Workday: Resilient Business Model And Sustainable Growth

Summary

• Workday is an attractive investment opportunity, given its deep moat in the enterprise HCM and Financial Management, steady growth, and strong cash flow generation.
• The sticky client base and its high-quality licensing business model will help in weathering the ongoing uncertainty.
• We expect a sustainable +20% growth with potential operating margin expansion above its 16% target in the near term.

Overview

We believe that Workday (NASDAQ:WDAY), the SaaS Finance and HR giant, presents an attractive long-term growth investment opportunity. Workday is one of the most disruptive players in the enterprise SaaS HCM (Human Capital Management) and Financial Management market. Over the last five years, revenue and FCF (Free Cash Flow) have grown by ~5x and ~9x consecutively. Despite being a +$3.6 billion-a-year business, Workday also still maintains a +20% growth with steady FCF profitability. In this first coverage of Workday, we will take a closer look at its high-quality business model and strategic go-to-market approaches, which we believe should allow the company to maintain its resilience and outperformance. We assign the stock an overweight rating.

Catalyst

We expect the strategic focus on client base expansion to drive growth and margin expansion. As the ongoing uncertainty may negatively affect the sales cycle for new deals, we believe that Workday will instead continue to benefit from targeting its client base. In doing so, Workday should drive growth and profitability by incurring lower marketing expenses and focusing on quicker wins with add-on sales. Over the last few quarters, the company has reportedly achieved a 100% net retention rate as the add-on business has seen rapid growth.

(source: company's 2019 analyst day slide)

In Q1, the add-on business maintained its momentum as Workday achieved its first-ever $1 billion revenue quarter with $1.02 billion quarterly revenue, up 23% YoY. Assuming that a significant portion of the growth for 2020 will come from the existing client base and that Workday has comprehensive add-on offerings in its fast-growing Financial Management segment, we think that the +20% growth is highly sustainable.

(source: company's 2019 analyst day slide)

Furthermore, the operating margin would have been at 20.6% instead of ~12.8% if the company did not pay the one-time bonus payment for its employees amid the pandemic. Consequently, while the 12.8% operating margin in Q1 already demonstrates a strong expansion from that of FY 2019, we continue to see upside potential in margin expansion this year, driven by further delays on non-critical programs and traveling. As the company will also add more resources to target the growing install base opportunity through a more focused approach, we feel that Workday can potentially outperform its full-year 16% margin guidance.

Workday's high-quality business model helps weather uncertainty. We have also gained some insights into the mechanics of Workday's licensing model in Q1, which we think is highly robust and resilient despite based on a per-user pricing scheme. As described by the CFO Robynne Sisco, the licensing contract only recognizes the changes in the number of users on an annual basis, effectively leaving no room for unpredictable changes in the contract value accordingly. The company also applies a minimum base contract value, which can only be reset at a renewal:

Second, while our licensing model is based on the number of workers within our customers' organizations, we have measures in place that help reduce near-term volatility from employment changes. As an example, our contracts are typically only trued up annually to account for increases and decreases in worker counts. In addition, our contracts have base minimums, which limit our downside. And it is only upon contract renewal, which is typically every 3 to 5 years, that our customers have the opportunity to reset these base levels.

Risk

Despite the sticky customer base, Workday would have also been in a good position to invest in its go-to-market further to land new logos this year. During the analyst day last year, we noted the company's compelling vertical go-to-market strategy in growing the adoption of its Finance Management offering.

(source: company's analyst day 2019 slide)

As the company has decided to focus more on its install base for the foreseeable future given the ongoing uncertainty, we accordingly expect a slowdown in the Finance Management segment, which, unfortunately, has been the fastest-growing business for Workday.

Valuation

In our view, Workday has all the characteristics of an attractive large-cap tech and growth opportunity. It has a deep moat in the enterprise SaaS HCM and Finance Management with many large companies like Comcast (CMCSA), Hewlett Packard (HPE), and Netflix (NFLX) in its client base. Furthermore, the offering has proven to be disruptive as well, as shown by the exponential growth in revenue and FCF over the last five years. Last but not least, the client base stickiness stands out to us. At ~11x P/S, we consider Workday attractive enough, considering the strong positioning to reaccelerate growth through both new logos as well as client base expansion going forward, coupled with the adequate profitability lever. Given the expected 20% growth and potential FCF margin expansion to ~18% this year, the stock is only 2 points shy of passing the rule-of-40, which is a very minor problem that another one or two earnings surprises will fix. We maintain our overweight rating on the stock.

Analyst’s 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.

Comments

[mountainman86]

Totally agree on these points. Workday has a sticky product that many large companies have migrated to. That puts them in a great position for add-on offerings and longer term growth.