Workday: Valuation Ruined By Excessive Stock Based Compensation (NASDAQ:WDAY)

Woman working with human resources software on computer

grinvalds

Sometimes we get an idea for an article and get excited when it looks like shares are trading at an attractive valuation and that we’ll be able to write a bullish article about the stock. This was the case with Workday (NASDAQ:WDAY), everything was pointing to an attractive valuation until we looked at GAAP earnings and margins, and then realized that stock-based compensation for this company is out of control. We’ll get into more details later, but stock-based compensation in this case is the difference between a solidly profitable company, and one that still loses money. As we’ve said before, we believe that stock-based compensation is a very real expense, even if it is not a cash expense for the company.

This was particularly sad as we were happy to see that the company is one of Corporate Knights Global 100, a list of the one hundred most sustainable corporations in the word.

In any case, Workday is still a very impressive company, with a leadership position in Human Capital Management software. It is used by 50%+ of Fortune 500 companies and ~24% of the Global 2000. The company estimates that just within its existing customer base it has a $10B+ opportunity by offering them Financial Management software too, as well as add-ons. In other words, it believes it has significant growth potential just by expanding customer share of wallet.

Workday Expanding Share of Wallet

Workday Investor Presentation

Financials

A first glance the financials looks great, with a Non-GAAP operating margin of 22.4% for FY22, and annual subscription revenue growing 21% CAGR from FY20 to FY22.

Workday Margins

Workday Investor Presentation

However, when we look at GAAP operating margin, we suddenly get negative numbers. What could possibly explain the huge difference? Stock-based compensation. It is not the only GAAP to Non-GAAP adjustment that the company makes, but it is by far the largest and the one we have the most issue with because it is a very real expense.

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Data by YCharts

We can clearly see the impact in the Q1 FY23 results. For example, the company delivered a Non-GAAP operating margin of 20.1% for Q1 FY23 and a GAAP operating margin of -5.1%. This is a massive 25.2% difference, and it tells us that the company is not planning on moderating stock-based compensation anytime soon.

Workday Q1 FY23

Workday Investor Presentation

Competitive Advantages

The company has a strong competitive moat resulting from a combination of factors, including intellectual property and high customer switching costs. It is extremely painful for customers already using Workday to switch to another software suite, as that means a change with potential risks and its employees needing to learn how to use a different product. These switching costs are reflected in the high gross revenue retention rate that the company has.

Growth

While the days of hyper growth are probably over for Workday, it still has several important growth vectors, including the up-selling of add-ons, as well as Financial Management software subscriptions. Financial management subscriptions are growing faster than the company average at a ~33% rate. This helps the company maintain an overall growth rate above 20%, which is quite reasonable for a company with the level of maturity Workday has.

Workday Growth

Workday Investor Presentation

Balance Sheet

We don’t see any issues with the balance sheet, with the company having a couple billion dollars more in cash and short-term investments than long-term debt.

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Data by YCharts

Stock-based compensation

Stock-based compensation has been growing very quickly and currently represents more than 20% of revenue. In our opinion this is excessive, especially since Workday did not just IPO, nor is it a startup trying to recruit talent to scale up. Workday is a relatively mature software company and has been giving out excessive stock-based compensation for quite sometime now, and based on their guidance they plan to continue the practice at least for FY2023 as well.

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Data by YCharts

2023 Guidance

In its FY2023 guidance the company is guiding GAAP operating margin to be ~24% lower than non-GAAP. Given that they are guiding Non-GAAP margin at 18.5%, this means that shareholders will have to absorb another year of GAAP losses while the insiders receive massive amounts of stock-based compensation again.

Workday FY23 Guidance

Workday Investor Presentation

Valuation

It is a shame that so much value is being taken away from shareholders due to the massive stock-based compensation the company is giving, since otherwise it would not be too difficult to build a bullish case. Shares are trading close to a record low since its IPO in terms of EV/Revenues. Forward EV/Revenues are ~5.4x.

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Data by YCharts

The problem is that we are not sure that a company that is guiding for long-term Non-GAAP operating margin of ~25%, and that has a GAAP operating margin more than 20% below that, deserves such a big multiple of revenue. Should shareholders pay 5x revenues for a company with a GAAP operating margin of let’s say 5%? Probably not. The question of course then becomes, will the company ever reign in stock-based compensation? So far, we have not seen any signs it will, and that is critical to estimate a proper valuation for the shares.

Workday Target Model

Workday Investor Presentation

Risks

The main risk we see with an investment in Workday is that despite its level of maturity it is not yet GAAP profitable on a consistent basis. So far most of the potential earnings have been wiped out by excessive stock-based compensation, leaving shareholders with little to show for. If the company continues its practice of giving out ~20% of revenue in stock-based compensation, we believe shares are extremely overvalued at an EV/Revenues ratio of more than 5x.

Conclusion

When we started researching Workday, we thought we were going to be able to build a bullish case for its shares. Unfortunately, we found out that most of the potential profits are being given out as stock-based compensation, leaving little for shareholders. We cannot estimate a fair value given that we don’t know how much longer the company will continue this practice, but so far based on FY2023 guidance it seems they have no plan to stop. Given this we have no other option but to rate the shares as a ‘Strong Sell’.

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