Workday's Big Win - Should Investors Strike Up The Band?

| About: Workday (WDAY)
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Summary

Workday announced last week that it won a major deal in to supply Wal-Mart various modules of its core set of human resources applications.

The size of the transaction was not specified, but it seems likely that over time the deal will be worth more than $200 million and possibly more to Workday.

This is a company whose revenues come in ratably, and large deals take a while before they are fully deployed. Management has chosen not to change its forecast.

Workday shares have soared recently based both on this deal and other factors. At these valuations, I see little opportunity for positive alpha.

It is a well-run company gaining share and positioning itself to be a major player in cloud applications. But investors would do well to find a less extended entry.

Workday - A big win, a share price pop and now what?

I haven't used an American standard song title in my articles for a few weeks now, but something about Workday's (NYSE:WDAY) release of its gigantic win at Wal-Mart (NYSE:WMT) just uncorked my thought process. Strike Up The Band is the name of a musical associated with the Gershwin Brothers that made its Broadway debut on 1927. The story line is about a mythical trade war with Switzerland over a Swiss cheese tariff. Very catchy tunes and perhaps politically relevant these days.

But the question is: Should investors be impressed by WDAY's big win, and what might be done with the shares at these levels? I have nothing brilliant to add about the advisability of a tariff on Swiss cheese. I am against a tariff on caviar, which was the burning question of the day as the as the show ended.

No, rather than writing further about tariffs and embargos, I will return to assessing just how important the Wal-Mart win might be in looking at the prospects both immediate and further on for WDAY. Let me cut to the chase. It was a great win, it will surely be reflected in the company's derived bookings number, but it simply isn't enough to drive the shares to new highs or to produce positive alpha from this point forward.

Just to put the question in context, the shares fell sharply from about $84 to $66 in the wake of an earnings release that disappointed some and baffled others. (Very few companies talk about slipped deals before the end of quarter. WDAY management chose to suggest that deals scheduled to close in November would now close in January. Go figure.) I wrote about the company and its shares positively at that time. But just as the Lord "taketh away," he can give as well, and the shares have rebounded to $81/share, with much of that rebound coming on the heels of an announcement that Wal-Mart has awarded a contract worth 9 figures to Workday. The contract basically calls for Workday to supply Wal-Mart with most of the elements of its Human Capital Management suite. It is certainly the largest order ever won by WDAY, and the fact that it was won in a deal to replace the incumbent HCM vendor, SAP, makes the win even sweeter, I suspect.

I do not normally write about particular sales wins or losses. They tend to be random in nature. But given the significant share price gyrations experienced by WDAY shares over such a short period, I felt some commentary might serve a useful purpose for readers.

The press release of the event leaves much to be desired. Here it is, in all its unembellished glory:

"Workday announced that Wal-Mart Stores, Inc, a worldwide retailer, has purchased a subscription to Workday Human Capital Management, Recruiting, Learning and Planning. Workday is not updating its financial guidance for the fourth quarter of the current fiscal year ending January 31, 2017 or for the fiscal year ending January 31, 2018."

That's it, folks - all of it.

What's actually happening

Wal-Mart is an immense company with over 2.3 million associates worldwide. Human Capital Management systems, if they are going to be useful, need to encompass the entire workforce, and these days, compliance solutions more or less mandate that users develop and maintain a central repository in which all of their employees and all of their skills are tracked on a worldwide basis. The number of actual users of HCM systems is far smaller, of course, perhaps in the tens of thousands.

Needless to say, software vendors prefer to tout the number of employees kept track of by their systems, and sometimes the systems are priced that way. But mainly users pay for seats, or the number of users who are actually able to access the large database of employees.

Since we do not know how many seats are encompassed by this transaction, it would be just guessing to try to estimate the annual revenues encompassed by the subscription, and it is not very likely that we will ever learn any more specifics from either Wal-Mart or Workday.

The release actually stemmed from a research note by an analyst at William Blair. The William Blair note estimated that annual revenues from the transaction would be in the range of $30 million. The analyst also called out multiple additional contracts with organizations that had tens of thousands of employees.

Another note, by a bullishly inclined analyst at Drexel Hamilton, estimated that the transaction would be worth $100-200 million in annual revenues. I am inclined to think that the report, which appeared in Investor's Business Daily, is a misquotation. Software deals that exceed $1 billion have yet to happen, and I do not imagine this one will have produced such a record.

It would appear that the William Blair analyst has an informational advantage on WDAY with the ability to provide a significant amount of granularity regarding a company he has covered for some years. Whether or not I agree with his investment conclusion, I think his revenue expectations seems reasonable.

