Summary
- Down 50% from all-time highs and trading at levels seen in 2018, Workday, Inc. has grown its business tremendously over the years.
- Hyper-growth phase is over, but Workday management is projecting 20%+ growth for the next 3 years.
- If that happens, the current valuation depressed by the bear market might be a great opportunity.
Lately, I’ve been reviewing many stocks that have seen their valuations slashed during this bear market, with particular focus on growing, established, profitable companies. Workday, Inc. ( WDAY ) clearly fits the description, having achieved tremendous growth over the past decade while its stock is actually down around 50% from the all-time high. More interestingly, WDAY is now trading at levels last seen in late 2018, when the company brought in less than half the current revenue and was only starting to be Free Cash Flow ("FCF") positive.
Much has changed since then, as now Workday is entrenched in so many global enterprises’ operations while trading at very interesting levels. I believe the current valuation can likely deliver good results over the long-term if the company will grow as management expects. Let’s dive in deeper.
A leader in the making
Workday is a leading provider of cloud applications used by enterprise customers. Many companies manage their human resources or their finances through the use of software provided by Workday. The company adopts a Software-as-a-Service ("SaaS") model, and almost all the Revenue recognized is high-margin Subscription revenue. The company also generates some Revenue by selling professional services, usually at a negative margin, but that is a low percentage of total revenue and is a cost that any SaaS company is happy to pay, as it helps drive in more subscription contracts.
Workday Q2 2023 Earnings Report
Workday has achieved consistent revenue growth over the years. Between 2018 and 2022, subscription revenue grew 26% CAGR, from $1.8 billion to $4.5 billion, as shared by the company during the recent Financial Analyst Day . Some of the growth was generated organically, however, over the years the company has acquired a number of small competitors and integrated their services into Workday’s full suite. For example, during fiscal year 2022 WDAY acquired the companies Peakon ApS, Zimit and VNDLY for an aggregate value of about $1 billion.
Management has been successful in the past in integrating the various tuck-in acquisitions, and I have no reason to believe this won’t continue in the future. Thanks to this strategy, the Total Addressable Market of Workday has grown tremendously over the years and the company now sees a total addressable market ("TAM") of $125 billion, expanded since the company’s IPO in 2012 when it was only $39 billion.
Workday Financial Analyst Day
Despite a huge and expanding TAM, Workday has to confront many other companies as competition in the field is fierce. The enterprise software market often sees the entrance of new players and the launch of new products, a reflection to ever-changing needs of the business customers. The list of WDAY competitors is long, and names such as Oracle ( ORCL ) and SAP SE ( SAP ) are definitely on top of it. There are then companies that only compete against certain applications offered by Workday but that nevertheless are a threat for the company, such as Coupa Software ( COUP ), Anaplan, or even Microsoft ( MSFT ). The ability of Workday to offer a solution to so many different business needs is actually quite an advantage, as it provides its customers with consistency and simplicity against the highly fragmented and confusing enterprise software market. Customers clearly like Workday’s products, as the company already serves more than half of the Fortune 500 companies, and more than 70% of the top 50. In total, about 9,500 customers and over 69 million users utilize Workday software at their job every day.
Great results as of late despite macro concerns
Workday Q2 2023 Earnings Report
The most recent quarter (Q2 2023) was well accepted by the market, as the company posted 22.8% growth in subscription revenue, and Non-GAAP EPS was $0.83 (higher than expected). The company also maintaining full year guidance of 22% growth in subscription revenue. Subscription margin for the first 6 months of the fiscal year was about 82%, slightly down from last year's 83% but overall in line with the historical trend. The numbers were very good overall, not much to add as Workday has always been an example of sustainable growth. During the call , management has called out that despite the macro environment deteriorating, they did not see yet any effect on customers:
We are very cognizant of macro environment heading into the second half of the year, and so we are taking a cautious stance on hiring, but we didn't see any slowdown in July. It was about as strong a month as we could have hoped for.
Nevertheless, management has also started to see a slowdown in the sales cycle as potential new customers are starting to become more frugal in their spending. This could potentially impact full year results in my opinion, as the majority of new deals happen during Q4 due to seasonal cyclicality. Further deterioration might impact growth, but there are not many early signs of that. Definitely something to monitor for the future quarters.
The balance sheet is also in good shape as per the last report, with $6.2 billion in cash and cash equivalent, and $2.9 billion of long-term debt. The cash flow from operations is generally quite predictable for businesses that generate revenue primarily through subscriptions, and as such Workday could tolerate even much higher levels of debt in my opinion. It is worth mentioning how stock-based compensation ("SBC") is quite high ($1.1 billion in the last FY2022) however its growth has been slowing considerably over the decade that the company has been in the public market. I am not worried though as by operating this way the company retains a lot of cash that is being used for growing initiatives, both organic and through acquisitions.
The question with SBC is always about long-term value. Is the cash retained by the company put at good use? While doing so, is the share dilution under control? I believe both answers are a clear “yes” in WDAY’s case. Since 2017, total outstanding shares grew only about 4% per year, which is not nothing but is also not too worrying if the company is sustainably growing fast. At the same time, the cash is used for boosting the company’s growth and attracting more customers. Workday’s products are sticky in nature: once customers adopt Workday as the platform of choice and its employees get used to the software, they will become reluctant to change over to a competitor as it is somewhat onerous. The hope is that eventually the company will generate enough cash to reward shareholders directly through the use of share buyback programs for example, which would actively counter the share dilution put in place by SBC.
The valuation is attracting if the targeted growth will be achieved
It is not that easy to value Workday as the company is clearly reaching some scale but at the same time it is still investing a lot of cash right into the growth of the business. Non-GAAP P/E, which excludes the impact of stock-based compensation and other non-cash expenditures stands at 42, much cheaper than WDAY’s 5 year average of 97 but still expensive in absolute terms. On a P/S ratio the company is currently valued at 6.6, which is actually attractive in my opinion as management is targeting 20%+ growth for the foreseeable future. More specifically, management targeted $10 billion in revenue, which at projected growth rate would be achieved in FY2026, as well as long-term 25% non-GAAP operating margin and 35% operating cash flow margin. Considering a non-GAAP tax rate of 19% (as in FY2023), once the target will be fully reached the company would be valued at Non-GAAP FY2026 P/E of about 19 based on current levels, which is obviously very cheap for a fast growing business.
Based on this assumption, at today’s price Workday seems like a good candidate for an entry point and a very intriguing long-term idea if you believe in management’s growth targets. I happen to think that there are good chances they will be able to pull it off, and as such will look very closely at the next results due most likely in late November.
For further details see:
Workday: The Selloff Has Created An Opportunity