I first heard of Workday (NYSE:WDAY) last year when the company went public and the stock jumped 74% on its first day of trading. I immediately decided to do an analysis on the company to see what the excitement was all about. Almost six months have passed since the IPO, and I am still asking myself the same question.
This stock is certainly among the most expensive since the dot-com bubble. Regardless of the valuation metric used, the price simply does not make sense. Typically, a rich valuation means that investors are expecting high future growth from the company. However, in this particular case, Workday would need to achieve truly astonishing growth and profitability in order to justify the current price.
I have talked to many investors who are bullish on this stock. According to them, "the company's products are amazing!" That might very well be the case. However, as Buffett once said: "price is what you pay, value is what you get." No matter how great a products is, nothing is worth an infinite price. It is for this reason why this article will mostly focus on valuation. I will attempt to prove why I believe Workday is good short candidate at the current price.
Profitability and Financial Health
When it comes to financial health, Workday gets a passing grade. The company has over $790 million in cash and marketable securities (87% of it raised through the IPO). The company has minimal debt (capital leases of approximately $25 million and capitalized operating leases of approximately $44 million). In total, the company has $69 million in debt, which gives us a net cash position of $721 million. Most of the company's other liabilities (78% of total liabilities) consist of deferred revenue, which is not a true liability. Overall, the company's financial position is solid and I do not expect it to run into trouble anytime soon.
While Workday's balance sheet looks excellent, the company's profitability continues to deteriorate.
Note: Periods ending January 2011 and 2010 have been adjusted. Originally the annual accounting periods ended in December. For example, the period ending in January 2011 actually ended in December of 2010. However, to be consistent with the company's current accounting periods and to avoid confusion, I made this slight adjustment to the reporting dates.
Although the company has achieved some impressive growth over the past few years, growing revenues at over 100% per annum, its profitability has not improved much. In fact, the amount of money the company is losing seems to be accelerating, which is not a good sign this late in the game. If the company keeps burning through cash at this rate, it will be forced to raise additional funds by selling more shares (causing dilution) or by taking on more debt (increasing risk).
What is Workday Worth?
As of this writing, Workday had a market capitalization of $10.4 billion and an enterprise value of approximately $9.7 billion. Over the past four years the company has lost a cumulative of $271 million (owner earnings), and the losses appear to be accelerating. In the most recent year, the company had revenues of $274 million, giving us a price to sales ratio of 38x. Yes, that is no typo... currently, investors are willing to pay 38x sales for this stock! It does not matter how bright the future is for this company, this valuation is ridiculous. In fact, it could take Workday over a decade of double-digit growth in order to justify the current price, and that is if everything goes according to plan (very unlikely).
I am usually skeptical of looking at projected earnings and revenue growth; however, it is possible to use simple forecasting to show that a stock is overvalued. I will do a simple example to show that Workday would need to achieve unprecedented long-term growth and profitability in order to justify the current price. Again, I want to remind readers that the following example is simply to show how crazy the valuation is. In no way do I believe that Workday will be able to achieve this. For simplicity, we will ignore the time value of money in the example.
I forecast revenues to increase at 50% on a five-year CAGR basis. I also forecast profit margins to average around 50% during the five-year forecast period. This means that at the end of year five, Workday will have revenues of $2.1 billion and earnings of just over $1 billion. Assuming that the enterprise value remains the same ($9.7 billion), it will give us a forward earnings yield of about 10.8%, or a forward enterprise value to earnings ratio of 9.2x. The price to sales ratio (assuming market cap does not change) would be 5x.
The simple example above might look ridiculous to some, but I only did it to show that the current valuation is irrational. Workday will need to achieve truly phenomenal growth and profitability in order to deserve a $10.4 billion market capitalization. Investors betting on this are taking on too much risk, in my opinion.
The lock-up period expires April 10th, 2013. In fact, almost all of the outstanding shares will be eligible for sale. It is important to mention that the company has two classes of common stock. There are currently 26.2 million Class A shares, which are allowed to be freely traded. However, there are another 140.2 million Class B shares that are currently restricted from resale as a result of market standoff and lock-up agreements. The Class B shares are convertible to Class A shares and will become available to be sold on April 10th. In addition, approximately 21.0 million options will also be exercisable upon the lock-up expiration.
As should be plainly obvious, the market will be flooded with an enormous amount of shares. Since the stock is so grossly overvalued, I believe that there will be substantial selling by insiders (at least by the smart ones).
It should be apparent to most rational investors that this stock is grossly overpriced. The company will need to achieve some pretty spectacular results in order to justify the current valuation. Since the lock-up expiration is coming up in a few weeks, I believe that there will be substantial selling by insiders, which could cause the shares to plunge. Shrewd investors can take advantage of this by shorting the stock.