Workday: One Of The Better GARP Investments In The Enterprise Software Space (NASDAQ:WDAY)

Workday’s position as a recession impends

Workday, Inc. (NASDAQ:WDAY) is not the most obvious pick for investors concerned about the impending recession. After all, this is a company whose raison d’être is based on providing solutions for HR and for Finance of enterprises of all sizes. It is obvious that with hiring slowing, and with financial apps not considered by some commentators as a top of the mind requirement for most enterprises, growth in demand is likely to be soft, and revenue growth metrics are going to be depressed. Except, so far that hasn’t really proven to be the case, and there have been no signs that demand for Workday is at the edge of a precipice.

The thesis regarding an impending demand downturn for Workday is well known, and broadly discussed, and the company has quietly been taking appropriate steps to prepare for any storm including slowing its hiring cadence, and continuation on a focus of ensuring additional market share gains. It has been more than 2 years since I have written about WDAY for SA. Since that time, the shares have risen and fallen, more or less in step with other enterprise software companies…as of Friday’s close, they had lost a bit more than 10% over the past 2+ years. The IGV, a software ETF, is flat over the same span, while the WCLD, an ETF whose constituents are cloud based software equities, has fallen about 30%.

I think it is time for long-term investors to reconsider this name not just because of how much the shares have fallen in the last several months, but also because the company continues to be a share gainer in several key markets and its product initiatives have led to an expanding TAM (total addressable market). And it is worth considering because this is a cash-generating company with expanding free cash flow margins.

Will Workday’s business withstand the upcoming recession? The real answer is that no one knows, and pretending to know is a disservice to investors. But what I can say is that for a variety of reasons, the impact of a recession on Workday’s business is likely to be less than feared, and less than seems baked into the current valuation. No, I don’t expect that WDAY shares will be the most exciting holding in the software space when the recovery comes. But, of course, excitement can be found in the eyes of the beholder. On the other hand, with compressed valuations coupled with a surprisingly strong business outlook, and excellent execution, investing in this company makes sense to me as part of a growth portfolio in the software space.

I do want to make clear that this isn’t a call about a bottom, or that I have any expectations that WDAY shares are going to appreciate when everything else in the space is deflating. The shares fell 10% just in the last week which ended 9/16, for no other particular reason than that they were shares in a large enterprise software company and the market as a whole was falling based on fears of inflation and recession. I am not a technical analyst; perhaps the shares are oversold, but I will leave others to make such a call. I think WDAY should be on the shopping list of anyone looking for a company with market leading technologies in three large, high growth spaces with a strong management team that has built a profitable business despite, or some would because of, competitors such as Oracle (ORCL) and SAP (SAP). It has executed well for many years now, and I believe it will continue to execute at a high level during these difficult times.

This latest week, markets fell broadly based on the most recent inflation print coupled with very weak guidance provided by FedEx Corporation (FDX). Equities are now said to be pricing in a hard landing scenario. I am not about to offer any prognostication with regards to landings, hard, soft or in between. Workday does not exist outside of the economy, and if the economy is worse than expected, at some level that may impact Workday’s ability to grow. I am not trying to dispute that; what I am pointing out is that much of this is clearly priced in, and that WDAY is likely to fare relatively better than rivals in a hard landing scenario.

Workday once again reaffirmed guidance of revenue growth of about 20% in its first major in-person sales event, Workday Rising, that was held last week in Orlando. It also reaffirmed its target of $10 billion in annual revenues. While the company hasn’t and doesn’t explicitly provide multi-year growth forecasts, the $10 billion revenue expectation basically requires just another 2 years of continued growth beyond the current consensus forecast for next year.

Workday currently has more than $6 billion of cash on its balance sheet, and it is generating almost $1.3 billion/year of free cash at this point, so some kind of significant, presumably accretive transaction can’t be ruled out. Cash now represents 15% of the company’s market cap, so either there will need to be a more robust capital allocation strategy or an acquisition. Of course the company has about $4 billion of debt as well, but most of it was borrowed earlier this year and is not due until 2027 and later.

Like most software stocks, the shares of Workday have fallen sharply this year, down by 44%, and they are now down by 49% since they reached an all-time high in November, 2021. Over that span the company has continued to achieve growth of revenues at just greater than 20%, while earnings and free cash flow have also achieved robust growth. At the time of the last earnings release at the end of August, the company maintained its revenue growth guidance despite the macro environment, and despite some FX headwinds.