The largest software deal of which I have knowledge of recently was a deal sold by Salesforce (NYSE:CRM), which involved 55,000 seats of that company's CRM suite. The annual revenues in that case will apparently reach $70 million. There are almost certainly more agents connected in the Salesforce deal to that data base than there will be HR personnel connected to the Wal-Mart application. On balance, complete CRM applications tends to sell for a higher price per seat than HCM solutions.

I think it is reasonable to believe that the transaction will be worth $100-200 million over the life of the agreement, which might be for 5 or 7 years. No one is going to go through the onboarding expenses of a deal of this magnitude for less than 5 or 7 years - it is going to take a couple of years simply to roll out the solution and populate the data base with the information on 2.3 million associates, especially given the turnover that Wal-Mart experiences and the number of seasonal employees that are hired.

Currently, the consensus forecast for Workday's revenues is in the range of $2 billion for the fiscal 2018 year. So, while a transaction that adds $30 million a year to revenues is significant, it is not significant enough to move the needle noticeably. And given the likelihood that the order will take a couple of years to deploy, the incremental revenues for fiscal 2018 are probably less than 1%. No wonder the company saw no need to update guidance.

As mentioned above, the reaction of Workday to its Q3 earnings release was unpleasant, to say the least. The issue was pretty straightforward. Subscription bookings grew by "only" 37% to $380 million. Overall, the company had forecast that derived billings would be $445 million. Derived billings for Q3 turned out to be $454 million. Part of the problem, which confused some at the time, is the way the company calculates bookings. Not to re-litigate the argument, but the relatively weaker billings performance had much to do with shorter average contract durations that reduced the tabulated contract value rather than any diminution in the contract value of annual revenue growth. We have no idea just how the WMT contract is going to effect the derived bookings metric. And frankly, it doesn't matter for the business; it will, of course, matter for share value.

It may seem strange to write this, but as a result of that beat, Workday raised its total derived billings estimate to $1.89 billion, or 32% growth for the full fiscal year. The derived billings estimate for this current quarter was essentially unchanged. But the overall change between expectations on the Q2 call, and expectations on the Q3 call, were minute - the change amounted to the $10 million by which Q3 bookings over-attained.

Overall, the forecast for subscription billings growth falling to the mid-20% range for fiscal 2018 was very disappointing to some observers who lowered their ratings in the shares. Does the Wal-Mart deal, and the other deals talked about in the Blair note change that expectation? Here is an answer from company CFO Robynne Sisco that is eerily prescient given the state of play back in December: "No, we have not modified our current view of next year (based on) for these slipped deals that we saw in November. And again, its early days in Q4 and how we deliver in Q4 will have a significant impact on next year. So, we'll have better information for you on FY 2018 at next quarter's call." My takeaway from that, knowing what we know now, is that the Wal-Mart deal was anticipated, it wound up coming in a few weeks later than expected and its impact had been considered in the bookings forecast for the fiscal year that ends in a couple of weeks, and it will not have any impact on expectations beyond that.

During the conference call in December, the CEO and the CFO alluded to a couple of significant slipped deals that were expected to close this quarter. In fact, the CEO talked about a couple of larger deals that had been expected to close before the conference call slipping to a later point. I think it is very reasonable to imagine that the deals alluded to by the Blair analyst, including this one (Wal-Mart), are those deals. I imagine the relatively robust derived bookings estimate given in December, which called for subscription bookings to accelerate to $630-635 million, actually included some allowance for this deal and some of the others that the Blair analyst alluded to in his note.

Will the company's success at Wal-Mart increase the derived bookings growth beyond the forecast? I do not think we can be sure, although I do imagine that is now the expectation. One of the issues in that regard is going to be the specific contract terms. It is more than conceivable to me that the value of the contract that can be recognized and put into deferred revenues is somewhere below $100 million, even though the final sum of the revenues that Workday will realize could be greater than $200 million. We don't know the duration of the signed contract, and this company doesn't report a metric such as annual recurring revenues. Under the circumstances, will it matter a great deal to the share value if Workday reports $635 million or $700 million as the value of its derived bookings metric? It probably will in the short term, but it is going to be overwhelmed by other factors when this company reports its year end and puts forth a more specific forecast for fiscal 2018.

How did Workday do it?

I think it has been accepted by most observers that this was a competitive takeaway from the long-standing incumbent, SAP. How did it happen? We are really never likely to know all of the details. I am bound to think that pricing may have been part of the formula, although that will be stoutly denied by all concerned. Wal-Mart is known to be an aggressive IT buyer. Whether that works out for it in the long run is hard to know. But the company has always been an innovative user in the IT space and has always looked for concessions that are beyond what most normal large buyers seek to obtain. The flip side of that is Wal-Mart rarely has what might be called warm and fuzzy vendor relationships, and perhaps this was part of what did in SAP.

