Workday: Are Problems Lingering Ahead?

The market has awarded Workday (NYSE: WDAY  ) with the largest valuation premium of cloud-based companies. However, with the IPO of Paycom Software on tap, and the efficiency of peers Aspen Technology (NASDAQ: AZPN  ) and Ultimate Software Group (NASDAQ: ULTI  ) , problems surrounding Workday's valuation might soon put pressure on the stock.

1 thing's for certain
Workday is a growth machine! Last year, it grew revenue by 71% year-over-year to $468.9 million. Looking ahead, the company is guiding for revenue of $730 million for the current year, representing growth greater than 55% over last year.

As a result of its growth, expectations are sky-high for Workday, as it trades at a whopping 37.7 times 12-month sales. This multiple clearly reflects Wall Street's outlook for Workday to grow even larger long-term, but is also a reflection of the cloud-penetration levels possible for HR, payroll, and business management services like those that Workday provides.

However, this revenue growth and upside has left investors discounting if not ignoring the fundamental problems that exist, many of which might become a hot topic in the near future.

Excuses for inefficiency
As many Workday longs will point out, the company has consistently increased its operating margins over each of the last three years. However, in doing so, it has also seen total operating losses increase during each of the last three years. Yet, longs have had an excuse: Workday is growing now and will be profitable later.

The problem with this logic is that it doesn't reflect upon an industry that's seeing many of its leaders become more efficient. Specifically, The Ultimate Software Group offers many of the same HR/payroll cloud services. Last year, Ultimate Software saw total revenue growth of 24%, and by reporting $410.4 million, it's nearly the same size as Workday, although three times cheaper in market capitalization.

Yet, while Workday's operating margin was negative 30%, Ultimate Software's was positive 10.5%. Then, there's Aspen Technology, which doesn't operate in the HR space, but rather makes training, presenting, and software integration easier in complicated industries such as energy, chemicals, and engineering via the cloud.

During Aspen's fiscal second quarter, it grew revenue 27.8%, which fails in comparison to the growth earned by Workday. However, like Ultimate Software, Aspen has found a solid balance allowing it to both grow and be profitable. In particular, Aspen has operating margins over 26%, which is simply incredible in this space.

With that said, and in understanding the growth and efficiency of companies Ultimate Software and Aspen, is Workday's growth that impressive? To answer that question, you will find a very telling chart below.

 

Workday

Ultimate Software

Aspen

Revenue

$468.9 million

$410.4 million

$348.95 million

Operating Expenses

$622.2 million

$367.1 million

$256.3 million

Cost per $1 of revenue

$1.32

$0.89

$0.73

The above chart shows the operating expenses and total revenue for each company over the last four quarters. In seeing these numbers, we can determine how much each company spent to generate $1 in revenue.

Hence, Workday spent $1.32 for every $1 earned, which is clearly not a winning formula, and also shows that the company is paying immensely to create its growth. For investors, the multi-billion dollar question is how long Workday can operate at this pace without investors wanting to see consistent income, or how the company would fare in spending less money.

A new threat for Workday longs
Unfortunately for Workday, Paycom Software may force it to answer the tough questions regarding efficiency and growth sooner rather than later.

Paycom is a cloud-software company, one that is smaller than Workday but operates in the exact same industry. On Tuesday, Paycom filed its S-1 and is planning a $100 million IPO, giving it a market capitalization around $1 billion.

Now, with only $107.6 million in revenue last year, Paycom is much smaller than Workday, but does pose a threat for several reasons. First, Paycom is growing at 40% annually, and with an added $100 million it will likely be able to accelerate growth, much like Workday following its IPO. Second, Paycom's revenue retention rates have remained above 90% each of the last three years, among the best in the space, meaning its services are liked. Third, Paycom's platform has the same benefits of Workday; its software is all on one platform and eliminates the need for redundant data, or is simple to use. Fourth, its 58% of revenue from payroll processing has declined each of last three years as a percentage of total revenue, showing its growing in other areas of HR, which could be bad news for Workday.

The final reason that Paycom could be bad news for Workday is because the company's profitable, generating net income of $5.4 million last year, a profit margin of 5%. This efficiency challenges the thesis of Workday longs that growth costs money, and could lead to investors assessing the business practices of Workday.

Final thoughts
Look, Workday has had a great run. It came into the market overhyped and has more than doubled from its IPO high. However, the key problems of spending, and the additional issues that companies like Paycom could create are real threats to challenge the valuation model of Workday.

As a result, caution should be used before initiating a position in the stock, as Aspen, Ultimate Software, and even Paycom following its IPO look to be far better investment options.

In recent years, negative margins were acceptable, but now, profitability is becoming the norm. This fact could put pressure on shares of Workday as its forced to sacrifice growth in order to generate profits.

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  • Report this Comment On March 17, 2014, at 1:07 PM, Borisbmx wrote:

    I know this is a cliché, but doesn't look like apples to apples compar

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