While I like Workday (NASDAQ:WDAY) as a company, there are early signs that the company could face significant headwinds in the near term. While the stock is down almost 54% from its all-time highs, I am of the opinion that we could see more pain to come. In this article, I aim to highlight some of the risks that Workday may face as well as some of what I think are the key investment case for company today.
Workday continues to have a large and growing TAM comprising of its core human capital management market as well as its growing finance, spend and analytics market. The company continues to benefit from the secular trend of digital transformation and has a typical SaaS business model comprised of highly recurring revenues with relatively high retention rates. However, there are signs that Workday's core markets are experiencing intense competition that results in unfavorable industry dynamics like higher pricing discounts and lower margins. In addition, there are growing evidence that show that Workday is relatively more vulnerable to the worsening economy compared to other SaaS players due to its back-office focus.
Workday is a leading provider of enterprise cloud solutions for human resources and finance. The company particularly targets medium to large sized businesses. There are more than 9,500 organizations that use Workday's software-as-a-service (SaaS) solutions to add value in managing their workforce and finances. There are more than 50% of the Fortune 500 companies amongst its customer base.
It is worth noting that while Workday has expanded into a wider range of back-office business functions today, the company started out in and is known for Human Capital Management ("HCM"). Today, Workday has expanded into a new segment it calls Financial Management, which provides solutions for finance operations, another segment called Spend Management, which provides solutions for procurement operations, as well as an Analytics segment, which provides solutions to enable customers to make sense of the large amounts of data they collect.
One of the investment cases for Workday is the large and expanding total addressable market ("TAM"). While the company had a TAM of $39 billion when it first listed in the stock exchange in 2012, this has grown to a TAM of $105 billion today. This new opportunity set comes from what the company calls the FINS+ opportunity. Like I mentioned earlier, this includes the newer Financial Management, Spend Management and Analytics segments.
This growing and large TAM comes from Workday's expansion across the back-office business functions. What this implies is that this expansion brings further upsell and cross selling opportunities, although I would argue that competition is fierce in these segments.
With its leading position in human capital management, it can continue to leverage on this lead to continue its growth. This is done through engaging multiple levers, including expanding internationally, increasing penetration into medium size enterprises, and continuing to upsell and increase the average spend per existing customer. These levers can help Workday to continue to maintain and grow its lead in human capital management.
This ability to upsell and grow wallet share of existing customers along with cross sell abilities to new back-office business functions serviced by Workday helps drive unit economics and improve operating margins in the long term for the company, in my view.
As with other SaaS players, a large portion of revenues are recurring, and subscription based. Around 90% of Workday's revenues are recurring in nature and the company has one of the best-in-class retention rates of 95% relative to competitors. Also, Workday remains on track to meeting its long-term target of $10 billion in revenues and 25% operating margins.
In addition, Workday is able to ride on the secular trends that can enable it to continue to grow in the long term. This is due to continued trend of digital transformation of the enterprise, as human capital management, financial management and spend management transitions and moves to the cloud.
If you followed Workday closely, you would have known that the market reacted negatively to its recent disclosure of large deal delays and slight weakness in subscription growth, which resulted in share price plunging 9%.
There are multiple worrying signs for Workday, in my view. While Workday is the leader in HCM, this is a rather competitive market with various large, established players vying for market share. Currently, Workday has about 15% market share in the cloud HCM space. That said, there are several large, established players like Oracle (ORCL) and SAP (SAP). Besides these large players, there are other companies may compete specifically in certain regions like Coupa Software (COUP), Anaplan (PLAN), Microsoft (MSFT), Ceridian HCM Holding (CDAY) and UKG Inc. In Workday's recent quarter, although Workday denies that Oracle's aggressive pricing and bundling strategy is affecting their own sales cycles, there were checks done by UBS that found out that Oracle has indeed become more competitive against Workday.
