FDN - Workday: High Switching Costs And A $100 Billion TAM

• Workday provides the gold standard software for Enterprise Back Office Management.
• Its customers include over half of the Fortune 500. Examples include: Netflix, Visa, LinkedIn, Salesforce, Unilever, HP, ETSY, and many more.
• The company has a $105 Billion market opportunity across Human Capital and Financial Management software.
• A survey by Credit Suisse forecasts an increase in enterprise IT spending, which could act as a tailwind.
• Workday stock price is trading at the cheapest price-to-sales ratio relative to historic multiples and is fairly valued intrinsically.

Workday, Inc. ( WDAY ) offers a SaaS (software as a service) platform which is the gold standard in Enterprise Management. Its cloud-based platform helps track and improve the efficiency of back-office functions such as Finance, Human Resources and Spend Management. The company was founded in 2005 and initially funded by Duffield and VC Greylock Partners. A partner at Greylock is LinkedIn co-founder Reid Hoffman who is a master of "Blitzscaling." Thus, a platform such as Workday fits nicely into his portfolio, as it helps Enterprises run efficient operations and scale employment more easily.

Workday now has over 9,500 customers across 175 countries. They serve a substantial 50% of the Fortune 500, including 70% of the top 50 Fortune 500 companies. The company has high customer retention (95%), high switching costs and leading product reviews with a Customer Satisfaction score of 97%.

The stock price went on a tremendous bull run in 2020 and increased by a rapid 115%. However, since November 2021, the stock price has been butchered by over 50% on the back of the high inflation numbers released during the period and a slight miss on earnings expectations. The stock price is now trading at the cheapest price to multiple since its IPO in 2012. In addition, the stock is "fairly valued" intrinsically according to my Discounted Cash Flow Model.

Catalysts

Workday has recently announced (July 13th 2022) they have achieved FedRAMP Authorization . This is a major event, as it means Workday can now provide services to Federal Government agencies, which opens up a new growth avenue. In addition, a recent survey by Credit Suisse forecasts an increase in IT Spend for Enterprises. Let's dive into the Business Model, Financials and Valuation for the juicy details.

SaaS Business Model

The Workday Enterprise Management Cloud consists of three core platforms, Human Capital Management, Financial Management and Spend Management. The estimated total addressable market ((TAM)) across these segments is $105 billion, which means there is plenty of runway ahead.

1. Human Capital Management ((HCM))

Workday understands that employees are the lifeblood of any company, especially those in the consulting or service-based industries. As the old saying goes "if you can measure it you can manage it." Workday HCM offers the ability to view headcount, turnover, hiring needs, employee cost, and much more, all from one unified dashboard. As your company gathers more data, the system uses Machine Learning and natural language processing to help estimate the average "Time to hire Gaps" or fill specific management positions.

The Workday Onboarding solution enables the rapid onboarding of new employees and decreases the time to productivity so they can hit the ground running.

The retention and attrition sections give your company insights into how well employees are being retained and if there are any red flags you need to be aware off. The platform even enables the ability to build talent management programs, listen to employee feedback, perform consistent performance reviews, track diversity, set compensation levels, and much more.

The fact the solution is "cloud based" means it's ideal for remote workforces or even retail chains which can track employee metrics across multiple stores, states, and countries.

2. Financial Management

The Financial Management platform enables the ability to intelligently manage finance processes. From billings to revenue, cash flow and more. The machine learning helps with forecasting, forecasting and planning business strategy. In addition, the platforms gives visibility into international compliance and processes, which can be hard to track for organizations.

3. Spend Management

The Spend Management platform gives a seamless overview of all the costs associated with running an organization, to tracking various "cost centers," cost trends, and much more.

High Retention Rate and Moat

Workday has a high retention rate of over 95% , which means customers are staying with the product. I believe this is for a couple of reasons. The first is it's a great product, which is rated number one in Human Resources software for Enterprises on G2. In addition, the platform has 4.4 out of 5 star reviews on Gartner.

