Creativity and Value Investing

One foot hurdles are the best investments.  John texted me Thursday night asking which team I thought I would win the NBA Finals. Since I am on mountain standard time, my kids don’t usually go to bed until these games are almost over.  I replied to his text as my kids were going to bed, which happened to coincide with the game in the 4th quarter and the Warriors leading by 20.  I picked the Warriors to win, a classic one-foot hurdle (unless you are the Atlanta Falcons).

Some of the best companies today trade at valuations that may not be dot-com era expensive, but don’t necessarily appear to be one-foot hurdles.

When nothing looks easy, value investors tend to get creative.

Imagine a value investor pitching you on the idea that McDonald’s should be valued higher because of the market potential to sell children’s toys to all of its many customers on a daily basis.  If McDonald’s merely sold one toy to X% of its customers, it would increase its earnings by Y%.  Rest assured, these numbers would be quite precise.  

Workday is a company I have been following from a distance for about a year now.  I say “from a distance” because each time I get close to the numbers, it shocks me how expensive the company is that I immediately jump back.  That being said, the company has only gotten more expensive this year (up 57% ytd).  During this time period, I have thought many times whether it is me who isn’t being creative enough in estimating their future revenues and value?  

Workday is a cloud-based provider of enterprise resource planning software.  Workday’s primary focus early on was in Human Resource software, more specifically, HCM or Human Capital Management.  However, it is slowly broadening its portfolio to Financial software and potential other areas.

Workday 2016 2013
Revenue $1,569 $469
Operating Cash Flow $349 $46


We don’t need a detailed analysis of Workday’s financials.  The main point is the company is growing like a weed.  However, the valuation is growing like a weed on steroids.  Workday is currently valued around $21.5B.  That’s about 60x operating cash flow.  This doesn’t even take into account the roughly 2% of stock-based compensation annually (rough estimate).     

Some back of the envelope math, if Workday continues to grow at an astounding 35% for the next 3 years, and is then valued at roughly 40x operating cash flow (assuming roughly 2% stock compensation dilution), Workday would return approximately 14.5% from today’s prices.

Buffett likes to compare his method for investing to Aesop’s fable about the bird in the hand vs. the bird (or birds) in the bush.  In essence, this idea boils down to how much are you paying for the future growth of the business.  With Workday, you are paying up for a lot of birds in the bush.  

When thinking about Workday, it is quite possible to imagine a world in which Workday doubles its current HCM market share from 5% to 10% (SAP is currently around 10% and the market leader) and further expands into other software verticals financial reporting (already started) and customer relationship management (CRM–Salesforce’s home turf).  If you spend some time talking to customers of Workday, it becomes even more possible given how pleased Workday’s customers are with its products.  

I like writing to some extent because I can spill onto paper the debates I have in my head and with John.  This debate of being creative with the future growth is a tough one for me.  It is much easier to assume that Verisign will continue to charge website owners $7.99 for parking their address at a specific dot com then to imagine Workday growing at almost 40% for many years into the future.  

This is a value investor’s dilemma, we just aren’t that creative with the future.  We like one-foot hurdles and only paying for the bird in our hand, not the potential birds in a bush.  And I feel myself getting nervous when I begin to become “creative” in thinking about the ways a company “could” make money.  

Workday is hands-down beating the legacy operators of software in its current field (HCM-Human Capital Management or Human Resource). SAP, Oracle and other legacy providers are either growing slower, losing market share (IBM) or treading water in comparison to Workday.  It is tough not to want to own a company that pleases its customers.  I am, however, reminded of the phrase, “at an attractive price.”  I can only dream of owning Workday at an attractive price….With Workday, I would settle for a reasonable price.  

There is a contra argument to this idea, which I will post by Tuesday.  The idea that spending heavily now to gain large market share is the best idea for companies with low marginal costs of production and quasi-winner take all markets.

 

Verisign: The Golden Yardstick

Suzuki Violin is a method for teaching violin. There is a set of books that contain numerous songs that the children learn

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