I think this implies that Workday's core HCM market could see competitive pressures erode revenue growth and margins in the near term as the industry consolidates. This brings near term headwinds like Workday requiring to offer better terms and larger pricing discounts to customers as large competitors like SAP and Oracle continue to bid down future pricing to win market share.
When compared to other SaaS players, there are concerns about the impact of a downturn could impact Workday more significantly. The recent large deal delay was, in my view, early evidence that Workday could be more exposed to an economic downturn as a back-office focused player. Apart from this recent large deal delay situation, based on channel checks done to ascertain what are the types of software deals that would be delayed further if the economy continues to worsen. This channel check results showed that there was a consensus view that large back-office human resources and finance deals are high on the list of the deals they would push back. This, in my view, is very negative for Workday, whose HCM segment is considered its core segment and Finance is a segment it is hoping to leverage on for growth.
Although the Workday management mentioned that there were some non-macro reasons to the recent quarter's large deal delays, including changes in customer CEO, I am of the view that the delay was mostly due to macro reasons. I think that it is highly likely macro reasons contributed to the delay due to increasing customer caution related to economic downturn. The push out of deals to 2H and the absence of offsetting pull-ins are suggesting to me that the delay was due to something related to the macro environment which management cannot control. In addition, Workday's competitor, Anaplan also posted weak first quarter and April billings growth, which suggests that this weakness is more broad-based than market might expect. While it is a good thing that management continued to reiterate the full year guide, I think that if the downturn does get worse, we could see much larger downside risks to Workday as growth may stall beyond the next one to two quarters. This uncertainty on how the macro environment will turn out and how bad this downturn may get, along with the implications to Workday, leaves me unwilling to take the near-term downside risk for the company.
Workday currently trades at 40x FY2023 P/E and 31x FY2024 P/E while expecting to see a 13% decline in EPS for FY2023 while an EPS growth of 30% for FY2024.
Based on my forecasted FY2024 EPS of $4.02 and a P/E of 28x, my price target for Workday is $112.56, implying a 20% downside from current levels. As such, I initiate Workday with a sell rating due to near term challenges and uncertainties that will limit performance of the stock until there are signs these issues have improved
Competition in any one of its markets could be detrimental to Workday. For the core HCM market, although Workday is currently the leader in the market, it is a market that is very competitive with relatively lower barriers to entry. For the segment, its main competition comes from SAP and Oracle. Both companies are large and established companies with deep pockets that can afford to invest heavily into R&D or do M&A to compete against Workday's technology. In addition, they could intensify pricing discounts needed to win deals. For the financial management segment, there is the risk that competition from other players like Oracle might limit its growth in the near term. In the middle market segment, there is risk that competition could challenge Workday's attempt to gain market share in that segment.
If competition were to intensify in any one of these markets, it could mean further downside to share price as it could mean Workday loses market share, sees lower revenue growth and reduced margins.
The weakening of the macro environment may have a disproportionate impact to Workday, as elaborated earlier, due to its focus on the back-office functions. This might result in slower growth for Workday in the near term if the economy takes a turn for the worse.
With the provision of software over the cloud, this involves the transmission of its customers’ proprietary information regarding employees, end customers, suppliers, as well as finance and payroll data over the internet. In addition, Workday's data are stored in data centers operated by third parties. Any unauthorized access to the data due to security breaches or any outages that might impact the uptime of the systems could have a negative impact on Workday’s business.
I think it's important to note that I think Workday has long-term potential. This is due to its business model which has highly recurring revenues and high retention ratio. In addition, I think that the company has a long term potential due to a large and growing TAM and secular trends supporting its core markets.
That said, as elaborated in the article, there are significant downsides in the near term that endangers the return potential from the company. This comes as there are early signs that competition and the worsening macro environment may be limiting Workday's ability to get large deals and potentially limit its margins potential in the near term. As such, my price target for Workday is $112.56, implying a 20% downside from current levels and I recommend that investors avoid the stock in the near term until these risks subside.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.