Workday Shares Have Become A GARP Story - And A Good One At That

by

Summary

This article was highlighted for PRO subscribers, Seeking Alpha's service for professional investors. Find out how you can get the best content on Seeking Alpha here.

Will the current quarter provide visibility into future growth for Workday?

I basically do not try to call quarters. While I try to do a lot for the subscribers of my Ticker Target service, I rarely find myself trying to call quarters. And this article, despite its timing, is no exception. Once upon a time in my distant past as an institutional analyst, it was part of the job. Hedge funds and others expected the effort. Overall, it was a paradigm of the thrill of victory versus the agony of defeat. Needless to say, without an informational advantage, it was hard to consistently provide quarterly calls - and informational advantages are subject to -shall we say significant regulatory scrutiny.

Workday (WDAY) is set to announce earnings for its quarter that ended April 30, 2020 after the market close on Wednesday, May 27th. I am not going to try to call the company’s quarter. The preponderance of the evidence that is more or less publicly available, i.e. commentary from resellers and SI’s suggests that this is not going to be a strong quarter. And given what Workday sells, and the current environment, that is not terribly surprising.

Why write about WDAY shares now? Simply put, the company reported an inflection when it released its earnings at the end of February. Growth, particularly growth in RPO or subscription backlog, showed far stronger trends than had been anticipated. The strength was both far more than had been anticipated and it was strength in all product categories including the recently under-performing HCM segment. In another time, and in another market, the shares would have seen far better performance. Now, of course, fiscal Q1 is to be reported. Expectations are pretty low as mentioned. To a certain extent, the shares are likely to get a free pass since “everyone knows” that HCM bookings must be weak due to the huge loss of jobs across corporate America. Of course I am not going to second guess that - I have no evidence to do so. But neither will I forget just how strong the company had been performing at the end of its prior fiscal year-with the CFO commenting that fiscal Q4 had not been a back-end loaded quarter and thus there was plenty of momentum with which to start the new fiscal year. I will suggest that for investors looking for a recovery name, and feeling that the recent spike in valuations have left them without decent choices, considering Workday shares at this time and this valuation makes sense. Not the excitement of a Shopify (SHOP), or a Crowdstrike (OTC:CRWD) of course, but a reasonable investment, at a reasonable valuation that has gotten overlooked in the panic and then in the ensuing recovery.

Workday shares have been performing relatively poorly over the past year since concerns were raised about the company’s HCM potential growth-they are down by 22% over the past 12 months, which compares to a gain of 24% for the IGV and of 27% for the CLOU index. It is hard to actually rate how investors reacted to the company’s last quarter results which were announced on 2/27. The market had started into free fall at that point, and while the company’s shares were up nominally the day after the earnings release, as March wore on, the shares skidded to a low of $113, or a 34% loss by March 18thcompared the $171 price on February 27th. Since that time, the shares have appreciated by 49%, although they remain below the high they reached on February 18th, and are flat, year to date. By comparison, the IGV has recovered 38%, and the CLOU index (WDAY is, after all a cloud name) has appreciated by 52% over the same span and both have appreciated noticeably on a year-to-date basis.

As a result of this kind of performance, for the first time essentially since WDAY has been a public company, its valuation on an EV/S basis has slipped to average for its low 20% growth cohort, using consensus values for 12 month forward revenue. Over the years, WDAY has become consistently profitable on a non-GAAP basis (yes the company still has far too high a level of stock based comp at 24-6% for my approval) and its free cash flow margin, which reached 17% last year, and almost 26% last quarter is significantly greater than average for its growth cohort which I peg in the low 20% range.

WDAY shares are likely to appeal to a more conservative growth investor. This is not likely to be a story of hyper-growth, and the shares are no longer priced that way, either. This is not Shopify (SHOP) or Okta (OKTA), either. If investors are looking for hyper-growth, Workday shares are not the place to search. The question that is going to be explored in the balance of this article relates to the opportunity that this company has in a post Covid-19 world to return to growth in the low-mid 20 percent range, with continually improving gross profits. I think that will likely happen, and the shares are not currently priced for that expectation, and thus I recommend them.

