Workday: Already Priced For Perfection

Summary

• Workday reported great results for Q3. Subscription revenues were 2% higher than estimates.
• Despite strong win rates, some demand might have pulled forward from Q4 and thus guidance for Q4 and next year implies some deceleration.
• HCM cloud adoption doesn't seem to translate to financials management, which leaves Workday short of product diversity.
• Competition is becoming more intense as the industry matures and may slow adoption rates.
• Currently trades richly at over 100x forward earnings for 30% EPS forward growth rate.

Workday (NASDAQ:WDAY) delivered outstanding results on its third quarter with subscriptions revenues beating street estimates and its guidance by 2%. Operating margin of 6.7% was 270 bps higher than guidance. Win rates in its Human Capital Management ("HCM") segment have continued to be strong, and its financial management product segment was highlighted this quarter to have grown 50% from over a year ago. However, its disclosure regarding financials segment performance has been inconsistent, appearing to highlight selectively when the quarter performance was strong.

But despite its strong results, management's guidance for the fourth quarter and next year implied that there might be some slowdown. The company expects subscription revenue in Q4 to be up 6.3% sequentially, which is a deceleration from the third quarter which grew 10.4% sequentially. On the earnings call, Workday mentioned that there was some demand that was pulled forward into Q3 from Q4. The professional services segment was even guided to drop -5.7% quarter over quarter.

I rate Workday as a Sell as valuation is too high compared with peers. Its growth is strong but not compelling enough. In a base case scenario, I see 37% downside.

Lack of Diversified Product Range May Hurt Long-Term Growth

Workday offers cloud-based solutions to mostly large enterprises via two segments - human capital management ("HCM") and financial management. Recently, the company has shifted towards targeting mid-market, which I interpret that it is seeking to find growth elsewhere as adoption rate with Fortune 500 companies slows. Mid-sized companies have different needs from the large enterprises, and the costs of developing solutions may not necessarily be shared. So, I don't expect product development expenses to materially go down.

Reluctance in customers to shift financials into cloud

According to participant information gathered at this year's Rising event in Las Vegas, only 9 (8 in 2017) out of the Fortune 500 companies expressed interest in moving financials to the cloud. The connection between cross-selling HCM with financials has still been elusive, although it is heavily invested into and promoted by Workday. Given that an estimate of more than half of F500 companies have already adopted cloud HCM, the lagging adopters are in more conservative industries, such as public sector and banks, that don't necessarily have the urgency to do so. That said, financial deal wins in Q3 might have come from midmarket instead.

Lack of consistency in the disclosures regarding this segment leads me to think adoption here is more sporadic.

The industry is getting more and more competitive

Workday is no doubt a leader in HCM, but it faces competition from multiple vendors. I believe HCM adoption has matured with more than half of the F500 companies already onboard.

Oracle (ORCL) competes with Workday on price point, while the latter still maintains a better overall win rate as I think successful deal closure depends also on culture fit rather than just on price. But it does force price concessions from Workday, and Oracle is still gaining incremental traction, though.

SAP (SAP) is lacking on the feature front but has clear advantages with global/multinational companies as geographical integration and global support become important. As with Oracle, SAP is also gaining some share.

ServiceNow (NOW) is leading software vendor of IT helpdesk solutions and now is considered a cloud-based workflow management platform. On the most recent earnings call, the company mentioned that it aims to connect different software and cloud, and it does not want to directly compete with Workday on HCM or Salesforce.com (CRM) on CSM. But the company has successfully branched out into PaaS/SaaS by offering its own HCM/CSM solutions. Both sales and earnings growth are strong, but margins are well ahead of Workday.

Valuation: Too Rich and Ahead of its Peers

First, I want to start off and say that Workday has generally been able to beat its guidance. For the past couple of years, annual guidance on average proved to be 6% more conservative than actual figures. But this strength is common with most major cloud companies.

So, I model three cases here. 1) The base case is US$3bn in subscription revenue as guided, and 12.4% operating margin (vs. 12% guidance). 2) In the blue-sky scenario, I model +5% revenues over base and an expanded margin of 14.4%. 3) The gray-sky scenario will be -5% revenues under base and a lower margin of 10.9%. The rationale behind is that a higher revenue will produce a better margin as some costs are less sensitive to revenues and vice versa.

The base case is a 30.6% increase in adjusted EPS and 24.7% growth in revenues. But I don't think you would want to pay 100x forward earnings for 30% growth rate. Plus, this implies revenue growth decelerating and only operating leverage improvement to make up for it.

