Workday, Inc. 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion of our financial condition and results of operations in conjunction with the condensed consolidated financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q. Overview Founded in 2005, Workday delivers financial management, human resources, planning, spend management, and analytics applications designed for the world’s largest companies, educational institutions, and government agencies. We help organizations better manage their financial and human resources with one system that helps enable them to plan, execute, analyze, and extend — all powered by machine learning. Our diverse customer base includes medium and large global companies as well as smaller organizations that primarily use our planning product. Our cycle of frequent updates has facilitated rapid innovation and the introduction of new applications throughout our history. We began offering our HCM application in 2006 and our Financial Management application in 2007. Since then we have continued to invest in innovation and have consistently introduced new services to our customers. We have achieved significant growth in a relatively short period of time with a substantial amount of our growth coming from new customers. Our current financial focus is on growing our revenues and expanding our customer base. While we are incurring net losses today, we strive to invest in a disciplined manner across all of our functional areas to sustain continued near-term revenue growth and support our long-term initiatives. We offer Workday applications to our customers on an enterprise-wide subscription basis, typically with contract terms of three years or longer and with subscription fees largely based on the size of the customer’s workforce. We generally recognize revenue from subscription fees ratably over the term of the contract. We currently derive a substantial majority of our subscription services revenue from subscriptions to our HCM application. We market our applications primarily through our direct sales force. Our operating expenses have increased significantly in absolute dollars in recent periods, primarily due to the significant growth of our employee population. We had approximately 12,300 and 11,400 employees as of July 31, 2020, and 2019, respectively. Excluding the impact of certain COVID-19 factors further described below, we expect our product development, sales and marketing, and general and administrative expenses as a percentage of total revenues to decrease over the longer term as we grow our revenues, and we anticipate that we will gain economies of scale by increasing our customer base without direct incremental development costs. 28 Table of Contents We intend to continue investing for long-term growth. We have invested and expect to continue to invest heavily in our product development efforts to deliver additional compelling applications and to address customers’ evolving needs. In addition, we plan to continue to expand our ability to sell our applications globally, particularly in Europe and Asia, by investing in product development and customer support to address the business needs of local markets, increasing our sales and marketing organizations, acquiring, building and/or leasing additional office space, and expanding our ecosystem of service partners to support local deployments. We expect to make further significant investments in our data center capacity and equipment as we plan for future growth. We are also investing in personnel to service our growing customer base. We also regularly evaluate acquisitions and investment opportunities in complementary businesses, employee teams, services, technologies, and intellectual property rights in an effort to expand our product and service offerings. We expect to continue making such acquisitions and investments in the future, and we plan to reinvest a significant portion of our incremental revenues in future periods to grow our business and continue our leadership role in the industry. While we remain focused on improving operating margins, these acquisitions and investments will increase our costs on an absolute basis in the near term. Many of these investments will occur in advance of experiencing any direct benefit from them and could make it difficult to determine if we are allocating our resources efficiently. Since inception, we have also invested heavily in our professional services organization to help ensure that customers successfully deploy and adopt our applications. Additionally, we continue to expand our professional service partner ecosystem to further support our customers. We believe our investment in professional services, as well as partners building consulting practices around Workday, will drive additional customer subscriptions and continued growth in revenues. Due to our ability to leverage the expanding partner ecosystem, we expect that the rate of professional services revenue growth will decline over time and continue to be lower than subscription revenue growth. Impact of the COVID-19 Pandemic In December 2019, a novel strain of coronavirus disease (“COVID-19”) was reported, and in March 2020, the World Health Organization characterized COVID-19 as a pandemic (“COVID-19 pandemic”). The COVID-19 pandemic is having