Gross margin is a financial metric that gets a lot of attention from investors, analysts, and management teams -- and for good reason. An expanding gross margin is a sign of a desirable product or service, strong pricing power, and an increasing economic moat. And if a company can grow revenue at the same time it is increasing its margin, all the better.

Often, a young company, especially in Silicon Valley, will sacrifice its margin and profitability to win market share. However, there is one software creator that has managed to expand its margin while maintaining strong growth. In fact, over five-plus years as a public company, Workday (NYSE:WDAY) has steadily increased gross profit from 51% in fiscal-year 2012 to about 71% in its most recent quarter.

WDAY Gross Profit Margin (Quarterly) Chart

Data by YCharts.

Meanwhile, annual revenue has grown from just under $135 million to nearly $1.6 billion over that same period.

Decreasing dependence on professional services

Digging into the company's financial statements, it becomes obvious that the main driver of higher profitability is the reduced size of the professional services segment relative to the software subscription business. Professional services fees are charged to customers for assistance with software deployment, optimization, and training. The work can be performed by the Workday staff, a third party, or a combination of the two. It's an important service to provide, as a successful deployment leads to increased customer success and satisfaction. However, it's also a very low-margin business. As shown in the chart below, professional services are almost sold at cost:

Chart of professional services revenue vs. their cost, FY 2013 to present, revenue and cost bars are nearly equal.

Data source: Workday. Chart by author.

The professional services segment is still growing with the rest of the business. In the most recent fiscal quarter, it grew revenue 18.7% year over year. However, over 80% of the company's top line comes from highly profitable software subscriptions, which were up 43%. Since Workday has increased subscription revenue at a much faster pace than professional services, the software provider has become less dependent on the latter:

Revenue source

FY 2013

FY 2015

FY 2015

FY 2016

FY 2017

YTD 2018

Subscriptions

70%

76%

78%

80%

82%

83%

Professional services

30%

24%

22%

20%

18%

17%

Subscription and professional services revenue as % of total revenue. Data source: Workday. Table by author.

Investors should expect this trend to continue. Workday offers its customers numerous training options to support them in configuring and administering its services. The company also expects customers to engage directly with its partner firms for assistance with deployment, training, and optimization. Given the lack of profitability from professional services, investors should view this as a positive development.

Growing subscription profitability

That said, what should really get investors excited is how the company is growing profits in the subscription business. During the past five years, Workday has steadily increased its margin from 79% in fiscal year 2013 to 85% in its most recent quarter:

Chart of subscription services gross margin percentage, FY 2013 to present, the trend line is upward.

Data source: Workday. Chart by author.

After seeing a dip in fiscal 2017, Workday is off to a strong start this year, reporting gross margin of 84.1% during the first quarter and and 85% in the second. Workday hasn't publicly spoken to this progress, but one reason could be the company's ability to scale as it gets larger. Workday did announce its highest growth rate in three years for average contract value.

A further shift in the sales mix can also affect profitability. The company is making successful inroads with Workday Financial Management. It also recently announced the deployment of two analytic and reporting tools, Workday Financial Performance Management and Prism Analytics. Whether these newer tools are more or less profitable than Human Capital Management remains to be seen, but the fact that the company was able to achieve 85% gross margin last quarter is a good sign of progress.

Growing revenue and profitability is proving to be a powerful combination for Workday. Looking at the numbers from the latest quarter, it appears that promising trend is going to continue.

Palbir Nijjar owns shares of Workday. The Motley Fool owns shares of and recommends Workday. The Motley Fool has a disclosure policy.