Workday, Inc. quarterly report, Q2 FY2016

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Workday, Inc. — Q2 FY2016 Form 10-Q

Reporting period: Quarter and six months ended July 31, 2015; comparable periods ended July 31, 2014. Amounts below are in U.S. dollars.

Business context

Workday provides cloud-based financial management, human capital management (HCM), and analytics applications. It operates as one reportable segment. Subscription services are generally sold under non-cancelable, three-year contracts and recognized ratably; HCM represented a substantial majority of subscription revenue. Workday said growth is a key focus and expects continued investment in product development, sales, service capacity, and data centers.

Financial performance and liquidity

  • Q2 revenue: $282.7 million, up 51% year over year. Subscription revenue was $223.7 million (+56%); professional services revenue was $59.0 million (+37%).
  • Six-month revenue: $533.7 million, up 54%. Subscription revenue was $424.7 million (+59%); professional services revenue was $108.9 million (+37%).
  • Profitability: Q2 GAAP operating loss was $67.6 million versus $61.8 million; net loss was $69.4 million versus $69.2 million. Six-month operating loss was $121.0 million versus $113.9 million; net loss was $131.0 million versus $128.6 million. Q2 diluted loss per share was $0.37 versus $0.38; six-month loss per share was $0.70 in both periods.
  • Margins: Calculated GAAP gross margin was approximately 67.4% in Q2 versus 64.8% and 68.1% for the six months versus 64.5%. GAAP operating margin was approximately (23.9)% in Q2 versus (33.1)%; management’s non-GAAP core operating margin was (0.3)% versus (10)% in Q2 and (0.5)% versus (12)% for the six months.
  • Operating costs and stock compensation: GAAP costs and expenses rose 41% to $350.3 million in Q2 and 42% to $654.7 million for the six months. Share-based compensation was $64.8 million and $112.0 million, respectively, compared with $40.8 million and $69.7 million in the prior periods.
  • Cash flow: Operating cash flow was $15.5 million in Q2 versus use of $9.0 million; for the six months it was $109.6 million versus $12.7 million. Company-defined free cash flow was negative $10.3 million in Q2 versus negative $37.4 million, and positive $53.6 million for the six months versus negative $25.6 million.
  • Liquidity: Cash, cash equivalents, and marketable securities totaled approximately $1.91 billion at July 31, 2015. Current assets were $2.14 billion and current liabilities $706.3 million. Unearned revenue totaled $683.1 million, including current and noncurrent balances.
  • Debt: Convertible notes had $600 million aggregate principal: $350 million due in 2018 and $250 million due in 2020. Their combined balance-sheet carrying value was $502.0 million; reported fair values were approximately $728.1 million. The notes are unsecured and have fixed coupons of 0.75% and 1.50%.

Changes versus prior year and unusual items

  • Revenue grew faster than operating expenses, and management attributed improved core margins primarily to higher revenue and operating leverage. However, GAAP operating loss increased as expenses, including share-based compensation, rose substantially.
  • Management cited higher customer collections as the principal reason for improved operating cash flow. Six-month capital expenditures increased to $56.0 million from $38.3 million.
  • Other expense included a $3.2 million gain from the sale of a cost-method investment, which reduced reported other expense. The quarter also included an approximately $8 million net cash outflow for an acquisition; the filing does not identify the acquired business in the supplied text.
  • At July 31, 2015, property and equipment was $172.7 million, up from $140.1 million at January 31, 2015; total liabilities were $1.31 billion versus $1.23 billion.

Outlook, risks, and contingencies

  • Outlook: No specific revenue or earnings guidance is provided. Workday expected fiscal 2016 capital expenditures of approximately $150 million, primarily for data-center infrastructure and office space. It expected absolute product development, sales and marketing, and general and administrative expenses to continue increasing. Professional services margins were expected to be lower in fiscal 2016 as the company invested in its partner ecosystem.
  • Principal risks: Security or privacy breaches, outages or insufficient capacity at third-party data centers or AWS, rapid growth and hiring demands, intense competition, customer renewal and pricing pressure, international expansion and currency exposure, and continued losses. Workday stated it did not expect to be profitable for the foreseeable future.
  • Commitments and contingencies: Future minimum operating lease payments were $198 million. A 95-year land lease provides for additional payments of $0.2 million to $1 million if construction has not commenced by December 31, 2015. Management said ordinary-course legal matters were not expected to have a material adverse impact, while noting that an unfavorable outcome could affect a particular period. Certain office space is leased from an affiliate of the Chairman; rent expense under those agreements was $3 million for the six months.
  • Governance and accounting: Class B shares carry ten votes per share versus one vote for Class A, concentrating voting control. Management concluded disclosure controls were effective and reported no material quarterly change in internal control over financial reporting. The company was evaluating the future revenue-recognition standard and had not estimated its impact.

Key facts for investors to verify

  • Whether subscription growth, renewals, and unearned revenue support sustained growth as revenue is recognized over contract terms.
  • How GAAP losses and share-based compensation evolve relative to management’s non-GAAP core-margin measures.
  • Whether operating cash flow converts to durable free cash flow after the planned $150 million fiscal 2016 capital expenditure program.
  • The effect of the $600 million convertible-note principal, potential conversion or dilution, and future repayment obligations.
  • Execution of data-center capacity and international expansion plans, and exposure to cybersecurity, privacy, service disruption, and foreign exchange risks.