Workday: Key Indicators That Justify A Short Position

Sep. 4.14 | About: Workday (WDAY)

Summary

Workday is a well-known cloud/SaaS company that has been presenting fast growth. It divides opinions.

My opinion is that Workday is over-valuated, and can even be unable to ever present GAAP profits.

This article discusses some indicators that justify why I think Workday is a better short than long position.

I have been following Workday (NYSE:WDAY) since its recent (2012) IPO.

WDAY is a well-known cloud/SaaS company that has been presenting fast growth. Since it was created in 2005, it is still a relatively recent company. However, after 9 years of operation, and having already reached a market capitalization of around $17 billion, it must be considered to be well beyond the start-up phase. This is where things get interesting, since WDAY has still to make the transition from a "loss-incurring pure-growth phase" into profitability.

In spite of a serious correction in early 2014, the relatively consistent increase of the price of WDAY shares since its IPO (presented in the chart below) shows that, in general, most investors believe in its business model and are comfortable with its evolution.

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This is so mainly because those investors believe in the quality of WDAY products offer and, most of all, are quite happy with the rate of growth of its revenues. They reason that on that basis, WDAY will soon make the transition into profits, and then, due to the miracle of the SaaS business (and billing) model, sky will be the limit. Good examples of this extremely positive view can be found in these recent Seeking Alpha articles: Is It Time To Buy Workday Shares? and Salesforce.com Moving Out Of The Clouds.

Naturally, since WDAY never presented profits (and, in fact, its losses are growing on a par with its revenue), and since it already reached a market valuation that discounts strong profitability going forward (something that it may never achieve), there are also a number of analysts and investors with a negative view of this company. Some recent articles in Seeking Alpha present the reasoning for this negative view. Good examples include: Danger Zone: Workday, A Hitchhiker's Guide To A Reflating Tech Bubble: Short Workday and Lofty Valuation And Substantial Stock-Based Compensation Bode Poorly For Workday.

I'm also in this second group. I believe that WDAY is not only grossly over-valuated, but also that it will have great difficulty to even make the transition from losses into marginal profits. As such, I'm short WDAY. In the present article, I will present some very specific indicators that justify this point of view.

When I study a company that seems worth of investment (long or short), I develop a spreadsheet with a number of fundamental indicators, so as to easily evaluate their evolution through time.

The following table is a much simplified version of that table for WDAY. This summary table focuses on the quarterly evolution of the main indicators I want to discuss in this article. Note that WDAY only presents publicly available quarterly data starting in 2012.

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So, let's cover those main indicators.

1. Evolution of the revenues:

There is not much to say about revenue growth. It is WDAY's strength. Every reason to invest in WDAY that I could find in the articles I read revolves around its strong revenue growth. Some try to explain that growth on the basis of WDAY's wonderful set of products/services, most argue that growth can be maintained for a long time at present rates, and that translating the resulting extremely high future revenue into (very high) profits will be simple, almost automatic.

2. Evolution of the net income:

Unfortunately for this bullish thesis, no company can achieve revenue without costs. WDAY has the expected cost structure of a company involved in the "cloud industry": Software/services development, selling costs, administrative expenses, continued acquisitions of niche smaller competitors, etc.

In WDAY's case, even after 9 years of product development and selling experience and streamlining, even with its wonderful, superior product offering (that should attract clients without much effort), the aggregate of those costs remains vastly superior to each quarter's revenue. That results in continued net losses.

The continued losses do not discourage the longs. For them, selling costs will be reduced when WDAY so desires, and the already acquired clients will remain faithful (without further costs) due to the superiority of WDAY's products and due to simple inertia: If they already use a cloud services company, why change?

However, this reasoning fails to explain WDAY's very constant proportion between revenues and costs. If this were true (and I can think of many fundamental arguments to drill holes in the thesis, but now we are dealing with cold factual numbers, not ethereal ideas), WDAY should already have a strong basis on previous clients that should not present renewed costs to maintain. Thus, through time, its costs should be getting lower in relation to the revenue. But that is not happening!

For WDAY, quarter after quarter, the overall costs keep exceeding the revenues by an uncannily stable margin of around 37%. Naturally, if the overall costs are superior to the revenues, this produces a net loss. That net loss, for WDAY, is an almost fixed relation of the revenues. (See the table, in particular, the relationship "Net income/Revenue".)

3. Evolution of share-based compensation:

Most of the companies that are involved in the cloud story use (and abuse) the concept of share-based compensation. They are growing, they have high personnel costs; they don't have infinite cash, they pay their best personnel with fresh company stock, thus saving cash. Naturally, for a company that presents profits, that is a problem for shareholders, since it represents a continuous increase of emitted shares, and so dilutes continuously their proportion of the company. But for companies that continue to present GAAP losses, however, this is "anti-dilutive" - a wonderful concept that can arguably be attributed to Marc Benioff, and that means that if a loss-making company doubles its shares, the loss per share will be reduced to half... Good for them!

Some WDAY pears use this share-based compensation gimmick to replace GAAP losses for non-GAAP profits (CRM is probably the best-known example of this). But not WDAY: It remains faithful to losses, even in non-GAAP metrics, even after share-based compensation. However, that may change. WDAY's share-based compensation is positively exploding (talk about a hockey stick!). The table above shows that share-based compensation evolved from just 2% of revenues in the first quarter of 2012 to a whopping 22% (just in) the second quarter of 2014!

If WDAY's share-based compensation keeps growing at the present rate, it should surpass net losses in 2 or 3 quarters, and from that moment on, WDAY will be able to present non-GAAP profits!

(Again, good for them! That will be "anti-dilutive" for WDAY's happy shareholders!)

Conclusions:

Much more could be constructed from WDAY's fundamental numbers. One of the best examples would be to discuss the profits WDAY would have to reach to justify the present marker capitalization. Also, this article could present nice charts to illustrate the evolution of the above indicators (and several other). But let's keep things simple. Investors are smart, educated persons. Most will be able to reach proper conclusions if given the leads.

Of course, besides individual investors (that can, and usually do, study the companies they invest in, and then discriminate between them), there are the investment funds that must simply be long (in the "right" proportion, usually based simply on market capitalization) in all the companies that belong to some class of companies where (by charter) they must be fully invested. These investment funds, most of them ETF, include broad market trackers, sectoral trackers, momentum (growth) trackers, etc. Most of these funds don't attempt to conduct in-depth fundamental analysis of the companies where they invest. Many of them don't discriminate between companies that are cheap or expensive, or even between those that present profits or losses. And unfortunately, these "blind" mechanical tracking funds now represent most of the capital invested in the stock markets. This phenomenon (relatively recent, at least with the present intensity) tends to prevent efficient market corrections to the prices of specific companies unworthy of their stock valuations, thus increasing the success of strategies such as extremely high stock-based compensation schemes.

But that is another story. These are the markets we have at present, and we must be able to deal with them.

Final cautionary note:

I believe short positions should only be opened with extreme care.

They should either be:

  1. Short-term positions ready to be closed fast. (Acceptable in case one expects to "catch" a specific stock movement. Personally, I never try that. I don't try to predict short-term market movements.).
  2. Part of a well-structured long/short portfolio. (One of the best ways to invest, in my opinion.)
  3. Kept quite small in relation to the overall portfolio of the investor. (Short positions in companies' stocks have greater intrinsic risk in relation to long positions.)

Disclosure: The author is short WDAY.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.