2024-01-09 23:58:42 ET
Summary
- Workday stock has soared nearly 70% over the past year, but its valuation is a concern.
- Trading at ~8x forward revenue and a >40x P/E ratio, the stock is overdue for a correction that will overturn some of its late-year gains in 2023.
- The company is citing growth tailwinds in both AI and international expansion, but it's unlikely that either will be able to push Workday significantly beyond mid-teens top-line growth.
Late-2023 gains are still holding strong in the first few trading days of 2024, as investors continue to hold on to the hope of aggressive Fed rate cuts and a soft landing for the U.S. economy. While optimism continues to float higher, I prefer to take a more cautious tack, especially considering how valuations - both of the major averages as well as many individual stocks - are near peaks.
Workday ( WDAY ) is a stock that bears a careful analysis. The leading vendor in cloud-based HCM, Workday stock has soared nearly 70% over the past year. To its credit, Workday has executed tremendously well in a tough macro economy, while also calling for an acceleration in subscription revenue growth in FY25. Still, however, investors must ask: is there more room for upside?
I last wrote a cautious, neutral opinion on Workday back in October, though I had been previously bullish on the name. And while it's true that I missed out on the last leg of Workday's gains at the tail end of last year, I don't regret my call - and considering how sharply the stock has risen since then, I'm now downgrading Workday to bearish.
The core concern I have here is valuation. At current share prices near $276, Workday trades at a market cap of $72.35 billion. And after we net off the $6.88 billion of cash and $2.98 billion of cash on Workday's most recent balance sheet, the company's resulting enterprise value is $68.45 billion.
Meanwhile, for the next fiscal year FY25 (the year for Workday ending in January 2025), Wall Street analysts are expecting the company to generate $8.45 billion in revenue, representing 16% y/y growth; as well as $6.64 in pro forma EPS (also +16% y/y). This puts Workday's valuation multiples at:
- 8.1x EV/FY25 revenue
- 42x FY25 P/E
These are quite rich multiples for a company that is already in a leadership position in its two core market segments (HCM and financial software). Historically, Workday has traded at a 6-8x revenue multiple bands, briefly crossing into the low-double digit territory amid the pandemic tech bubble - but its growth rates were also richer back then, justifying a richer multiple.
Investors are certainly cheering the fact that Workday is expecting subscription revenue growth of 17-18% y/y next year in the guidance it introduced alongside Q3 earnings (versus 17% y/y growth in subscription revenue expected in Q4):
The company is citing a number of growth drivers are becoming more and more incremental to revenue growth, including the prospects of international growth as well as proliferation of more AI features across the Workday suite, especially into its Adaptive Insights planning tools. In spite of this, I don't see Workday materially being able to lift growth rates above the mid/high-teens as a result of its own massive scale.
All in all, Workday has become a classic type of software investment: "high quality for a high price." Due to my overall concern that the market may turn south as investors churn over the pace of interest rate increases and weigh the valuations of market averages (especially as many bank research desks are calling for downside in 2024), I'd steer clear of this stock and invest elsewhere.
Q3 download
This being said, it would be remiss not to acknowledge that Workday has continued printing impressive results, especially in a tough macro environment for HCM companies (subscription companies that have priced per seat have struggled this year as companies laid off employees).
Workday's Q3 earnings results are shown in the snapshot below:
Workday's revenue grew 17% y/y to $1.87 billion, slightly ahead of Wall Street's expectations of $1.85 billion (+15% y/y) and accelerating slightly from Q2's 16% y/y growth pace.
The two big growth drivers that the company cited are international growth and AI. On international, Workday noted that its EMEA region crossed $1 billion in ARR (annual recurring revenue) for the first time, as the company deepens its traction with the partner ecosystem overseas.
In addition, more and more customers are showing interest in adopting AI solutions, which Workday has sprinkled across its portfolio. In its finance solutions, Workday has implemented AI to identify repetitive manual tasks and replace them with intelligent automation. The company has also implemented conversational AI capabilities in its Adaptive Insights product and other talent and recruiting tools to help users quickly reference key information and make core planning decisions.
Zane Rowe, Workday's CFO, noted that renewals activity was strong and that the company saw better-than-expected new bookings. Per his remarks on the Q3 earnings call :
The result was driven by strong new ACV bookings and healthy renewals with gross and net revenue retention rates of over 95% and over 100%, respectively.
Early renewals in the quarter exceeded our expectations, adding more than a point of growth to 12 month backlog and early renewals from prior quarters also continued to benefit backlog growth in Q3. 24 months subscription revenue backlog was $10.58 billion at the end of Q3, up 23%. Early renewals in the quarter added nearly 2 points of growth to the results. Total subscription revenue backlog at the end of the quarter was $18.45 billion, up 31%. Backlog benefits from increased contract duration, which speaks to our customers' continued commitment to our platform."
On profitability, Workday notched a 24.0% pro forma operating margin this quarter - up 420bps y/y relative to 19.8% in the year-ago quarter. On top of 17% y/y revenue growth, Workday is still just clinging to "Rule of 40" status. Year-to-date free cash flow of $969.2 million also grew 43% y/y.
Key takeaways
There's little doubt that Workday continues to chug along with strong execution, but in my view, this outperformance is already more than well reflected in the stock's 8x forward revenue multiple. It's time to lock in gains here and move to the sidelines.
For further details see:
Workday: Terrific Execution, But Too Expensive To Consider