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Workday: Being Bullish Will Pay Off

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About: Workday, Inc. (WDAY)
by: Gary Alexander
Gary Alexander
Software, internet, media, IPOs
Summary

Shares of Workday slid ~6% after reporting Q3 results.

Though Workday beat expectations in Q3 and guided above consensus for Q4, the company's preliminary outlook for FY21 startled investors.

Citing maturation of its core HCM product (which isn't new news), Workday is guiding to 21% y/y subscription revenue growth in FY21, two points below consensus of 23% y/y.

Workday's valuation in the ~$150-160 range, at ~8x forward revenues, is compelling and betrays its huge TAM and profit growth.

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For yet another quarter, cloud software giant Workday (WDAY) has continued to linger in the penalty box. Recall that in October, Workday was the primary catalyst behind a sweeping, sector-wide correction in software stocks when it announced that its core human capital management (HCM) product was reaching maturity and would experience near-term deceleration. This isn't "new news", but after Workday released its preliminary outlook for FY21 on its third-quarter earnings call, investors essentially reacted to the same news and sent shares downward another ~6%:

ChartData by YCharts

Putting context around Workday's slip - and why it's still a buy

In my view, Workday is a perfect "buy the dip" opportunity. Shares have lost ~30% since their mid-summer peaks above $230, yet I find that the quality of the business hasn't wavered in the least. All large software companies see maturation in their core products - Salesforce.com (CRM), as one prime example, only sees low-teens growth in its core Sales Cloud product. As I wrote in a previous article, Workday has already taken steps to diversify its business beyond HCM - especially with the addition of entirely new categories of software like Adaptive Insights, which puts Workday head-to-head against the likes of Anaplan (NYSE:PLAN) in the enterprise planning space.

To be specific about the guidance that investors are begrudging: during her prepared remarks on the Q3 earnings call, CFO Robynne Sisco offered the following commentary:

"While we are early in our FY '21 planning cycle and still have an important Q4 to close, we'd like to provide a preliminary and high level view of FY '21. As a reminder, and as we discussed in detail at our recent Analysts Day, we have a lot of new products coming to market in FY '21, including Workday Cloud Platform, People Analytics, and our Employee Experience Solution. Given the timing of these launches, and the time it takes the new product to impact subscription revenue growth at our scale, these emerging products won't start to have any notable impact on our revenue growth until fiscal '22, and beyond. In addition, while we are very excited by the pending Scout RFP acquisition and the long-term opportunity that we see ahead of us in the spend management category, Scout is expected to contribute less than 1% to our subscription revenue growth in FY '21.

With that context, we are currently planning for FY '21 subscription revenue of approximately $3.73 billion, gross of approximately 21% year-over-year. We continue to expect pronounced and compounding seasonality towards Q4 with our Q1 being the seasonally slowest in terms of net new bookings. We currently expect subscription revenue in Q1 of FY '21 to grow approximately 4% sequentially from Q4 FY '20. We remain focused on investing to drive long-term durable growth, while progressing towards our 25% plus non-GAAP operating margin goal. While we are still in our FY '21 planning process or early view of FY '21, non-GAAP operating margin is approximately 14%, which includes roughly 1.5 points of expected dilution from the Scout RFP acquisition. But in other way, without the Scout acquisition, we would have expected a non-GAAP operating margin of approximately 15.5%."

Analysts, on the other hand, were hoping for 23% y/y subscription growth. But as we've seen in the past with Workday, the company often offers reasonable targets that it can eventually beat - especially when it's guiding further out than a single quarter. Even some analysts believe Workday's guidance tends toward the conservative side.

A slowdown in growth is natural as Workday approaches a ~$4 billion annualized subscription run rate. What investors should focus on at this time is the fact that Workday is making use of its growth consolidation to hammer down profits - as we'll discuss shortly in Workday's most recent results, operating margins have shot through the roof. During turbulent market times when investors have seemed to shy away from high-flying growth stocks and into more value-oriented names, I find this profit growth to be compelling enough to paper over Workday's slight deceleration expectations.

