Workday: A Market Leader Only For The Long Term

Summary

• Workday is market-leading in cloud HCM software, with 45% of the Fortune 500 as clients.
• It has successfully expanded into financials, planning, and analytics, which keeps growth in the mid-20s, and there are still plenty of opportunities, especially internationally.
• However, given the high level of stock-based compensation and related dilution, the company isn't profitable on a GAAP basis, and its GAAP EPS is actually trending down.
• There isn't much operational leverage yet, so we feel investors need a fairly long time horizon.

Workday (NASDAQ:WDAY) has been an amazing company. In a short few years, it has established itself as the leading HCM (human capital management) cloud application, and it's now seemingly on course to repeat this with their financial management applications, taking on competition from Oracle (ORCL) and German SAP (SAP). Investors, of course, have noticed:

It's no surprise that the stock price has retreated recently in the market mayhem, and with companies like Nutanix (NTNX) and Microsoft (MSFT) warning about the impact of the coronavirus on their expected results, even if management argued during their FY2020 Q4CC that they hadn't experienced any impact from that.

Data by YCharts

Investors should be aware of both the ongoing revenue growth, nearly five-folding the size of the company in 5 years as well as the continuing GAAP deterioration, which, at first sight, is pretty shocking at nearly half a billion in GAAP losses the last year.

The non-GAAP figures are much better. Take, for instance, operating profit in Q4:

• GAAP operating loss was a whopping $146M or an operating margin of -15%
• Non-GAAP operating income was $116.6M, producing an operating margin of 11.9%

There are three questions here:

• What is producing this large difference?
• What is the trend?
• What is the cash flow situation?

The answer to the first question is simple:

Data by YCharts

That is, share-based compensation is 23.7% of revenue. This is, of course, not free for investors:

Data by YCharts

As to the second question, about the trend:

Data by YCharts

It is at least moving in the right direction, although basically stalling since 2018. With respect to cash:

Data by YCharts

Unsurprisingly, the massive stock-based compensation is responsible for the positive cash flow. Without it, free cash flow would actually be negative. We think this is one reason the shares have lagged the S&P 1500 Application Software Index (10-K):

Growth

Like other SaaS business application companies, there are numerous ways which Workday can grow:

1. Get a foot into the door with a killer app, something at which the company is good at that fulfills a real business need.
2. Convert license clients into recurring revenues via SaaS in the cloud.
3. Expand users (seats) at existing customers.
4. Expand geographically.
5. Have a nice side business called services where you help customers understand the product, show what it can do for them, and train them and help in installation, configuration, etc.
6. Open a partner channel; that is, build a community or ecosystem.
7. Use the recurring (subscription) revenues to build out sales and R&D.
8. Use R&D to build additional functionality and/or verticals, modules that can be used to up-sell ('land and expand').
9. M&A might be used for the same purpose as R&D, to acquire new capabilities to up-sell.
10. Open up the platform for third-party/customer apps and take a share of the cut or use it to solidify the platform position and value.
11. Grow revenues in order to achieve operational leverage.
12. Ultimately, earn enough free cash flow to deleverage (where applicable) or allow the company to buy back the shares that are issued as stock-based compensation and/or pay dividends.

Not all of these are equally relevant, but we'll comment on the most important ones for the company. We know that one in four clients has both HCM and the Financial suite, and that's about it.

Killer app

Their killer app is, of course, HCM, where the company now has a leading position (Q4CC):

In total, we added 11 new Fortune 500 customers, almost equalling our best every quarter and now have 45% of the Fortune 500 as HCM customers, including 60% of the Fortune 50. We also added 16 new Global 2000 customers and now have almost 20% of the Global 2000.

One might, with 45% of Fortune 500 and 60% of Fortune 50 companies as customers, think that growth opportunities are dwindling here, but this would be the wrong conclusion. HCM has two further growth avenues:

• International
• Medium enterprise

Medium enterprise is the company's biggest longer-term opportunity for HCM to keep growth going. It's a segment where the company offers a lower cost solution with significant opportunities especially overseas, so combining this segment with international growth.

