2023-10-30 09:32:13 ET
Summary
- Workday's stock has fallen from its peak in September, owing to macro conditions and higher interest rates.
- The company's growth is slowing down despite the company citing a market opportunity of over $125 billion with less than 5% current penetration.
- Offsetting growth deceleration, however, are respectable margin gains that still put Workday in the "Rule of 40" club.
- Watch and wait for this stock to reach $175 before buying.
It has been a painful few months to be a tech investor, as tech stocks have had to compete with sharply rising risk-free interest rates. When cash is yielding more than 5%, we have to ask ourselves if paying premium multiples for unprofitable stocks really makes sense.
Against this backdrop, Workday ( WDAY ) has shed most of its year-to-date gains, though the stock remains up ~20% since the start of January. With the stock falling sharply from a peak of $250 in September, however, many investors are wondering whether it's time to buy the dip in Workday while it's in a technical bear market.
I last wrote on Workday in June, issuing a neutral opinion on the stock when it was trading in the ~$215 range. Since then, the stock's growth has continued to decelerate (we'll review the company's most recent results in the next section). Though the company has cited strength in emerging vertical solutions such as in the retail and hospitality sectors, Workday can't overcome the fact that most companies are slashing headcount in response to softer macroeconomic conditions - which hurts a company like Workday which prices its solutions per seat.
To me, this is the core disjointed logic with Workday: the company claims to have a TAM of greater than $125 billion:
Yet at the same time, Workday's growth is slowing to the mid-teens. It is already one of the most recognizable names in both of its core markets: HCM (which is essentially HR software) and financial services software. Yes, the company has competitors, but most of them address smaller niches of these larger markets (for example, various competitors focus on the recruiting or talent management side of HCM; on the financial services side, BlackLine ( BL ) focuses just on the period-end close processes). The question here is: if Workday's market is so large, and its penetration of less than 5% still leaves so much room on the table: why isn't Workday growing faster, especially when it seems like it's already the dominant player in these markets?
I remain neutral on Workday, especially given the fact that its high valuation leaves the stock quite exposed in a jittery market that has slashed premium valuation multiples across the board.
Valuation is risky: but watch for the key $175 level
At current share prices near $206, Workday trades at a market cap of $53.65 billion. After we net off the $6.66 billion of cash and $2.98 billion of debt on Workday's most recent balance sheet, the company's resulting enterprise value is $49.97 billion.
Meanwhile, for next fiscal year FY25 (the year for Workday ending in January 2025), Wall Street analysts have a consensus revenue target of $8.45 billion for the company, representing 17% y/y growth. This, in my view, is quite optimistic given growth has already decelerated to the 16% level in the most recent quarter - which basically implies a macro rebound next year, lifting paid seat and subscription counts. The Street is also expecting Workday to generate $6.61 in pro forma EPS, or 18% y/y growth.
This puts Workday's valuation multiples at:
- 5.9x EV/FY25 revenue
- 31x FY25 EPS
While I feel no immediate rush to buy Workday at current levels, I'm setting a price target of $175 for the stock (representing ~15% downside from current levels). At that threshold, Workday would fall to a much more reasonable 5x revenue multiple that balances out its deceleration risks.
Hanging on to the "Rule of 40" while revenue decelerates
We've touched quite a bit on Workday's growth deceleration, but in doing so we haven't yet given Workday enough credit for two items: one, Workday's growth is organic, whereas many software peers at Workday's scale have relied on massive acquisitions to drive growth; second, the company has made up for deceleration by scaling up margins.
Take a look at the Q2 results in the table below:
Revenue grew 16.3% y/y to $1.79 billion, decelerating one point versus Q1 growth rates and slightly beating Wall Street's $1.77 billion (+15.4% y/y) expectations.
In spite of deceleration amid the softer macroeconomy, the company noted that it closed a number of high-profile deals in the quarter. It executed successful go-lives with Nike ( NKE ), Korean Airlines, and Rite Aid, while also closing a government agency deal - its first FedRAMP full platform rollout.
One opportunistic anecdote on go-to-market potential: Workday recently invested in building out a dedicated sales force for its financial services software products. These investments are expected to be fully ramped within the next year, and early indications are that the FINS products cross-sell nicely with the whole Workday platform. During the Q&A portion of the Q2 earnings call , co-CEO Carl Eschenbach noted as follows:
Six months ago, we decided to put a big investment in the go-to-market side, specifically around FINS. And while it takes six to 12 months to get your reps up and ramped, we're seeing early indications of it providing significant leverage in the business. One of the ways it's turned up here this quarter, as Zane just talked about, is we saw a really good growth in a number of new FINS units sold on a year-over-year basis into the market. But it's more than just selling FINS. We're also seeing the knowledge set that we have across the field now with financials is actually impacting our full platform sales. our full platform sales are only accelerating as we sell both HCM and FINS into the market at the same time.
And we saw that specifically kind of into your next question, in the medium enterprise business. The medium enterprise, we see full platform sales very regularly at this point. And I think that's attributed to the build-out of our FINS sales force. And then the last thing I talk about is the FIN sales force helps us continue to drive a land sale with planning."
On the margin side, opex discipline plus a greater mix of subscription software revenue helped Workday drive up its pro forma operating margin to 23.6%, an improvement of 400bps y/y. On top of 16.3% revenue growth, Workday still technically belongs in the "Rule of 40" club (if rounding up!) which does help to justify some level of premium for its stock.
Key takeaways
"Watch and wait" is my preferred approach here, but if Workday does slide to the ~$175 level, I'd take much more comfort in the stock's valuation cushion to take a bullish position. Longer term, Workday still does address an attractive, high-margin market opportunity as it flexes its category leadership across both HR and finance software - but it's all about entering at the right price.
For further details see:
Workday: This Is A Watch List Stock, But There's Further Downside From Here