[Investing Research] Workday - WDAY
Looking at Workday, the HR & Finance ERP provider, using Phil Fisher’s 15 point investment checklist. A first pass of the company from the 2019 annual report, proxy statement, articles on culture and personal anecdotes from my accounting/consulting days.
1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
What does the company do? It provides enterprise cloud applications for finance and human resources. It’s Oracle in the cloud.
It was co-founded in 2005 by the founder of Peoplesoft (Oracle’s HCM product) and the VP who ran Peoplesoft for 11 years after it was acquired by Oracle. Naturally, WDAY started as a HCM product that built out the Workday Financial Management (WFM) product.
WDAY makes money through subscription and professional services. Subscriptions are the contracts clients pay to use the software and the professional services are the training and deployment/implementation of the software. Subscriptions are 85% of sales and professional services are about 15%. Generally, subscriptions tend to be contracted for 3 years and are invoiced annually in advance. That gives them a nice chunk of cash early to reinvest. And much less of an issue of clients saying they won’t pay their software bills for ‘tough months’ (i.e. COVID rent/debt deferrals).
HCM is still the crux of the business with 81% of the subscription revenue coming from that product and 19% from WFM.
WDAY’s main clients are large and medium enterprises. Most are in North America (75% of revenue) with 2.2K+ and some 600+ in the rest of the world making up 25% of revenue.
If I were to think about market penetration, WDAY’s HCM product is in 40%+ of the F500 and 50% of the F100. This is keeping in mind that WDAY concentrated in a few industries (Healthcare and Energy) and is still expanding in Professional Services and Financial Services.
So is there room for WDAY to expand into the remaining F500? Sure. But it won’t be easy. WDAY is really banking on all large companies to move to the cloud and though they have 40% for the F500, 25% is taken by competitors (mainly SAP/Oracle) and they see a market opportunity set of 35%. Realistically, they probably can’t nap all of them.
This means they have to look at the global market. WDAY calls this the Global 2000 (G2K) and in this market, they have 17% market share with 13% taken up by other cloud HR vendors. They see this 70% gap as their opportunity and with a 60% win rate, odds are, they have a chance of taking over 50%. Not saying they will. But if they can maintain the win rate into the new industry verticals… there is a reasonable chance.
Given their dominant position in HCM cloud products and how they’ve been able to challenge Oracle and SAP, who’ve been slow to move over to cloud products… I’d say there is sufficient potential to see continued increase in sales for the next few years. From 2016 to 2020, sales have grown at a CAGR of ~33%. Though WDAY has been driving expansion in their TAM with more products, I’m not sure how long-term their growth could possibly be.
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
Given WDAY’s track record of continue product expansion through product development and acquisitions, as can be seen by how they expanded their TAM from just HCM, I’d say so. The company doesn’t have an explicit mission statement and I’m not sure what drives the co-founders to continuously grow WDAY. I remember hearing a rumour that there was some spiteful tension between Larry Ellison and the WDAY Co-founders… I think Larry Ellison openly said WDAY was public enemy no.1…. So this ‘rivalry’ doesn’t seem to be anything too imaginative on my part.
Hopefully….. crushing Oracle isn’t the key determination. But, the co-founders are also pretty invested in the company. Co-founders (Dave Duffield - Chairman and Aneel Bhusri - CEO) have 77% voting control of the company through Class B shares. They have less than 1% through the Class A shares (the ones listed on the public market) but if the Class B’s were converted, the Co-founders would collectively have 32% of outstanding shares. Bhusri is 54 years old and I imagine he is in no hurry to retire.
WDAY has been in operations for 15+ years and it still has negative income. The main reason is the continued investment into Product Development (PD) and Sales & Marketing (S&M). These two expenses make up 75% of the revenue. So, management is putting all the dollars to work in building more products and growing the company continuously… though it’s important to keep in mind that stock-based compensation (SBC) was 24% of sales and 70% of it was attributed to employees in PD and S&M. Technically.. SBC isn’t a cash outflow immediately and it can be used as a tool to align long-term incentives….. But I am indeed a little uneasy with how large a portion it is for the company… and how the business wouldn’t have any operating cash flows if they didn’t back out SBC from net income… But, if that is the tool they are using to attract talent and invest for growth. Then management definitely is determined.
3. How effective are the company's research-and-development efforts in relation to its size?
This would be the PD department. One can look at the sales growth (33% CAGR over a 4 year period) or it’s leading share in HCM cloud services as proof that R&D seems to be working as that is their core product. It’s ability to expand into finance ERPs is also worth considering a feat… even if they don’t have a dominant position there since the giants (SAP and Oracle) have a foothold.. though it is mainly in on-premise products.