Workday reported some signs of lengthening sales cycles and increased deal scrutiny in the quarter it reported at the end of May. At that time, despite reporting a strong quarter, the company talked about some deal slippage that impacted the growth in backlog, and also referenced macro headwinds. The shares wound up falling by 6% the next day, and they continued to fall thereafter, reaching a low point for the year on June 22nd, before rallying with the rest of the tech market.

While the results for fiscal Q2 which were announced on 8/26 were better than feared and some of the slipped deals from Q1 bolstered reported results and led to a strong gain in backlog, and while guidance was maintained, the reaction of the shares was quite muted; up a couple of percent on the day after the earnings release, before falling a bit along with the rest of the market, and then rising with the market the last few days. The share price is lower now than it was after the release of Q1 earnings, which means, given the company’s growth and its increased free cash flow forecast, that its valuation has continued to compress.

At the time of the call, the company reported that results in July were consistent with expectations, the exact language was that “July was about as strong a month as we could have hoped for.” The company reported backlog, essentially similar to the RPO balances reported by other companies. The Q2 2 year subscription backlog balance reached $8.37 billion at the end of the fiscal quarter, which was growth of 22% year on year, and 5% sequentially, while the total subscription revenue backlog was $13.47 billion, growth of 27% year on year, and of 6.5% sequentially.

The company’s guidance was reasonably consistent with prior expectations, and in this environment, and given some of the negative expectations with regards to the specific set of solutions this company sells, that has to be considered a win. In fact, while maintaining expectations with regards to revenue growth, the company actually increased its margin guidance a bit. The company CFO, Barbara Larson, indicated that guidance, based on the growth of the backlog, and the momentum in the last couple of months would ordinarily have been increased. But the macro environment, and some signs of lengthening large deal sales cycles were factors that led the company management to decide to keep its forecast consistent with prior levels.

The 3 most significant competitors of Workday are Oracle, SAP and Microsoft (MSFT). All of these companies, are, to be sure, much larger, and have far broader product offerings when compared to Workday. But I think it is fair to say that despite macro headwinds that are undoubtedly having some demand impacts, the magnitude of those impacts can easily be overestimated. The ability of Workday to grow in the 20% range at its scale and with its market share, even with those headwinds speaks volumes regarding the strength of the company’s position in its specific markets as well as to the strength of those markets themselves.

Workday’s Analyst Day – an update in terms of its functional capabilities

I have to confess that reviewing a company whose specialties are human resources and financial software can be a daunting task. I mean, just how fascinating can HR and Finapps actually be? Turns out, more interesting than some readers might imagine. From the start of covering this company when it emerged as an IPO in 2012, I always wondered about how a company that specialized in the HCM sector would be able to achieve functional differentiation. Of course, the fact this was one of the first Cloud first software vendors was significant in that regard. And the fact that one of the co-founders of the company was Dave Duffield, who had led Peoplesoft until its acquisition by Oracle, meant to me that Workday was likely to be a special business. Mr. Duffield has now retired, although he is still Chairman Emeritus-he is now 82, but the company is now led by his long-time colleague and co-founder, Aneel Bhusri, who is highly competent and well regarding, along with Chano Fernandez, the company’s co-CEO.

The company held its first in-person sales meeting, Salesforce Rising since the start of the pandemic. These kinds of events are meant to showcase new technology, provide a venue for interaction with customers, and to help motivate the field sales force. There are also a number of technical sessions, as well as an updated analyst presentation. In addition, significant customer wins are typically announced; Workday announced that a substantial expansion of its relationship with Salesforce (CRM), which essentially now has acquired the entire set of enterprise financials offered by the company. It is one of the bigger wins for Workday for its finance offering, and at this point, Salesforce has both Workday’s HCM and financials. The company had previously announced that another Fortune 500 enterprise had selected its financial apps this past quarter.

Most of the product announcements at the event were more incremental than epochal. The company announced a new user interface across its product line. The new interface is said to modernize and simplify the user experience. It wouldn’t be modern if it weren’t intuitive and easy to learn. It’s a nice upgrade, but doesn’t really change any market dynamics in a dramatic fashion. There were other incremental enhancements; again this wouldn’t be software in 2022 if there wasn’t some more integrations that were made available. One that was highlighted was with Slack. Many of the announcements were focused on the planning area. Workday bought a company called Adaptive Insights about 4 years ago. Adaptive was then, and remains the principle competitor of Anaplan which was taken private by Thoma Bravo a few months ago. There are probably some incremental market share opportunities that may arise with Anaplan now belonging to a P/E firm. Other announcements focused on additional finapp capabilities, with an emphasis on machine learning as well as an app to focus on ESG goals. In addition, the company announced some additional initiatives for joint development of planning and analytic applications with its partners. Nothing other than incremental and nothing likely to move the growth meter.

