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Don't Be Deceived by Workday Inc.'s Lack of Profitability

By Palbir Nijjar - Apr 28, 2016 at 5:17PM

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At first glance, Workday appears to be bleeding red. A deeper dive shows the company is creating more value than meets the eye.

Over the past five years, net income at cloud software provider Workday (WDAY -2.63%) has decreased from -$80 million to -$290 million. Yet, since its IPO in October 2012, the stock price has increased 175%.

Many value-oriented investors will often grow frustrated with this type of performance from an unprofitable business. Words like "bubble," "frothy," and "overvalued" are popular adjectives used to describe Silicon Valley-based technology companies. These same words have been used to describe (CRM -2.48%)

The year before it launched on the Nasdaq in 2004, Salesforce incurred losses of $10 million. Since then, the company has fluctuated between losses and meager profitability. However, net income in 2015 came in at -$263 million. The company's stock price since becoming public is up an incredible 1,680%.

So what gives?

Growth potential
A mistake many value investors make is that they look at how a company has performed in the past and how it's performing now. For example, since 2000, net income at Wal-Mart has tripled. Its stock price since then is up 2.9%. One of the reasons is what the market is forecasting going forward. Wal-Mart has done a poor job gaining traction in e-commerce, and the market is pricing its expectations accordingly.

Workday, on the other hand, has grown revenue 54% annually over the past five years, from $134 million in 2011 to nearly $1.2 billion in its latest fiscal year. Naturally, as the base grows higher, it becomes harder to grow the top line at such a strong pace. Growth slowed to 43% in its latest quarter, but there's still a long runway ahead.

According to Grand View Research, the HR software market size is projected to reach $10 billion in 2022. The global enterprise resource planning market is expected to reach $41.69 billion by 2020. Workday CEO Aneel Bhusri sees higher potential, as he pegged Workday's market opportunity at $60 billion, with an opportunity in financial solutions being larger than human capital management (HCM).

For comparison purposes, Gartner estimates the customer relationship market (CRM) that Salesforce competes in to be just under $25 billion in size. Salesforce does control a much larger share of its respective market than Workday does for HCM and financials. However, the opportunity is there for Workday to become at least as large as Salesforce. In terms of market capitalization, Salesforce is a $52 billion company, while Workday is worth $15 billion.

Looking at the income statement of Workday, it's understandable why investors would quickly move on to the next idea. 













Net loss






Net loss per share






All numbers in thousands of U.S. dollars. Source: company filings.

However, a closer look at the cash flow statement tells a better story.







Operating cash flow






Capital expenditures






Free cash flow






All numbers in thousands of U.S. dollars. Source: company filings.

Free cash flow is often a better measure of profitability, since it's not beholden to accounting rules and management estimates in the income statement. You can see with Workday that free cash flow is painting a much brighter picture than the income statement. In fact, Workday became free cash flow-positive this past year, generating nearly $125 million in cash. That's important, since that cash can be invested right back into the business, lessening the need to dilute shareholders by raising more equity.

There are two main reasons for the large gap in free cash flow and net income.

The first is that share-based compensation of $250 million is included as an expense in the income statement but it is not actually a cash outlay for Workday. However, I'm not a fan of giving companies credit for issuing stock to employees and management. There's nothing wrong with giving team members incentive, but it does come out of shareholders' pockets. It may not hit the cash flow statement, but it does dilute the equity.

The more important metric in measuring Workday's success is its increase in deferred revenue. Workday typically offers customers access to their applications with a three-year agreement. The customer will pay for one year at a time until the three-year subscription expires. Because of accounting rules, although the customer is obligated to pay for three years and pays one of those three years upfront, revenue isn't recognized immediately. It's spread out over the term of the agreement. In its latest fiscal year, Workday's deferred revenue increased over $260 million to $900 million, nearly the same amount in actual revenue.

As my Fool colleague Tim Green noted in this article, free cash flow isn't always free. If Workday were to all of a sudden stop growing like gangbusters yet maintain the same cost structure, the company would burn through cash really quickly. However, if it can maintain growth, the free cash flow can be a great source of funds to grow its business while it leverages its operating costs over time. A quick look at Workday's cost structure compared with its peers shows that the company can become very profitable when it no longer needs to invest in its business at the rate it does today.






Cost of sales





Sales and marketing expense















Operating profit





Source: latest annual company filings.

Workday is already on pace to catch up to Salesforce in terms of gross margins. Workday was able to achieve 76% gross margins in its latest quarter, surpassing Salesforce's 2015 margin. The bulk expense weighing down Workday's profitability is its development costs. Workday spends 40% of its revenue on product development compared with its peers, which are spending a mid-teens percentage of their budget on the same category. This expense should come down as Workday's product matures and as the company grows the top line. Reducing development costs in half will lead operating margins close to breakeven.

Workday is still a long way from achieving profitability. Like many fast-growing technology companies, its focus right now is investing in its sales team and product. If the company can continue to grow at a rapid pace and improve margins down the road, investors may be rewarded accordingly. However, buyer beware: With the company priced at 13 times sales, any hiccups can lead to a volatile ride.

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Stocks Mentioned

Workday, Inc. Stock Quote
Workday, Inc.
$148.05 (-2.63%) $-4.00
Salesforce, Inc. Stock Quote
Salesforce, Inc.
$181.31 (-2.48%) $-4.61

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