Have Value Investors Been Wrong About Workday?

Workday (NYSE: WDAY  ) has been the quintessential example of irrational exuberance to many retail and institutional value investors. The reason is due to its market-leading valuation multiple. But after a strong earnings report, should bears revisit their thesis?

An impressive quarter
Workday is part of an exciting new class of companies that sells software-as-as-service through the cloud. In particular, Workday offers products for human resources, creating sales from new and managed subscriptions.

The company's shares soared 13% on Tuesday after it reported earnings, as Workday blew away analyst expectations with accelerated growth .

The company saw its total revenue grow 76% year over year to $127.9 million, an acceleration from the 71% growth in the company's last quarter. Investors were encouraged, especially with its 82% growth in subscriptions and its $352 million in unearned revenue, which indicates future sales.

With that said, Workday is still expensive, and is an investment in the future rather than today. For many investors, this concept is hard to grasp, especially with the stock trading at 36 times the trailing 12 months' sales.

One major improvement
After assessing Workday's quarter, there was one improvement that really stood out, and that was expenses.

Aside from valuation, the biggest knock on Workday has been that the company is spending aggressively while it is not profitable. Some investors wonder if Workday can produce such growth without the spending. The company answered this question in the third quarter.

Workday did something remarkable: It not only accelerated growth from the prior quarter, but increased spending on research and development and sales/marketing by just 56%, far lower than sales growth. As a result, operating margins improved.

Workday's ability to improve margins and slow spending is not something we've seen among its peers, such as Salesforce.com (NYSE: CRM  ) . In Salesforce.com's most recent quarter, the stock declined 3% due to spending concerns.

Salesforce.com saw revenue of $1.08 billion, or growth of 36% year over year. However, its operating expenses rose 38% to $905 million, including sales/marketing and R&D costs that increased 36% and 50%, respectively, totaling $752 million. These numbers and this trend make Workday's growth that much more impressive, and raise additional questions for Salesforce.com.

Buying for the future
So, where do we go from here? And is Workday now a buy?

The company has very ambitious goals: Workday currently has 550 customers and hopes to grow that number to 5,000. If we look at Workday's trailing 12 months of sales, at $408 million, we can see that the company has room to grow if its 5,000-customer goal is met.

In fact, Workday is expected to grow rapidly in the immediate future, including $450 million in the full year 2013, and $665 million in 2014. However, even if we apply next year's targeted sales growth of nearly 50%, Workday still trades at a very pricey 22 times future sales.

But as previously stated, investors are buying Workday for its long-term future. Therefore, the question becomes, "How large can Workday become?" The answer is speculative, but might be found by assessing the performance of larger and similar -- or competing -- companies.

Many don't realize that Oracle (NYSE: ORCL  ) is actually the largest cloud company in the U.S., as 20% of its net revenue comes from software-as-a-service licenses and cloud subscriptions. In Oracle's last quarter, its cloud segment grew 4% year over year , which was far better than the 1% growth it saw in the prior quarter .

Many Workday bulls believe the company is stealing market share from Oracle. However, Oracle created sales of $1.66 billion in its most recent quarter from this segment, compared to $127.9 million for Workday. Hence, the two companies are on completely different levels in terms of size, and Oracle is far more diversified in the products that it offers.

But for the sake of argument, let's say Workday fully monetizes its 5,000-customer goal and creates $3 billion in revenue. Then, the company creates new segments to produce total sales of $6.5 billion, matching Oracle. If so, Workday is currently trading at 2.2 times peak sales, or its best-case scenario. On the other hand, Oracle trades at 4.2 times current sales; this should really put into perspective the expectations and price being given to Workday, a company that is still very much in its infancy.

Final thoughts
While Workday's strong quarter must be acknowledged, it's almost impossible to logically defend an investment at these levels. The company is performing better than other cloud peers, but is by far the most expensive in the software-application industry, which trades at 4.5 times sales . Workday should be the best-performing company in the space.

Sure, there is a lot of excitement right now, but eventually growth will slow and the company's valuation will align with its fundamentals. Sooner or later, this anomaly occurs with every momentum stock, whether it be one year of an intense pullback -- like Green Mountain Coffee Roasters -- or a long period of flat trading. Either way, Workday might trade higher short-term, but the downside risk still exists despite this very strong quarter.

As a result, the long-term bear thesis appears intact, but as of this moment, bulls are the short-term winners.

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