First – disclaimer.
If you work at a Fortune 500 company, there’s a good chance you’ve used Workday. If not, you may never have heard of them. Either way, here’s a summary of what they do.
Workday’s suite of enterprise cloud applications addresses the evolving needs of the C-suite across various industries and is designed to be open, extensible, and configurable, allowing integration with other applications and the ability for users and our partners to build custom applications. Workday offers Financial Management, Spend Management, Human Capital Management (“HCM”), Planning, and Analytics applications.
Workday was founded in 2005 to provide cloud native HR and Finance applications to companies. Today, over 60% of Fortune 500 companies are Workday customers and revenue has grown from $3.6B to $8.4B in the last five years. Clearly they do something useful.
The question for investors is whether their best days are still ahead of them.
My Analysis
Workday breaks down revenue into subscription services and professional services. Subscription services are what customers pay for the actual software (typically on a recurring basis), while professional services are what they pay Workday to get everything up and running. The professional services piece is quite uninteresting from an investor perspective as its basically offered at cost, so workday makes no money here. The subscription service revenue is what we need to focus on.
Based on management guidance for the current and following fiscal year, Workday will add about $1B in subscription revenue each year. I expect this to continue till Fiscal 2031 as the absolute growth rate slows. I’ve included a model here for you to put in your own assumptions for revenue growth over the next five years. Here are some factors to consider –
Given they already have 60% of the Fortune 500 as customers, how much growth is ahead of them? They compete against Oracle and SAP for large enterprises and against smaller nimble startups like Rippling for smaller companies.
As a counter to the point above, they are focused on growing within hospital and health systems as well as universities and governments. They are also focused on international expansion. Currently, only 25% of revenue is from outside the U.S., so there’s certainly room here.
The big risk with all SaaS companies applies here too, which is that over time corporations replace employees with AI. Workday is paid based on ‘seats’ and so this would lead to revenue shrinking among existing customers over time.
Workday is exceptionally sticky with a 98% retention rate in the most recent fiscal year.
In my base case, I expect subscription revenue to be about $14B in five years. Could it be higher? Certainly. But this feels like a reasonable assumption to me.
The next question is what do margins look like. I doubt gross margins improve much given they are going to be paying hyper-scalers for AI workloads, so I assume fiscal 2025 gross margins hold.
The big question is what happens with operating costs. For the next year, we know from guidance, that they will go up about 13%. Beyond that, I model them only going up 5% and then 4% in the last 3 years. If revenue growth slows as I expect, the market is going to demand better profitability, so I expect Workday will take a page out of the Salesforce play book. Salesforce has improved their operating margins from 2% to 21% in the last three years by keeping operating costs steady and letting the bulk of the revenue growth drop to the bottom line.
Five years from now, I expect Workday to earn a 25% operating margin (and this is a GAAP number, not the made up operating margins that management shares every quarter which exclude stock based compensation). All of these assumptions imply about $3B in net income five years out. Put a 25 multiple on that (because revenue is now growing 8%) and you get a $75B market cap. The market cap today is $60B, so this is certainly not exciting. That’s a five year IRR of less than 5%.
The bull case is that revenues end up closer to $16B vs the $14B in my base case, so net income is $4B in five years. You could also argue for a higher multiple given the stickiness of the product (say 30x?) and now you end up with a market cap of $120B and you’ve got a compound IRR of 15% over the next five years.
Given how unappealing the base case returns are here, I’m going to take a small position to see how things play out. I think the downside is low because the company could cut head count more aggressively to get to $3B in net income in the next couple of years, so you’re only paying 20x that today. Obviously if AI leads to a 5% reduction in the white collar workforce every year starting soon, all bets are off.