Workday Working Some Major Market Mojo

By Stephen D. Simpson, CFA | August 20, 2013 AAA

One way or another, Workday (Nasdaq:WDAY) is going to be a fun stock to watch. Investors angered by the rich valuations once awarded to Salesforce.com (NYSE:CRM), and there certainly were plenty of them, are probably going to be apoplectic over the valuation on the shares of this fast-growing SaaS enterprise software vendor. Although I can't conceive of a credible scenario in which these shares look anything close to fairly valued, I do believe the company will be quite successful and the interplay between the company's rapid growth and share gains in the enterprise resource management/planning (ERM/ERP) market and its valuation in the stock market will be very interesting to watch over the next few years.

A Disruptor In A Big Market
Workday was founded by veterans of PeopleSoft, a very successful ERP software company that captured about 5% market share only five years after its IPO and ultimately accepted a takeover bid from Oracle (Nasdaq:ORCL). Management is looking to once disrupt the enterprise software market, this time with a model that directly challenges how industry leaders like SAP (NYSE:SAP) and Oracle do business.

For all of the talk of software as a service (SaaS), on premise software (and/or hybrids with SaaS) are still quite common throughout enterprises. These ERP systems are large, expensive, and complex and SAP/Oracle have essentially pushed through a business model that uses contracts to bundle licenses across multiple products and lock in lucrative maintenance contracts – often leaving customers no choice but to continue paying for maintenance on unused/unwanted products, as it is difficult to unbundle them and replacing an entire system would be extraordinarily disruptive. The rich profit margins that flow from these contractually-bound customers goes a long way towards explaining the margins and cash flow that SAP and Oracle can produce.

Workday is looking to turn that on its ear. In place of licenses and long-term maintenance contracts, Workday's model functions on more of a subscription basis. With that, Workday can deliver the same sort of human resources and financial accounting functionality but at a total cost of ownership that some industry-watchers have calculated at 30% to 50% below the lifetime cost of a comparable Oracle or SAP package. At the same time, the nature of the SaaS model allows for more flexibility and a faster updating process.

The Markets Are Large And Worth Pursuing
Analyst Lisa Rowan at market research company IDC estimated that the ERP market in 2011 was a roughly $39 billion market, divided very roughly into Human Capital Management and Financial Accounting umbrellas, with other functions like Payroll Accounting, Procurement, Order Management, Project Management and so on dovetails off of these.

For now, Workday is focused primarily on the HCM and Financial Accounting markets, which are estimated to be worth about $26 billion in combined revenue opportunity in 2013 (with about $9 billion for HCM). SAP and Oracle are the established players in the market, with an estimated combined 39% share of HCM and 23% of the Financial Accounting markets, and smaller players like Kronos, Ultimate (Nasdaq:ULTI), Sage Group (Nasdaq:SGPYY), and Intuit (Nasdaq:INTU) factoring into the markets as well. At present, Workday holds somewhere around 1% share in these combined markets, but the 61% revenue growth and 31% billings growth Workday reported for its fiscal first quarter are well ahead of the underlying market growth rates, and the company is quickly gaining share.

Longer term, there are plenty of adjacent markets for Workday to address – areas like Payroll Accounting (where Oracle has less of a presence), Procurement, and Project/Portfolio Management (a market worth an estimated $4 billion (2013) and where Microsoft (Nasdaq:MSFT) holds sizable share). Were Workday to grab 5% of the ERP market over the next five years, it would likely translate into around $3 billion of annual revenue (versus $274 million in the last fiscal year).

Hard To See The Value
I am on board with the idea that Workday's well-respected offerings can drive significant adoption in the market and shake up the industry in a big way. That said, Oracle and SAP are hardly lightweights and are offering their own combinations of on premise, SaaS, and hybrid ERP products. Likewise, Workday will have the not-inconsiderable task of successfully managing growth and Wall Street expectations.

Unfortunately, it's hard to see how these shares are anything like cheap. My base case assumption calls for over 32% revenue CAGR over the next decade and a high teens free cash flow margin, and that doesn't come close to today's price. Likewise with that assumption of 5% total market share in 2018.

I don't expect growth investors to care though, as Workday should be posting pretty eye-popping growth for quite a while and momentum stocks can defy gravity longer than bears expect. It's also true that Workday could appeal to an acquirer like IBM (NYSE:IBM) or Microsoft, though the extreme valuation would seem to preclude that. I can't, in good conscience, recommend this stock at this price, but it won't surprise me at all if the shares are at $100 by year end. So while growth/momentum investors may find something to like here, I don't think the value or GARP crowd is going to be interested, apart from maybe taking a very small “let it ride” position just for kicks.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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