High-Flying Workday Comes Back to Earth

NEW YORK (TheStreet) -- One of the remarkable performers in the last couple of years in tech has been Software as a Service, or SaaS, companies. With a predictable revenue stream, investors have been willing to look past stretched margins and ride with the momentum when the market was rising.

However, when the momentum ended, SaaS stocks pulled back. Probably no company better exemplifies this than Workday (WDAY). Its shares, at $81, are up nearly 40% for the past 52 weeks but down 2.3% for the year to date.

Founded in 2005 by Aneel Bhusri and David Duffield, of PeopleSoft fame. Back then, PeopleSoft had been acquired recently by Oracle (ORCL) after a contentious battle by Larry Ellison to own the company. Duffield and the rest of PeopleSoft's board fought the deal tooth and nail but ended up getting a great payout.

In hindsight, it was the perfect time to sell PeopleSoft and move to the next big thing in enterprise computer: SaaS and the cloud.

Oracle took over the old way of doing HR software when it bought PeopleSoft. It was client software that fed back to the server. When Duffield and Bhusri decided to start Workday, they basically re-envisioned PeopleSoft as a SaaS company. The same focus. The same industry. Just doing it as SaaS.

It's been a hit. It went public in late 2012 below $50 and it topped out at $116 at the end of February. It now sports a market cap that is about half of Salesforce.com's (CRM) -- $14 billion versus $33 billion.

Why do investors like SaaS companies so much? It's their predictable revenue stream.

All these companies go out and sign up new customers, who get on a monthly or annual subscription plan. For the most part, once a customer, always a customer. Therefore, companies knock themselves out to sign up as many new customers as fast as they can.

To a regular value investor, it looks like these companies are losing money. From a SaaS management perspective, though, their future revenue stream is incredibly steady so they don't mind spending a lot on sales and marketing to get new customers in the door. In fact, if they're not spending a lot of money they're probably holding back their business.

Investors can look past GAAP losses if they are seeing cash flow and very strong top-line revenue growth. It's the revenue growth that makes investors excited. It shows the product is really selling itself to new customers.

Therefore, over the past couple of years, these SaaS companies' stock price trajectories have been remarkably straight up. There hasn't been a lot of volatility until a month ago.

Workday and another high-flier, Splunk (SPLK), went public with price-to-sales ratios around 11x. To a lot of industries, that multiple looks stretched. However, SaaS companies' revenue are so predictable and resilient that investors looked past this. At the highs at the end of February, Workday got to a price-to-sales ratio of 30x and Splunk got up to the high 20x level.

But the momentum ended. Workday got sold off 30% in this five-week pullback. Splunk was even worse, down 40% from the highs earlier this year.

Were these pullbacks deserved? Yes, at such stretch valuation levels. Are they a good buy now? They're bouncing today but I don't think they have the all-clear by any means. Decreased valuations still look pretty stretched here, despite the relative security of their future revenues.

At the time of publication the author had no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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