New Trade – Just Getting Through the $WDAY

by Dan June 23, 2015 3:00 pm • Commentary

In late May I took a look at cloud based human resource applications provider Workday (WDAY) prior to the company’s Q1 earnings report, and concluded the following:

the problem with WDAY is two fold, an inability to turn a profit since its inception despite sales growth that has been above 50% and should be about 45% this year to $1.1 billion.  The stock trades 15x sales and has nearly an $18 billion market cap.  This juxtaposed to CRM which is expected to have nearly $7 billion in sales this year, mildly profitable, and only trades about 7x its sales with a market cap around $48 billion.  I can’t believe I just made an argument why CRM is cheaper than WDAY, but you can see how this M&A stuff can quickly get out of hand.  I suspect there are many out there who feel that if MSFT were to buy CRM then ORCL or SAP would make a $25 billion bid for WDAY.  Seems a bit nuts, the size, but who knows in an environment like the one we are in? If you are a CEO of a major tech company I suspect you have more cover when things go wrong if you bought best of breed as opposed to a second tier player with a ridiculous valuation.

Unfortunately for WDAY, Q1 results and current quarter guidance did little to advance the notion of potential profits and the stock got hit 11.5% the following day as result of the weaker than expected forward guidance. The company is facing growing competition that has weighed on pricing, particularly on large deals, and thus profitability of deal signings.  WDAY has also expanded outside the U.S. and felt the adverse affects of the strength of the dollar.

The stock is now down about 1% on the year, and down 15% from the 2015 highs. For the better part of the last year the stock has traded between $77 on the downside and $95 on the upside, with the 200 day moving average about $85.50 (yellow line):

WDAY 1yr chart from Bloomberg
WDAY 1yr chart from Bloomberg

Options prices on a short dated basis are now at all time lows, with 30 day at the money implied vol at 28.5%:

WDAY 1yr chart of 30 day at the money IV from Bloomberg
WDAY 1yr chart of 30 day at the money IV from Bloomberg

Despite options prices being cheap, they could prove to be expensive in a low vol environment in a stock that does not have an identifiable catalyst for 2 months.  The company will not report Q2 earnings until late August.

WDAY looks like it found a bit of support at $80, and with software stocks like (CRM) and Adobe (ADBE) at or near all time highs, I suspect WDAY could retrace a bit of the earnings gap back towards its 200 day.  I want to define a range where I believe the stock could trade back to, but do so in manner where I define my risk, and mitigate decay, thus an in the money call butterfly.  Here is the trade:

Trade: WDAY ($81.10) Buy July 80/85/90 Call Butterfly for 1.40

-Buy to Open 1 July 80 call for 3.00

-Sell to Open 2 July 85 calls at .95 each, or 1.90 total

-Buy to Open 1 July 90 call for .30

Break-Even on July Expiration:

Profits: up to $3.60 between $81.40 and $88.60, with max gain of $3.60 at $85

Losses: up to $1.40 between $80 and $81.40 & between $88.60 and $90, max loss of $1.40 below $80 and above $90

Rationale:  This spread is in the money, helping to offset most of the decay (only .30 of the trade is extrinsic premium, the other 1.10 is intrinsic), and offers a break-even less than 1% higher than current levels while targeting the stock’s converging moving averages.