today they are the prime deployment partner with approximately 80% of our new customers.

Total unearned revenue at quarter-end was $252 million, up 64% from a year ago. Over 90% of our unearned revenue is from subscription fees. Short-term unearned revenue was $164 million, an increase of 8% sequentially and 79% from last year. Long-term deferred revenue was $88 million, down 8% sequentially and up 41% from last year. During this fiscal year, as our balance sheet strengthened, we changed our sales compensation structure to de-emphasize multiple year upfront cash collection to finance the business. So the percentage of the contract billed upfront is comparably less than in prior periods. This change negatively impacts the comparisons to our unearned revenue, calculated billings and cash flows, but in the long term we believe it improves the economics of our business.

Looking ahead to the fourth quarter, we are mindful about the macroeconomic environment and the impact of the fiscal cliff on enterprise procurement behavior. However, the strength of our business model and continued momentum provide very good revenue visibility and we expect a solid fourth quarter.

Total revenues for the fourth quarter are expected to be within a range of $75 million to $79 million or a growth of 74% to 83% as compared to the prior year. Subscription revenue is anticipated to be within a range of $56 million to $58 million, reflecting year-over-year growth of 93% to 100%.

When we report the results of our fourth quarter, we expect to provide revenue guidance for our fiscal year ending January 2014. However, as you think about the first quarter of fiscal 2014, we currently expect billings to be slightly down sequentially from our fourth quarter, representing seasonality of the enterprise software sales cycle.

Let's spend a few minutes on operating expenses and our results of operations. Unless otherwise noted, all references to our expenses and operating results are on a non-GAAP basis which are reconciled in the press release tables and posted on our IR website.

Our total headcount at the end of the quarter was 1,620 people. This reflects an increase of 168 in the quarter and an increase of 524 people since the beginning of the fiscal year. Approximately two-thirds of our total non-GAAP expenses are employee-related.

Our third quarter gross margin was 59%. We anticipate improvements to our gross margin over time as a percentage of revenue generated from software subscriptions should grow faster than our professional services revenue. The third quarter subscription gross margin was 81% and includes the costs related to providing our cloud applications, compensation and related expenses for operations staff, and data center networking and depreciation.

Our third quarter operating loss measured on a non-GAAP basis was $23.5 million or a negative 32.3%. This was better than expected and largely the result of operating leverage. The timing of our hiring during the quarter, modestly slower than expected hiring, and most of our capital spending occurring at the end of the quarter resulting in lower-than-expected depreciation charges. We do not currently expect margin improvement and in fact you should expect our operating loss to increase as we continue to invest.

Product development expense in the third quarter was $26.8 million, up 16% sequentially and 66% from a year ago. We continue to invest in our product development as we strengthen and extend our suite of applications, particularly in financial management. Our HR and financial management applications are enterprise system of record applications at the core of our customers' business. We are building solutions for large, complex global enterprises, and we believe continued investment in our applications will be a key driver of future growth.

Sales and marketing expense was $31.6 million, up 9% sequentially and up 76% from last year. We currently have sales representatives in fewer than 10 countries and plan to make significant investments over the next several years to leverage our global market expansion efforts.

General and administrative expense was $8.1 million, up 22% sequentially and 153% year over year. Increase is primarily a result of adding staff to support the needs of a public company.

The non-GAAP loss per share was $0.39 on 62 million weighted average shares. During the quarter we issued 26.2 million shares in the IPO and converted all of the outstanding preferred shares to common shares. Given our net loss, all outstanding stock options and common stock equivalents are anti-dilutive and not included in the loss per share calculation. We anticipate our fourth quarter weighted average share count for GAAP calculations to be approximately 161 million to 163 million shares. As mentioned, we expect our operating loss to increase in the fourth quarter as a result of increased headcount and professional fees, costs associated with Workday Rising, and increased sales compensation.

Taking into account our adjustments to GAAP operating income that Mike disclosed at the start of the call, we currently expect our fiscal fourth quarter non-GAAP operating loss to be within a range 42% to 44% of total revenue. For the full year, we expect the non-GAAP operating margin to be within a range of negative 36% and 37% of revenue. The GAAP operating margin for the fiscal fourth quarter is expected to be 8 to 9 percentage points lower than the non-GAAP margin. And the full-year 2013 GAAP operating margin is expected to be approximately 10 to 11 percentage points lower than the non-GAAP operating margin. Our third quarter GAAP results also include a one-time charge of $11.3 million from our contribution of 500,000 shares to the Workday Foundation.

