Workday (NASDAQ: WDAY), which provides human capital management (HCM) and financial software, has been growing quickly over the past several years as it attracts large corporate customers with its cloud-based solutions. That momentum continued in the third quarter, with year-over-year revenue growth of 34.3% and new customer wins that included Lowe's, M&T Bank, Lloyds Banking Group, and Oshkosh, though its forward guidance for subscription revenue was a bit disappointing.
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The company continues to prioritize growth at the expense of margins in the near term, but provided some key details on the conference call with analysts about where management sees margins heading in the future. Additionally, management sounded particularly upbeat about the demand they're witnessing in the company's financial products.
The one metric to watch
Workday sells its software products (including support and updates) via subscription, so the majority of its revenue is subscription revenue. The beauty of Workday's business model is that subscription revenue is recurring in nature -- providing a reliable indicator of future revenue given the company's high customer satisfaction ratings (98% year-to-date).
While Workday tracks several different revenue metrics, when asked about the best way to gauge the strength of the business, CEO Aneel Bhusri responded:
In terms of what's the best guide for how we're doing, I still think it's subscription revenue growth. There might be some delay in what you see, but that's what we run the business off of and that's how we project what we're going to invest in next year.
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For the quarter, subscription revenue grew even faster than overall revenue -- up 37.2% from last year -- and came in well ahead of the company's guidance. For the full year, Workday raised its subscription revenue outlook to a range of $1.780 billion to $1.782 billion, implying growth of 38% at the midpoint.
However, in its initial guidance for next year, the company expects subscription revenue of $2.25 billion, representing roughly 26% year-over-year growth -- which would be a notable deceleration from this year's increase. That may explain why the stock has seen a minor sell-off following otherwise strong results reported in late November.
Margins are improving, but don't expect profits anytime soon
Workday isn't yet profitable on a GAAP basis, but the company's non-GAAP operating margin rose by 7.1 percentage points to 9% as revenue growth outpaced growth in expenses.
On the conference call, Workday says it expects full-year non-GAAP operating margin of 9.5%, rising to 10% next year. There should be plenty of upside remaining in the years ahead as well, as CFO Robynne Cisco explained:
... we remain committed to measured incremental non-GAAP margin improvement with an intermediate term target of 20% while establishing a new long-term target of 25%.
However, the company hasn't provided any time frame for hitting those targets -- and profits will likely remain elusive for the foreseeable future. Cisco noted:
We continue to prioritize growth and have made, and will continue to make, significant investments in product this year and beyond that will limit the pace of margin expansion in FY19.
Financial management -- a star in the making?
While Workday's HCM offering is its largest by far, its financial management product is No. 2, and its contribution to Workday's overall results continues to grow. The company added 37 new financial management customers, up more than 60% from last year, and the company was clearly enthused about the prospects for more robust gains in the near-future.
Bhusri talked about the trends Workday is seeing in the size of its financial customers:
It's definitely an average bigger customer today than it was a year ago, and much bigger than a couple of years ago. The ones that we highlighted in our opening remarks were all greater than 10,000 employees ... I'd say the other good trend is we'll have some good news for you when we report our next quarter, with some wins that are above the 20,000-employee size, that are more Fortune 500 type of accounts. They're beginning to emerge in the pipeline and becoming more predictable. It's more a matter of getting from being selected to getting the deals closed.
The company should also continue to benefit from an accelerating shift to cloud-based enterprise solutions. Bhusri stated:
I think it's a big positive when all of the vendors in a given marketplace are talking about a shift to the cloud. It creates demand. This is a huge market. Financials market is twice the size of the HR market. As it flips over, there is a ton of market opportunity ... I think we're very well positioned to get our fair share. ...
On the financial management front, we are increasingly being viewed by analysts as one of two leaders in the space as the market begins to transition from on-premise to cloud solutions.
While Workday's subscription revenue growth remains an area to monitor closely, the company's improving margins and momentum with financial customers are two big positives as it heads into next year.
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Andy Gould has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Workday. The Motley Fool recommends Lloyds Banking Group and Lowe's. The Motley Fool has a disclosure policy.