2023-06-14 04:11:59 ET
Summary
- WDAY has experienced a rebound in its backlog and subscription bookings growth, primarily driven by early renewals. The company's significant growth in long-term contracts indicates strong customer engagement.
- The company has maintained an impressive margin expansion over the past years and guided a 350-bps increase in non-GAAP operating margin in FY2024, indicating a primary focus on operational efficiency.
- WDAY stock is currently trading at 28x EV/FCF FTM, below the software industry average of 42x, which implies that WDAY may offer a more attractive valuation based on its FCF profile.
Investment Thesis
Despite a strong rebound on 1Q backlog due to early renewals benefit, Workday (WDAY) has only raised the lower end of its FY2024 subscription revenue guidance. This may imply a weaker bookings growth in the coming quarters. WDAY, as a leader in the cloud-based Human Capital Management industry, faces intense competition with relatively low barriers to entry. Therefore, I'm not surprised to see a near-term slowdown in its subscription revenue growth.
However, WDAY has maintained an impressive margin expansion over the past few years and has guided a 350bps increase in non-GAAP operating margin in FY2024, indicating the company's primary focus on operation efficiency. In addition, the stock is currently trading at 28x EV/FCF FTM, which is significantly lower than the software industry average of 42x.
While WDAY has experienced a growth slowdown largely due to competition, the company has been able to secure more long-term contracts from existing customers, which signifies strong customer engagement. Therefore, I'm bullish on the stock, as the current valuation is not overstretched after a 23.8% YTD rally, compared to the Software Index ETF's ( IGV ) 31.8% gain.
Strong Customer Engagement
WDAY experienced a strong total backlog growth of 31.6% in 1Q FY2024 primarily driven by early renewals, which can be attributed a 55% YoY growth in its subscription bookings. We should keep in mind that in the software industry, companies typically refer to remaining performance obligations (RPO) as backlogs, which is a key growth metric. Additionally, we can define the 24-month backlog as the "current" RPO. Before we discuss more details regarding the company's growth outlook, it's helpful to understand the company's growth metrics.
Bookings also play an important role as a forward-looking growth driver. They represent the additional contract value that customers commit to a company within a specific period. Bookings metrics includes two segments: subscription revenue and the dollar change of RPO. These obligations can be converted into future billings, ultimately contributing to subscription revenue.
To calculate the bookings metrics, we need to collect the data from the company's press release history, specifically the "24-month Subscription Revenue Backlog" and the "Total Subscription Revenue Backlog." I know it's a little confusing. Let me provide a numerical example to demonstrate. In 1Q FY2024, the company reported a 24-month backlog of $9,790 million, while in 4Q FY2023, the backlog stood at $9,680 million, resulting in a difference of $110 million. By adding this difference to the total subscription revenue of $1,528 million, we can estimate the 24-month subscription bookings to be $1,638 million.
Now, let's take a look at the charts. As mentioned earlier, the company benefited from a positive impact of early renewals, which suggests a lower growth for subscription bookings in the upcoming quarters. During 1Q FY2024 earnings call , the management explained:
"Many of the customers that expanded their strategic footprint elected to co-term and renew their existing contracts ahead of schedule. These early renewals in the quarter added roughly 1 percentage point to both 24-month and total backlog growth."
Therefore, it would be inappropriate to solely rely on the bookings growth from the last quarter to gauge the revenue growth potential. The pull-forward effect from early renewals might lead to a flat QoQ growth in the backlog. Regarding the growth differential between total backlog and 24-months backlog, the management also added:
"In addition to the benefit from early renewals, we continue to see an increased average contract duration on both new deals and renewals, causing total backlog to grow significantly faster than 24-month backlog."
We can confirm this by looking at the company's latest press release. In 1Q FY2024, we saw a 31.6% growth in the total backlog, while the 24-month backlog experienced a growth of 22.8%. This comparison suggests that subscription bookings are expected to grow at a faster rate than 24-month bookings in the future. This may imply a high net retention rate from existing customers. As the company explained:
"It's a function of we're getting a larger percentage of our revenue from our existing customer base doubling down and back to rationalizing a number of suppliers".