Now on to our balance sheet and statements of cash flows. Cash and short-term investments at quarter-end were $797 million, up $675 million from Q2, driven by net IPO proceeds of $685 million. Third quarter operating cash flows were a negative $9.4 million for the third quarter and a negative $1.4 million for the trailing 12 months.

Free cash flows for the quarter were a negative $23.8 million and for the trailing 12 months a negative $32.2 million. When calculating free cash flows, we conservatively subtract the gross value of all equipment even when acquired under capital leases so we can evaluate our progress on free cash flows independent of our capital financing decisions.

To summarize, we are very pleased with our solid third quarter performance and want to thank all of the Workday employees, our partners and our customers. We are investing for the long term and see a very large opportunity in front of us. You should expect us to continue making significant investments in our product development and global market expansion to maximize our long-term growth opportunities.

Now I will hand it over to Aneel.

Aneel Bhusri

Thanks, Mark. I want to start by joining Mike and Mark in welcoming everyone to our first analyst call as a public company. I also wanted to thank those of you that spent time with us before and during our IPO event.

From a company update perspective, the big event of the last few months, other than our IPO, was our annual user conference Workday Rising, the sixth such conference we've had since starting the company. At this year's gathering we had over 2,500 attendees including people from over 170 prospect companies, and total attendance was up 80% over 2011.

During our main keynote, Dave and I talked about our continuing focus on innovation and customer satisfaction and made three major product announcements. The first major announcement was the general availability of Workday 18, our newest update pack full of new features. I wanted to highlight a few of them.

First one being global capabilities for Financials, including enhanced global tax and payment support and expanded reporting. Secondly, industry-specific functionality for education and government, including fund accounting and a new grants management application. Thirdly, enhanced mobile support for both iOS and HTML 5 platforms. And lastly, mobile and web time clocks to support our new time tracking application.

The second announcement was the introduction of Workday Recruiting. This was an important area of demand from our customers having been the number one requested new application from our HCM Customer Advisory Council for the past three years. Designed from the ground up to work seamlessly with our core HR and onboarding applications, Workday Recruiting is a fresh take on today's recruiting challenges. Some of the key elements include a core design around hiring teams using a mobile first approach, built-in pipeline and sourcing analytics, and the ability to evaluate internal and external candidates for job openings. We expect Workday Recruiting to be available to our customer design partners in late 2013 and will be generally available in the first half of 2014.

And finally, our third announcement was the introduction of a new line of business for us which we are calling Workday Big Data Analytics. Leveraging the powerful Hadoop framework, Workday will shortly be delivering a new platform that will enable customers to combine external data with Workday data in a single data store to be used for reporting and analytics purposes. This new platform will handle any type of data including structured data, unstructured data, documents, machine-generated data, and social feeds of the likes of Twitter, Facebook and Google Plus. Indeed one of the major advantages of Hadoop over relational technology is its ability to handle all of this unstructured data which now accounts for more than 80% of the data being generated today.

As it relates to our Big Data Analytics, it's also worth noting that we've taken a technology approach that enables customers to have the same user experience and same security model that they are already accustomed as Workday customers. And leveraging the scale and architecture of Hadoop, we believe we can deliver our analytics platform at a fraction of the cost of proprietary hardware-oriented data warehouse offerings.

We've been working on our Big Data Analytics since the beginning of the year and have already made a lot of progress towards availability. As such, we expect this new offering to be available in limited release in the first half of 2013 and will be generally available in the second half of 2013. We have already received quite a bit of interest in this new offering from customers and prospects alike, many of whom are dealing with the costs and complexities of traditional data warehouse offerings.

So that's a quick run-through of our major announcements at Workday Rising. Taken together, Workday 18, Recruiting and Big Data Analytics demonstrate our desire and our ability to continually innovate for our customers.

And lastly and in many ways more importantly, my co-founder Dave announced the results for Annual Customer Satisfaction Survey at Workday Rising. We are pleased to say that 97% of our customers were positive about Workday, a number that we believe is significantly higher than those given to traditional legacy vendors. Our results were supported by an independent survey done by CedarCrestone where Workday was ranked the number one vendor amongst all HCM vendors in terms of customer satisfaction.

