Ceridian: Recurring Revenue Growth To Drive Margin Expansion (NYSE:CDAY)

Ceridian (NYSE: CDAY) is a cloud-based Human Capital Management / HCM solution for human resources, payroll, benefits administration, workforce management, and talent management.

CDAY went public in 2018, and the stock briefly reached an all-time high of ~$128 per share in 2021, before gradually declining to ~$66 per share today. At that level, the share price still doubled from its opening IPO price of ~$31.

I rate CDAY a buy. At $65.7 per share today, the share price is undervalued in my opinion. I also believe that the stock will benefit from some near-term catalysts that will drive revenue growth and margin expansion. Furthermore, risk remains minimal to moderate.

Catalyst

There are some catalysts that may help CDAY achieve a twofold effect of steady revenue growth and margin expansions beyond Q2 and FY 2023. This includes a strong focus on operational efficiencies and solid sales execution (across SI / System Integrator partnership and internal sales team) to address the increasing demand for its offerings.

As a result, I expect CDAY to see further improvements in its fundamentals. Since FY 2020, when revenue growth was at a depressed level of ~2% due to the effect of COVID 19, CDAY’s growth, operating cash flow / OCF, and operating profitability have already improved quite significantly. Revenue growth accelerated to ~22% since 2020, but in Q1, growth accelerated even further to ~26% while overall profit margins also expanded.

On the profitability side, I expect the operational efficiency initiatives implemented in recent times to continue driving margin expansions, as they did in Q1, where gross margin expanded to over 40% from 35% last year:

We see the fruits of our efforts from last year in modernizing our support organization, shifting some of the work into lower-cost jurisdictions, embedding automation in the product to ease the burden on the support. So all those things that we’ve started a couple of years ago start to materialize now, and we continue to expect cloud recurring gross margin to grow throughout the year as well.

Source: Q1 earnings call.

There are two reasons why I feel that margin expansions may extend beyond Q2. First, the operational efficiency initiatives seem to have targeted cost improvements within the cloud recurring business, which is already a higher-margin, faster-growing, and the largest business for CDAY. Recurring cloud revenue made up almost 80% of total revenue as of Q1, up significantly from ~71% in Q1 last year. Secondly, the initiatives also seem to have been structural in nature (e.g. outsourcing support to lower-cost jurisdictions and then adding an automation layer to it), potentially creating a sustained operating leverage going forward.

Another key part of the overall margin expansion is the continuing growth in cloud recurring revenue. As cloud recurring revenue continues to grow with a target segment margin expansion of 80%, I think that it is realistic to expect CDAY to achieve over 45% gross margin for the overall business.

In Q1, cloud recurring revenue already saw over 40% growth, which is impressive for a company of CDAY’s scale. I have seen many smaller cap cloud software stocks struggling to achieve even low-teen double-digit growth under the ongoing tough macro situation today. In the meantime, CDAY continued to see demand for its full-suite HCM offering as it landed various international customers.

What’s more interesting here is that given the multinational nature of their customers’ businesses as well as their employee size, it appears that CDAY may have not captured the full opportunities just yet. This means more room for potential expansion in Q2 and beyond through cross-sells and upsells:

I mean, we cited in our sales wins in our press release a humanitarian aid organization in Australia with 27,800 employees with plans to double. So they go in with one tranche and then they expand to the rest of their organization. We also cited one of the largest auto manufacturers in the world, 8,000 employees in Canada with plans to expand. We talked about this a little bit last quarter as well. But that’s a very, very common trend in our business that global multinationals look at taking bite-sized pieces. They make a holistic commitment. They roll them out one region at a time, generating results and using that result to drive further growth and efficiency.

Source: Q1 earnings call.

CDAY also guided to an FY 2023 revenue of $1.48 – $1.5 billion, projecting an annual growth of 19% to 20%. Looking at CDAY’s solid sales execution track record to move things toward the go-live stage, this seems to be achievable.

Risk

I think that near-term risk remains minimal to moderate. I would point to two macro factors that may affect CDAY’s overall business. The first one is the potential shift in the interest rate environment that would directly affect CDAY’s interest payment on its debt and float portion of its recurring revenue. The second one is the level of employment in the US, where CDAY generates over 60% of its revenue.

Since CDAY periodically collects funds for payroll and tax payments on behalf of its customers, CDAY typically holds and invests these funds into low-risk instruments such as high-quality bank deposits, and then recognizes the interest income as float revenue.

While we will possibly remain at a high-interest rate environment into FY 2023, the lower interest rate will negatively affect CDAY’s float revenue, which is recognized under the recurring revenue stream. CDAY’s cloud recurring revenue growth was over 40% in Q1, though excluding float revenue, growth was around 25% – 26%. Nonetheless, my view is that 25% cloud recurring revenue growth is still relatively solid and that excluding the float revenue is actually a more appropriate way to assess CDAY’s fundamental strength as a cloud software business.

However, a good thing about the float revenue is that it also counterbalances the effect of volatility in interest expenses associated with CDAY’s debt. As such, a change in the interest rate regime poses a minimal risk in my opinion. For instance, CDAY had over ~$1.2 billion of debt and paid over $9 million of net interest payments in Q1. However, as float revenue also supported growth and profitability expansion, adjusted EBITDA-to-interest coverage on an annualized basis will still be ~2.5x in FY 2023. Meanwhile, the debt-to-equity ratio was also below 1x at ~0.6x, as of Q1.

On the other hand, CDAY’s FY 2023 guidance, which includes an assumption of a steady level of employment into the full year, may present a more moderate risk. The US unemployment report published in June, just a month after CDAY’s Q1 earnings call, pointed to unemployment rate rising to 3.7% in May. At this point, it remains uncertain if the situation will continue or how it will affect CDAY’s Q2 results and full-year projection, though, in my opinion, the unemployment hike in May was rather soft.

Valuation / Pricing

My target price for CDAY is driven by the following assumptions for the bull vs bear scenarios of the FY 2023 target price model:

1. Bull scenario (70% probability) assumptions – CDAY to finish FY 2023 with $1.5 billion of revenue, at the top end of its guidance, reflecting a 20% YoY growth. I also expect the adjusted EBITDA margin to expand to 25%, in line with the guidance.
2. Bear scenario (30% probability) assumptions – CDAY to finish FY 2023 with $1.37 billion of revenue, implying a merely 10% YoY growth and missing its 19% – 20% guidance significantly. I also expect the adjusted EBITDA margin to contract to 10%, half as much as last year’s figure.

I assign CDAY an EV/adjusted EBITDA of ~43.4x based on its current trading price, across all scenarios. As such, my bull scenario may be a little conservative since the valuation multiple may also expand as higher-margin recurring cloud revenue grows in FY 2023. Moreover, my bear scenario probably captures a more extreme worst-case scenario that seems unlikely to happen, despite the 30% probability I attach to the projection. Nonetheless, some of the effects there will definitely be offset by my assumption of steady cash and debt levels into FY 2023.

Consolidating all the information above into my model, I arrived at an FY 2023 weighted target price of ~$76 per share. With CDAY trading around $65.7 per share recently, the stock offers a ~15% upside in FY 2023, and therefore an attractive buy.

Conclusion

CDAY will continue to benefit from the secular enterprise shift into cloud HCM globally. Fundamentals have been decent and improving. CDAY has catalysts for revenue growth and margin expansions, including operational efficiencies and sales execution. Near-term risks include potential interest rate shifts and US employment levels. The FY 2023 target price is $76 per share, offering a 15% upside. I rate the stock a buy.