Workday's (WDAY -1.19%) stock price has risen 35% over the past 12 months as the cloud-based human capital management (HCM) services provider impressed investors with its stable growth and rising margins in a tough macro environment.
Back in late August, I said Workday's stock still had room to run and looked reasonably valued relative to its growth potential. Its recent rollout of new artificial intelligence (AI) features seemingly supported that bullish view. But an unexpected reduction to its long-term guidance overshadowed that positive development. Let's review this green flag and red flag for Workday's future, and see if its stock is still a worthwhile long-term investment.
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The green flag: Its new AI marketplace
Workday's platform -- which is used for staffing, payroll, budgeting, and analytics purposes -- hosts a lot of data for more than 10,000 organizations worldwide. Therefore it makes sense to use AI tools to crunch all of that data more efficiently.
That's why the company just hopped aboard the AI bandwagon with its Workday AI Marketplace, which hosts AI and machine learning (ML) apps and directly integrates them into its main HCM platform. Those apps can be created with third-party development tools or Workday Extend, its first-party platform for creating custom apps that can be tethered to its own large language models. It will also bundle together all of its AI and ML apps in its new Workday AI Gateway.
Workday is already running a beta test for the AI Marketplace with 15 early adopters, including Amazon and Accenture, and it will officially launch in the first half of 2024. It's also introducing new generative AI features to perform common tasks like analyzing contracts, writing job descriptions and knowledge base articles, and creating employee growth plans.
Co-CEO Aneel Bhusri said the new AI Marketplace would enable its customers to "harness the incredible amount of AI innovation happening today" and "give them the peace of mind in knowing that each solution is proven, trusted, and meets Workday's stringent standards for responsible AI." Those new features could lock in its customers, ensure its net revenue retention rate remains above 100%, and widen its moat against bigger and more diversified competitors like Oracle.
The red flag: A slight reduction to its long-term guidance
Workday previously claimed it could grow its annual subscription revenue by at least 20% over the long term. Its subscription revenue rose 22.5% in fiscal 2023 (which ended in January 2023), but it only expects 18% growth in fiscal 2024.
That slowdown wasn't surprising, since its near-term growth has been throttled by the macro headwinds, but co-CEO Carl Eschenbach said it was still "positioning the business to return to 20%-plus subscription revenue growth when the environment improves" during the company's fourth-quarter conference call in February. Eschenbach reiterated that goal during the company's first-quarter conference call in May, but he curiously didn't mention it again during its second-quarter conference call in August.
During its investor day presentation on Sept. 27, Workday management abruptly reduced that guidance to just 17%-19% annual growth in subscription revenue over the next three years. That guidance cut wasn't disastrous, but it caused Workday's stock price to drop 8% on Sept. 28 as investors realized its slowdown would drag on for a lot longer than it had initially anticipated.
Workday expects to maintain an annual adjusted operating margin of 25% through the end of fiscal 2026, which would represent a steady expansion from its target adjusted operating margin of 23.5% for fiscal 2024. However, investors might have been expecting a more significant expansion in its operating margins as its revenue growth cooled off.
This could be a good buying opportunity
Workday's guidance cut was certainly disappointing. But at $210, it trades at just 38 times this year's adjusted earnings and 32 times next year's adjusted earnings. Those valuations are reasonable relative to those of its industry peers.
For reference, ServiceNow, the digital workflow services provider that is growing slightly faster than Workday, trades at 45 times forward earnings. Salesforce, the customer relationship management (CRM) leader that is growing at a slower rate than Workday, trades at 26 times forward earnings.
If Workday can continue to grow its subscription revenue at 17%-19% annually over the next three years as it consistently expands its operating margins, it could still be a great investment. Furthermore, Workday still expects its key investments to drive its growth "beyond fiscal 2027" as its operating efficiencies "drive scale across its business."
Workday's upside potential might be limited over the next few quarters, but it still has the potential to generate multibagger returns even if it only maintains a high-teens revenue growth rate over the next few years. In other words, it's a good growth stock for long-term investors who can tune out all the near-term noise.