Before I end, I'd like to thank our customers, employees and partners for their commitment to Workday. With them we look forward to a busy fourth quarter.

And now I will turn it back to Mike for the Q&A session.

Mike Haase

Thanks, Aneel. Operator, let's begin the Q&A process.

Question-and-Answer Session

Operator

[Operator Instructions].

Your first question comes from the line of Adam Holt with Morgan Stanley. Please proceed.

Adam Holt – Morgan Stanley

Thanks very much, and congratulations to you all for a terrific first quarter as a public company.

My first question is about the customer adds in the quarter, a good number obviously. Could you talk a little bit about what you saw from a -- in terms of the modules and services that folks are adopting? And specifically, can you talk about what the Financials product and service and what you can say there?

Mark Peek

Sure. Largely, as we look at the overall opportunity, we are best-of-class from an HCM perspective in enterprises, and so we continue to have a lot of green field in front of us in HCM. And so HCM becomes -- it really drives our business and our new customer acquisition. We're seeing more and more customers along the way, however, add payroll, add time tracking and add modules around HCM.

At this point we're not going to break out the number of customers by product for each quarter, we may provide that annually. But we're seeing the same type of momentum with Financials that we'd seen prior to the IPO.

Aneel Bhusri

Just to add that we're very pleased to add J.B. Hunt as a customer for Financials. They're a large public company. It's another step along the way of our ability to show that we can scale our financial products to meet the needs of large companies.

Adam Holt – Morgan Stanley

Terrific. And just turning if I could to renewals, you noted in the prepared comments that renewals weren't material, but stuff did you see in terms of renewal activity in the quarter and what gives you confidence as you get in the deeper renewals that you're going to have very high renewal rates?

Mark Peek

Yeah, our history has been, just given the length of our contracts, the history on renewals right now is very light and so we don’t have a lot of data points. But what we're seeing is that customers that are up for renewal are renewing. They typically renew at more than 100% of the original contract. This is partly based on the contract terms, and as they add people to their businesses, the renewal fee also increases.

Aneel Bhusri

And I would add, Adam, that in many ways it's similar to ERP wave on client server. When a customer chose a solution whether it's PeopleSoft or one of the other vendors, they typically stuck with that solution and they're only coming back to market now with the shift to the cloud. And I would expect the same trend with the cloud. Once a company picks a system of record for HR, for finance, they'll likely stick with it through this lifecycle of technology, unless frankly the vendor screws up. And we don’t plant on screwing up.

Adam Holt – Morgan Stanley

Terrific. Thanks very much.

Operator

Your next question comes from the line of Heather Bellini with Goldman Sachs. Please proceed.

Heather Bellini – Goldman Sachs

Thank you very much, and I will echo my congratulations, great quarter and nice debut to the public markets. I was wondering, Aneel, if you could share with us what were kind of the two or three biggest themes you heard from customers at Workday Rising. And I guess I'm wondering what they're asking you to focus on next.

And then the follow-up question would be, at this type of event, I guess what's the typical timeframe from a customer signing up for HCM to them adding another Workday product? What's that timetable? Is it starting to shrink versus maybe what you would have seen a few years ago? Thank you.

Aneel Bhusri

Okay. On the second part of the question, I don’t think there's any straight pattern about when a customer decides to take on a new module. Every new module is driven by generally a business case around that new module. Typically what will happen is the customer will get live on core HR and then evaluate what other projects they'd like to take on. And the big difference between now and two years ago, we have modules like payroll that are now mature product offerings. We have modules like time tracking coming online. We just have a lot more modules that they can choose from. I'd say that's the biggest change.

In terms of the first part of the question, I'd say at the highest level our customers are really, really happy. And that came through in spades for anyone that was at the user conference. I think that one of the themes that my co-founder Dave always talks about is the power of one, having everybody on the same update. And so it creates this great sense of community and sharing amongst our customers on new features that they want or how they're using existing features. And so I think in general the mood was very, very positive.

The biggest request frankly over the last couple of Risings had been recruiting. And so we announced it probably a little bit earlier than we wanted to, but we had already started talking to customers about it, we have signed up several design partners for it, and that was very well-received. And I think that would be the biggest area I'd highlight.

Everything else, from feature function, if you'd seen the Forrester report recently, we're already ahead of the legacy systems, so in most cases on the HR side people are very happy with where the functionality is.