I haven’t recommended WDAY shares for some time now. In point of fact, in the past I have raised questions about some particular points of accomplishment over the past couple of years, and have suggested that the shares made no sense for retail investors. That was then, and the relative valuation is such that I want to revisit the story. Workday is not a virus stock - the shares are not likely to be first past the post in a virus recovery scenario. This is not a work-from-home story or a new security solution or even an identity management product set. For those unfamiliar with what Workday does, the name is a rather good clue. The heart of the company is its Human Capital Management solutions which are rated #1 by third party consultants and have been for the past 4 years. In addition, the company offers a set of planning and financial management solutions as well as analytics. The applications also are rated top of class by Gartner and others. Perhaps in 2020 not the most exciting set of products and clearly not the products that have been 1st priority for many users. But there are more than a few shoots - green and other bright colors that make it reasonable to look at the name again for a certain class of subscriber to this blog.

When investors have looked at WDAY shares in the past couple of years, the issue has been how fast will financials grow, and how fast will HCM’s growth decelerate. Some time past, the company acknowledged what has been evident for awhile, now; the cloud based HCM space while still expanding with Workday continuing to gain market share - is just not enough to keep the growth rate anywhere close to 30%. The question is: Can the growth in financials start to fill in for the growth hole left by the decline in HCM revenue performance? That is the issue that will be explored in the balance of this article - although to relieve any suspense on the part of readers, last quarter, HCM had a substantial growth spike that was not really anticipated by me or other observers.

Reviewing last quarter and projecting some expectations for the quarter to be shortly reported.

Last quarter seems so long ago at this point, but it is probably worth reviewing if for nothing more than to set the stage. Revenue growth for the quarter was about 24%, better than feared at that time. Revenues for the quarter were about 1% greater than the company had previously forecast.

Non-GAAP operating margin climbed by more than 300 basis points for the full year, but was flat last quarter. Operating margins were also greater than forecast for the quarter. Operating cash flow rose by 42% last year and was 24% of revenue, better than previously forecast. As mentioned earlier, Workday uses a substantial amount of share based comp. That didn’t change in the prior fiscal year, and is unlikely to change greatly in this year.

The company reports a metric called subscription backlog. This metric is essentially the same as RPO of which I have written on several occasions. It rose by 23% year on year last quarter and now represents 2.3 years of revenue-a substantial non balance sheet asset. Backlog growth was more than 15% sequentially, a very strong figure and the strongest figure on a percentage basis for all of fiscal 2020. The quarterly increase in deferred rose by 12% year over year, a significant component of the increase in operating cash flow. That figure too, was the highest of the fiscal year. The RPO backlog is the absolute best way to evaluate to look at the company’s success in the market. There are, to be sure, elements in RPO that vary by quarter and aren’t terribly germane in terms of looking at business success. But that 15% sequential growth was a block-buster number for a business of this size; it was a dramatic and underrecognized inflection that should notionally had lead to a massive share valuation rerating.

Back then, the company provided a rather positive outlook for both the quarter to be reported Wednesday and for the full year; that outlook was more optimistic than analysts had been projecting and was one factor that lead to decent share price performance for a day in the midst of overall market declines. Subscription revenue growth was then forecast to be 22% for the year, with Q1 growth expected to reach 25%. Specifically, the company forecast that its HCM subscription revenues would rise in the high teens, while the revenue growth in FinApps would be in the high 40% range. The growth forecast in HCM subscription revenues was far better than feared, and frankly far better than I expected to see given the saturated nature of the HCM market as a whole which had been expected to achieve a CAGR of 8%-9% over the coming years by 3rd party observers. Self-evidently, that kind of growth implies substantial market share gains in an extremely competitive market, although it appears as though Microsoft (MSFT) Dynamics may be growing a bit faster on an apples to apples basis.

It would be difficult not to be positive about this company’s future if its core technology could actually achieve such a forecast. What has probably happened to HCM bookings since the time of the conference call is an artifact of the time of the virus. Fewer employees, means fewer employees to track which probably has a direct impact on Workday HCM bookings. What hasn’t been discounted, however, is the possibility that the longer-term future of HCM is much, much better than is embodied in the current valuation for the shares.

So, what do I think is going to happen on Wednesday? Needless to say, estimates for Workday have come down since it last gave guidance. The current First Call consensus revenue estimate for the quarter has fallen to $1 billion, which compares to guidance of $1.01 billion-not much of a reduction. That kind of estimate change really doesn’t accurately depict the cut in expectations in response to the economy. Most of WDAY’s revenues in a given quarter comes from the balance sheet, and not from subscription revenues generated in a specific quarter. Even for the full year, which is a better depiction of the anticipated impacts of the economy on this company’s sales performance, revenues which had been expected to be $4.360 billion are now anticipated to be $4.27 billion-just a 2% reduction in expectations. Most likely, the largest elements in sales underperformance will be seen in the metrics for RPO and for calculated billings. Calculated billings growth might fall from the low 20% range that had been anticipated to a high single digit number. I would expect a similar or perhaps greater decline in the percentage change for bookings-this company will almost certainly see some of its customers who themselves are seeing financial issues, cease paying in advance, and building the deferred revenue balance.

