In what could be the most important election of 2016, TheStreet is looking for the Worst Stock in the World and we need your help. In these times of market turbulence, it's our job to watch out for the worst investments that can sink your portfolio. Our search is not merely limited to the worst stock in the Dow or S&P. We are going global and accepting nominations from our readers for the absolute worst stock in the world. This article is part of an ongoing series talking about these stocks and why they're the worst. If you have an idea as to what the worst stock in the world is, email us at email@example.com.
Negative earnings. Increasing costs. A business model completely reliant on easy money. Sounds like the worst of the worst was thrown together to make the Frankenstein of companies right?
Well, it looks like the marketplace didn't even need Igor to create the worst stock in the world. All investors needed was their undying love for the "cloud." Their ignorance helped form Workday (WDAY - Get Report) , a human capital management software vendor that has the potential to go to zero.
It's been very amusing watching investors drool over cloud-based companies these last few years. Did they even know what the "cloud" was? Or what it was used for? There's no way to tell. But if they heard a company had something to do with the mystical cloud, they wanted it.
As investors clambered over each other to scoop up shares, they threw due diligence out the window and tossed aside the obvious warning signals. They ignored the reality that most of these companies' business models were unsustainable. Instead, investors just bought and bought. The result was the massive run-up in cloud names.
But investors could only avoid reality for so long. Eventually they would have to look into the eyes of the monsters they helped create. And that time came earlier this month when Tableau reported earnings. As a maker of data analysis and charting software, Tableau was considered one of the highflying cloud names. But after the company reported a failure to harvest tax benefits from some assets, investors dumped shares, and the stock lost about 50% of its value in one day.
The carnage wasn't contained to Tableau. It spread across the entire cloud space. Big names such as Salesforce and SAP fell, too. And one of the hardest hit was our very own Frankenstein, Workday. It dove more 16% on the news.The team at Foundation had a nice chuckle that night over some fat Cuban cigars. We knew Workday was a mess, and we had shorted its shares on Jan. 28. The stock's chart had revealed that a huge multiyear topping pattern was coming to a completion.
Courtesy of TradingView
The trade has worked out pretty well. But the move isn't over yet. Workday has a lot farther to fall. Here's why.
First, memorize this simple equation: easy money = dumb business model. The Federal Reserve's policies after the 2008 market crash pumped a lot of liquidity into the economy, and this had a big impact on technology. Investors found themselves with tons of cash and were forced further out on the risk curve in search of returns. As is always the case in an easy-money environment, the dollars poured into the newest, shiniest, most unproven business model -- cloud computing.
Tech companies loved it, shamelessly sucking up any new capital coming in. These huge cash flows made it easy to ignore the usual rules that keep companies financially disciplined. When you build your business on the assumption that an easy-money environment will continue forever, you expose yourself to the cycle's turning. And that's why Workday is in a terrible position right now.Workday is a prime example of a company that abused easy money. Its favorite move was to issue new shares every time it needed to pay for something. This chart shows the upward trend in its shares outstanding.
It was a nice relationship that developed. Investors loved Workday, and Workday loved free money. Investors would bid up the share price, and Workday would issue more shares to collect the proceeds. It would then turn around and use this money to "buy" growth.Strong sales growth is essential for a company like Workday. And it's true Workday has had great growth since its 2012 IPO. But it's important to see how that growth was manufactured. In Workday's case, it was very expensive. Take a look at the upward trend in the company's sales & marketing and R&D costs below.
The sales and marketing expense equals almost 37% of total revenue. And R&D costs equal nearly 41%. Combine them, and they take up nearly 80% of revenue! And these costs will only increase going forward because this is how Workday buys its revenue. To put this in perspective, competitor Oracle's sales and R&D costs as a percentage of revenue are half of Workday's.The high cost of growth doesn't leave much left for bottom line. Take a look at Workday's earnings per share since its IPO. The company hasn't made a dime.
Since late 2013, things have gotten worse. The company's loss per share has been getting worse.
But it didn't matter to investors as long as Workday was "growing." And so the company had no incentive to control expenses. It could continue to throw all its cash into sales and development. Investors rewarded Workday and bid up the stock price.
Some bulls claim that if Workday cut these two expenses, it would be profitable. But this isn't true. The company's revenue is entirely dependent on heavy spending in these two areas. If it cuts spending, where will new growth come from?
