AGB 2020.9 - Workday (WDAY)
Enterprise SaaS - Low Churn, High Unit Economics
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Workday is the leading cloud native provider of Human Capital Management (HCM) and Financials software for medium and large enterprises. The company has over 45% of the Fortune 500 and 20% of the Global 2000 as customers (3,000+ customers total) of their core HCM platform. The HCM platform is still growing in the mid 20%s annually. Workday’s faster growing Financials platform (+50% annually) now has over 900 customers, most of which are medium enterprises but the company is scaling up as more large enterprises are moving their financials infrastructure to the cloud.
Workday was founded by PeopleSoft founder, David Duffield and executive, Aneel Bhusri after Oracle’s hostile takeover of PeopleSoft in 2005. PeopleSoft was a leader in Enterprise Resource Planning (ERP) software, which consists of HCM, Financials, Supply Chain, Order Processing, Manufacturing, Planning, Procurement, etc. The two founders recognized that the HCM portion of on-premise ERP software was ready for cloud adoption. So Workday was formed and gained traction within the large Enterprise early on.
The company completed its IPO in late 2012 with much fanfare at one of the highest valuations (at the time) for a software company at 19x EV/NTM sales. Expectations were elevated at the onset and the growth rates were equally as high (subscription revenue for FY12 grew +142% y/y), which led to the forward multiple peaking at 25x in early 2014. We don’t usually discuss valuation much in AGB, but we mention it here because it took quite some time for Workday to grow into its high multiple.
Workday has grown its HCM business in the large enterprise market and achieved annual subscription revenue growth >100% y/y for many years. Workday initially competed against Oracle (essentially PeopleSoft) and SAP (SuccessFactors) as these two companies are the most successful incumbents of enterprise ERP software. Other HCM competitors include Ultimate Software, Cornerstone OnDemand, Kronos, etc.
As of FY20, Workday’s HCM business generates more than $2.5B in subscription revenues, but growth in that segment has come down from the +100% y/y growth to a more sustainable growth rate in the mid +20%s. The company recognized that the early growth rates in HCM were not sustainable long-term, so the company continued to reinvest capital in the form of R&D to develop a leading Financials solution. Evidenced by the growth in Financials, Workday has found its 2nd S-curve product and continues to develop or acquire potential 3rd and 4th product lines.
Financials started off competing the mid-level enterprise market while also leveraging its established relationships in HCM within large enterprise. Workday has found that mid-level enterprise clients want a more comprehensive package and are less encumbered by a legacy ERP solution, which makes switching to a cloud native offering easier. These mid-level customers oftentimes want Financials + HCM, which allows Workday to benefit from its increasing scope of product offerings. Verticals also matter quite a bit in Financials. Workday started targeting Healthcare, Education and State/Local Government as its first verticals. The company then specialized to target Financial and Professional Services businesses. Technology, Media, Retail and Hospitality are newer verticals for Workday.
When analyzing Workday, one must also consider other successful enterprise cloud companies like Salesforce.com and Service Now. These are all good businesses and they all benefit from (1) low customer churn, (2) high unit economics, and (3) customer growth.
Later on, we go over some of the differences among these three companies. The reason Workday looks so interesting is that (1) it’s early on in its path to growing its 2nd S-curve product, (2) it has much more potential leverage remaining in the operating model, (3) and it’s finally grown into its multiple.
Why is it a good business?
As most of us already know, enterprise SaaS businesses are best in class, not only because of the recurring nature of the revenues, but also because of the attractive unit economics (long-term value of the contracts vs. the cost to book and service the contracts). Furthermore, SaaS companies typically charge on a per-seat basis, so as companies grow and/or continue to use the product, they tend to purchase more seats. And as these SaaS companies offer more ancillary products, they upsell customers for these new modules. Contracts are billed in advance, non-cancellable and typically have 1-3 year term lengths. What’s not to like?
Similar to most other software vendors, Workday benefits from its customers having ever increasing switching costs. Workday is typically displacing on-premise software providers like SAP and Oracle, but these software vendors also once benefited from its customers’ high switching costs. So we recognize that it’s not enough to say that switching costs will provide a large moat for the business over time. Clearly, the SaaS model has much less friction than the on-premise model and that should help Workday retain its customers over time, but the company must continue to put out the best products for its customers to retain its position.
Workday and other best in class SaaS vendors like Salesfore.com and Service Now benefit from having enterprise customers as their core customer base. Having more large customers is an obvious benefit due to the larger contract sizes and the high likelihood that these businesses stay open over time. Enterprise customers also tend to churn less as they are less price sensitive but rather put more weight on reliability and usability.
But a more subtle benefit of enterprise customers are the better unit economics. Both Salesforce.com and Service Now have stated that enterprise customers have much better unit economics as measured by the customers annual contract value or ACV.