Heather Bellini – Goldman Sachs

Great. Thank you.

Operator

And your next question comes from the line of John DiFucci with JP Morgan. Please proceed.

John DiFucci – JP Morgan

Thank you. I have a question for Mark and then a follow-up for Aneel. Mark, just about everything -- every number you guys put up here is better than we were looking for, except for total deferred revenue, which was about in line, though it looks like all of that was really due to long-term deferred revenue, and you did a good job explaining in the prepared remarks that your billings period has been shortened by design. I'm just curious though, was there anything else other than that affected the long-term deferred revenue?

Mark Peek

No, John. It's really about the amount of cash that we're collecting upfront from our customers and that is in fact by design. It was about a year of annual contract value for this quarter. And that's an area where we feel really comfortable at this stage.

One other element that's more of minor component to deferred revenue is professional services in deferred revenue, and that number is declining and that just is largely because we have -- the revenue recognition that does require us to defer revenue and bundle the pricing. But that's a relatively small factor.

John DiFucci – JP Morgan

Okay, great. And I just want to make sure I heard, you said it's about a year of annual contract value is billed?

Mark Peek

It's about a year.

John DiFucci – JP Morgan

Okay, great. And Aneel, just to follow up, you mentioned Workday Big Data Analytics, which sounds really interesting, but how important has it been to customers that Workday has traditional analytics capability embedded in the product?

Aneel Bhusri

I think that's one of the biggest selling features for Workday; you don't have to buy a third-party business intelligence system. The demand that we're hitting with the big data application, just to take it a step further, customers want to bring in third-party data and do the heavy-duty reporting that they're used to with traditional warehouses, and with this new offering we now give them that capability as well, and frankly it goes far beyond the traditional data warehouse solutions in terms of the kinds of data and the scale of data it can handle.

John DiFucci – JP Morgan

Okay, great. Nice job, guys. Thank you.

Mark Peek

Thank you.

Operator

Your next question comes from the line of Jason Maynard with Wells Fargo. Please proceed.

Jason Maynard – Wells Fargo

Hi, good afternoon, guys, and congrats on the quarter. I had two questions for you, Aneel. First, I'd love to get your take on what were the buying triggers that you saw really this quarter, even in the past few quarters, around adopting HR? And then second, what are you seeing maybe similar, different in those triggers that are prompting customers to move to the financial management applications? Thanks.

Aneel Bhusri

So, the triggers really haven’t changed much over the last few years. I'd say the number one trigger is that customer is facing an upgrade of a legacy system. At that point they'll get a proposal from an SI or they'll look to do it themselves, and it'll be in the tens of millions of dollars. They'll have heard about the cloud, they'll have hopefully heard about Workday, and they'll explore alternatives. And that's where we typically intersect an opportunity, really around an upgrade. At that point we show them basically a new way of doing business in the cloud, a much better user experience, lower cost of ownership. And importantly now, the way we embrace mobile is becoming a huge leverage point, and I think that's becoming more and more important in the sales cycles.

Jason Maynard – Wells Fargo

And in the financial application area, what would you say is similar or different as you start to really engage with that product in the marketplace?

Aneel Bhusri

I'd say it's very similar. The one addition in financial applications is the fact that it's much easier to generate business information for analytics purposes, especially with our concept of Worktags where we can basically tag a business event in any sort of dimensions and then report against that as opposed to trying to work through a code block and trying to get business information out of an accounting system. We actually built a business system that happens to generate accounting data which is sort of flipping it on its head. But other than that, the dynamics are very similar, it's typically around the painful upgrade for a legacy system.

Jason Maynard – Wells Fargo

All right. Thank you very much. Congrats.

Operator

And your next question comes from the line of Brendan Barnicle with Pacific Crest Securities. Please proceed.

Brendan Barnicle – Pacific Crest Securities

Thanks so much, guys, and great first quarter out of the box. Aneel, I want to follow up just quickly on the Big Data Analytics product. As you think about that longer term, do you guys envision building your own apps that you'll sell to customers or run on that, or is it something that will be purely a platform for which customers will build their own application?

Aneel Bhusri

I envision us delivering pre-packaged applications, but they won't be the same kinds of business process applications that you get from a transactional system. There'll be the kinds of applications that might be profitability by customer, those kinds of analytic apps. And I don’t suspect that we'll charge extra for those; those will be part of the platform.

