Beware of Valuation Risks on Workday Stock

Shares of Workday (NASDAQ:WDAY) fell about 6% in late August after the hyper-growth cloud enterprise resource planning company reported second-quarter numbers which topped expectations. Management also hiked the full-year 2020 revenue guide. In other words, Workday reported a double-beat and-raise second-quarter earnings report, and in response, WDAY stock fell.

Beware of Valuation Risks on Workday Stock

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A stock failing to rally on a double-beat-and-raise report should raise red flags. It is almost always a sign of overvaluation.

Is that what we have with Workday stock? I think so. Workday is a great company doing great things. The financials look really good, the narrative is robust, and the long-term potential is promising. But, Workday stock is priced for all that good stuff — and then some.

Indeed, my numbers indicate that a fundamentally supported fiscal 2020 price target for WDAY stock is somewhere around $140. WDAY stock trades hands north of $170 today — and we are only halfway through fiscal 2020.

Thus, Workday stock seems overextended here. To be sure, overextended stocks can stay in rally mode so long as investors keep buying. But, investors aren’t buying anymore. WDAY stock is down 20% over the past two months.

I think this is the beginning of a bigger downturn in WDAY stock. As such, I’d avoid buying the dip here for the foreseeable future.

Workday Has Solid Fundamentals

First, I want it to be understood broadly that Workday is a good company doing really innovative things and gaining share rapidly in a big market. There is nothing fundamentally wrong with Workday.

Enterprises everywhere are migrating to the cloud. As they do, they are adopting cloud ERP solutions to digitize, automate and optimize finance, HR and corporate planning processes. SAP (NYSE:SAP) and Oracle (NYSE:ORCL) have traditionally dominated the ERP market. But as the market has pivoted to the cloud, Workday has stepped in as a third legitimate player. A few years ago, hardly anyone used Workday. Today, 50% of Fortune 50 companies and 40% of Fortune 500 companies use Workday for their cloud ERP.

There’s still plenty of room for growth here. Only one-fifth of enterprise workloads have migrated to the cloud so far. Further, while 40% of Fortune 500 companies use Workday, only 17% of global 2000 companies do so, too. Thus, Workday has a tremendous opportunity over the next few years to: 1) grow wallet share among big enterprises, and 2) increase adoption among smaller enterprises on a global scale.

Consequently, revenue growth will remain big for the foreseeable future. Most of that revenue growth will come through the high-margin subscription revenue pipeline, so it will be additive to gross profits. At the same time, big revenue growth should drive consistent positive operating leverage, so operating margins and profits should both move higher with revenues.

Net net, Workday projects to be a big revenue and profit grower for a lot longer.

Workday Stock Is Overvalued

Sound like a great growth narrative? It is.

But, WDAY stock is already priced for all this. Revenue growth is slowing from 30%-plus rates, to 20%-plus rates. The margin expansion trajectory is flattening out because Workday is having to spend big to compete at scale. Gross margins in the subscription business are also showing signs of being maxed out. Thus, while profit growth will remain robust, it won’t be as robust as it has been.

Realistically, I think this a 20% revenue growth company with healthy, but not huge, margin upside drivers. That combination leads me to believe that $6 in earnings per share is an optimistic but doable target by 2025.

That would represent more than 250% growth from 2020’s projected EPS. But, that’s just not enough growth. If you apply an application software average 34-times forward earnings multiple to that 2025 EPS target of $6, you arrive at a 2024 price target for WDAY stock of over $200. Discounted back by 10% per year, that equates to a 2020 price target of under $140.

Workday stock trades north of $170 today. We aren’t even halfway through fiscal 2020. Thus, WDAY stock seems aggressively overvalued today.

The Party Appears to Be Over

To be sure, aggressively overvalued stocks can stay aggressively overvalued for a long time, so long as investors keep buying into the stock and the party stays alive.

Unfortunately, the party in WDAY stock appears to be winding down.

Markets have been choppy over the past few months. But not too choppy. Since mid-July, the S&P 500 is down about 3.5%. Cloud stocks are down about the same, with the First Trust Cloud Computing ETF (NASDAQ:SKYY) down about 5%.

WDAY stock is down more than 20% over that same stretch. That is a noticeable underperformance of both the market and Workday’s peers over the past few weeks.

This underperformance leads me to believe that the party is over, meaning that this stock may not find support until its fundamentals give it support — which doesn’t happen until $140.

Bottom Line on WDAY Stock

I’d stay away from Workday stock for the foreseeable future. The party appears to be over, and now the market is left with an aggressively overvalued cloud stock that investors don’t want to touch. That dynamic should ultimately result in WDAY stock falling back below $150 over the next few weeks to months.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities. 

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