Unit Economics = ACV / Cost to Book and Service a Customer
Salesforce.com stated that Enterprise customers on average have 5% better unit margins than SMB customers. Service Now illustrated an example where a $5M ACV customer has 3x and a $20M+ ACV customer has 5x the unit economics of their average customer. While Workday hasn’t disclosed specific unit economics by customer size, we do know the company predominantly has enterprise customers for HCM and is looking to do the same in Financials.
Workday is also best in class when compared to other enterprise focused SaaS companies in terms of gross churn rates and CAC ratios. The company’s gross churn rate ranges between 3%-4%, better than Salesforce.com’s 7%-8% and slightly behind Service Now’s 2%-3%. A low gross churn rate implies that the length of time a customer remains a customer is high and that there is potential for much better efficiency of its sales & marketing efforts. For example, an annual churn rate of 3% implies the average customer stays for 33 years, while a 7% churn rate implies the average customer stays just over 14 years.
Workday’s CAC Ratio at 1.5x is also close to Salesforce.com’s 2.0x and Service Now’s 1.6x, according to Workday’s calculation at its FY18 Analyst Day. CAC Ratio is calculated by measuring the change in gross margin dollars for every incremental dollar spent in sales and marketing.
CAC Ratio = Δ Subscription Gross Profit Dollars / New Customer Related Sales & Marketing
This determines sales and marketing efficiency and while we couldn’t replicate the calculations according to the slide, we recognize there are many assumptions that go into incremental dollar spent in sales and marketing. But the big takeaway is that each of these companies is capturing really good unit economics because every incremental gross margin dollar goes a long way due to the low churn rates (long life time value) of customers.
Many analysts like to come up with an LTV/CAC ratio for SaaS companies to measure efficiency across companies that target different sectors, customers and product needs. However, we don’t do it here because we felt like we would be making too many assumptions to get to a precise number. Furthermore, differences in sales efficiency, how each company measures clients, the differences in multiproduct vs. single product customers, and incremental gross profit dollar contributions from new vs. existing customers would make the number less meaningful. But we know for a given period of time (usually annual),
LTV/CAC = (Δ Subscription Gross Profit Dollars / Incremental S&M expenses) x
(1 / Churn x Discount Rate) x (New Customers / Total Customers)
Thus, in our view, knowing that each of these companies has a good CAC Ratio and a low churn rate is enough to be satisfied that the LTV/CAC is in a healthy range.
Returns on capital?
Over the past 10 years, Workday has spent $1B in capex, $2.1B in acquisitions and $5.5B in R&D. The bulk of the investments that the company has made has been in R&D, but Workday has made two large acquisitions in FY19 and FY20. Workday has built its HCM and Financials software suites from the ground up and the company prides itself on the commonality between its product lines.
In addition to the core HCM platform, Workday has developed modules that companies can choose to attach to their core subscription. Learning (12% -> 34%), Time Tracking (57% -> 63%), Payroll (58% -> 61%) and Recruiting (59% -> 70%) have all seen their attach rates improve over the past 2 years. Within Financials, Workday offers Inventory (16% -> 20%), Project Billing (24% -> 32%), Analytics (3% -> 17%), Expenses (89% -> 90%) and Procurement (84% -> 85%) to name a few, as add on modules, which have all seen their attach rates improve the past 2 years as well.
Workday continuously evaluates the build vs. buy case for any new areas that the company feels is ready for cloud deployment. In FY19, Workday acquired Adaptive Insights, a company that the venture arm of Workday had invested in the past. At the time of acquisition, Adaptive had over 4,000 customers and subscription revenue growth was in the mid +30% range. Adaptive was more geared towards small to mid-level enterprise (77% of customers) and getting folded into Workday meant that the large enterprise market would be easier to penetrate. Adaptive gives Workday a very competitive solution in budgeting and planning. The attach rates for planning has increased from 34% in FY18 to 51% in FY20.
The Scout acquisition from FY20 gives Workday a competitive product in the sourcing space. Coupa Software has seen tremendous success in procurement and sourcing, and is on track to reach almost $500M in revenues in this upcoming fiscal year. Sourcing has the potential to have certain network effects, but it remains to be seen if they are strong or weak, given that being in one network doesn’t preclude a vendor from participating in another. Sourcing as well as planning have the potential to become a large part of the Workday ecosystem.
We estimate that Workday has achieved very high returns on incremental capital invested over the past 10 years. While growth rates have slowed in recent years, we estimate that returns on capital for the past 4 years have averaged between 35%-50%. The slowdown in returns for the past 2 years mostly have to do with the Adaptive acquisition, since the acquisition was large at $1.55B and the multiple was high at 10x revenues.
While annual HCM subscription growth has come down to the mid 20%s, Workday has plenty of share gain/module add-on opportunities remaining. At its 2019 Analyst Day, Workday highlighted the company’s high win rates and market shares vs. other HCM cloud vendors. Workday now has over 45% of the Fortune 500 as customers and other cloud vendors have 25%, which implies that 30% still have yet to transition to the cloud. With Workday’s 60+% win rates in both HCM and Financials, the company could potentially win another 20% of the remaining on-premise to cloud opportunity among the Fortune 500.