I think the biggest use will be customers coming up with their own custom apps that are very specific to their industries. For example, we showed at Rising was one working with our customer AIG to understand employee performance tied to the sales of claims and policies. And we wouldn't have imagined that that kind of example were not close enough to the insurance business to do that, but it was a natural opportunity for AIG to say, hey, this is how we would this kind of big data platform. And I suspect we will see a lot of that, people will solve problems that are very unique to their businesses with this platform.

Brendan Barnicle – Pacific Crest Securities

Great. Then, Mark, I had two quick follow-ups. You mentioned that billings will be down sequentially, but I just wanted to be clear that's billings, not revenue, down sequentially as we go into Q1. And then also if you had any other color on your commentary about slower hiring, is that environment more challenging, maybe a little more color on what was slowing that down?

Mark Peek

Yes. On billings, our current thought, and we'll give more guidance on fiscal '14 when we report back to you in late February or early March, is that billings will be down sequentially in the first quarter relative to the first quarter. But just given the model around subscription revenue recognition, we'd certainly expect subscription revenues to be up sequentially.

Professional services is a bit lumpier and it's really partly dependent upon demand, partly dependent upon how much we're able to have the ecosystem do as the prime. So that's the one area that we'll continue to believe -- I believe has some volatility as you look at total revenues over time.

On hiring, it was really just one of the factors as we went through a very busy summer with the IPO, preparing for Rising, our expansion of products with a product release is that hiring was a little bit slower than we had anticipated for the third quarter, which led to the part of the operating performance that you saw, which was frankly better than we had anticipated. It's not something that we're particularly concerned about at this point. It's important to note that we've -- when you look at a trailing 12 months, we've grown our headcount by 75%, and so there's just a lot of growth and we're making sure that we take time to do quality, not quantity as we add people to the company. But it was a factor in the operating performance. And as we indicated in the guidance for operating results for the fourth quarter, we think we'll do some catch-up in hiring during this quarter, and [we've really had strength] so far.

Brendan Barnicle – Pacific Crest Securities

Great. Thanks, guys.

Operator

Your next question comes from the line of Richard Davis with Canaccord. Please proceed.

Richard Davis – Canaccord Genuity

Hey, thanks. Kind of a follow-up just off of what Brendan asked. A lot of times I talk to software [heads] and kind of find out where people are going from and where they're going to, and at least one [head] said that he thinks you guys are getting wheelbarrow-full of resumes every day. I'm just assuming that's exuberance. But in terms of quality of people, I mean the fact of the matter is you're trying to sell enterprise -- big enterprise apps. Is it fair to say that you're getting, I don’t know, cream of the crop, really good quality people? Because that's the kind of data point that I'm hearing and to me that sounds like good news for you guys in the future.

Aneel Bhusri

I think we're getting cream of the crop. And as my co-founder Dave likes to say, at some level sales people are [corn-operated] and they go to places where they feel like they can sell well, and that has definitely worked. We also try to go to places where they believe the product is strong and there's a great culture, and I think we have all of those things working on our behalf right now.

I'd say one of the places where we really haven't tapped into sales hiring to a great extent is in Europe and other parts of the world, and now we're beginning to do that. And there's clearly a group of people that want to join Workday that we're able to tap into that are ready to go.

Richard Davis – Canaccord Genuity

Perfect. Thanks so much.

Operator

And your next question comes from the line of Pat Walravens with JMP Securities. Please proceed.

Pat Walravens – JMP Securities

Great, thank you. I have two questions, I'll just put them both out there first. The first question is, I know you haven’t guided for fiscal '14, but is there anything you can share with investors in terms of how they should be thinking about that at this point?

And then secondly, Aneel, maybe for you, by our math you have something like half of a percent of the ERP market to date. Where do you see that going? Thank you very much.

Mark Peek

Yeah, Pat, just on fiscal '14, we're really just beginning the planning process now for '14 and it's dependent upon a lot of factors. We're looking, I think like all enterprise companies, at the macro environment, even though the US election is past us, there still is a lot of uncertainty about tax legislation and the fiscal cliff and there's a certain element of nervousness. So we're approaching fiscal '14 at this stage cautiously, although not letting up on the pedal as far as it goes for investments because we are building complex products and we're building this company for the long term.

So, outside of the fact that we believe billings will be down sequentially from Q1 versus Q4, we don't really have a lot of color around fiscal '14.

