As the market turns fearful, Workday's (WDAY - Get Report) price stability has given investors the illusion of safety. Furthermore, its share price's continual ascent is attracting investors with the fear of missing out.
However, in reality, this appraisal could not be further from the truth. Workday is vastly overvalued and makes for a very risky investment that should be avoided.
Investors' Delight - Strong Growth, Subscription-Based Model
Workday's revenue growth continues to delight Wall Street. Over the last three years, Workday has consistently posted revenue growth in the mid 30%, with Q1 2020 continuing to be strong by being up 33.4% year-over-year.
In an environment where many large tech companies are struggling to find meaningful traction, Workday stands out. On the surface, the company looks spotless. What more could investors ask for than a rapidly growing, subscription-based software business? With approximately 75% of its revenue coming from the U.S., it avoids much, if not all, uncertainty over potential tariffs.
Moreover, without much debt on its balance sheet, it has plenty of flexibility to execute against its ambitions to deliver cloud applications to global enterprises. On the surface, the company's financial performance looks perfect.
Follow The Leader?
Now onto some troubling dynamics. Despite huge differences between its GAAP and non-GAAP results, Workday goes to great lengths to focus on its non-GAAP numbers. However, given that all of Workday's C-suite executives get such large amounts of stock-based compensation, investors should be mindful of this huge drag on profitability. In fact, for its fiscal 2020 guidance, the difference between its non-GAAP and GAAP operating margin amounts to roughly 27%.
For instance, in 2018 each one of its top executives made more than $6 million in stock compensation, with Workday's CEO Aneel Bhusri's stock compensation reaching closer to $10 million. Accordingly, it becomes insightful to track Workday's insider trading movements.
When one insider sells its stock, there could be a multitude of reasons and it becomes irrelevant. On the other hand, when numerous insiders aggressively sell the stock, shareholders should look closer.
Using this guideline, we can see how during the month of March 2019, as Workday's stock traded close to its five-year high, management went full throttle and sold an above average number of shares -- more than $150 million worth of stock in the open market.
Beneath The Surface Cash Burn
Despite Workday being a software business, it's actually surprisingly capital-intensive. It guided for fiscal 2020 cash flow from operations of $790 million, representing growth of 30% year-over-year.
However, that's the headline figure. The graph below compares Workday's cash flow from operations numbers with its adjusted free cash flow. It takes into account Workday's total cash outlay for its data center infrastructure needs, as well as office space to support growth (termed real estate projects), in addition to its capital expenditure.
As you can see, it's a markedly different story from the one management spins. The blue line is smooth and increases rapidly, whereas the red line is its adjusted free cash flow. Not only is the red line bumpier, but it's not growing anywhere near as fast as its cash flows from operations.
In light of these cash movements, it is perhaps unsurprising why in Q1 2017, Workday's balance sheet boasted a strong net cash position of $1.5 billion and as of this latest quarter's results, its net cash balance had dwindled to just $570 million.
Valuation - Priced To Perfection
The table above speaks for itself. Workday's peer group is being fairly reasonably priced, while Workday is the outlier which has its stock priced at more than 70x its cash flows. And as we have seen, its cash flows have a very poor conversion to free cash flows.
The Bottom Line
It's not all bad for Workday and there are numerous positive aspects to the company. For example, for the third year in a row, Workday was named by Gartner as a Leader for Cloud Core Financial Management Suites for Midsize, Large, and Global Enterprises.
Nevertheless, I contend that its shareholders are not likely to be rewarded for being invested here and should avoid this stock.