Is Workday Headed Lower, or Just Taking a Breather?

Shares of Workday (NASDAQ: WDAY) recently tumbled after the enterprise cloud services provider reported its second quarter fiscal 2019 earnings. The decline was surprising since Workday's numbers easily topped analyst estimates. Workday's revenue rose 28% year over year to $671.7 million, beating consensus analyst expectations by nearly $9 million.

The company's core subscription service revenue grew 30% to $565.7 million, while services revenue climbed 17% to $106.1 million. For the third quarter, Workday expects its subscription revenue to rise 49% against the 2017 quarter, compared to analyst forecasts for 43% growth. However, that figure will be slightly inflated by Workday's recent acquisition of Adaptive Insights, a transaction which was completed on Aug 1st.

On the bottom line, Workday's non-GAAP net income grew 32% to $72.4 million, or $0.31 per share, which cleared estimates by five cents. On a GAAP basis, its net loss widened from $82.5 million to $86.2 million, but remained flat on a per share basis at $0.40 due to a higher number of outstanding shares.

Workday's growth looks solid, but the stock was probably due for a breather after rallying more than 50% this year. Should investors buy Workday after its post-earnings dip, or wait for the stock to cool off some more?

What does Workday do?

Workday offers enterprise cloud applications that help companies staff, pay, and organize their workforces. Its portfolio of machine learning and analytics tools, which includes Adaptive Insights' business planning and financial modeling tools, assists companies in making data-driven business decisions.

Simply put, Workday offers "all-in-one" solutions for companies that want to digitize their HR and financial departments. Its growing list of customers includes heavyweights like Walmart, Target, and Bank of America.

How fast is Workday growing?

Workday is still a high-growth cloud services company, but its subscription and sales growth have gradually decelerated over the past year.

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Workday's $1.6 billion takeover of Adaptive Insights (shortly after the company filed for an IPO) was clearly aimed at boosting its own sales growth. But the projected overall impact isn't that impressive -- Workday expects Adaptive Insights to boost total annual revenue by $51 million this year ($42 million in subscriptions and $9 million in services), which would account for just 2% of Workday's projected sales.

For the full year, Workday expects its subscription revenue to rise 31% year-over-year, compared to the 39% growth rate it achieved in fiscal 2018. The company sees services revenue growing 19%, compared to 25% growth last year. This means that Workday anticipates just 29% total sales growth for the year, compared to 36% growth last year.

Will Workday ever become profitable?

Workday is profitable on a non-GAAP basis but unprofitable on a GAAP basis, mainly due to stock-based compensation (SBC) expenses, which are excluded from the former but included in the latter. Like many younger tech companies, Workday relies heavily on stock bonuses to retain employees and reduce its use of cash.

Workday's SBC expenses rose 21% against the prior year quarter and gobbled up 22% of total revenue, compared to 23% in the second quarter of fiscal 2018. That decision is odd, since Workday could easily pay out more cash -- its cash and equivalents rose from $1.13 billion at the beginning of the year to $1.69 billion at the end of the quarter.

But if we look beyond Workday's SBC issues, its non-GAAP operating margins still look solid. The company finished 2018 with a non-GAAP operating margin of 10.1%, and it originally expected that figure to hit 12% this year. Management now expects that figure to drop to 9%, but only due to the costs related to Adaptive Insights.

There's no clear path for Workday to achieve GAAP profitability yet, but investors should recall that many larger cloud service companies face similar issues. Salesforce, for example, only started generating consistent GAAP profits in 2015 -- 11 years after it went public.

But mind the valuations

Workday is still a solid growth stock, but its valuations are frothy. It trades at nearly 130 times this year's non-GAAP earnings and 95 times next year's earnings. Those are nosebleed multiples in the context of its projected non-GAAP earnings growth of 21% this year and 32% next year.

For comparison, Salesforce trades at just over 60 times this year's earnings and 56 times next year's earnings. Workday also trades at about 12 times this year's projected sales, while Salesforce trades at 9 times current-year projected sales.

Therefore, it clearly appears that Workday's post-earnings dip was caused by overheated valuations and profit-taking instead of fundamental problems with its business. Investors should be cautious about buying this dip, since the valuations indicate that the stock is still pricey relative to its growth potential.

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Leo Sun has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends and Workday. The Motley Fool has a disclosure policy.