At this juncture, I am not inclined to think that Workday has vast functional advantages in the HCM space, although it apparently continues to have a certain cachet as the most advanced HCM solution, particularly when it comes to talent management. The company is rated as the leader by Gartner, but its advantage in technology is not huge, according to the MQ report. Readers should note that the competition in the HCM space is really between WDAY and two other cloud-based best-of-breed vendors, SuccessFactors and Taleo, that were swallowed up by SAP and Oracle (NYSE:ORCL) respectively earlier in this decade.

About a year ago, an article appeared in an online publication called Diginomica. The article detailed why Sanofi (NYSE:SNY) chose Workday to replace SAP HR. It was a significant competitive displacement, although not on the scale of the WMT win. But it is, I believe, a template that probably explains much about WDAY's success in displacing SAP as an incumbent at Wal-Mart.

It would appear that Sanofi was more focused on talent management than what is considered to be core HR functionality, and was willing to take some chances to ensure it had what were considered the latest and greatest bits of talent management functionality. For SAP, a sales situation with that set of priorities will inevitably present problems At this point, SAP has its core HR technology embedded in S4/HANA, while its talent management solution is part of its SuccessFactors offering. The two are not yet integrated.

The issue is that while SAP has a good HR solution and SuccessFactors has a leading talent management solution, users report that integration between the two applications is flawed, uneven or hard to use. (By the way, the same observations hold true for Oracle/Taleo as well.) And so, it seems logical that companies like Sanofi and Wal-Mart, looking for a broad integrated solution and migrating to the cloud in any event, are open to migrating from one vendor to another, defying the well-known "stickiness" of major enterprise applications.

The result at Sanofi also appears to have been the result of a very flawed series of miscues by SAP/SuccessFactors that, at the time, was still in the process of being integrated into SAP. Sanofi wanted to be told that users wouldn't be able to customize the solution. Workday provided a definitive answer and SuccessFactors did not. Did that happen at Wal-Mart. Unless someone at Wal-Mart says it did, outsiders will never know.

Why was WDAY successful with WMT? I think the sales contest involved many of the same factors that led to the result seen at Sanofi. The SuccessFactors solutions are just now in the process of being integrated into S4/Hana. That is still a work in progress, and will be so for some time to come. Wal-Mart must have decided to move its application to the cloud in any event, which makes the decision to change vendor somewhat less of an issue than would otherwise be the case.

I have no idea as to whether or not the sales effort from SAP was flawed. Those things happen. But until the SuccessFactors solution is tightly integrated into S/4 HANA, SAP would seem to have some vulnerabilities that Workday can, and will, exploit.

The meat of the coconut

I suppose I betray my age in using that phrase. Apparently, the phrase has gone out of fashion, and now the meat of the coconut is defined as... well, the meat of the coconut. According to what I read searching on Google, the meat of the coconut is a superfood with many healthy properties - I guess I lived enough years in the south to say that I am particularly fond of coconut cake, which I can't imagine is all that healthy.

But back in my childhood, the meat of the coconut meant the substance of a thing and determining what was the important element in an idea. Simply put, the meat of the coconut for investors is determining the longer-term growth trajectory of WDAY. The growth rate of 27% that is the consensus forecast for WDAY's fiscal 2018 is probably inadequate to support even current valuations. The 30% number that the CEO said was comfortable is a little closer, and most likely the company has to grow faster still if its shares are to achieve positive alpha.

At the end of the day, this analysis is only useful in trying to figure out if the large win at Wal-Mart means owning WDAY shares will provide a positive performance to portfolios. I don't care, particularly if Workday wins or loses a particular order, large though it may be, unless it means that I need to rethink the company's growth perspective over the next two or three years. I just don't think this order provides substantiation for that conclusion. There would be other transactions that would be more significant to me and would mean more for the future of this company.

The current average rating from the consensus of 39 analysts posting their recommendation on first call is 2.6, squarely between Buy and Hold. And the average price target is only $82. The problem is that it is very difficult to maintain that the consensus forecast for sales and earnings is valid and still find some rationale for recommending the shares and for producing a price target above current levels. There is a basic inconsistency that requires analysts to suggest that management forecasts are sandbagging likely future results.

The consensus growth forecast for next year is less than 28%, and the high forecast for the period amongst 39 analysts would be just 30%.

The only way to make sense of the valuation is to believe that the growth rate for the company can maintain itself at or above 30%. In the last conference call, the CEO spoke to his comfort with that kind of expectation, i.e., 30% growth for some years to come. He also said the company would be able to achieve that kind of growth without a huge contribution from its suite of financial apps. Many people find that difficult to accept as a forecast. There are market analysis forecasts that suggest HR apps are showing just a 2% CAGR over the next 5 years. Some of that is the old devil of definition. Other forecasts have different functional definitions with higher growth rates ranging from 10-15% through 2022.