widespread, rapidly evolving, and unpredictable impacts on global societies, economies, financial markets, and business practices. In response to COVID-19, we have temporarily closed the majority of our global offices, required most of our employees to work remotely, implemented travel restrictions, and have decided to postpone certain of our customer, industry, implementation partner, analyst, investor, and employee events and convert others to virtual-only experiences. Despite the economic challenges brought on by the COVID-19 pandemic, we are committed to the long-term overall health of our business, the strength of our product offerings, and our ability to continue to execute on our strategy. During the three months ended July 31, 2020, we experienced a favorable impact to our new subscription bookings as compared to the first quarter of fiscal 2021, as companies are adapting to the COVID-19 uncertain environment and are increasingly realizing the need to move forward with their digital transformation initiatives and the migration to cloud-based solutions. Our operating margins for the three months ended July 31, 2020, have been favorably impacted by our revenue growth outpacing headcount growth as well as moderation of operating expenses in response to the COVID-19 pandemic, including reduced travel, marketing and event spending. We do not anticipate the extent of the favorable margin impact experienced for the three months ended July 31, 2020 to continue long-term as we remain committed to investing in our strategic initiatives across all functional areas. Our near-term revenues are relatively predictable as a result of our subscription-based business model. However, if the economic uncertainty remains for a prolonged period, we may experience a negative impact on our ability to win new business, renew existing customers, sales and marketing efforts, revenue growth rates, customer deployment, customer solvency, product development, or other financial metrics, any of which could harm our business, operating results, and financial condition. For further discussion of the potential impacts of the COVID-19 pandemic on our business, operating results, and financial condition, see Risk Factors included in Part II, Item 1A of this Quarterly Report on Form 10-Q. Components of Results of Operations Revenues We primarily derive our revenues from subscription services and professional services. Subscription services revenue principally consists of fees that give our customers access to our cloud applications, which include related customer support. Professional services revenue includes fees for deployment services, optimization services, and training. Subscription services revenue accounted for 88% and 87% of our total revenues for the three and six months ended July 31, 2020, respectively, and represented 97% of our total unearned revenue as of July 31, 2020. Subscription services revenue is driven primarily by the number of customers, the number of workers at each customer, the specific applications subscribed to by each customer, and the price of our applications. 29 Table of Contents The mix of the applications to which a customer subscribes can affect our financial performance due to price differentials in our applications. Pricing for our applications varies based on many factors, including the complexity and maturity of the application and its acceptance in the marketplace. New products or services offerings by competitors in the future could also impact the mix and pricing of our offerings. Subscription services revenue is recognized over time as services are delivered and consumed concurrently over the contractual term, beginning on the date our service is made available to the customer. Our subscription contracts typically have a term of three years or longer and are generally noncancelable. We generally invoice our customers annually in advance. Amounts that have been invoiced are initially recorded as unearned revenue. Our consulting engagements are generally billed on a time and materials basis or fixed price basis. For contracts billed on a time and materials basis, revenue is recognized over time as the professional services are performed. For contracts billed on a fixed price basis, revenue is recognized over time based on the proportion of the professional services performed. In some cases, we supplement our consulting teams by subcontracting resources from our service partners and deploying them on customer engagements. As our professional services organization and the Workday-related consulting practices of our partner firms continue to develop, we expect these partners to increasingly contract directly with our subscription customers. As a result of this trend, and the increase of our subscription services revenue, we expect our professional services revenue as a percentage of total revenues to decline over time. Costs and Expenses Costs of subscription services revenue. Costs of subscription services revenue consists primarily of employee-related expenses related to hosting our applications and providing customer support, data center expenses, and depreciation of computer equipment and software. Costs of professional services revenue . Costs of professional services revenue consists primarily of employee-related expenses