The company’s analyst presentation was, as is almost the case, upbeat and didn’t really reflect the macro concerns that concern most investors these days. As mentioned, the company reaffirmed its target of reaching $10 billion of revenues, mainly through organic growth of 20%+. In addition, the company maintained its business model goals. Some time ago the company relied on new name accounts/takeaways for its growth. That made sense at the time. The presentation highlighted that “expands” in the base was now up to 40% of its new annual contract value, double the percentage from a few years ago. But of equal interest was the success that the Workday is having in the medium size enterprise. The company is now leveraging its market position as the leader in the HCM space, and as a strong competitor in finapps to reach beyond the large enterprise. Key to the ability for this company to sustain 20%+ growth through a recession will be market share gains, and extending its selling motion to focus a bit more on the mid-market is a way of growing market share.

The company presented a rather exhaustive insight into its strategy. Trying to encapsulate the presentation into a couple of sentences is never particularly easy. That said, the three takeaways that I gleaned include the concept of connecting the back, middle and front offices, an approach that puts public cloud first and which is built on the technology of Workday Extend, Orchestrate and App Builder. WDAY has architected an API-First platform, designed to appeal more substantially to developers and to partners. Finally, the company is fully embracing AI and machine learning which will be embedded into everything the company offers.

These presentations are commercials, of course, and more directional than specific. I attend lots of them, virtually for the most part, although occasionally in person. My impression based on conversations with sales staff and a couple of users was there was quite a lot of excitement and enthusiasm, perhaps because this was the first in-person event in 3 years. Self-evidently, there was nothing said during the presentation to analysts or the product announcements, that turned out to be significant for the share price in the short term.

Workday’s market share story – the real reason why the shares should be bought

Many analysts seek to avoid making market share judgements, and I acknowledge that much of the time that is a safe stance. In a robust demand environment, it isn’t completely necessary to get market share trends quite right; the rising tide winds up raising lots of boats. So far, despite demand signals by many software companies that reflect economic turbulence, that hasn’t been the case in the markets in which Workday operates. I am not completely sure I can provide some facile answer to account for that. No doubt, some of the explanation relates to the priority that many enterprises have placed on digital transformations which are facilitated by modern, cloud first, AI enabled applications. Presumably, the ROI of these applications is so considerable, that users have prioritized them compared to other applications with “softer” ROI justification.

Workday has become the leader in HCM market share, overtaking SAP and Oracle. Both Oracle and SAP have grown their HCM businesses through acquisition; in the case of Oracle, their solution still is a descendant of Peoplesoft’s app, and in the case of SAP, much of its HCM application is a descends from its acquisition of SuccessFactors. The market for HCM software is growing at a moderate rate of 9.1%; that said, the growth rate of cloud based HCM is significantly greater than 9.1%, and overall, the HCM market with 9% growth has shown a noticeable reacceleration.

Workday, in the Gartner MQ analysis linked here, is a leader in the HCM space, but so too are Oracle and SAP. That said, Workday has been gaining share in the space for years, although its share gains at this point aren’t huge. According to the linked analysis, it is winning these days because of its analytics capability, its integration with its financial app and because it has the most modern set of HR functionality. According to Gartner, it’s not cheap, but the company is easy to work with in terms of procurement.

Workday is also a leader in what is called the Cloud core financial management suites. This space is also has a CAGR of around 9%, and Workday has been a major share gainer in the space since its financial apps became available. The Gartner magic quadrant analysis linked here shows that Oracle and SAP are also highly ranked. When I first wrote about Workday for SA 6 years ago, I commented then that the key to the company’s future would be the level of success it could achieve in this space. That is still the case; the difference is that WDAY has spent the last half-dozen years building a significant competitive position in core financials, and has linked it to planning and HCM for a formidable competitive presence. The Gartner review cites consistent year-over-year customer satisfaction as the greatest strength for the company. Other strengths are the fullness of its analytics offering and its leading planning capabilities. While so far the company has been more successful selling its finapps in the services than the product verticals, that is apparently changing.

Typically Workday wins against Oracle, its most frequent competitor, because it enables users to go live far more rapidly, and it offers much less complex set of what are described as post-go-live complexity. This in turn, has led to significant market shares gains as can be seen in the blog linked here.