That makes it very hard to accept that WDAY can achieve a 30% growth rate through the foreseeable future without a major contribution from its financial apps. Closing in on $2 billion of revenue, most of which is coming from HR apps, the company would have to achieve stunning market share growth over the next few years to achieve 30% growth overall without material contribution from other parts of its business and particularly due to its de-emphasizing of services revenues.

That's really the conundrum, and the large WMT order and other large HR orders do not solve it. As mentioned earlier, if a large enterprise is moving HR to the cloud, it opens up a significant opportunity for WDAY. Neither Oracle or SAP have really integrated their advanced and rewritten cloud-based ERP with their externally derived talent management functionality. That lack of integration can pose problems for some users. If a user is going to the trouble of moving to the cloud, why go to further trouble of using a solution that apparently comes in mis-connected parts? I buy that. I buy that WDAY will grow significantly more rapidly than the market for HCM solutions as a whole for several years to come.

But numbers are important. If the market is growing at a 10% CAGR, and that seems the most likely set of expectations, then how fast does WDAY have to grow in HR if it wants to grow at 30% overall? The only way to answer that question is by taking a guess at how fast financials are going to grow. And management is not adding much visibility in making that call, although the CEO suggested that adding visibility into financials might be a feature of the Q4 earnings call.

Management says it sees no immediate sign of "breakout growth" in financial apps, although CEO Aneel Bhusri said he wouldn't be surprised to see it happen. From my perspective, it simply has to happen to make investing in WDAY worthwhile.

Is there any real way to handicap the odds of success? Is there some special sauce that make WDAY financials more functional than the competition? Search as I did, there really is nothing in terms of functionality to distinguish what Workday has to what users can buy from Oracle or SAP. There will be opportunities for WDAY to enter the competition on a more level playing field when a user chooses to migrate financial apps to the cloud. There will be opportunities for the company to leverage its HCM installed base as those users move to the cloud. It has won some decent deals of note in financial apps, including from Panera (NASDAQ:PNRA), Denny's (NASDAQ:DENN) and a large unnamed financial management enterprise. But I think it would have been far more comforting to see WDAY secure a large order based on its financial application solutions - that might have provided the ammunition needed to suggest the company could really grow at a 30% rate for some years to come. WDAY says it has an advantage in terms of implementation costs for its cloud financials when compared to its larger competitors. That is hard to validate.

On the other hand, WDAY Planning, a relatively new product, has seen a fair amount of market success in that it is more fully featured in the cloud than competitors. It is a way of sneaking into the world of pure financial apps. It is really hard to innovate an accounts payable module - software just doesn't facilitate going out and grabbing the checkbook of a customer - OK, that is not the funniest or most apposite of phrases. On the other hand, planning is a complex and ill-defined field, and WDAY has been able to show advantages and has built solid momentum in that space and expects to have hundreds of live customers early in its new fiscal year. I would like to recommend WDAY shares. But even going by the more optimistic expectations with which Mr. Bhusri expressed confidence, I just can't quite get there. I think investors will need to find a better entry point into this name if they expect to see positive alpha.

Valuation

No, Workday shares aren't cheap, and unfortunately for prospective investors, they just got more expensive. As of Friday, the company's market cap was just shy of $16 billion. Net cash on the balance sheet was about $1.5 billion, so the enterprise value is currently $14.5 billion. The EV/S ratio, using the consensus for the 2018 fiscal year, is a bit greater than 7X. That really is a bit high for a company with 27% growth that has gradually seen falling percentage growth rates. No one is buying WDAY shares because of its non-GAAP earnings - certainly not yet. The P/E on non-GAAP earnings is astronomical, and GAAP earnings will not exist, according to the CFO, until the company's growth subsides significantly.

In fiscal Q3, there were few signs of significant expense management of GAAP expenses. Overall, the GAAP operating loss widened noticeably and operating expenses rose 43%, faster than revenue growth of 34% or even subscription revenue growth of 38%.

Workday does generate a fair amount of cash, and its cash flow generation has risen significantly. But again, using very optimistic assumptions, it would be hard to imagine that the company could produce a free cash flow yield of much above 3% next year - and even that figure is a stretch.

Workday is an admirable company that is gaining market share and growing at prodigious rates that are likely to continue. But the rates are not quite prodigious enough for me to believe they will support valuations necessary to produce substantial positive alpha going forward. I am looking for a more optimal entry point before I commit my funds to this name at this point.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.