Internationally, there are still many greenfield opportunities as only a quarter of revenues come from abroad (10-K):

Newer products

Over the past several years, the company has introduced a host of new products (either developed internally or acquired), like Financial Management, Planning and Prism Analytics, as well as custom solutions for specific verticals (like education, professional services, healthcare).

Of these, Financial Management is the most established and enjoyed a strong quarter, as well as their other newer solutions (Q4CC):

Switching over to our financial management applications Q4 was our best quarter ever. We added a record number of core financial management customers, including KeyBanc, Beth Israel Lahey Health, Dun and Bradstreet, and West Virginia United Health System. In addition to the strong growth from our core financial applications, we saw continued momentum from our expanding suite of products that support the Office of the CFO. Both Workday and Prism Analytics and the adaptive insights business planning cloud had outstanding quarters. We added over 100 new Prism customers and over 350 planning customers, which includes over 100 on a broader Workday platform. Our new workmates of Scout RFP had an excellent initial quarter as well, with strong momentum on sourcing opportunities, both standalone and as part of Workday fund management offerings.

The latter (Scout RFP) has just recently been acquired. Still in beta is its cloud platform, which (10-K) "is designed to allow customers to extend Workday's core applications, enabling customers to address unique business or industry use cases. The platform includes tools for building, deploying and serving extension applications from within the Workday cloud."

This could open a path to a marketplace for third-party add-ons, but we're not aware of this being in the works. The more product lines there are, the more the company can cross-sell to existing clients, and while this is happening, data is scarce.

Management argues that CFOs are looking at planning and transactions applications together and want a unified system This is what Workday can offer, so there are likely to be cross-selling opportunities here as well.

Professional services

Like most business SaaS companies, the company also sells quite a bit of professional services, helping customers with implementation (10-K):

But the margin on these professional services is actually negative on a GAAP basis:

This is, of course, not unusual, and professional services aren't a profit center but exist to smooth customer adoption, so at least, part of their benefits are not captured by a narrow profit/loss view.

The company does have an ecosystem of partners, from the 10-K:

to both broaden and complement our application offerings and to provide services that are outside of our focus. These relationships include software and technology partners, consulting and deployment service providers, Workday Ventures partners, and business process outsourcing partners, who help enable Workday to address challenges our customers face while focusing on executing against our strategy.

But we didn't come across figures that indicate what percentage of business they bring in and/or facilitate and how that is evolving, and according to the same 10-K, their direct sales force is their primary channel.

Q4 results

Revenue grew 24% with subscription revenue at 25% growth. The company doesn't break down revenues according to product line (just the distinction between subscription and professional services).

Non-GAAP EPS came in considerably ($0.10) better at $0.50, and revenue beat by $11.2M at $976.3M. Despite the beat in revenue, the law of large numbers is asserting itself as the growth rate is gliding downwards (despite a number of acquisitions):

Data by YCharts

Guidance

On the basis of the good Q4 results, management has raised FY2021 (which started last February) guidance a tad with FY21 subscription revenue now at $3.755-3.77B from the prior $3.73B. Management expects operating cash flow in FY21 to be approximately $1.08B (+25%).

CapEx will be $230M for real estate investments and an additional $350M to support other capital needs.

Valuation

Data by YCharts

Analysts expect non-GAAP EPS to come in at $2.23 this (fiscal) year, rising to $2.81 next year, so on an earnings basis, the shares are really quite expensive.

Given the dilution as a result of share-based compensation, we feel that non-GAAP EPS doesn't tell the whole story, and indeed, GAAP loss per share is actually trending mildly downwards.

Data by YCharts

One might also want to keep in mind that the company actually has over $1B in long-term debt (convertible notes), although this is more than covered by the $1.94B in cash and equivalents.

Conclusion

Despite being a market leader and having reached a level of maturity especially in its core HCM market, the company isn't actually all that profitable. In fact, without copious amounts of share-based compensation, the company isn't profitable at all, not even cash flow positive.

While we recognize the core competitive strength of the company and would normally not hesitate to put a buy rating on the stock, the large share-based compensation and resulting dilution and minimal operational leverage sort of sticks in our throat a bit.

As we know from the likes of Nutanix and Microsoft, even business software companies aren't necessarily immune to the economic effects of the coronavirus outbreak, so we stay on the sidelines with this one, at least until the dust settles.

Analyst’s 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.