associated with these services, subcontractor expenses, and travel expenses. Product development . Product development expenses consist primarily of employee-related expenses. We continue to focus our product development efforts on adding new features and applications, increasing the functionality, and enhancing the ease of use of our cloud applications. Sales and marketing. Sales and marketing expenses consist primarily of employee-related expenses, sales commissions, marketing programs, and travel expenses. Marketing programs consist of advertising, events, corporate communications, brand awareness, and product marketing activities. Sales commissions are considered incremental costs of obtaining a contract with a customer and are deferred and amortized. Sales commissions for initial contracts are deferred and then amortized on a straight-line basis over a period of benefit that we have determined to be five years. Sales commissions for renewal contracts are deferred and then amortized on a straight-line basis over the related contractual renewal period. General and administrative . General and administrative expenses consist of employee-related expenses for finance and accounting, legal, human resources, information systems personnel, professional fees, and other corporate expenses. Results of Operations Revenues Our total revenues for the three and six months ended July 31, 2020, and 2019, were as follows (in thousands, except percentages): Three Months Ended July 31, Six Months Ended July 31, 2020 2019 % Change 2020 2019 % Change Subscription services $ 931,698 $ 757,155 23% $ 1,813,654 $ 1,458,179 24% Professional services 130,269 130,597 —% 266,698 254,628 5% Total revenues $ 1,061,967 $ 887,752 20% $ 2,080,352 $ 1,712,807 21% Total revenues were $1.1 billion for the three months ended July 31, 2020, compared to $888 million during the prior year period, an increase of $174 million, or 20%. Subscription services revenue was $932 million for the three months ended July 31, 2020, compared to $757 million for the prior year period, an increase of $175 million, or 23%. The increase in subscription services revenue was due primarily to an increased number of customer contracts as compared to the prior year period. Professional services revenue was $130 million for the three months ended July 31, 2020, compared to $131 million for the prior year period, a slight decrease of less than $1 million due to the timing of deployments as a result of the COVID-19 pandemic. 30 Table of Contents Total revenues were $2.1 billion for the six months ended July 31, 2020, compared to $1.7 billion during the prior year period, an increase of $0.4 billion, or 21%. Subscription services revenue was $1.8 billion for the six months ended July 31, 2020, compared to $1.5 billion for the prior year period, an increase of $0.4 billion, or 24%. The increase in subscription services revenue was due primarily to an increased number of customer contracts as compared to the prior year period. Professional services revenue was $267 million for the six months ended July 31, 2020, compared to $255 million for the prior year period, an increase of $12 million, or 5%. The increase in professional services revenue was due primarily to Workday performing deployment and integration services for a greater number of customers than in the prior year period. Operating Expenses GAAP operating expenses were $1.1 billion for the three months ended July 31, 2020, compared to $1.0 billion for the prior year period, an increase of $0.1 billion, or 7%. The increase was primarily due to an increase of $80 million in employee-related expense driven by higher headcount, offset by a decrease of $28 million in reduced travel expenses due to the COVID-19 pandemic. GAAP operating expenses were $2.2 billion for the six months ended July 31, 2020, compared to $2.0 billion for the prior year period, an increase of $0.3 billion, or 14%. The increase was primarily due to increases of $204 million in employee-related expenses driven by higher headcount, $79 million related to a one-time cash bonus paid to non-executive employees to help accommodate unforeseen costs brought on by the COVID-19 pandemic (“COVID-19 one-time employee bonus”), and $36 million in facilities and IT related expenses, offset by a decrease of $45 million in reduced travel expenses. We use the non-GAAP financial measure of non-GAAP operating expenses to understand and compare operating results across accounting periods, for internal budgeting and forecasting purposes, for short- and long-term operating plans, and to evaluate our financial performance. We believe that non-GAAP operating expenses reflect our ongoing business in a manner that allows for meaningful period-to-period comparisons and analysis of trends in our business. We also believe that non-GAAP operating expenses provide useful information to investors and others in understanding and evaluating our operating results and prospects in the same manner as management and in comparing financial results across accounting periods and to those of peer companies. Non-GAAP operating expenses are calculated by excluding share-based compensation expenses, and certain other expenses, which consist of employer payroll tax-related items on employee stock transactions and amortization of