Workday

Workday's second-quarter total revenue grew 13% year over year to $2.65 billion. Non-GAAP operating margin of 31.1% expanded 210 basis points compared with a year ago. Annual recurring revenue, or ARR, from agentic AI is approaching $600 million, representing over 200% year-over-year growth.

Why it matters: Workday's agentic AI is giving the firm a top-line boost, with over $100 million in new contract value this quarter. However, artificial intelligence monetization remains premature. Out of the 5,500 Workday agentic AI customers, the majority are not paying and only 200 signed up for Flex credits. We believe its core human capital management, or HCM, and financial management modules will remain the primary factors that support our double-digit subscription revenue growth forecast over the next three years. The $600 million agentic AI ARR accounts for less than 6% of Workday's subscription revenue. Gross revenue retention of 97% and net revenue retention of around 105% show that Workday's core products continue to enjoy high switching costs. The platform retains its pricing power as the key system of record for enterprise customers' most important data.

The bottom line: We increase our fair value estimate for narrow-moat Workday to $156 per share from $150 as it continues to deliver stable revenue growth and margin expansion. Shares currently look overvalued, and we think the market might be too eager about Workday's agentic AI monetization. We understand Workday's rationale to onboard enterprise customers with free agentic AI trials. Despite strong initial interest in AI, the technology's probabilistic nature is an issue that would make CIOs think twice before rolling out AI agents across their mission-critical back-office workflows. We look forward to Workday's new research arm coming up with breakthroughs in enterprise AI security and governance that can potentially drive more widespread agentic AI adoption and bring upside to our revenue growth forecasts.

Management narrowed its full-year revenue guidance toward the high end to $10.65 billion-$10.66 billion. Full-year non-GAAP operating margin guidance also increased by 50 basis points to 31%. Despite decreasing operating cash flow and free cash flow this quarter, management maintained full-year guidance of $3.45 billion for operating cash flow and $3.18 billion for free cash flow, showing that AI investment's pressure on cash flow is temporary.

During the call, Workday also gave a preview of its fiscal 2028 subscription revenue growth outlook of 11% and non-GAAP margin improvement outlook of 200 basis points. The numbers are in line with our expectations, and we expect to hear more about the company's long-term roadmap at its investor day in October.

Workday continued with its aggressive pace of share repurchases in the second quarter, spending a total of $1.3 billion. The company has $4 billion remaining in share repurchase authorization, and management called out buybacks as an important part of its capital allocation philosophy. We expect the buyback program to effectively reduce Workday's total number of shares outstanding.

Our fair value estimate of $156 per share for Workday implies a fiscal 2027 enterprise value/sales multiple of 3 times and an adjusted price/earnings multiple of 14 times. We forecast that Workday will grow revenue at a five-year compound annual rate of 10%. The robust performance of Workday’s core HCM and financial management offerings should continue to attract new customers on board, ensuring stable future revenue growth.

Workday’s net retention rate has been consistently above 100%, demonstrating healthy trends of existing customers increasing their spending as they see positive returns from previous investments in Workday. This is also evident from the increase in product attach rates over the past six years, with Prism Analytics’ attach rate increasing from 1% to 30%, financial planning from 9% to 36%, and employee learning from 12% to 55%. In addition, Workday still has many opportunities to acquire new customers, especially in the international market. Currently, only 25% of Workday’s revenue comes from outside the US, but the total market opportunity overseas should be equivalent to the US. We believe Workday’s continuous effort in new product development, as well as collaboration with partners in the international market, should drive low-double-digit revenue growth over the next three years. Workday’s professional services revenue should grow in the low single digits as the company continues to provide direct support and training for customers.

We expect moderate margin improvement as Workday expands its revenue base, with gross margin expanding around 200 basis points and non-GAAP operating margin expanding around 500 basis points over the next five years. Workday recorded its first positive GAAP operating margin in fiscal 2024, and we believe there is still much room for the company to improve its margin profile, which is consistent with other large enterprise software providers. Workday’s research and development expense has been higher than sales and marketing expense over the past few years, but we think sales and marketing should overtake product development in the near term as the company focuses more on expanding new growth areas in the US public sector and international markets.

We assign Workday a narrow moat rating, driven by strong switching costs. Workday provides cloud-native enterprise resource planning software that serves as a mission-critical system of record for clients’ human resources and financial data. It is unlikely that existing customers will leave Workday for an AI-native solution because Workday’s switching costs are deeply rooted in its data and internal logic, a realm beyond the scope of today’s generative AI tools. However, with AI quickly evolving and fundamentally shifting the cost and speed of software development, we think a narrow moat rating best reflects the strength of the switching costs Workday can enjoy, given the recent advancements in large language models.