The impact of the economy on the company’s earnings and cashflow is not expected to be substantial. No one has published a reduced estimate for EPS, and the analyst at Cowen, who lowered his rating and price target, did so without changing his EPS estimate.

The impact of the economy on Workday’s expected results is certainly no secret. It ought to be obvious that in an economy where layoffs have been huge, there will be substantial pressure on Workday’s HCM business-which employs seat based pricing as its standard. At the least, the acquisition of new users within the HCM space must have been unusually difficult for this company during late March as users tried to react to the shutdown of the economy on their own operations.

I am not entirely sure that current estimates for the quarter to be reported adequately account for an unprecedented situation in the last weeks of a quarter that is typically back-end loaded in any event-although it may have been less back-end loaded this current quarter. But equally, I am not too sure how much most investors/shareholders are going to care. The impact of 36 million layoffs in the economy on this company is more or less history at this point. Just how well the company was able to close business this April is not a great sign-post for how well this company will be able to close business during a recovery scenario.

To reiterate, what seems to have been lost in the weeks since the company last reported was just how strong HCM results were last quarter, and equally how strong guidance was with regards to growth in that sector. In fact, that inflection essentially went uncommented by most analysts as they rushed to reduce estimates to take account of the closing of many workplaces and to find their own epiphany of virus stocks-which certainly never included Workday. In fact, the shares are almost uniquely disdained by analysts in the ratings as reported to First Call, with just 12 buy recommendations out of 39 ratings. The last rating change to be made on these shares was a downgrade by the Cowen analyst in late April who complained that the company was more dependent than some peers in selling to SMB’s during the quarter. I think the analyst at Cowen apparently overlooked the very high RPO ratio and strong growth in that metric I pointed out earlier. Just before the Cowen downgrade, came an upgrade by the Morgan Stanley analyst. Overall, the reactions to either the upgrade or the downgrade have been negligible.

Management speculated that the surprising success that the company had seen in its Q4-HCM results was somewhat influenced by its customers, just below the mega-enterprise level, buying suites. I am not sure what the cause may have been; what I think is fairly obvious is that because of the exact timing of the earnings release, the news was lost in the chaotic panic that marked the first few weeks of March. But besides the spike in HCM bookings, last quarter was a halcyon period for financials. It has been a long, long time coming, and analysts-and that includes this writer-have been speculating about when the company might achieve a real breakout in the growth of FinApps. That time was last quarter.

Regardless of the specifics of the April quarter, the preponderance of investors will be focused on guidance and some forecast regarding the shape of a recovery. The economic situation brought on by a response to the virus is unprecedented. It isn’t something that has analogs in the great financial crisis or the internet bubble. So how a management might respond in terms of forecasting a recovery is a total guess. All I can observe is that the company had a surprising level of momentum when the crisis struck both in HCM and financials, and I have seen nothing that might suggest that the momentum it had will not continue when the economy emerges from its shutdown, both in the US and around the world. I am going to speculate that guidance will be better than feared, at least when it comes to the decline in bookings growth-but that is just a guess on my part and not based on a crystal ball or an informational advantage.

What’s driving the momentum?

The CEO believes that its next large market is going to be financial services. The company closed a major deal at KeyBanc (KEY), a relatively large financial services win, to go with that company’s Workday HCM deployment. As many readers will recollect, the company bought Adaptive Planning just prior to its IPO. KeyBanc wanted a financial solution that included planning as well as transactions on a single platform. That has bee part of the WDAY message since it acquired Adaptive and this is one of the more high-profile wins for a total platform over that time period.

For some time now, this company has achieved growth in HCM because of market share gains, primarily against Oracle, but also against SAP. It appears that the trend accelerated in the prior quarter during which several newer Oracle cloud based HCM Installations were displaced because they could not be deployed. It is hard for this writer to validate exactly what happened to whom and when, and why it happened, but I have little reason to doubt that the displacements, reported by the CS analyst did not take place or were outliers. There is simply no other way for Workday, at the scale it has achieved, in HCM to have high-teens growth in the space without continued substantial displacements of both Oracle and SAP - and that is almost invariably going to be associated with successful or unsuccessful deployments.

When considering acquiring a position in Workday, one of the themes is that its technology - both in HCM and in FinApps have lead to successful deployments, and in turn, successful deployments are a significant factor in the market share gains the company has been able to achieve.

