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Next Wave Portfolio—New Addition: Workday (WDAY)

By Rob DeFrancesco on December 21, 2015

The cloud software megatrend will power through 2016 in full force because organizations continue to realize the multiple benefits of migrating to the cloud from legacy on-premise solutions.

Software accessed from the cloud is not only easier to install, manage and operate, it’s also less expensive and more efficient in the long run. The lower total cost of ownership is often the deciding factor, especially when pricey annual maintenance fees charged by on-premise software vendors are added into the mix. The best-positioned cloud-software providers have years of growth runway ahead of them.

I am adding Workday (WDAY), one of the main beneficiaries of the cloud software megatrend, to the Next Wave Portfolio. The company is a leading provider of cloud-based software used for human capital management (HCM) and financial management (FM). It sells mainly to very large organizations.

For fiscal 2016 (ending January), Workday’s consensus revenue estimate of $1.16 billion represents growth of 47%. The company’s total addressable market (TAM) right now is estimated at $60 billion+, meaning Workday has less than 2% penetration. Looking at it a different way, Workday has just over 1,060 customers, or less than 4% of the 27,000+ organizations with 1,000 or more employees.

As Workday continues to expand its product portfolio, it will be better positioned to address the overall enterprise application market, which is valued at roughly $150 billion.

Human resources (HR)/HCM represents one of the fastest growing segments of enterprise software, with a TAM valued at more than $12 billion. Within HCM, the company has been steadily taking market share from legacy software vendors—mainly Oracle (ORCL) and SAP (SAP). About 70% of Workday’s HCM wins are legacy replacements.

Workday continues to gain traction with its core payroll and recruiting modules, both of which have high attach rates. In the second half of calendar 2016, the company will roll out a new learning module, representing a significant push into the $3-billion learning management systems (LMS) segment. With Workday Learning, customers will help empower their employees to expand their careers via training and development courses. The company’s solution will have a collaborative element, encouraging an interactive community for learning and coaching.

Workday is going after an even bigger market when it comes to its financials applications, which handle everything from core accounting tasks to revenue/expense management and procurement. The TAM in the financials segment is estimated to be greater than $26 billion. Workday has been building out its presence, and now has about 160 FM customers, up from 30 three years ago. It’s widely expected across Wall Street that 2016 will be the year in which Workday really begins to build momentum with its FM product portfolio.

Within the financials segment, Workday next year will launch a planning & inventory management module, which is useful for budgeting and forecasting. The planning solution, which will unify real-time finance and HR data with analytics, represents a deeper push by Workday into the enterprise resource planning (ERP) software market. The upcoming planning module will be fully integrated into the Workday platform, meaning any changes made to inventory will automatically flow into the budget. The company will first focus on the healthcare vertical because it’s an industry that can really benefit from inventory tracking, especially when it comes to materials management.

Workday shares started out 2015 on a firm note (the 52-week high was reached in February), but then drifted downward through the summer months, hitting a 52-week low of $65.33 in August. The stock has once again begun to show some upside momentum, recently trading around the $79 level.

It helps that Workday last month reported solid results for the fiscal third quarter (ended October), beating expectations on both the top and bottom lines. The company delivered flat EPS (four cents above the consensus estimate) on revenue of $305.3 million (up 42% year over year), vs. the consensus of $303.5 million. Billings of $340 million rose 41% and easily topped the high end of the guidance range of $310 million to $315 million. Unearned revenue rose 41% to $718 million. For fiscal 2016, management expects backlog to be up at least 52%.

Workday in the latest quarter continued to gain traction with its FM offering (90 customers are live on the platform, up from 80 in the previous quarter), adding Aon as its largest customer to date. In the HCM business, FedEx was added as the largest customer to date. The FedEx account alone is so big that it represents the equivalent of adding 20 to 30 mid-market accounts.

On the fiscal third quarter earnings call, Workday CEO Aneel Bhusri said win rates against legacy competitors remain strong, indicating large enterprises continue to transition over to the cloud and don’t see the need to stick with on-premise providers pushing their own Software-as-a-Service (SaaS) solutions. On Oracle’s recent earnings calls, management often mentions Workday as a key benchmark competitor, indicating the legacy software giant is feeling the heat from the fast-rising cloud-software vendor.

For the fiscal fourth quarter, Workday issued revenue guidance of $317 million to $320 million, below the consensus estimate of $320.3 million. For the January quarter, easier payment term for some customers (involving less cash up front) will weigh on Workday’s growth rate by 500 basis points. While revenue recognition issues are causing a bit of near-term disruption, the bottom line is it’s better for Workday over the long run to offer more attractive payments terms on certain large accounts instead of discounting entire contract values.

At a recent market cap of $15.1 billion, Workday trades at 9.7 times the fiscal 2017 consensus revenue estimate of $1.55 billion (growth of 33.6%). While the stock’s elevated valuation has been somewhat of a gating factor, the 17% pullback from the 52-week high of $95.17 provides a more attractive risk/reward balance. With continued progress on the top line thanks to product portfolio and TAM expansion, Workday is steadily growing into its valuation.

Workday is a ‘Buy’ in the Next Wave Portfolio up to $85 a share.

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