I believe it's a positive sign for a company to have customers who want to extend the contract duration. This indicates stronger customer engagement, and it's more likely that existing customers have incentives to do so.
Margin Expansion
WDAY has maintained a resilient non-GAAP operating margin profile. Although the company experienced a significant contraction of 780bps in 4Q FY2022, it has shown a strong recovery in its operating margin, improving from 19% in 4Q FY2023 to 23.5% in 1Q FY2024. Despite facing a significant growth slowdown due to intense competition, we can't ignore that the company is currently prioritizing its margin profile, which may result in a trade-off with weaker revenue growth.
In addition, we also can see that WDAY's FCF margin remains healthy. When considering the management's guidance, we can calculate a 22.9% FCF margin for FY2024, indicating a slight improvement on a year-over-year basis. However, the company cut its FY2024 operating cash flow guidance by $100 million to $1,950 million. This downward revision was attributed to a new semi-annual bonus plan payment cycle scheduled for 3Q FY2024. Despite this shortfall, the company plans to offset it by reducing CapEx by $40 million, which will reduce overall FCF by $60 million in FY2024.
Valuation
Source: J.P. Morgan Estimates, Company Data, Bloomberg Finance L.P., and Capital IQ
WDAY is currently trading at a 41x P/E FY2024, which is slightly lower than the software industry average of 45x. This suggests that the valuation doesn't appear to be overstretched compared to the software industry. When considering its mid-teen double-digit growth outlook, a comparable competitor like ServiceNow ( NOW ), with a 22% FTM revenue growth, is trading at a higher P/E ratio of 59x.
Additionally, we also notice that WDAY's 28x EV/FCF FTM is not only lower than the software industry average of 42x but also cheaper than both NOW's ratio of 38x and Oracle's ( ORCL ) ratio of 42x. This implies that WDAY may offer a more attractive valuation based on its FCF profile. Therefore, it's possible that the stock can mitigate some downside risk resulting from a valuation compression, assuming that there is no significant deterioration in the company's fundamentals.
Downside Risks
Investors should also consider several downside risks when evaluating the company. Firstly, it's important to note that high-growth companies typically demand higher valuation multiples compared to mature companies with strong FCF profiles. According to the management's statement, WDAY has demonstrated strong customer engagement among its existing customer base. However, there is a risk that the company may struggle to attract new customers, which could negatively impact total bookings and backlog growth.
Furthermore, WDAY being a software company with a history of over 20% growth, WDAY faces intense competition due to low barriers to entry in the Human Capital Management industry. If the company experiences a sustained deterioration in its subscription growth, despite maintaining a resilient margin profile, it's likely that its valuation multiple will be compressed. In such a scenario, the stock may not trade at a growth stock valuation.
Lastly, we should keep in mind that WDAY operates in a cyclical industry where the demand for human capital is closely tied to different stages of the business cycle. In the event of a recession that results in a high unemployment rate, WDAY's business could be adversely affected. This could create a near-term headwind in terms of bookings growth because customers may be more hesitant to commit to long-term contracts, resulting in shorter contract durations.
Conclusion
In sum, we saw WDAY has shown a growth rebound in its backlog and subscription bookings growth due to early renewals. Particularly, the company has seen a stronger growth in the long term contracts, reflecting strong customer engagement and the potential for sustained revenue growth. Despite facing intensified competition, WDAY has maintained a solid non-GAAP operating margin, indicating its operational efficiency. Although the company cut FCF guidance by $60 million in FY2024, its overall FCF profile remains healthy. In terms of valuation, WDAY's 28x EV/FCF FTM makes the stock more attractive compared to the software average and major competitors. I believe the company's resilient margin profile and FCF generation can support its current valuation. However, to see a significant valuation expansion, we have to see a consistent rebound in the subscription revenue growth.
For further details see:
Workday: Extending Deals Duration A Positive Signal Amidst Competition