acquisition-related intangible assets. Non-GAAP operating expenses were $804 million for the three months ended July 31, 2020, compared to $770 million for the prior year period, an increase of $34 million, or 4%. The increase was primarily due to an increase of $42 million in employee-related expenses driven by higher headcount, offset by a decrease of $28 million in reduced travel expenses. Non-GAAP operating expenses were $1.7 billion for the six months ended July 31, 2020, compared to $1.5 billion for the prior year period, an increase of $0.2 billion, or 14%. The increase was primarily due to increases of $118 million in employee-related expenses driven by higher headcount, $79 million related to the COVID-19 one-time employee bonus, and $36 million in facilities and IT related expenses, offset by a decrease of $45 million in reduced travel expenses. Reconciliations of our GAAP to non-GAAP operating expenses were as follows (in thousands): Three Months Ended July 31, 2020 GAAP Operating Expenses Share-Based Compensation Expenses (1) Other Operating Expenses (2) Non-GAAP Operating Expenses (3) Costs of subscription services $ 145,007 $ (14,825) $ (8,844) $ 121,338 Costs of professional services 139,270 (24,552) (918) 113,800 Product development 418,681 (128,505) (4,554) 285,622 Sales and marketing 276,497 (49,854) (7,913) 218,730 General and administrative 99,266 (33,500) (975) 64,791 Total costs and expenses $ 1,078,721 $ (251,236) $ (23,204) $ 804,281 31 Table of Contents Three Months Ended July 31, 2019 GAAP Operating Expenses Share-Based Compensation Expenses (1) Other Operating Expenses (2) Non-GAAP Operating Expenses (3) Costs of subscription services $ 121,161 $ (12,001) $ (11,739) $ 97,421 Costs of professional services 145,173 (18,991) (1,233) 124,949 Product development 378,122 (105,758) (5,380) 266,984 Sales and marketing 280,200 (42,690) (10,449) 227,061 General and administrative 85,593 (29,781) (2,021) 53,791 Total costs and expenses $ 1,010,249 $ (209,221) $ (30,822) $ 770,206 Six Months Ended July 31, 2020 GAAP Operating Expenses Share-Based Compensation Expenses (1) Other Operating Expenses (2) Non-GAAP Operating Expenses (3) Costs of subscription services $ 290,270 $ (28,717) $ (18,487) $ 243,066 Costs of professional services 299,637 (47,118) (4,019) 248,500 Product development 862,165 (250,527) (16,704) 594,934 Sales and marketing 595,054 (96,804) (18,489) 479,761 General and administrative 194,437 (64,742) (3,756) 125,939 Total costs and expenses $ 2,241,563 $ (487,908) $ (61,455) $ 1,692,200 Six Months Ended July 31, 2019 GAAP Operating Expenses Share-Based Compensation Expenses (1) Other Operating Expenses (2) Non-GAAP Operating Expenses (3) Costs of subscription services $ 233,630 $ (22,416) $ (24,399) $ 186,815 Costs of professional services 275,923 (35,141) (4,692) 236,090 Product development 725,953 (196,995) (19,011) 509,947 Sales and marketing 553,136 (81,544) (23,283) 448,309 General and administrative 170,048 (58,360) (5,319) 106,369 Total costs and expenses $ 1,958,690 $ (394,456) $ (76,704) $ 1,487,530 (1) Share-based compensation expenses were $251 million and $209 million for the three months ended July 31, 2020, and 2019, respectively, and $488 million and $394 million for the six months ended July 31, 2020, and 2019, respectively. The increase in share-based compensation expenses includes the impact of restricted stock units (“RSUs”) granted to existing and new employees. (2) Other operating expenses include employer payroll tax-related items on employee stock transactions of $7 million and $11 million for the three months ended July 31, 2020, and 2019, respectively, and $30 million and $38 million for the six months ended July 31, 2020, and 2019, respectively. In addition, other operating expenses include amortization of acquisition-related intangible assets of $16 million and $20 million for the three months ended July 31, 2020, and 2019, respectively and $32 million and $39 million for the six months ended July 31, 2020, and 2019, respectively. (3) See “Non-GAAP Financial Measures” below for further information. Costs of Subscription Services See the table above for a reconciliation of GAAP to non-GAAP operating expenses. GAAP operating expenses in costs of subscription services were $145 million for the three months ended July 31, 2020, compared to $121 million for the prior year period, an increase of $24 million, or 20%. The increase was primarily due to increases of $7 million in employee-related expenses driven by higher headcount, $5 million in third-party expenses for hardware maintenance and data center capacity, and $4 million in depreciation expense related to equipment in our data centers. GAAP operating expenses in costs of subscription services were $290 million for the six months ended July 31, 2020, compared to $234 million for the prior year period, an increase of $56 million, or 24%. The increase was primarily due to increases of $16 million in employee-related expenses driven by higher headcount, $11 million in third-party expenses for hardware maintenance and data center capacity, $6 million in depreciation expense related to equipment in our data centers, and $5 million related to the COVID-19 one-time employee bonus. 