And that's why we say the company is buying growth. Without an increasing flow of money into sales and development, revenue growth stops.
There's another issue related to the easy-money environment. So long as the stock's price was increasing, employees were more than happy to take stock options instead of cash. The company then put the cash it saved on compensation right back into buying growth. As of November 2015, Workday had more than 12 million shares in exercisable options. That comes out to an equivalent of almost 10% of the company's current market cap. That's a lot of shares.
But here's the problem with this whole business model. It only works when the stock price is rising. It falls apart when the stock price goes the other way.
Take the new Workday employees for example. They're all excited kids straight out of college, ready to change the world through better HR systems. They believe in the dream and also in their product. So it makes sense that they also think their stock price is undervalued. They gladly accept options over cash. It's the obvious choice.
But no matter how devoted these kids are to the cause, they still need money. They need to see the stock price rising. If they don't, stock options look a lot less attractive. They aren't stupid. A falling stock price means less cash in their pockets in the future. So they would rather have money right now.
This is where the model starts to fall apart. Without a strong stock price, Workday has to pay up a lot more for the best talent. The cash that starts going to employees gets taken away from the growth-buying strategy. So sales and development spending go down. This in turn causes revenue to take a hit. Lack of revenue angers investors because they see less growth. And as always, their solution is to take their frustrations out on the stock price, which gets hammered. A lower stock price exacerbates all of Workday's previous problems. It makes hiring even more expensive. Plus it's tough to issue new shares to get cash because investor demand shrinks. And even if Workday can issues shares, it's getting less cash for each offering because of the lower stock price. This once again leads to less spending on sales and development. Which leads to less growth and more disenfranchised investors. And that leads to more of the same.
The downward spiral becomes obvious. It turns into a gigantic negative feedback loop that tanks the company. And remember how easy it was to start this chain reaction. The Tableau earnings release was the inflection point that signaled the beginning of the end. It caused the initial large price drop that triggered the negative feedback loop.
But Workday's problems don't stop there. There are many other companies that jumped into the space copying the same flawed business model. So now, not only are all these businesses in trouble, but the vicious competition between them is cannibalizing whatever revenue they've been able to gain thus far.
Workday operates in the Human Capital Management (HCM) solutions market. The following chart shows how fragmented this space is.
Courtesy of Apps Run the World
SAP holds the top spot in the HCM market with an 11% share, and Workday comes in second with 9%. But these percentages aren't much of the total pie. Competition is tough and has turned the whole space into a bloody red ocean where the economics have become terrible.
Take the dogfight between Workday and Oracle, for example. Oracle recently decided to offer heavy discounts to its HCM customers. Workday's response was to switch up its billing model to make it more lenient. And according to analysts, this move was the equivalent of telling their customers to pay them whenever they felt like.
Many of these analysts downgraded Workday after seeing how the new billing models affected the bottom line. Steve Koenig of Wedbush Securities cut his price target, citing disappointing revenue growth due to the new, more flexible payment schedules. Barclays and Nomura Securities also downgraded the company for similar reasons, while also commenting on the heightened competition in the HCM industry.
And it's not just Workday and Oracle feeling the competition. It's everyone. Here's what SAP CEO Bill McDermott said about explained about competitors such as Workday: "So, should SAP decide to focus on a margin rate and not compete in those markets and let them have the marketplace? The answer is: Hell no! You will have to compete, in some cases, on a lower profile margin rate."
It's a race to the bottom for HCM companies.
What we have here is a business model dependent on easy money along with terrible industry economics and mounting losses. Workday is clearly in trouble.
Bulls may still try and say that none of this matters as long as there's revenue growth. This thinking may work in a bull market, but not in a bear market. It doesn't matter how fast you grow your revenue when investor sentiment changes. As Joe Floyd of Emergence Capital Partners reveals in the diagram below, multiples can compress a lot faster than revenue can grow.
Courtesy of Joe Floyd
Workday is also one of the most expensive stocks out there in terms of valuations. Take a look at the company's price-to-sales ratio compared to its competitors. It's almost double the industry average.
Workday is still overvalued even after its recent steep drop. This makes it a great short. Foundation is currently waiting for an area to add to its short position. Investors are chasing their very own Frankenstein out of town. We believe Workday has a lot further to fall.