SAPGF - Workday: Management Transition Macro Headwinds And Workforce Reductions

Summary

• A surprise management succession plan was announced as Workday is bringing an industry veteran, Eschenbach, as co-CEO.
• The near-term opportunity for Workday remains poor as a result of an uncertain macro backdrop causing customers to be cautious on spending.
• The company announced that it will be reducing its workforce by 3% earlier in the year, bringing incremental upside to operating margins.
• I expect that the fourth quarter earnings could beat on lowered expectations while the guidance for FY2024 could disappoint.
• My 1-year target price for Workday is $154, implying 17% downside from current levels.

This article was first posted in Outperforming the Market on 21 February 2023.

Investment thesis

Workday ( WDAY ) will be reporting its fourth quarter earnings on 27th February and this article aims to provide a recap of its third quarter, some of the major news since then, as well as a preview of what the fourth quarter earnings could look like.

I remain on the sidelines for Workday given how the stock is richly valued, in my view, as well as the weakness the business is showing with the current uncertainty in the macro environment. Furthermore, I think that the competitive pressures in Workday's businesses remain strong as there are large and established players in the markets it is planning to expand into. Until I see an improvement in the demand situation, I remain on the sidelines for Workday.

I have previously written an article on Workday about why I remain cautious in the near-term.

Leadership transition

In a surprise announcement , Workday announced that its current co-CEO, Chano Fernandez, will be stepping down. He will be replaced by Workday board member Carl Eschenbach . Eschenbach was also President and COO of VMware ( VMW ).

This move was done to facilitate succession planning for the CEO position as Eschenbach will eventually be the sole CEO of Workday starting January 2024. By then, the other co-CEO of Workday, Bhusri, who is also co-founder, intends to transition away from the co-CEO role to executive chairman role.

While the leadership transition was a surprise from Workday, the succession plan is certainly one that gives confidence given that the new incoming co-CEO Carl Eschenbach has previous experience in running enterprise sales at a scale similar to that of Workday. In his previous role as COO and President of VMware, the company was operating at $7 billion revenue run rate and had 20,000 employees, which is similar to Workday's current scale, which is at $6.5 billion revenue run rate and 17,500 employees. Furthermore, I think the co-CEO model in the meantime will enable co-founder and co-CEO Aneel Bhusri to guide Carl Eschenbach and ease him into the role in the next one year.

Workday also reaffirmed its fourth quarter guide and preliminary FY2024 guidance of 17% to 19% subscription revenue growth and expansion of operating margins by 150 to 200 basis points. This does imply that the change in CEO was not likely performance related given that the guidance was re-affirmed.

Review of the third quarter

Workday had a third quarter results that was rather mixed in my view. The actual third quarter results did beat expectations on revenue and EBIT. However, management's commentary was not encouraging as they highlighted weakness and challenges in the business. Management saw more challenges in net new logos and the pipeline as a result of uncertainty in the macro environment that is causing spending to become more cautious. This was more evident in the EMEA region and in the larger enterprise deals.

Although the long-term opportunity remains, co-founder and co-CEO Aneel Bhusri had this to say about the nearer term:

And while we expect that the macro uncertainty will cause our growth to moderate in the near-term, we continue to believe we are well-positioned to navigate this environment and emerge even stronger.

While the 24-month subscription revenue backlog increased two percentage points more than guidance at 21% growth year on year, the fourth quarter guidance for the 24-month subscription revenue backlog came in one percentage point lower than market consensus at 19% growth year on year.

Furthermore, along the lines of guidance, the rather soft guidance for FY2024 subscription revenue growth of 18% was lower than its long-term target of achieving at least 20% subscription revenue growth. What was positive was that the lower end of the guidance for FY2024 was based on an assumption that the macro environment will worsen compared to what we are seeing today, which does price in some conservatism into the guidance and likely the reason for the softer subscription revenue growth expected than when compared to the long-term target. Lastly, management expects that operating margin will expand by 150 to 200 basis points as a result of a more moderate pace of hiring, which comes as the company grew its headcount by 23% year on year.

Workforce reductions

Workday announced that it will be reducing its workforce by 3% earlier in the year. Most of the reduction in headcount will come from the Product & Technology team. This works out to about 500 to 600 employees being laid off. While it announced reductions in workforce in January 2023, it noted that the company's future growth prospects remain strong, and the company even stated its intent to increase the workforce size in FY2024.

This reduction in the workforce will likely drive about $100 million to $150 million in annualized cost savings going into FY2024, which implies about 2% impact to margins.

That said, I think that the key question for Workday continue to be about the demand environment for FY2024. I think we could see slower growth in FY2024, with human capital management showing more resilience than Financials.

What I am looking out for in the fourth quarter

I think that its operating margin guidance is likely to be achieved given the moderation in pace of hiring, as well as the recent reduction in workforce. I do think that we could see a beat to the fourth quarter and the main reason being that management has managed investor expectations and already guided downwards which does imply conservatism in the fourth quarter guidance.

However, I will be looking for commentary on the FY2024 guidance as I do see risks on slower growth as a result of the current macro conditions persisting, and I think that we could see slower growth in new enterprise projects. This brings a risk to slower growth for Workday than expected as global corporations reduce their budgets as they remain cautious on spending. This could also result in difficulty in the financial segment seeing an inflection in adoption.

Valuation

Taking into account the 18% subscription revenue expected for FY2024 and the 150 to 200 basis point improvement expected, my forecasted FY2024 EPS is at $4.40. I applied a P/E multiple of 35x given the historical P/E multiple range for Workday and its long-term growth potential.

This implies a 1-year target price of $154, implying 17% downside from current levels.

As highlighted earlier, I do think that the company continues to face near-term challenges as the macro environment remains uncertain and enterprises control their spending in the near-term. Over the longer term, I think that management remains confident in the business and the company will remain a leader in human capital management and potentially see an inflection in its other businesses as well.

Risks

Competitive pressures

I think that competition in Workday's businesses is a key risk. While it is a leader in human capital management today, the markets it plans to expand into and invest in like financial management have large and established players. These players could ramp up competitive pressures if needed and Workday could be left with the customers in the market where none of the large established players are entrenched in. The market Workday operates in is a competitive market with lower barriers to entry. As larger software players like SAP ( SAP ) and Oracle ( ORCL ) compete with the company, Workday needs to ramp up innovation or risk losing an edge to these players.

Weak and uncertain macro backdrop

As I have mentioned a few times in the article, Workday's business has felt the effects of a weakening and uncertain global backdrop as its customers are pulling back on their budgets and spends, resulting in slower growth in the near-term. If the macro backdrop were to worsen or persist, this could bring downside revisions to the company's FY2024 guidance.

Conclusion

All in all, Workday is in a position where it is trying to address the challenges that the business is facing with a weak macroeconomic environment, as enterprises are cautious on spending and thus, affecting Workday's near-term growth. I think that the fourth quarter results could beat, as a result of the lowered guidance for the quarter from the prior quarter, which helped lower investor expectations. That said, I do think that there is a risk for FY2024's guide to be lower than what the market expects as macro uncertainty and headwinds could be baked into the guidance.

I think that new co-CEO Eschenbach is an industry veteran in running enterprise sales organization, especially one that is at Workday's scale. I think that there is ample time for him to transition into Workday and come January 2024, he should be ready for the challenge ahead of him and could bring positive changes to the company.

My 1-year target price for Workday is $154, implying 17% downside from current levels.

I continue to remain on the sidelines until I can see the light at the end of the tunnel when the demand environment improves.

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