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  • KPB & Co Research

WorkDay (NASDAQ: WDAY) presented its Q1 of FY-20 results recently, where it continued to put up strong growth in revenues and operating cashflows. Total company wide revenues came in at US$825.1Mn representing an increase of 33.4% over that of Q1 FY-19. Of note, is the growth in subscription revenues, and operating cashflow which came in at 34.4% and 13% respectively. With the stock trading at almost 85x forward free cashflows, the company has to put up solid growth in revenues for a long time in the future to justify current valuations. This is the same for other companies in the cloud human capital management industry. The high expectations implied in these valuations, reduces the degrees of freedom that management has to balance complex issues, such as employee expectations, wall street expectations, growth opportunities, and raising capital.

High Stock Prices IS A Double Edge Sword

As with most technology companies attracting, motivating, and retaining talent is very expensive, as most of the these employees are developers, PhDs, and data scientists. The salary range for these roles start at US$75k, which is almost 1.5X the national average. Most technology companies offer a big equity component as part of total compensation through the use of stock options, and restricted stock units. In the case of Workday, share based compensation expense amounted to approximately 23% (11% - adjusted for share price increase) of revenues in FY-20, and almost 8% of shares outstanding are due restricted share units and stock options. For Paylocity, stock based compensation amounted to 8% of revenues, Paycom approximately 6.5% , Cornerstone On Demand 12%, and Ultimate Software 12%. Traditional "meat and potato" businesses typically have stock based compensation of around 2% of revenues or less. With higher stock prices, restricted share units have to be granted at increasingly higher prices. What does this mean? The management team has to keep the stock price moving up, as a fall in the stock price would essentially give employees a pay cut, creating an incentive for them to take their talents elsewhere. Maintaining high valuations is always tough job, especially with wallstreet analysts breathing down theirs necks, and asking for higher growth, and smoother earnings.

Higher Growth Comes From Investments, which May Lead To Volatile Earnings

The growth of any business is driven by investments in people, processes and equipment. On the other hand, the spending money on equipment and processes leads to additional recurring maintenance Capex, and spending on software development leads to bigger intangible assets that have to be amortized. At the same time revenues will trickle in slowly leading big operating losses in the short term. In the enterprise software business sales cycles tend to be very long and software development has high degree of uncertainty given the pace of change. Once signed, revenues tend to be sticky and recurring, with margins expanding as the business scales. As such companies in this space benefit from having a long investment time horizon and patience. According to Industry analysis done by Markets and Markets , the cloud human capital management industry "is expected to grow from US$14.50Bn in 2017 to US$ 22.51 Bn by 2022, at an estimated Compound Annual Growth Rate (CAGR) of 9.2%." With this expected growth rate, and many industry incumbents operating at sub-scale levels, it is natural that companies will have to spend big amounts on software development. Furthermore, there are scale advantages from having a wider assortment of services, making the impetus to grow even more compelling.

Earnings Volatility Scares Wall Street

On Workday's Q1 of FY-20 conference call, the attentive listener can capture the moment when the the Chief Financial Officer - Robynne Sisco carefully explain to analysts the volatility in earnings - at 10:36 and 18:02, as way to adjust their expectations accordingly. When companies are trading at 20X forward earnings and higher, the game becomes high stakes, in the sense that the company has to consistently deliver high growth in earnings to justify the valuation. Any earnings surprise to the downside can lead to upwards of 40% reduction in the stock price, even if the surprise is due to a short term phenomena.

Managing The Capital Structure and Financing Growth

The companies in the cloud human capital management industry balance the issues outlined in many different ways. Some companies like Ultimate Software decided that turning over control to a private equity group is more compelling. An investment consortium led by Hellman & Friedman, Blackstone, GIC, the Canada Pension Plan Investment Board, and JMI Equity acquired Ultimate Software for US$11Bn- a 19.3% premium to the last trading price. The expectation is that the company will be able to crystallize much of the gains in the stock price - to the benefit of employees and other long time holders, while eliminating the pressure that comes from meeting quarterly earnings targets as they ramp-up investment in the business. They will also benefit from having deep pocketed investors they can bank on to do second round investments. Workday choose to acquire a range of companies that allowed them to expand their product capabilities, while avoiding big expenditure on product development. They acquired RallyTeam to boost their machine learning capability. One of the biggest acquisition the company undertook was adaptive insights - a provider of cloud-based business planning and financial modelling tools - for US$1.6Bn. To finance this acquisition the company issued US$1Bn in convertible bonds. According to the company:

Workday expects to use the net proceeds from the offering of the notes for general corporate purposes, potential repayment or repurchase, or payment of cash amounts due upon conversion, of its outstanding 0.75% convertible senior notes due 2018 and 1.50% convertible senior notes due 2020 and potential acquisitions and strategic transactions, and to pay the net cost of the convertible note hedge transactions (after such cost is partially offset by the proceeds to Workday from the sale of the warrant transactions).

ADP followed a similar pattern where they would acquire companies to gain access to additional products rather than invest in product development themselves. Of course, it is this same strategy that led to activist investor Bill Ackman running a proxy contest to remove the CEO and get 4 seats on the board. At the time, Bill Ackman thought that the company was not optimized as management had under invested in the company for years.

Growing a business from scratch is never easy, the management team has to deal with several complex issues that have no easy answer. Also, management teams at all times have several key stakeholders who need to be managed simultaneously so that value can accrue to everyone in the best way possible. The stake holders themselves have their own responsibilities they must honour, and sometimes the incentives does not align perfectly.

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