How Innovative Is Workday?

Organic innovation is hard enough. Creating products that help usher in entirely new categories is rare. The most innovative companies combine both qualities to disrupt incumbents and unleash massive wealth for early investors.

Is Workday (WDAY -0.75%), which helped bring the cloud revolution to large-scale enterprise resource planning (ERP) and human resources (HR) software, that sort of multibagger in the making? It's certainly growing fast enough: Revenue rose 36% in fiscal 2017 and 2018, and it's up another 30.8% over the trailing 12 months, according to S&P Global Market Intelligence.

Continued improvements in the underlying platform have contributed to those gains. For example, in August 2007, Workday unveiled the beta release of its financial management platform. Today, the company is signing big names every quarter and reports over 60% growth in annual contract value (ACV) for its financial management suite of products. Recent wins include FOX, H&R Block, and the Atlanta Braves baseball team.

Ambitious, effective innovation will be required to make continued gains in a tough category, so it's worth understanding how effective Workday's R&D efforts have been to date, and whether investors have reason to expect even better results in the future. Let's go under the hood and apply my four-question test.

Check out the latest Workday earnings call transcript.

Innovation isn't just about bright ideas. Image source: Getty Images.

Revisiting the innovation test

I created an "innovation test" as a way to understand the quality of engineering efforts when making a complex product with rule-breaking potential. Here are the four core categories and the questions I put in each:

1. Organic growth: Does the company have internally developed products? What are they, and when were they released?

2. R&D output: Is overall revenue growing faster than R&D investment over the period when these products were released? By how much?

3. Pricing power: Is gross margin expanding?

4. Pipeline: Can you point to evidence of new products being developed? How soon will they be released?

Version 1.0 of the test was serviceable enough, featuring just yes or no answers. However, a closer look at some other companies revealed a flaw: What if some attributes are more valuable than others?

Motley Fool CEO Tom Gardner put that question to me and now version 2.0 of the innovation test includes a sliding-scale scoring system -- here's how it works:

In tweaking this test, I'm placing a bit more emphasis on organic growth and penalizing "one-hit wonders" that have a great product, but nothing in the pipeline.

Workday headquarters in Pleasanton, Calif. Image source: Workday.

Survey says?

Now, on to the quiz. Here's how Workday rates as an innovator:

1. Does Workday have internally developed products? What are they? When were they released?

   Sort of (plus 1). Workday has made nine acquisitions since 2014, so clearly, a portion of its growth is inorganic. Yet the company is also 14 years old this month and generates $2.6 billion in annual sales. You can't simply acquire that much growth over that long a period of time. Taking back the ERP market that Workday co-founders Dave Duffield and Aneel Bhusri lost when Oracle bought PeopleSoft out from the under them has been a long road, and they're still working at it.

2. Is revenue growing faster than investment in R&D over the period when these products were released? By how much?

   No (0). R&D spend is up 519% since the end of the 2014 fiscal year while revenue is up 458% over the same period. That's not necessarily a bad thing in that it means Workday is still putting considerable resources into serving its customers in hopes of writing long, multiyear contracts. R&D spend will start to come down as that happens more and more.

3. Is gross margin expanding?

   Yes (plus 1). After spending most of the past five years with gross margins in the 60s, Workday reached over 70% in fiscal 2018 and has remained above that plateau over the trailing 12 months, according to S&P Global Market Intelligence.

4. Can you point to evidence of new products being developed? How soon will they be released?

   Yes (plus 1). In October, Workday unveiled machine-learning methods for tracking job skills to help customers do a better job of identifying and plugging gaps. A month later, the company announced plans to give more customers around the globe the option of running their Workday environment in AWS. In each case, the company has shown both a desire and an ability to give customers what they want in a package that best fits their needs.

With three out of the maximum five points, Workday is a committed innovator with potential to improve. Meaningful gains in turning R&D into productive outcomes for customers seem likely, which would increase the odds of the stock beating the market by a wide margin in the years to come.