Aneel Bhusri

On your market share question, we're still in the very early innings, and we take the point of view that this is a platform shift much like we saw from mainframe to client server, and that over the next 10 to 15 years everybody is going to go into the cloud at least for the cross-industry applications like CRM, HR and finance. And I think that as time passes on that becomes clearer and clearer that's the case. And so if you look at that, our chunk is the HR and finance market. And we still come across companies today that skips client server, still running mainframe applications, but I got to believe that's less than 10% of the market. So maybe in the next 10 years 80%, 90% of the market switches over to cloud for HR and finance applications, much like what's happened in CRM. You can do your math but it's a massive market opportunity and we do consider it a market share land grab opportunity and we constrain our growth really by our ability to support customers, not by market opportunity.

Pat Walravens – JMP Securities

Great. Thank you.

Operator

And your next question comes from the line of Peter Goldmacher with Cowen & Co. Please proceed.

Peter Goldmacher – Cowen & Co.

Hi, guys. Can you hear me okay?

Mark Peek

Yes.

Peter Goldmacher – Cowen & Co.

One of the interesting dynamics you're selling into when you're competing against Oracle and SAP is these guys have been able to bundle contracts. So it gets harder to, say, make a straight swap, cancel maintenance and go with a new product. Can you talk a little bit about that dynamic and how it impacts your sales cycles?

Aneel Bhusri

That dynamic comes up, but when they're facing an upgrade, the cost of the software is actually the smallest part of the cost. It's the cost of the reimplementation of the legacy package that's the great big part of it. So, is it problematic for customers? Yes. Does it get in the way of them moving off the legacy systems? No. Because it's the cost of the implementation an ongoing support cost for those legacy packages that really drives 90% of the cost.

Peter Goldmacher – Cowen & Co.

Okay. Thank you.

Operator

And your next question comes from the line of Brent Thill with UBS. Please proceed.

Brent Thill – UBS

Thanks. Good afternoon. Aneel, just on the SI channel, can you just talk through what you're seeing in terms of the shift and what some of the big traditional SIs are doing in terms of their capacity builds and maybe just give us a sense of kind of who's coming on the strongest and what you're seeing from a very high level? And I had a quick follow-up for Mark.

Aneel Bhusri

Sure. We've seen a market shift in the last two years. The SIs have really begun to embrace Workday in a big way and around the globe. The one that led that transition is Deloitte, and they doubled down by buying a company called Aggressor earlier in the year. Second is Accenture, and rapidly catching up are IBM and PwC. And we've also had a great partnership with Towers Watson from the early days. So we see it across the board from the SI community making big investments.

We've also seen now with Aon Hewitt buying a boutique as well, that there's an opportunity for us to go after the BPO market as well, with the partnership of Aon Hewitt. So, really all the big SI firms including BPO providers are getting very heavily invested in Workday.

Brent Thill – UBS

Great. Just as a quick follow-up, when you think about the international build-out, can you just help us understand the high-level milestones that you're hoping to pass over the next couple of years from just a high level perspective? That would be great. Thanks.

Aneel Bhusri

It's coming off of a small number. We don't share those breakouts at this point. But the business in Europe is growing quite a bit faster than the business in the US, and I would expect that that continues with the foreseeable future and expands into the new markets. We're entering France right now. We expect to enter more markets in Asia. Over time we'll enter in really all of Europe and all of Asia. And so that's all really still in front of us. The UK is really our first -- was our first big market, and we're doing very, very well in the UK.

Brent Thill – UBS

Thank you.

Mike Haase

Operator, we're going to take two more questions. Thanks.

Operator

No problem. We will now take two more questions.

Your next question comes from the line of Laura Letterman with William Blair. Please proceed.

Laura Letterman – William Blair

Thank you for taking my questions, and my congratulations on the quarter as well. Can you talk a little bit about milestones for the financial product in terms of what you see going forward that will help you compete even more effectively for global financial deals? I mean, new modules, do you think need reference customers? In other words, give us some milestones to look at in terms of understanding your success in that business long term.

Aneel Bhusri

So the financial products are at a stage where HR products were about, two years ago, were very closing the gap with legacy systems, I would guess for about 80%, 85% of the way there. And I believe that we'll close most of that gap in the next 12 months.