The blue-sky scenario is the upside risk if revenue is 5% more than guidance. An operating margin of 14.4% is quite generous. I think, given where the stock is trading post-earnings, I think this is the scenario the markets are pricing in - perfection. But there a lot of execution risks throughout the year, namely from competitor wins vs. Workday. And most importantly, as they continue to grow into the cloud market, there is less and less demand left since what remains are adopters which are not at all incentivized to utilize clouds. That will put pressure onto multiples as well as the year goes on.

The gray-sky scenario is the downside risk if revenue is 5% below guidance and operating margin shrinks to 10.9%. This will probably happen if we see tough competition and/or slowdown in the broader economy.

Source: Himalayas Research estimates

Source: Company, Himalayas Research estimates

GAAP Income Statement

Source: Company

Share-Based Compensation is >20% of Revenues, Difficult to Turn a GAAP Profit

Even though, on a non-GAAP basis, Workday is turning a profit, it is important to be aware that its share-based compensation expenses are adjusted out of its non-GAAP earnings. In the third quarter, that stood at 28% of revenues! Typically, it's in the low-20s percentage range. If we count stock compensations as an expense (it really should be), I don't believe Workday will be profitable by next year. But, at some point, high growth tech firms will begin to mature as will their industry, and growth rates will slow, meaning that share prices will begin to plateau. Share-based incentives work really well to compensate staff in ways other than cash, which companies obviously don't have a lot of in their nascent stages, but it can become an issue once the share price stops going up. Investors will not continually accept dilution if they cannot be rewarded with further capital appreciation. Staff would also lean towards cash compensation.

Now, street values these cloud companies typically on non-GAAP earnings because these are growth companies, and it's clearer to look at underlying business fundamentals this way. But, as I said earlier, share-based compensations are in fact expenses, and they will at some point become relevant to the bottom line or cash flow. In my model, I assume the share-based compensation is fixed at 22% of revenues (Q3: 28%). As you can see, even if they beat revenues and margins (in the blue-sky scenario), they will still be making a loss (-0.64 per share).

Note: For example, in FY2020, we get share-based compensation by share of 3.08 by applying 22% to revenues (FY2020E: 3,503m) and dividing by 250m shares.

Source: Himalayas Research estimates

Workday's Valuation vs. Peers

Source: Koyfin, Himalayas Research

Workday's expected sales growth is somewhere between CRM and NOW, but its EBIT margin is the lowest. This is the biggest concern to profitability. They are chasing top-line growth with little cost discipline. I think a 60x forward earnings is more appropriate, so that it trades along the lines with CRM and NOW. So, in other words, I think if the company is able to meet guidance, I think it should only trade at 60x, which is about 37% downside. On the other hand, if they beat guidance and market continues to value it at 100x (albeit unlikely), then we have about 25% upside. CRM also traded at 73x in January before contracting to 56x now even as their earnings grew.

	Base PT	Blue-sky PT	Gray-sky PT
40x P/FY2020E	69.26	81.91	59.76
60x P/FY2020E	103.90	122.87	89.63
100x P/FY2020	173.16	204.78	149.39

Click to enlarge

Source: Himalayas Research estimates

Why Sell a Stock with Record Earnings at Record Highs?

Adobe (ADBE) also reached an all-time high as it beat earnings in September, and both its sales and earnings were at record highs, yet it's still trading 10% below its peak. Its valuation multiples contracted. And I think this will apply to Workday.

Risks

Outperformance in HCM and financials; higher win rates vs. its competitors.

Faster-than-expected adoption rates for its cloud-based solutions.

Becomes a target for acquisition.

Conclusion

I regard Workday as a high risk sell with 37% downside in my base case scenario. Despite reporting great results for the last quarter, I think markets are overly optimistic about its continued growth potential as I see headwinds in its financials segment, while HCM is maturing and adoption rate might begin to slow. Competition is becoming more intense with Oracle, SAP, and ServiceNow, which are offering solutions in the same space. Workday's valuations are also very high compared with peers of similar growth profile, while its margins are lower, thus I think contraction of multiples is likely. For a pair trade, one could short Workday and long ServiceNow.

Disclaimer: All research, figures and interpretation are provided on a best effort basis only and may be subject to error. Any view, opinion or analysis do not constitute as investment or trading advice, please do your own due diligence.

Analyst’s Disclosure: I am/we are short WDAY. 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.