Since publishing my cautious note on Workiva Inc. (WK) some months ago, the shares are up about 40%. The calls I recommended people switch to are up about 305% since then, though, so I feel the switch was worthwhile. Since publishing that article, the company has had two earnings announcements, so I thought I'd check in on the same to see if it's reasonable to change my stance. For those who don't like reading through entire articles, I'll jump right to the point. While there are certainly some positive developments, I remain cautious. I think this company is troubled and I think investors would be wise to avoid the shares.
That said, I've seen nothing over the past several months to indicate to me that the market has gotten any more sane, so I think there is a strong possibility that shares will continue to climb from these levels. If the market continues to fetishize the (hushed tones) "recurring revenues from SaaS businesses," or focus on ROIC and not earnings (i.e., the source of all investor returns), then the shares may climb higher. For that reason, I recommend the same (successful) call strategy that worked out so well from January to now.
The company did manage to drop the net loss by 22% and loss from operations by 23% relative to the same period a year ago. This is a significant positive in my view, given that it may break a trend of higher revenues leading to higher losses. For my part, I don't think one quarter of lower losses is sufficient evidence of anything, and I'm chalking this quarter up to an anomaly.
There are a few other elements I'd like to highlight from the two financial reports published since my previous article:
The correlation between revenue and net income remains strongly negative (r=-.87). Of course, this prompts the question: If revenue that's grown at a CAGR of 19% over the past six years doesn't lead to profitability, what does?!
The pace of dilution has increased dramatically. Specifically, during the first three quarters of 2019, the company issued an additional 1,588,871 shares (this compares to an issuance of 2,021,570 for the entire year in 2018). Over the past six years, shares outstanding has grown at a CAGR of about 5.6%.
In 2018, both gross and net margin improved somewhat from the previous years. In particular, gross margin rose by ~200 bps (from 71% to 73%), while net margin improved by ~80bps (from negative 21.3% to -20.5%). I'm open to the possibility that this company may eventually be profitable.
All of this suggests to me that, while there are some bright spots, there's little to like about the financial performance we've seen here over the past several years.
Source: Company filings
Investing is about more than simply finding a company that is growing its cash flows. It's possible that a mediocre company such as Workiva can be an excellent investment if the price is right. For that reason, I should spend some time looking at the stock as distinct from the business itself.
While the shares are less expensive now on a price to free cash flow basis than they've been, at a price to free cash flow ratio of 379, they remain morbidly overpriced in my view. Thus, the combination of relatively poor (though improving) financial performance and a stock that is priced for perfection is troublesome in my view.
Options to the Rescue
I've argued on this forum and elsewhere that call options actually lower risk for a host of reasons. First, they employ less capital than share ownership, while achieving much the same upside. Lower capital at risk for similar returns is the definition of lower risk in my view. Second, the limited life of a call option is actually a positive for many investors who may lack the discipline to sell a loser. When I was still in the business, I would review investors who had large holdings of companies that had been losers for years, and the investors couldn't sell the shares because doing so was emotionally too painful. This capital would languish, earning no return at all, because investors believed "it was coming back...any day now." The fact that calls expire forces us to reevaluate our previous perspectives.
In my previous article, I recommended calls that have increased $13 in value as the shares have risen. The shares have climbed ~$15.50 in value since I wrote my cautionary article in January. The calls represented about 10% of the capital employed in shares and achieved 84% of the gains. I thus consider that trade idea to be a success on a risk adjusted basis. With that in mind, I recommend taking profits on the Workiva calls at these levels before they lose too much time value.
Since the market still favors Workiva's SaaS model and seems to enjoy its (negative) return on invested capital, we may as well participate in any further upside by buying more calls. In particular, I'm recommending buying the January Workiva calls with a strike price of $55. These last changed hands at a price of $7.60 (i.e. 13% of the current stock price). I think this trade represents a win-win for investors for the following reasons. If between now and January the market realizes that recurring revenue is nothing particularly special, that this company earns a negative return on capital, that the TAM here is overestimated, that management continues to dilute shareholders massively (sorry...got carried away), then they will have only 13% of their capital at risk. If, on the other hand, mania continues to drive these shares higher, investors will participate as they did on my previous call option plays.
I've switched my thinking on Workiva somewhat since my last article on the company. I think there are certainly some bright spots that have appeared, or at least the negative trends may be reversing. That said, I'd wait until there's further evidence of turnaround before deploying capital. I also think the current market is manic and favors this stock, and so I think it will likely continue to march higher. Thus, I think more active investors would do well on a risk adjusted basis to take advantage of this mania by buying calls. I think more passive investors would do well avoiding this name completely until we see some combination of lower price and further evidence of financial improvement.
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.