Valuation attractive post-dip

At present levels around $163, Workday stock trades at a market cap of $37.66 billion. After netting out the $2.10 billion of cash and $1.25 billion of convertible debt on Workday's balance sheet, the company has an enterprise value of $36.81 billion.

For FY21, Wall Street analysts are expecting total revenues of $4.41 billion, per Yahoo Finance. This puts Workday's current valuation at just 8.3x EV/FY21 revenues - bearing in mind that the company has historically traded at valuation multiples in the low teens, I find Workday's current share price to be quite a steal.

Here's how that valuation multiple stacks up against other major SaaS large-caps:

ChartData by YCharts

Historically, Workday has traded at a slight premium to Salesforce (whose growth tends to trail a few points behind Workday); now, that gap has more or less converged. This leads me to believe there's at least one or two turns of multiple expansion available to Workday. My price target on the stock is $196, representing a 10x EV/FY21 revenue multiple and 19% upside from current levels.

Q3 download

Amid the fuss over Workday's preliminary FY21 guidance, it's also important to recognize that Workday blew results out of the ballpark in Q3. The earnings summary is shown below:

Figure 1. Workday 3Q20 resultsSource: Workday Q3 earnings release

Revenues grew 26% y/y to $938.1 million, surpassing Wall Street expectations of $920.6 million (+24% y/y) by a considerable two-point margin. Subscription revenue growth of 28% y/y also grew slightly faster than overall revenue growth.

And despite widespread concerns of deceleration, Workday notes that it continues to gain market share in the HCM space. Per CEO Aneel Bhusri's earnings call commentary:

"With that, let's quickly review our third quarter results. Starting with HCM, we continue to gain market share with an industry-leading true cloud platform, which believe has the deepest product capabilities and unparalleled user experience, and the highest levels of customer success. In Q3, we added six more Fortune 500 customers, and 11 in the Global 2000. A few of the new HCM customers include Anheuser-Busch InBev, Magna International, Royal Bank of Canada, and Sutter Health. Some notable go-lives in the quarter included Glencore National AG, the Dow Chemical Company, and Telstra Corporation."

The company has also put a lot of recent R&D focus into its Financials suite, where it's building out new spend management and procurement tools to flesh out its capabilities in that space.

What's perhaps most important to highlight in Workday's Q3 results, however, is the incredible leap in profit margins that it was able to deliver. Workday's pro forma operating margins in Q3 clocked in at 15.2%, 850bps better than 3Q19 at just 6.7%. As Workday's revenue growth as slowed down, it has managed to rein in operating efficiencies - particularly on the sales and marketing front, which for Workday (as for most other SaaS companies) is one of the largest drivers of spend. Note as well that Workday has a long-term operating margin target of 25%, so there's still plenty of headroom to go on the profitability side.

Note as well that Workday's pro forma EPS of $0.53 absolutely crushed Wall Street's expectations of $0.37 with 43% upside. The company also more than doubled operating cash flow in the quarter to $258.3 million, while year-to-date OCF has grown 59% y/y:

Figure 2. Workday cash flowsSource: Workday Q3 earnings release

Key takeaways

As usual, investors are overreacting to Workday's early view of its FY21 results, which some analysts have already billed as conservative. Workday's expected deceleration in HCM is a normal milestone in its growth trajectory, which will be supplanted by growth in Financials and other growth initiatives. With >$2 billion of cash on hand, Workday also has the flexibility to drive another category-expanding acquisition like Adaptive Insights in the near future. At the same time, the company is also hugely expanding its bottom-line potential - at a critical time in the markets when tech investors have begun putting more weight on profitability. Trading at just ~8x forward revenues, far below historical multiples, investors have a well-timed opportunity to get in on Workday at the ground floor.

Disclosure: I am/we are long 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.