The combination of user satisfaction, a rapid go-live cadence, and less complexity have all been major factors driving market share gains. As mentioned, these days, Workday is getting 40% of its new ACV from adds by existing customers. That is far less heavy lifting than having to find large new name accounts to forklift replace existing installations of competitors. Happy customers are typically growing customers.

Workday’s demand resiliency-some thoughts

While I am a long term investor, and try to provide insights into the longer-term opportunities and pitfalls of the company’s I research, it is inevitable in this environment to consider things such as demand resiliency in a recession. While labor market signals are neutral or contradictory, I can’t think there is much doubt that a global economic contraction is either underway or impending. The earnings miss announced by FedEx and some of the current conditions reports from regional Fed surveys highlight this if more highlighting is needed. Regardless of my own views as to Fed policy and the inability of policy makers to really be forward looking, the economy is responding to numerous imbalances and there are cracks in the demand picture. And while not totally universal at this point, those cracks are spreading to enterprise demand.

As it happens, at this point, Workday’s business, and so far as it goes, the business of its major competitors including Oracle, SAP and Microsoft (Dynamics 365), simply haven’t seen the demand weakness that many other enterprise software companies have been reporting. Of course, this hasn’t done much to spare Workday’s share price so the issue is whether the share price is foretelling of demand issues or whether market participants just haven’t considered factors that have led to demand resiliency thus far.

I believe that there are three basic reason why so far at least, demand for Workday solutions have proven to be resilient. One of these is vendor consolidation. Typically, in a constrained budget environment, businesses try to minimize the number of their vendors. Whether or not that makes sense, it is a tactic as old as the space itself. The concept is that by focusing what spending is available on a few vendors, company’s ensure that mission critical priorities are funded, while newer projects, whose worth has yet to be tested, are delayed. Workday, and indeed some other vendors such as Oracle, SAP and Microsoft are beneficiaries of that practice, and will continue to be beneficiaries.

A second factor is market share gains. My background, for readers/subscribers unfamiliar with it, is in sales and marketing roles of various kinds in software companies. Of course that was a very long time ago, and much of what I learned is probably thought by some to be less relevant in 2022. But when I evaluate demand signals, market share is a lodestar for me. I appreciate market share gainers, and strategies that deliver market share gains. And it is self-evident, I think that Workday has been and remains a market share gainer based on all the statistics I can glean, and for the reasons I tried to summarize earlier.

The final factor is that the problems that Workday solves really are mission-critical. I really hate that phrase and it is overworked to be sure, but many of the problems that Workday solves for its users are of signal importance. While of course, essentially 100% of enterprises have some form of finapps, and almost all enterprises have HCM software, most of these systems are old, inefficient and cost too much to maintain for the value they provide to users. Further, even today, many HCM and finapps solutions are run on on-prem infrastructure which requires payroll and physical resources that are not available in a constrained budget environment.

For example, one of the current concepts in finapps software is what is called an all-in-one financial management suite. As the name suggests, this solution combines many separate apps into a single unified offering. It is a very high ROI application, and its benefits are really easy to quantify simply because it is all about replacing legacy offerings that are so expensive to maintain and which are often very inflexible and difficult to use in a changing environment. Just about all users want to integrate their planning and finapps for obvious reasons. Just about all users want to eliminate different systems for each department or business unit within a company. Workday is one of the leaders in this trend with what they call an Enterprise Management Cloud. I have linked to their commercial, as well as to the Gartner prediction called: “The office of finance is consolidating applications.”

With regards to demand resiliency in the HCM space, lots of it has to do with cloud migration. But in addition to cloud migration, there are some new HCM requirements that continue to evolve. Many of the newer requirements have to do with analytics and compliance. Workday’s time to benefit in HCM is very short, mainly because it has a no-code solution that makes it easy for current HR employees to learn how to drive the system. If there is a single unifying thread in Workday’s competitive advantage, it is rapid time to benefit. These days, Workday HCM is mobile first, which is a big deal for many users. I believe that the odds are that HCM demand for Workday will be a little less resilient than demand for finapps, but not a complete wipeout, either. Just for the record, while I think demand resiliency for HCM may be challenged to an extent in future quarters, and the company’s forecast is consistent with such challenges, in the recently reported quarter the company won substantial new name deals with companies including Electrolux, Korean Air and Raymond James.

Workday’s business model

Workday is a profitable company on a non-GAAP basis and generates substantial free cash flow margins. Before discussing the specifics, I will note for those interested in such things that the company’s stock based compensation expense is around 20% of revenues. It has been in that range for some years now. There are many readers and commentators on SA who focus on that metric; I have previously expressed my opinion which is quite different. I am well aware of SBC, but it simply is not correlated with valuation-and that is just the least of it.