If I were to use employee compensation (estimating around 70-80%) of the PD and S&M to capitalize that as part of ‘capital employed’ in the business over a 4 year period (their Restricted Stock Units vest over 4 years and are forfeited if people leave before then)... and calculating my own version of owner’s earnings taking out the reinvestment capital from operating cash flows… I get return on capital employed of ~30% over the last few years. Decently effective.
If I include goodwill and intangibles to account for management’s capital allocation ability through M&A… the ROCE falls to ~20%.
4. Does the company have an above-average sales organization?
Based on the above numbers… I’d say so.
Something else to take note of is how WDAY sells. A core part of their strategy is using consulting/technology deployment partners. I became familiar with the company back in my consulting days when I had peers specialize as WDAY deployment consultants. It was such a huge income opportunity for the firm that most consultants were encouraged to become WDAY consultants. Oracle and SAP deployment consultants were commonly out of work and had to become proficient in Guidewire or WDAY.
Also.. unlike Oracle, SAP or Guidewire.. WDAY required the deployment consultants to take training courses and get a license. All this was paid for by the consulting firm but all consultants had to get certified. I was part of a Guidewire implementation and this ERP didn’t have such a barrier. Neither does Oracle or SAP… this was something completely unique to WDAY and I think it’s a core part of their sales process… because the consulting firms invest a lot of money to get these licenses for their consultants. Once the consultants have the license… they will spend all their consulting lives only working on WDAY deployment projects since that’s what the firm invested in for that consultant. It creates a nice internal sales focus through the deployment partners.
5. Does the company have a worthwhile profit margin?
Well.. by GAAP measures… Nope. They do GAAP adjustments for the SBCs to get some Operating margins but I ignored those. If I were to capitalize the PD and S&M expenses, I do get a 40% margin. With 10-year gross margins (GM) at 67%, that’s pretty worthwhile.
Something to note is that though WDAY has 2 revenue segments (subscription and professional services), the GM for subscriptions is 81% while professional services is -8%.
6. What is the company doing to maintain or improve profit margins?
WDAY boasts a 95%+ retention rate over the last 5 years. They are definitely doing something right. As their contracts are typically in 3 year increments, plenty of customers seem to be staying with them.
It’s not unusual for ERPs. The reason people love these businesses is that they are incredibly sticky. They are essential for operating your business, they don’t cost you materially, and they can take years to implement (deployment + training… which can take 1 year for a small company to 4 years for a large one).
Even the sales cycle for WDAY takes 6 to 18 months. The barrier to entry is decently high and as far as for the F500 clients… it probably will only have a handful of players competing against one another (probably SAP, Oracle, WDAY for HCM and one other industry niche player).
WDAY’s moat is really in the switching cost and brand value. ERPs are really a commodity. Sure, WDAY is great at cloud but that is part of their brand. When a Finance or HR exec decides to implement an ERP, they aren’t going for something innovative. They are going for trustworthy, stable and reliable. It’s all about downside protection. It’s a place that costs a decent amount of money to implement and the place people will still slash the budget on with every chance they get.
During my consulting days, ERP projects were the largest in income size but the lowest in ROI because billing rates were so low. When I talk to friends who are finance execs, they are doing everything they can to cut budgets and fire consultants as soon as possible. No one likes implementing ERPs. So….. when you know there is all kind of pain involved, you go for the brands. Kind of like when you pick an auditor. Though it’s the new kid on the block… WDAY has managed to quickly become that brand. It’s no SAP or Oracle but it’s definitely there with HCM.
7. Does the company have outstanding labor and personnel relations?
At first glance it seems so. Management highlighted in their 2020 proxy statement:
"being ranked #1 on San Francisco Business Times’ Best Places to Work in the Bay Area list, #1 on the UK’s Best Large Workplaces list by Great Place to Work Institute, #4 on the 100 Best Companies to Work For list by Fortune and Great Place to Work Institute, and #1 for the second year in a row on the Fortune Future 50 list, which recognizes the global companies with the strongest long-term growth potential."
It also boasts a Glassdoor rating of ⅘ with 1100+ reviews and 96% approval for Bhusri. The annual report and proxy doesn’t shed further light on how they think about the employees other than the usual fluff: our people are important, we care, core values blah blah. But nothing concrete.