The TAM is also growing. Even after most Enterprise customers transition from on-premise to cloud, there are still opportunities for growth such as add-on modules, growth of the customer base and price increases. The HCM market grew from $11B in 2014 to $18B in 2019, a +10% 5-year CAGR. Gartner estimates that the SaaS vs. on-premise mix in HCM is 70% in 2020 and will increase to 81% by 2022.
But on top of the HCM opportunity, Workday has its 2nd leg of growth in core Financials. Here, the company is much less penetrated in the Fortune 500, as this business started in the mid-level enterprise and focused on only a few verticals. As Workday’s product offering expands and is more successful in converting its core HCM customers over to Financials, growth for this segment should remain elevated. Gartner estimates that the SaaS vs. on-premise mix in Financials is 34% in 2020 and will go to 44% by 2022.
From a top down financial perspective, Workday is still in the middle of its transition to its long-term operating model. The company estimates that 25% non-GAAP operating margins is achievable, especially since core HCM is not that far off at >20% margins. Assuming declining growth rates in HCM and steady Financials growth rates, it would imply that total revenue could reach over $7B before the company reaches its operating margin target.
We estimate that Workday has reinvested between 40%-60% of its capital back in the form of R&D, Capex and M&A over the past 4 years. The reinvestment rate was especially high in FY19/FY20 with the Adaptive acquisition given the high purchase price of $1.55B. With a return on capital between 35%-50%, we estimate that Workday’s intrinsic value has compounded at rate between 20%-25% over the past 4 years.
What else is important?
Further Comparisons of Workday vs. Salesforce.com and Service Now
Workday, Salesforce.com and Service Now are the three largest pure Enterprise SaaS companies by revenue and it may be helpful to compare and contrast the three. They all serve a different need for the modern day enterprise, which includes sales, services, marketing, HCM, financials, procurement, IT and other back office functions. Each has great CAC ratios and low churn rates, which imply a strong LTV/CAC.
Interestingly, the largest difference may be how capital is allocated among the three companies. Workday puts more of its capital in R&D (and acquisitions as of late), while both Salesforce.com and Service Now spend more on Sales and Marketing. Looking back historically, Salesforce has been the more acquisitive company among the three and Service Now hasn’t really made any large acquisitions, but rather solely focused on organic growth through their sales engine.
Workday’s R&D as a percentage of revenues is in the low 40%s range while Salesforce.com is at 15% and Service Now at 20%. We estimate that there are structural reasons for the difference, one being that creating software for HCM and Financials especially, is a much more difficult task. Workday has the potential to lower its R&D spend to the 30%s as Financials becomes a more mature product offering.
Workday also has a much higher mix of service revenues to subscription revenues, implying that implementation of their software requires longer times. Core HCM and Financials implementations take 6 to 9 months whereas the add-on modules such as planning and sourcing can be done in much shorter times. Workday has mentioned that it has brought down its implementation costs, especially in the medium enterprise which is helping with win rates.
Finding the 2nd and 3rd S-Curve Products
The most impressive thing about Salesforce.com has been the company’s ability to maintain high growth rates at ever increasing scale. The company has grown its subscription revenues between 25%-35% over the past 10 years, even as subscription revenues approached $19B this fiscal year. Sure, there were large acquisitions that were made along the way, but Salesforce was able to maintain such high growth due to its 2nd and 3rd meaningful product lines.
Since the company has started breaking out its different sources of revenue, we can see that Sales Cloud has grown from $2.5B in FY15 to over $4.5B in FY20. While impressive, that’s a 13.5% annualized growth rate, much below company average. What’s amazing is that other areas picked up the slack, such as Service Cloud, which has grown from $1.3B in FY15 to almost $4.5B in FY20 (27.5% CAGR). Most impressive is the platform business which has grown from $745M in FY15 to almost $4.5B in FY20 (43% CAGR).
Workday is similarly on a path to sustain subscription revenue growth rates with the growth in its non-HCM business segments. Financials has the potential to be just as large as HCM and it presents more opportunities to add other modules on top of the core offering.
A meaningful acquisition could move the needle for Workday. The company has been more acquisitive as of late and while the company feels like its product offerings are almost rounded out with the addition of planning (Adaptive) and sourcing (Scout), there are other areas that could be worth pursuing.
It seems like sourcing and procurement could be the largest opportunity for Workday, given Coupa’s success in that area, but Workday would be a contender coming after the established leader in that space. If Workday can leverage its medium to large enterprise customer relationships, there may be an opportunity to bifurcate the market to Workday’s advantage. We have to remember that Workday competed against other cloud vendors in HCM like Ultimate Software and still managed to gain the majority of the Fortune 500 as customers.
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