At this point, the company has used its elevated level of free cashflow to reduce its weighted average share count and I expect that will continue to be the case for the foreseeable future. There is no point in me expressing my view that a focus on share based comp is misplaced and the real financial analysis ought to be around free cash flow margins, gross margins and non-GAAP opex trends.

The company’s non-GAAP gross margin on license revenues last quarter was 85%, compared to 86% in the year earlier quarter. Overall, gross margins for the quarter were 77% compared to 77.5% in the year earlier quarter. This has been a year in which the company returned to normal travel and event expenses which has had the impact of reducing reported operating margins, although somewhat less than had been forecast.

This has always been a company that spends heavily on product development to achieve differentiation from competitors. In some regards, this has created a business model that is similar to that of Veeva (VEEV) and of Atlassian (TEAM), both of whom spend significantly above average on research and development, significantly below average on sales and marketing and wind up with above average levels of non-GAAP profitability and free cash flow.

The strategy has worked over the years for Workday, and I believe it continues to do so. Last quarter, research and development expense was 26% of revenues, compared to 25% in the prior year. On the other hand, the company’s sales and marketing expense level which was 25% of revenue last quarter, compared to 24% of revenue in the prior quarter, is relatively less than many other enterprise software companies. General and administrative expense runs at a reasonable 5.8% of revenue and that compares to 6.1% in the year-ago quarter. Overall, the company’s non-GAAP operating margin this quarter was 19.9% this quarter as compared to 23.8% in the quarter ended 7/31/21. Typically, Workday’s margin pattern is seasonal, with margins highest in fiscal Q4 and lower in the first 2 quarters of the fiscal year.

Through the first half of the fiscal year, the company’s operating cash flow margin was 18.6%. The company is forecasting a full year operating cashflow margin of 26%. There is a strongly seasonal pattern to Workday’s cash flow margins which peak in Q4 and are expected to do so this year as well.

The company’s longer-term forecast, i.e. over the next 3 years, calls for non-GAAP operating margins to reach 25%, with operating cash flow margins of 35%. The strategy of using research and development to create pricing power, improve gross margins and to optimize sales and marketing spend has worked for this company and I have every reason to believe it will continue to do so, at least when the economy returns to a less turbulent pattern.

Workday’s valuation – summarizing the recommendation

Last week was a dire week for equities, and IT growth stocks have fared more poorly than most other asset classes. This has left WDAY with an estimated EV/S of less than 5.5X. In the wake of the FedEx warning, investors seem to believe that almost all estimates, regardless of when and how they have been composed, are suspect and are likely to see downward revisions. I think this concern is perhaps a bit overdone, and in the case of WDAY, more overdone than is the case for other software businesses with a compressed valuation.

WDAY’s Rule of 40 valuation is about 40, which has left it below average in terms of that metric, with probably more visibility than most of its peers. The company has been a share gainer for years in both of its major verticals, and nothing has taken place to change that dynamic. Its non-GAAP gross margins have been stable for some time now, and despite the macro environment, there is little to suggest pricing pressure. The company is now getting much of its growth from expanding the usage by its largest users and selling a rising number of medium sized users.

The question of demand durability during a recession is subjective, at best. WDAY was a nascent company when there was last a recession so historical analogs really aren’t particularly helpful. The conventional wisdom, particularly as it applies to HCM, is that when unemployment starts to rise, HCM seats for this company, as well as other competitors will start to stagnate or decline. That obviously hasn’t yet happened, and yet it has already been considered as part of the guidance the company has provided. It can be difficult to evaluate the strength of the secular tailwinds vs. the current economic turbulence; WDAY actually gave guidance just a bit more than 3 weeks ago and its guidance already took cognizance of macro headwinds.

I have no belief that WDAY shares have any significant probability of appreciating during this bear market. The shares didn’t appreciate a few weeks ago when the company reaffirmed revenue growth guidance, and increased estimates for operating margin and cashflow generation. And the shares didn’t appreciate in the wake of an upbeat investor presentation that featured a signature 78,000 seat finapps win at Salesforce. So, they aren’t going to appreciate while tech sector valuations keep compressing. Two years ago I described Workday as a quintessential GARP investment in the enterprise application space. The fact is that is still the case. It may not be the most defensive GARP investment, but I believe it represents excellent value for money and I believe it will create plenty of positive alpha over the coming years.