32 Table of Contents Non-GAAP operating expenses in costs of subscription services were $121 million for the three months ended July 31, 2020, compared to $97 million for the prior year period, an increase of $24 million, or 25%. The increase was primarily due to increases of $7 million in depreciation expense related to equipment in our data centers, $5 million in third-party expenses for hardware maintenance and data center capacity, and $4 million in employee-related expenses driven by higher headcount. Non-GAAP operating expenses in costs of subscription services were $243 million for the six months ended July 31, 2020, compared to $187 million for the prior year period, an increase of $56 million, or 30%. The increase was primarily due to increases of $12 million in depreciation expense related to equipment in our data centers, $11 million in third-party expenses for hardware maintenance and data center capacity, $10 million in employee-related expenses driven by higher headcount, and $5 million related to the COVID-19 one-time employee bonus. We expect that GAAP and non-GAAP operating expenses in costs of subscription services will continue to increase in absolute dollars as we improve and expand our data center capacity and operations. Costs of Professional Services See the table above for a reconciliation of GAAP to non-GAAP operating expenses. GAAP operating expenses in costs of professional services were $139 million for the three months ended July 31, 2020, compared to $145 million for the prior year period, a decrease of $6 million, or 4%. The decrease was primarily due to decreases of $5 million in reduced travel expenses due to the COVID-19 pandemic and $6 million due to converting an implementation partner event to a virtual-only experience, offset by an increase of $8 million in employee related expenses driven by higher headcount. GAAP operating expenses in costs of professional services were $300 million for the six months ended July 31, 2020, compared to $276 million for the prior year period, an increase of $24 million, or 9%. The increase was primarily due to increases of $31 million in employee-related expenses driven by higher headcount and $12 million related to the COVID-19 one-time employee bonus, offset by a decrease of $9 million in reduced travel expenses. Non-GAAP operating expenses in costs of professional services were $114 million for the three months ended July 31, 2020, compared to $125 million for the prior year period, a decrease of $11 million, or 9%. The decrease includes $5 million related to reduced travel expenses due to the COVID-19 pandemic, and $6 million due to converting an implementation partner event to a virtual-only experience. Non-GAAP operating expenses in costs of professional services were $249 million for the six months ended July 31, 2020, compared to $236 million for the prior year period, an increase of $13 million, or 5%. The increase was primarily due to increases of $20 million in employee-related expenses driven by higher headcount and $12 million related to the COVID-19 one-time employee bonus, offset by a decrease of $9 million in reduced travel expenses. We expect GAAP and non-GAAP costs of professional services as a percentage of total revenues to continue to decline as we continue to rely on our service partners to deploy our applications and as the number of our customers continues to grow. Product Development See the table above for a reconciliation of GAAP to non-GAAP operating expenses. GAAP operating expenses in product development were $419 million for the three months ended July 31, 2020, compared to $378 million for the prior year period, an increase of $41 million, or 11%. The increase was primarily due to an increase of $39 million in employee-related expenses driven by higher headcount. GAAP operating expenses in product development were $862 million for the six months ended July 31, 2020, compared to $726 million for the prior year period, an increase of $136 million, or 19%. The increase was primarily due to increases of $97 million in employee-related expenses driven by higher headcount and $31 million related to the COVID-19 one-time employee bonus. Non-GAAP operating expenses in product development were $286 million for the three months ended July 31, 2020, compared to $267 million for the prior year period, an increase of $19 million, or 7%. The increase was primarily due to an increase of $17 million in employee-related expenses driven by higher headcount. Non-GAAP operating expenses in product development were $595 million for the six months ended July 31, 2020, compared to $510 million for the prior year period, an increase of $85 million, or 17%. The increase was primarily due to increases of $46 million in employee-related expenses driven by higher headcount and $31 million related to the COVID-19 one-time employee bonus. We expect that GAAP and non-GAAP product development expenses will continue to increase in absolute dollars as we improve and extend our applications and develop new technologies. 