The other reason I believe the product has high retention is its high switching costs. The product is deeply embedded into vital operations such as Finance and Human Resources. There is also the training costs for employees having to relearn a new software. Thus, I believe Workday could demonstrate "pricing power" in the future, as even if there are slightly cheaper alternatives on the market, companies would be unlikely to switch due to the aforementioned reasons.

Powering the platform's success has been an army of 15,900 employees, and as an extra data point it is interesting to see the company has 4.2 out of 5 star reviews for great places to work. Even the negative reviews don't seem too bad. For example, someone commented about the lack of "free food," which personally I don't believe is needed to be offered by a company.

Growing Financials

Workday has been rapidly growing its financials over the past few years. As you can see from the chart below, Annual Subscription Revenue has compounded by a 21% CAGR since 2020 and was $4.5 billion for FY22.

Total Revenue for the quarter ending April 30th 2022 also showed a similar increase, jumping to $1.43 billion, up by 22.1% over the prior year. The majority of this was driven by subscription revenue, which was up 23.2% YoY to $1.27 billion. Total Subscription Revenue Backlog also showed rapid growth of 26% to $12.65 billion.

The Non GAAP Operation Margin has improved by 900 bps over the past couple of years, with Non-GAAP operating income of $228.6 million, or 20.1% of revenues. The company did generate an Operating loss of $72.5 million, or -5.1%, which was greater than the -3.3%, or -$38.3 million, in the prior year.

Total costs and expenses increased by ~24%, which is at a slightly faster rate than revenue growth of ~22.1%. Approximately $100 million of this increase can be attributed to Product Development, which is okay. However, I would like to see General and Administrative expenses and overall costs growing at a slower rate longer term. I believe the company can accomplish this, as they offer a cloud SaaS platform which should have operating leverage - theoretically.

Share-based compensation increased by 17.7% to $311.5 million, which does lead to some concern about the sustainability of long term compensation plans. Stock-based compensation makes up ~20% of revenue, which does seem very high for a company which isn't a startup and is a mature technology company. The good news with high stock based compensation is it attracts the best talent and gives employees "skin in the game." Thus, this promotes a harder working and more aligned organization. Of course, when valuing the company's equity, it makes sense to take this into account.

Workday's balance sheet has cash, equivalents, and marketable securities of $6.26 billion, up a substantial 72% from $3.64 billion in the prior year. However, the company does have a substantial amount of total debt - $4.83 billion. The good news is this is well covered in the short term with $1.15 billion being in current debt. However, it is unusual to see a "money losing" technology company with such high debt levels, definitely something to keep an eye on but not a major issue right now.

Valuation

In order to value Workday, I have plugged the latest financials into my advanced valuation model, which uses the discounted cash flow method of valuation. I have forecasted 20% growth rate for next year and 19% growth rate for the next 2 to 5 years, which is aligned with managements guidance.

I have forecasted the operation margin to increase to 22% in the next five years as the company scales operations.

In addition, I have capitalized the company's large R&D spend over the past couple of years to increase model accuracy.

Given these factors, I get a fair value of $141/share. The stock is currently trading at $139/share and thus is "fairly valued."

As an extra datapoint, Workday is trading at a price-to-sales ratio = 5.7, which is the cheapest it's ever been historically since the IPO in 2012.

Workday is trading at a midrange price-to-sales ratio (forward) = 5.7 (purple line) relative to other enterprise software companies.

Risks

Valuation and High Debt

Despite the major pullback in share price, the stock isn't really cheap but is fairly valued. The high debt levels are also a concern and definitely something to keep an eye on.

Competition

Gartner outlines various alternatives in the Human Capital Management space. These include;

• SAP SuccessFactors.
• Oracle Fusion Cloud HCM.
• Ceridian Dayforce.
• Darwinbox.
• Workforce Now.
• BambooHR.
• PeopleStrong.

and many more. However, I do believe Workday is the gold standard solution for enterprises.

Final Thoughts

Workday is a tremendous company which offers the gold standard in Enterprise Management Software. The platform has an elite customer base of Fortune 500 giants and high customer retention. The recent crash in share price now means the stock is "fairly valued," and thus this could be a great opportunity for the long-term growth stock investor.

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