The second piece is scalability, the scalability of the system. Today we're comfortable selling to medium enterprises. In a year we'll be able to sell to large enterprises. And it's just the natural evolution of the technology platform, much like we experienced in HR. There's just more demand on financials from an online transaction processing perspective. We measure it in terms of the ability to edit journal lines, and by the end of this year will be around 50 million journal line edits or the ability to edit journal line -- 50 million lines. And we would hope that by the end of next year it's double to 100 million journal lines.

And when you start getting to those levels, at the end of next calendar year, I would suspect while we might not be a fit for Fortune50 company, we'll be a fit for a typical Fortune1000, Fortune500 kind of company, and over time we'll just continue to scale and grow the functionality much like we have on the HR side.

The last item is just the global capabilities, and we added a lot of that with Workday 18 and we'll continue to add that with Workday 19, 20 and 21. And so we're very, very bullish on what we see with Financials, and it's following almost the exact trajectory as a charted, as the product matures, it opens up more market and we gain more and more customers.

From a referenceable customer perspective, we're in pretty good shape there. We've got some very good go-lives coming soon in the form of Netflix next year and Lifetime Fitness is live with a lot of our financial products and we're going live with the rest of it. Chuck E. Cheese's at some point next year will be going live. So we have several important companies going live. And we already have about 15 companies live on the system today.

Laura Letterman – William Blair

Great. And one final question for me, if you look at the pipeline complexion now versus a year ago, are the type of companies bigger in the pipeline? Are you seeing more Oracle visa vie SAP replacements in the pipeline? So I'm just trying to understand how it looks today versus let's say a year ago or even six months ago.

Aneel Bhusri

Well, on the HR side, I think you just have to look at the names we just signed like DuPont and HP. There's just not many companies bigger than HP. I think on the HR side we can pretty much sell to any size commercial enterprise on the planet at this point. So I don’t see any constraints on the HR side.

On the financial side, probably feeling comfortable selling to companies 5,000 to 10,000 employees now, and by the end of next year, hopefully that's in the 25,000 to 30,000 employee size. And that's reflected in the pipeline.

Laura Letterman – William Blair

Thank you.

Operator

And your last question comes from the line of Mark Murphy with Piper Jaffray. Please proceed.

Mark Murphy – Piper Jaffray

Yes, thank you, Mark. You had mentioned a change in the upfront billings mix, and I'm wondering if you can maybe ballpark the year-over-year impact that that had on your current deferred revenue just so that we could try to get a better feel for your true underlying billings growth?

Mark Peek

Yeah, Mark, it's -- if you think about it, for Q2 we ran at about 120% of ACV, and as I mentioned earlier on the call, it's about 100% this year. It has moved around a bit, and one of the things that's important to understand about our business is that it can be lumpy. If you look at the size of the customers that we sign and you look at the names that we signed this quarter, on the other end of that spectrum there are smaller companies and sub $1 million total contract value accounts that we signed. And so we're really covering the spectrum. And it's not every quarter that you'll sign an HP or a DuPont or a Yale University. So it's an enterprise sale, and enterprise sales have long lead times to them as well.

But right now we're comfortable with the fact that we have strong balance sheet, adequate financing, and that, you know, collecting a year upfront on billings is about where we're comfortable. Sometimes customers want to pay more upfront, and we'll certainly talk to them about that when they want to do so.

Mark Murphy – Piper Jaffray

Thank you. And also, Aneel, I wanted to ask a question on your expense product, wondering how broadly adopted that is within your customer base, if you can talk about it even qualitatively. And are customers realizing any kind of significant synergy in using an expense product that's inherently integrated with their ACM or their payroll system, or in some cases, with their financial system? And if so, how frequently do you think that they're migrating off of another vendor's expense product when they adopt yours?

Aneel Bhusri

So you actually basically said it perfectly. For a company that is primarily people-based, which is many of the technology companies, professional services companies, financial services companies, the seamless integration between expenses and the core HR system is very valuable. You can really look at cost data at an employee level in a completely holistic way. And so we've had quite a few customers embrace that. We're not breaking out how many people are using, but at this point I would say most of the people coming over to expenses are coming over from legacy systems. I haven't seen that many replacements of Concur; I think Concur is a great company. And in general we're replacing the legacy systems of the past, from an expense perspective.

Mark Murphy – Piper Jaffray

Great. Thank you very much.

Mike Haase

Okay. Thank you, everyone. That concludes the call. We'll talk to you next quarter.

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