Deep Dive – $WDAY

by Enis November 19, 2013 7:33 am • Commentary

As we’ve seen high fliers get hit hard in the past 6 weeks (see TSLA, LNKD, FB, YELP, Z, etc.), one name that has held up relatively well is WDAY.  We first mentioned Workday in our CotD post on September 30th, highlighting its classic, momentum price action of breakout-consolidation-breakout-consolidation.

The stock is still above the $70 breakout level that we highlighted in the post.  However, it is trading below its 100 day moving average for the first time all year:

WDAY daily chart, 50 day ma in pink, 100 day ma in green, Courtesy of Bloomberg
WDAY daily chart, 50 day ma in pink, 100 day ma in green, Courtesy of Bloomberg

When I wrote that post though, what most stood out to me was that Workday was an almost $15 billion market cap company providing “enterprise cloud-based applications” to a diverse customer base.  The company was founded in 2005, IPO’ed in late 2012 at $28 (which was around a $5 billion market cap), and immediately traded to near $50 after the IPO.

That’s a very impressive success story – building a multi-billion dollar business in less than a decade, particularly in a sector as competitive as cloud-based enterprise software.  Workday describes its business model in its most recent 10-Q as follows:

We offer Workday applications to our customers on an enterprise-wide subscription basis, typically with three-year terms and with subscription fees based on the size of the customer’s workforce. We generally recognize revenues from subscription fees ratably over the term of the contract. We currently derive a substantial majority of our subscription revenues from subscriptions to our HCM application. We market our applications to enterprise customers primarily through our direct sales force.

Essentially, Workday provides corporations with a suite of cloud-based software applications to help them manage payroll, human resources, procurement, sales, and a number of other management analytics.  About 85% of its revenues so far in 2013 have been in the U.S., and 15% international.  As Cisco’s recent earnings demonstrated, many companies (particularly in emerging markets, but my hunch is also in the small to mid cap arena in the U.S.) are choosing to use networking and software applications that are sourced to service providers like Workday or Salesforce, rather than build the infrastructure in-house.

The company targets corporations with more than 1,000 employees, and it had more than 500 customers for its services as of July 2013.

Workday’s revenue growth has been quite impressive, rising from around $120 million to around $200 million between July 2012 and July 2013.  Expenses have also risen rapidly though ($165 million to $264 million – R&D was $33 million of the increase), as has the organization itself (1,450 employees to 2,100 employees).  Managing such rapid growth is no small task.

As with many of the momentum leaders in 2013, the strategy on paper is to grow revenues and invest in the business in the near-term, with the hope of profits in the long-term.  Again, from the 10-Q:

We intend to continue investing for long-term growth. We have invested, and expect to continue to invest, heavily in our application development efforts to deliver additional compelling applications and to address customers’ evolving needs. In addition, we plan to continue to expand our sales and marketing organizations to sell our applications globally. We have committed to make significant investments in our data center infrastructure in the current fiscal year as we update our technology and plan for future customer growth. We are also investing in personnel to service our growth in customers.

These investments will increase our costs on an absolute basis in the near-term. Many of these investments will occur in advance of experiencing any direct benefit from them and will make it difficult to determine if we are allocating our resources efficiently. As a result of these investments, we do not expect to be profitable in the near future. We expect our research and development, sales and marketing, and general and administrative expenses as a percentage of revenues to decrease over time as we grow our revenues, and we anticipate that we will gain economies of scale by increasing our customer base without direct incremental development costs and by utilizing more of the capacity of our data centers.

In fact, in the risks section, Workday management acknowledges that the company has never made money:

We have incurred significant losses in each period since our inception in 2005. These losses and our accumulated deficit reflect the substantial investments we made to acquire new customers and develop our applications.

Now, here’s my problem.  WDAY has had 8 years to make money, and does not seem to be even close to achieving profitability (analyst estimates don’t expect a profitable for at least the next 3 years).  But more importantly, what will change in the future that makes this such a great investment?

More specifically, my simple take is that the overall business of cloud-based enterprise software might not be nearly as lucrative as the hype might suggest.  Oracle and SAP are Workday’s biggest competitors, and you can bet that their battle for enterprise contracts is fierce.  Moreover, a company like (an indirect, and potential future competitor) has been a public company for almost a decade now, and though it is profitable, its profit growth has hardly been stellar (the stock price appreciation is a different story altogether).  So the company’s expectation that achieving scale will lead to significant profits seems dubious.

For both WDAY and CRM, revenue growth seems to be matched by expense growth of almost equal magnitude, excluding R&D.  In other words, the businesses don’t show the operating leverage I would expect this far along in its growth cycle.  In CRM’s earnings report last night, gross profit for the quarter increased by $205 million, while marketing and sales expense plus the General and Administrative expense increased by around $193 million.  So almost no operating profit, NOT including R&D expense.

Maybe Workday’s applications are so innovative as to blow the competition out of the water.  But a human resources application that is indispensable?  Somehow, I find that hard to believe.

Perhaps the most informative part of Workday’s quarterly statement is its discussion of the risks.  To me, Workday is in a business with no major moat, no clear distribution or pricing advantages, and increasing competition as far as the eye can see.  While the stock can certainly go higher anyways, I wouldn’t touch this stock on the long side with even my enemy’s money.