AI Spending Risks And Slower International Expansion Will Challenge Margins Yet Support Long-Term Potential

Catalysts

About Workday

Workday provides cloud applications that unify human capital management and financial management on a single platform for enterprises worldwide.

What are the underlying business or industry changes driving this perspective?

• Although AI products contributed around 1.5 percentage points to ARR growth and are included in over three quarters of net new deals, the heavy investment needed to keep AI capabilities competitive could limit how much of that AI related demand flows through to net margins and earnings.
• While unifying HR and finance on one platform gives Workday a clear role as enterprises consolidate systems, the complexity of large deployments and reliance on partners in new regions may lengthen sales and implementation cycles. This can delay revenue recognition and slow operating margin progress.
• Although Workday GO is gaining traction in the medium enterprise with added features like Global Payroll and AI deployment agents, serving a broader base of smaller customers can require higher sales and support effort per dollar of ACV. This may weigh on future margin expansion even if subscription revenue grows.
• While new AI focused acquisitions such as Paradox and Sana are already contributing to subscription revenue and cRPO, there is a risk that integration, product overlap and ongoing M&A spending could dilute returns on invested capital. This could put pressure on earnings growth if synergies take longer to materialize.
• Although Workday is expanding internationally with an EU sovereign cloud, an AI Centre of Excellence in Dublin and new offices in markets like Dubai, varying regulatory requirements and the need for localization can increase R&D and go to market costs. This may temper the impact of international revenue on overall operating margins.

Assumptions

How have these above catalysts been quantified?

• This narrative explores a more pessimistic perspective on Workday compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Workday's revenue will grow by 9.6% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 8.6% today to 14.1% in 3 years time.
• The bearish analysts expect earnings to reach $1.8 billion (and earnings per share of $7.02) by about July 2029, up from $847.0 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as $2.8 billion.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 13.9x on those 2029 earnings, down from 46.6x today. This future PE is lower than the current PE for the US Software industry at 28.6x.
• The bearish analysts expect the number of shares outstanding to decline by 7.0% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.82%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• Workday is leaning heavily into AI with products like Illuminate AI, agents, Evisort, HiredScore, Paradox, Sana and Pipedream, and management is increasing AI related hiring and acquisitions. However, if AI spend across the sector ends up being more cautious or customers conclude they can rely on a smaller set of AI features rather than a broad suite, Workday could be locked into a higher cost base than revenue supports, which would constrain net margins and earnings.
• AI point solutions and newer vendors are already seeing some customer fatigue as enterprises worry about data quality, integrity and security. While Workday currently presents this as an advantage, if larger buyers decide to slow or rethink AI projects altogether or consolidate around fewer agents than Workday is building for HR and finance, that could cap AI driven upsell potential per customer and soften long term subscription revenue growth.
• The business is becoming more dependent on acquired growth engines, including Paradox, Sana and Pipedream, and early feedback is positive. Even so, integration risk, overlapping capabilities and the need to re-platform products onto Workday’s stack could lead to slower than expected cross selling, which would weigh on future ARR expansion, operating efficiency and ultimately earnings.
• Workday is pushing internationally with an EU sovereign cloud, an AI Centre of Excellence in Dublin and new regions such as the Middle East and India. However, varying regulation, localization demands and reliance on partners can increase go to market and R&D costs faster than revenue scales in these regions, which could limit the contribution of international revenue to operating margins and free cash flow.
• The company is targeting medium enterprise and smaller customers with Workday GO, Global Payroll and managed services. Yet this segment often comes with shorter contracts, more price sensitivity and higher support intensity per dollar of ACV, so if uptake does not offset these economics, long term revenue growth could come with lower incremental margins and slower earnings expansion than investors expecting sustained share price gains might assume.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Workday is $99.32, which represents up to two standard deviations below the consensus price target of $168.64. This valuation is based on what can be assumed as the expectations of Workday's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $275.0, and the most bearish reporting a price target of just $92.0.
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2029, revenues will be $13.0 billion, earnings will come to $1.8 billion, and it would be trading on a PE ratio of 13.9x, assuming you use a discount rate of 8.8%.
• Given the current share price of $159.69, the analyst price target of $99.32 is 60.8% lower. Despite analysts expecting the underlying business to improve, they seem to believe the market's expectations are too high.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.