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Workday's Moat Widens

The company's ability to retain customers causes us to upgrade our rating.

Workday’s WDAY second-quarter results did not disappoint, as non-GAAP earnings per share beat Capital IQ consensus by 27% and subscription revenue surpassed the high end of management’s guidance. The strong quarter reflects our thesis that Workday is relatively resilient amid the COVID-19 pandemic. While we believe the coronavirus outbreak has decelerated the company’s top line to some extent, we agree with Workday that employee engagement for enterprises is even more important amid the pandemic, and human capital management software plays an integral part in such engagement.

Independent of (but supported by) the great quarter, we’ve upgraded our economic moat rating for Workday to wide from narrow, as the company’s consistently high gross retention rates and ability to achieve returns on invested capital confirm our belief that Workday’s software is incredibly sticky, even without adoption of its latest offerings. The strong quarter and our wide moat upgrade have us more confident in Workday’s long-term potential, leading us to raise our fair value estimate to $198 per share from $183.

Sales were up 20% year over year in the second quarter, to $1.1 billion. Subscription revenue was $932 million, marking year-over-year growth of 23% and far ahead of the company’s guidance of $913 million-$915 million. Even adjusting for a $6 million one-time benefit in the quarter, which came from a customer being acquired and thus paying the remainder of its contract upon exit, Workday significantly surpassed the high end of its guidance. The company attributed this to outperformance all around--in human capital management, financial management, and newer offerings like Prism Analytics. Professional service revenue was flat year over year at $130 million.

Gross retention was over 95%, while net retention, including upsells at the time of renewal, was over 100%. Both of these rates are in line with Workday’s consistently exceptional retention rates. Non-GAAP operating margin was 24%, compared with 13% in the prior-year quarter, largely as a result of slower hiring and moderated travel and marketing costs.

For the third quarter, Workday expects subscription revenue to grow 19% year over year to $948 million-$950 million. Non-GAAP operating margin is forecast to be 19%. For the full year, management increased its subscription revenue expectations to $3.73 billion-$3.74 billion from $3.67 billion-$3.69 billion previously. It improved its non-GAAP operating margin outlook for the year to 18%, up 200 basis points from prior guidance.

With the results came the news that current co-president Chano Fernandez will join Aneel Bhusri as co-CEO. This was a surprise to us, especially as Oracle and SAP have undone the co-CEO model over the past year. Robynne Sisco, currently co-president and chief financial officer, will assume full responsibility in the president role and remain CFO. There has been a recent trend toward the co-CEO model, with Netflix being one of the latest companies to switch to it. While Workday’s change in its management model was unexpected, we do not have any compelling reasons to believe it will substantially change the company’s ability to achieve solid results.

We feel confident in our upgrade of Workday’s moat rating to wide from narrow because the company has shown us consistently year after year just how sticky its software is, and we believe this will continue well beyond our explicit forecast. We consider Workday to be a best-of-breed cloud-only platform for human capital management software. By debuting in 2005 as a first mover in the cloud human capital management space at an ideal time--when enterprises were looking to make the move from on-premises to cloud software solutions--Workday has benefited from its timeliness as well as its high-quality product and reputation for smooth implementations. Now that customers have transitioned to a cloud solution with Workday, we think the possibility of another vulnerable event that would leave Workday susceptible to customers switching is unlikely. Instead, we see Workday as having robust switching costs that will only get stronger, in our view, as the company builds on its core human capital management offering.

Workday is now the human capital management platform for 60% of the Fortune 50 and 45% of the Fortune 500, as of fiscal 2020. Workday been able to take share from legacy employee resource planning software companies Oracle and SAP, which is tough enough based on the switching costs that we believe are inherent in most ERP software. Even more impressive is that Workday has been able to do so by initially unbundling human capital management software from the ERP ecosystem. By doing so, customers understand that they will need to go through integrations between different ERP solutions by mixing and matching, but in return, they hope to get the best-of-breed human capital management solution, and will pay a premium for Workday.

Now, Workday is in its next chapter of allowing the option to “rebundle” human capital management with other ERP solutions, as it now offers a financial management suite and planning suite, which has been further boosted by its recent acquisition of Adaptive Insights. As Workday’s core addressable market continues to expand and the company finds adoption of its new products to be strong, it is poised for continued robust top-line growth and strengthening switching costs, in our view.

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