I don’t know what their retention is but it appears that WDAY doesn’t pay as well as their competitors. At least, that’s what they say in their annual report and is a common complaint on Glassdoor. This may also be why there is some criticism as to how they tend to attract a less experienced talent base (i.e. college grads vs. 20-year veterans).
From whiffing through interviews by senior leadership and the WDAY blog there is mention of leadership programs for people leaders/HR folks and how they have weekly surveys every Friday from partnering with Great Place to Work (I wonder if that also helped with their rankings they cited.. Conflict of interest?). But nothing that talks about how they actually designed their organization systems to actually foster their core values.
So nothing that says outstanding.
8. Does the company have outstanding executive relations?
The Co-founders are both involved in the business. One is really involved as the CEO and they both have interests tied. But they don’t have a shareholder letter. That’s a big no-no for me. How can management say they value shareholders when they don’t take a few hours once a year to write a shareholder letter?
Then we look at compensation. All board members (BoD) don’t receive any cash compensation but about ~$350K in restricted stock units (RSU) equity comps. I guess this aligns long term incentives and pushes away rent-seeking BoDs.
In regards to management compensation:
The long-term incentives are all RSUs that vest over 4 years without any performance metrics attached to it. They had performance based stock compensation in the 2012 plan but they no longer have that. Not a good sign. As far as how RSU determination goes: "sizes of these awards are not determined based on a specific formula, but rather through the exercise of the Compensation Committee’s judgment after considering the individual performance of each of the executive officers, including financial, operational, customer, strategic, product and competitive factors, the recommendations of our Chief Executive Officer (except with respect to his awards), the appropriate level of compensation for the position given the scope of responsibility, the need to hire or retain an individual in a particular position, the current unvested equity held by such individuals and related vesting schedules, the level of each executive officer’s total target cash compensation (base salary plus target cash bonus opportunity), and the perceived retentive value of the proposed awards"
Though I like that insiders and founders run the business… it’s far from outstanding.
9. Does the company have depth to its management?
At the top, yes. The COO’s been with the company since 2007 and the CFO since 2012 and the Co-President since 2014. So there is some decent amount of tenure in the core C-suite but there are many new faces with under 5 years at the organization though they may come from other SaaS or ERP companies. But the lack of internal promotions for such a large company is troubling… possibly an inability to retain the talent they had?
10. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
I think the major thing is how WDAY was able to make a name for itself in such an entrenched industry (ERPs) by going directly to the cloud and starting with a simple out of the box product. Also how it was started by the Peoplesoft folks who went on to challenge Goliath (Oracle).
I also think their unique licenced deployment consultant model is also quite unique. It is one layer of stickiness to implement at the partner-sales level.
11. Does the company have a short-range or long-range outlook in regard to profits?
I’d lean towards the long range. Management tends to look over 5 year periods when talking about financials and operational developments. Their continuous reinvestment in the business and build out of major new products to continuously cross-sell indicates a long-term outlook as well.
12. How good are the company's cost analysis and accounting controls?
As far as disclosures go, it’s weak on the cost analysis. Not much shared
13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?
They are currently in a net cash positions and the two major acquisitions of 2019 were made primarily with cash. Given how they could probably cut back on employee expenses quite easily if they needed to… I don’t foresee a near-term risk/need for equity financing.
Actually, one can say that they are using it plenty through the SBC being 24% of revenue.
14. Does management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur?
I haven’t read a transcript/earnings yet. Too bad they don’t have a shareholder letter.
15. Does the company have a management of unquestionable integrity?
No idea. I don’t know if I would get to that stage of research.
16. Valuation. 10-bagger?
I get about a ~3% yield on my owner’s earnings. The business has demonstrated an ability to grow rapidly… and there seems to be availability on a global scale… though competing with niche players will be a challenge as the rest of the world is not like North America. They also have opportunities to expand through the “cloud” approach and this won’t be easy since On-prem takes a long time to pull out… The thing with ERPs is that it sticks for a long time. The migration to cloud may be an opportunity… but one can also consider that the easier implementation of cloud ERPs may be easier to pull out in the future as well. WDAY’s retention says otherwise but that needs to be considered. But, in 10 years time do I think WDAY can be 10x bigger? Currently, Oracle and SAP are each 3x the size of WDAY by market cap. I don’t want to anchor myself but considering the ERP market… I’m not so confident WDAY has that opportunity.
Disclaimer - I’m writing this for myself. For my past, present and future self. Much of what I write is my opinion. If it somehow ignites agreement in you then great, I’d love to hear about it. If it sparks disagreement in you, don’t reach out because I don’t care for it. There always are obvious exceptions and the flawed person in me hasn’t considered them all.