Workday: Remaining Cautious In The Near Term (NASDAQ:WDAY)

Investment thesis

Workday (NASDAQ:WDAY) will be reporting its third quarter results soon and I take some time to review my analysis of the company. Firstly, based on some checks with Workday’s partners and customers, while the demand for Workday continues to be resilient, there are signs that weakness could come as partners expect more deal delays to come. Furthermore, I find that the company’s expansion into other markets like the Financial Management segment seems to be lacking and not reaching an inflection point, likely a result of a highly penetrated market with strong incumbents. Lastly, the mid-market segment that has been holding up well will likely see weakness in the quarters to come, in my view, as the macroeconomic conditions worsen.

I have previously written an article on Workday detailing some reasons on why I am negative on the company.

Findings after a round of channel checks

Before Workday’s third quarter resulting release on 29th November, I like to do some checks with the channel to figure out beforehand how the overall demand and supply landscape looks like.

I looked to check with 9 partners and customers of Workday to determine how the demand for back-office has shifted, and how the growth outlook for 2023 looks like.

The first finding that I think generally sums of Workday is they are continuing to soldier on despite the relatively tough and uncertain macro. For the Workday partners that I spoke to, they continue to meet or exceed their growth targets for the quarter, which definitely sounds good. However, there are signs that the demand trends look relatively weak as well as these partners continue to see delays in deals. In my opinion, I find that this was a positive surprise given that I would have expected demand for Workday to be weaker than this.

The second finding is that the partners working on the mid-market are seeing better trends than those working on the larger organizations. While I think that this is to be expected, I do expect future weakness from the mid-market in time to come.

The takeaway from my conversations with these partners and customers makes me wonder why the current back-office demand remains resilient amidst the current macroeconomic environment. Some of the reasons cited were the strong pent-up demand as a result of deals being delayed during the covid period, the need to change aging ERP and HR systems in some verticals, as well as the overall gains in efficiency that their customers see when shifting and migrating to a new modern ERP and HR system.

Investor day raises optimism

Workday laid out its plans to achieve its goal of reaching $10 billion revenues and a sustainable 20% subscription revenue growth to get there. Human Capital Management growth was rather durable in the last year as it continued to grow 21% year on year over the last 12 months and remains less than 10% penetrated in the total addressable market of $52 billion.

In addition, there are opportunities for Workday Financial Management segment to grow as it remains less than 5% penetration in the $73 billion total addressable market as it recovers from the headwinds as we move past the pandemic. The Financial Management segment grew 28% year on year over the past 12 months.

The long-term margin targets for operating margins are current at 25% for operating margins and 35% for operating cash flow margins. These new margin targets do imply some upside that management expects to achieve from the operating leverage from research and development and general and administration expenses. The management noted that in the next year, Workday will see an expansion in margins after heavily investing this year.

During the investor day, management continued to comment positively about medium enterprise momentum. Interestingly, the average SKUs per net new customer was up to 9 today, from 4 in FY2015.

That said, the competitive landscape for Workday remains unchanged as many of Workday’s customers are already deeply entrenched with SAP (SAP) on the Financial Management segment and Oracle (ORCL) was strong on the cloud financial management segment, despite Workday’s leadership in the Human Capital Management segment. Conversations with the customers and partners during the investor day showed that they were seeing steady adoption of the Financial Management platform although there remains some prudence due to budget hurdles and cloud hesitancy.

Key positives and negatives from the second quarter

First, management shared that 2 of the larger deals that were pushed out from the first quarter has been closed this quarter. During the second quarter, the key operating metrics continued to remain strong, which underpins the importance of Workday’s role in the digital transformation of finance and HR.

In particular, the second quarter wins were primarily for the Human Capital Management segment as customers continue to migrate to the cloud, with new customers like Raymond James (RJF), Korean Air, Group Adeo, to name a few.

For Workday’s Financial Management segment, it successfully added 2 Fortune 500 customers into the segment. Namely, one of those was Salesforce (CRM), the global leader in customer relationship management. Some of the other new Financial Management customers introduced in the second quarter includes American Electric Power (AEP), Apex Fund Company and the state of Vermont.

I think that Workday’s second quarter print was a much-needed one after its disastrous first quarter results after it disclosed deal delays and reduced guidance. In particular, the guidance for backlog growth for the second quarter was 20%, which was beat by about 1.5 percentage points as the backlog growth for the second quarter came in at 22%. In addition, the backlog growth guidance for the third quarter of 19% was aligned to market expectations and management continued to reiterate full year guidance for revenues as well as increased margins and cash flow guidance.

In addition, management highlighted that demand for July did not see any slow down while demand for August remained decent. The strong mid-enterprise segment was a key positive for Workday as it has a high exposure to the mid-market which is seeing a different reality compared to the large enterprises as they have not seen any belt-tightening thus far. This segment remains more solid as there are fewer deal delays compared to the larger companies.

Valuation

Workday shares are currently trading at 43x 2023 P/E and 33x 2024 P/E. The company will see a decline in EPS of around 15% in FY2023 while growing at 30% in FY2024. I think that the acceleration in margin expansion should bring greater earnings growth over the next few years relative to revenue growth.

I assume a 1-year forward P/E of 30x and forecast the EPS for FY2024 to be at $4.10. With that, my 1-year target price for Workday is at $123, implying 16% downside from current levels. I continue to think that there will likely be near-term challenges for the company and the global macro uncertainties will continue to affect its business in the near-term. In addition, the competitive landscape for Workday looks tough outside of its Human Capital Management market.

Risks

Competition

Workday is currently the leader in its core Human Capital Management market. As it looks to expand into different markets like the Financial Management market, there are entrenched players leading the market that have very strong value propositions that could make it difficult to replace. The easier option for Workday is to capture the part of these markets that have yet to be a customer of a leading player in the segment.

That said, I think that the company is operating in a very competitive market that has relatively lower barriers to entry. As other large players like SAP and Oracle operate in these markets and compete with Workday, they can continue to invest heavily to compete with Workday. Also, competition in the middle market segment may intensify as other players attempt to challenge Workday’s attempt to gain market share in that segment.

Uncertain macroeconomic conditions

As Workday is focused on the back-office functions, it is still unclear how a prolonged weakening of the macro environment may affect the company’s business. If the economy worsens, we could see material downside to Workday’s growth profile as customers take a back seat in spending on digital transformations for the back office.

Security breaches

As Workday provides its software over the cloud, the transmission of its customers’ proprietary data regarding key stakeholders as well as finance data over the internet may pose risks.

Conclusion

With the recent channel checks, I continue to remain cautious about the outlook for Workday. Deal delays are still in the horizon, in my view, as the macroeconomic situation is likely to worsen. This means that the mid-market segment that Workday is exposed to may experience deterioration soon as I take the view as they are not as resilient as what we are seeing today. In addition, strong competitive pressures from other large, leading companies as well as smaller startup companies add to increasing difficulties for Workday to cross-sell and expand meaningfully into new markets. My 1-year target price for Workday is at $123, implying 16% downside from current levels.