Founded in 2005, Workday is a pioneer in cloud-native ERP systems. The entire application follows the standard cloud-based software engineering practice of adopting a three-tier architecture. The presentation tier provides the user interface for end users to interact with the system. The application tier includes hard-coded logic that modifies data based on user inputs. And the data tier sits at the bottom, where all the information is stored and managed. Each tier can be updated or scaled independently to fit evolving business needs.

When it comes to switching costs that support economic moat, we believe LLMs’ disruption is limited to the presentation tier, in that AI enables vast new ways for users to interact with underlying data. Keeping the legacy user interface for familiarity is no longer a reason to stay with the incumbent system. Therefore, any switching costs built on the presentation tier are at risk. However, the application tier and data tier should be safe from AI’s disruption, in our view, since the specific logic and data still require a rigid one-to-one mapping during the migration process. In other words, AI does not make an ERP system’s migration easier as long as the client needs to move the underlying data. Moving from one ERP system to another is still a multi-year project that would cost millions of dollars, and AI could not help much during the process because of the deterministic nature of this process.

We see strong evidence that Workday’s switching costs come from its logic tier and data tier. The goal for an enterprise ERP system is to create a reliable source of truth where users can quickly find what they need, and they know that all information from the system can withstand the strictest audit. Within a reasonable total cost of ownership, chief information officers would like to maximize the data security, integrity, and query performance that the system can bring, areas where Workday thrives thanks to its robust logic tier and data tier architecture. Historically, Workday boasts a gross retention rate of over 95% and a net retention rate of close to 110%. As long as Workday continues to deliver on the data security and integrity front, we do not see enterprise IT decision-makers authorizing million-dollar budgets to swap out the Workday platform and pursue AI-based offerings.

Another sign that Workday’s value lies in its logic and data tiers is that the company has offerings to monetize its underlying data. Workday Extend is a developer toolkit that allows companies to build their own applications based on business needs. To us, this indicates that customers are willing to pay for the sole purpose of accessing data without all the convenience that comes with Workday’s user interface.

Workday’s data flexibility also enables integration between Workday and other enterprise systems, including LLMs, which should enhance the company’s switching costs. The Workday platform provides over 600 prebuilt integrations with third-party software, which means developers can easily feed Workday’s data into other platforms right out of the box. That said, switching to another HCM or financial management system would require IT departments to rewire all the connections among corporate systems, which is a complicated process that might disrupt day-to-day back-office workflows.

We recognize that LLMs fundamentally reimagined how end users can interact with enterprise data, which may quickly render Workday’s current user interface obsolete. However, Workday’s newly acquired companies, most notably Sana, can provide AI-native employee experiences powered directly by LLMs. If this is the ultimate direction that the user interface of ERP systems is heading, an eventual integration of these new modules can unlock massive potential that ensures Workday’s overall user experience stays competitive in the long term.

We also see traces of network effect in assessing Workday’s moat source. Workday Marketplace is a service that provides first-party and third-party applications and solutions to address specific use cases for customers. First-party solutions developed by Workday are currently free, but third-party developed products usually require service contracts with partners. As Workday’s customer base grows, third-party solution providers like Accenture and Deloitte should have more incentive to bring innovative solutions that extend Workday’s usability, which, in turn, provides a better experience that attracts more customers to Workday.

This two-sided network is too early to support a moat, as monetization opportunities remain limited. However, Workday has launched different initiatives to support the expansion of its marketplace ecosystem. Workday also brings artificial intelligence capabilities to developers via Workday Illuminate, which enables sentiment analysis and document intelligence to streamline decision-making. We believe Workday’s continuous buildout of Workday Marketplace could eventually lead to a network effect moat source to the business as a whole.

Workday has already gathered a large customer base as enterprises move their corporate systems to the cloud, offering the company upsell opportunities as it rolls out new modules.

Workday is strengthening its partnership with IT organizations globally, bringing its product to key international markets like Japan and Europe.

Using Workday’s human capital management and financial management systems together provides a better customer experience, which should help the company land more full-suite deals.

Workday’s FINS platform still misses some advanced functionality compared with other solutions, which may limit future financial management module attach rates.

Workday’s expansion in verticals with specialized feature requirements, like government and education, may be slower than expected.

Competition among enterprise software vendors to introduce new AI agents has been intensifying. Workday faces heavy investment pressure to remain a relevant player.