Are Workday Shares a Good Investment for the Long Haul?

Workday  (NYSE: WDAY  ) recently announced first-quarter fiscal 2015 results that showed its revenue grew 74% during the quarter to $159.7 million, but the company also reported an operating loss of $32.6 million. Meanwhile, shares have lost nearly 32% of their value this year. So, are the shares good long-term investments?

Stocks of young SaaS, or Software-as-a-Service, companies such as Workday, Splunk  (NASDAQ: SPLK  ) , ServiceNow, NetSuite, and Concur Technologies, among others, are notorious for their stomach-churning volatility. However, even stocks of more mature SaaS companies such as salesforce.com  (NYSE: CRM  ) tend to be more volatile than the average stock in the S&P 500.

These stocks also typically trade at stratospheric valuations.

Another major characteristic of many young SaaS companies is that most sport unusually high sales and marketing expenses as a percentage of revenue. Workday spends 42% of its revenue on sales and marketing, while Splunk spends 70% of its revenue on marketing expenses. Salesforce, a more mature company, spends more than half of its revenue on sales and marketing expenses.

Workday's sales and marketing expenses compare quite well to those of other leading SaaS companies.

The big difference between SaaS and other software companies
The core business models of traditional software companies such as Oracle and SAP revolve around selling ''perpetual licenses,'' then selling upgrades later. Customers typically pay for the software licenses up front, in addition to recurring annual maintenance fees (usually 15%-20% of the license fee). For these companies, the timing of their revenue and expenses tends to be perfectly aligned.

SaaS companies like Workday, however, face a problem here. These companies do not sell perpetual licenses, but instead sign up customers to use their software, which is hosted by the SaaS companies, on an ongoing basis. Revenue comes in gradually as the months roll on, yet the companies incur most costs, especially customer acquisition costs, up front. Thus, the timing of income and expenses for these companies tends to be misaligned.

Bearing this in mind, to get a more accurate idea of Workday's true state of affairs, consider its deferred income. A good proxy is the company's billings, which are usually calculated by taking the revenue of one quarter and adding the change in deferred revenue between the current quarter and the previous quarter.

Workday invoices customers for cloud applications contracts using annual and multi-annual instalments.

Source: Workday 10-Ks

Thus, Workday's unearned revenue balances for fiscal years 2012, 2013, and 2014 were $188 million, $285 million, and $414 million, respectively.

Workday's revenue, as reported in its 10-Ks, therefore, significantly understates its true financial performance. For instance, in fiscal year 2014, which ended in December 2013, the company's billings exceeded the reported revenue by $128 million.

The company's billings have been growing at a robust pace of approximately 60% every year. This suggests that the company has great growth runways ahead, as it continues to win more market share. That is, perhaps, why investors are willing to pay a big premium for its shares.

Why does Workday spend so much on sales and marketing?
Rapidly growing SaaS companies such as Workday, Splunk, and Salesforce spend heavily on marketing, sales, and customer management functions to acquire as many customers as possible. This is because once their installed customer bases get big enough, cash generated from ongoing operations will be more than enough to cover the additional cost of acquiring more customers.

Once an SaaS business matures, and most customer acquisition costs are charged on its balance sheet, the company can then harvest incoming cash flow as profit. To see how much Workday spends on customer acquisition costs, take its sales and marketing expenses and divide by the by the number of customers acquired over the period in which the expenses were incurred.

It's also important to check whether the company is getting high-quality customers who will generate profit. This is referred to as the customer lifetime value. In a good SaaS business, the customer lifetime value should be at least three times the cost of acquiring customers.

Workday does not typically disclose its customer acquisition costs, but we can assume that the company spends 70% of its sales and marketing expenses on customer acquisitions. Also, the company does not disclose customer lifetime value in its 10-Ks, nor does it disclose its annual recurring revenue or contract value, so we can use the average subscription revenue per customer as a proxy here.

Note: CAC--customer acqusition costs, LTV--customer lifetime value
Source: Workday 10-Ks

At the current rate, Workday will eventually earn $6.30 for every $1 it spends to acquire new customers. The good part is that this figure is growing rapidly, which is great. The absolute amount of money that Workday spends on sales and marketing costs might look quite large, but it's money well spent. These costs are responsible for the company's losses, but they should eventually start paying off before long.

Foolish bottom line
Workday's losses can be attributed to the company's high sales and marketing expenses. But, a deeper look into the problem reveals that the company is spending this money on high-quality customers that are more likely to generate additional revenue in the future. The shares are, therefore, good investments.

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  • Report this Comment On June 04, 2014, at 12:15 PM, kakakabat wrote:

    the so called Saas companies are very hard to value. Even their sales and marketing expenses contain share compensation expenses. For example, SPLK just had $71 mill of S&M and $19 mill was share based comp out of it.

    There has to be more clarity on these companies before they become investment and not speculative plays.

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