The company’s co-president is Chano Fernandez, basically the head of sales and field operation. Since his arrival, the company has focused on defined verticals such as financial services, professional business services, health care, education, and government. This has proven to be a very successful strategy - in particular, there were large wins last quarter in healthcare and in professional business services. It has taken a couple of years for the strategy to bear fruit…it did so in the last quarter. How much of this will have been disrupted by the impacts of the economy on demand is hard to tell - and not terribly relevant for longer-term investors. The share price, to a greater or lesser extent, is discounting a poor results for the March quarter, and not much in the way of guidance specific to Workday and its recovery.

Last November, Workday acquired a vendor called Scout RFP. Scout is a company with an on-line procurement platform. Workday paid $540 million for the acquisition which was an enormous premium compared to its latest post-money valuation. Scout’s competitors are primarily SAP-Ariba (SAP) and Coupa (COUP). Scout is going to be integrated into other Workday solutions including Procurement and Inventory. Workday has been taking measured steps to acquire capabilities in most significant back-office functionality in order to compete more substantially with SAP and Oracle. The broader footprint should allow WDAY to compete more efficiently and to streamline its overall selling motion. Scout is not likely to move the growth meter greatly in 2020-but e-procurement is a dynamic space and I think the revenue opportunity for Workday is quite substantial. The acquisition of Scout will inhibit the rise in operating margins and in free cash flow by as much as 150 basis points next year. I will just say it here-Scout is not likely to have a material impact on the success of Coupa - it doesn’t need to in order to deliver positively incremental results for Workday.

Do all of these initiatives add up to mid-20% growth for Workday for a couple of years? I think they do - and it is the basic reason why I have chosen to take this opportunity to recommend the shares once again.

Some thoughts on Workday’s business model and wrapping up a recommendation

Workday is a profitable company although even at this point, its profitability remains based on non-GAAP presentations. That has been so for years now, and is likely to remain so for the foreseeable future. I might like to see a different structure in terms of costs so that the company generated GAAP profits, but it is not terribly relevant in this discussion.

Over time, subscription services has been an increasing proportion of revenues, and that is a trend I expect to see maintain into the foreseeable future. Subscription has higher gross margins than professional services. Subscription gross margins reached a bit more than 84% on a GAAP basis last quarter, compared to a bit less than 84% in the prior year. As mentioned, the company saw no leverage at scale last quarter. This was mainly a function of a somewhat more rapid growth in research and development costs than for the other opex expense categories. Overall, research and development expense grew by 25% last quarter and by 28% for the year. As mentioned the company is trying to build-out additional capabilities in many of “back-of the house” applications - it is likely to be a winning strategy.

As mentioned the company has raised its non-GAAP operating margin projection to 14.5% for the current year. I am inclined to believe that this will not happen. The company, despite its size is still growth oriented and it is likely to take advantage of talent acquisition opportunities which will probably result in opex rising more rapidly than revenue.

For the year as a whole, stock based compensation was 24% of revenues. Most of the stock based comp is generated on the research and development line where hiring activities have been concentrated. Stock based comp growth will probably recede this year because of some lesser increase in hiring, but I do not think it will stop, overall, anytime soon.

The company’s free cash flow margin is also continuing to grow. Overall, free cash generation rose by 22% last quarter and was 25.6% of revenues. The company had been anticipating a free cash flow margin to decline in the current year based on a spike in capex. Given that the capex is related to data centers to handle greater transaction capacity I do not think it likely the company will try to skimp on that expense. In addition, the company had budgeted a substantial sum to acquire additional real estate. This company is not a real estate titan such as CRM, but it still manages to spend 5-6% of its revenues on real estate year on year.

There are plenty of analysts and plenty of numbers that have different estimates for this company as it goes through the trough of demand due to its exposure to HCM and the overall slowdown of the enterprise IT market. I have presented such estimates elsewhere. What I think should be the focus of investors was the obvious inflection of demand in fiscal Q4, and the likely continuation of that trend as the virus wanes. The company’s EV/S ratio is around 9X, just about average for its growth cohort - but as explained, the growth opportunities for this company are substantial and not entirely in current growth estimates. The company is far more profitable than average, albeit with a fair amount of stock based compensation.

Unbeknownst to many, the shares of Workday have become a GARP story, and a good GARP story. I doubt that the opportunity to acquire these shares based on a GARP valuation will long continue. I think positive alpha is highly likely for the balance of 2020 and beyond.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in WDAY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.