33 Table of Contents Sales and Marketing See the table above for a reconciliation of GAAP to non-GAAP operating expenses. GAAP operating expenses in sales and marketing were $276 million for the three months ended July 31, 2020, compared to $280 million for the prior year period, a decrease of $4 million, or 1%. The decrease was primarily due to decreases of $16 million in reduced travel expenses due to the COVID-19 pandemic and $6 million in marketing and event spending, offset by an increase of $15 million in employee-related expenses driven by higher headcount. GAAP operating expenses in sales and marketing were $595 million for the six months ended July 31, 2020, compared to $553 million for the prior year period, an increase of $42 million, or 8%. The increase was primarily due to increases of $42 million in employee-related expenses driven by higher headcount and $25 million related to the COVID-19 one-time employee bonus, offset by decreases of $25 million in reduced travel expenses and $7 million in marketing and event spending. Non-GAAP operating expenses in sales and marketing were $219 million for the three months ended July 31, 2020, compared to $227 million for the prior year period, a decrease of $8 million, or 4%. The decrease was primarily due to decreases of $16 million in reduced travel expenses and $6 million in marketing and event spending, offset by an increase of $9 million in employee-related expenses driven by higher headcount. Non-GAAP operating expenses in sales and marketing were $480 million for the six months ended July 31, 2020, compared to $448 million for the prior year period, an increase of $32 million, or 7%. The increase was primarily due to increases of $29 million in employee-related expenses driven by higher headcount and $25 million related to the COVID-19 one-time employee bonus, offset by decreases of $25 million in reduced travel expenses and $7 million in marketing and event spending. We expect that GAAP and non-GAAP sales and marketing expenses will increase in absolute dollars as we continue to invest in our domestic and international selling and marketing activities to expand brand awareness and attract new customers. General and Administrative See the table above for a reconciliation of GAAP to non-GAAP operating expenses. GAAP operating expenses in general and administrative were $99 million for the three months ended July 31, 2020, compared to $86 million for the prior year period, an increase of $13 million, or 16%. The increase was primarily due to an increase of $12 million in employee-related expenses driven by higher headcount. GAAP operating expenses in general and administrative were $194 million for the six months ended July 31, 2020, compared to $170 million for the prior year period, an increase of $24 million, or 14%. The increase was primarily due to increases of $19 million in employee-related expenses driven by higher headcount and $6 million related to the COVID-19 one-time employee bonus, offset by a decrease of $4 million in reduced travel expenses due to the COVID-19 pandemic. Non-GAAP operating expenses in general and administrative were $65 million for the three months ended July 31, 2020, compared to $54 million for the prior year period, an increase of $11 million, or 20%. The increase was primarily due to an increase of $9 million in employee-related expenses driven by higher headcount. Non-GAAP operating expenses in general and administrative were $126 million for the six months ended July 31, 2020, compared to $106 million for the prior year period, an increase of $20 million, or 18%. The increase was primarily due to increases of $14 million in employee-related expenses driven by higher headcount and $6 million related to the COVID-19 one-time employee bonus, offset by $4 million in reduced travel expenses. We expect GAAP and non-GAAP general and administrative expenses will continue to increase in absolute dollars as we further invest in our infrastructure and support our global expansion. Operating Margins GAAP operating margins improved from (13.8)% for the three months ended July 31, 2019, to (1.6)% for the three months ended July 31, 2020. Our GAAP operating margins for the three months ended July 31, 2020, have been favorably impacted by our revenue growth outpacing headcount growth as well as moderation of operating expenses in response to the COVID-19 pandemic, including reduced travel, marketing and event spending. GAAP operating margins improved from (14.4)% for the six months ended July 31, 2019, to (7.7)% for the six months ended July 31, 2020. Our GAAP operating margins for the six months ended July 31, 2020, have been favorably impacted by our revenue growth outpacing headcount growth as well as moderation of operating expenses in response to the COVID-19 pandemic, including reduced travel, marketing and event spending. 34 Table of Contents We use the non-GAAP financial measure of non-GAAP operating margins to understand and compare operating results across accounting periods, for internal budgeting and forecasting purposes, for short- and long-term operating plans, and to evaluate our financial performance. We believe that non-GAAP operating margins reflect our ongoing business in a manner that allows for meaningful period-to-period comparisons and analysis of trends in our business. We also believe that non-GAAP operating margins provide useful information to investors and others in understanding and evaluating our operating results and prospects in the same manner as management and in comparing financial results across accounting periods and to those of peer companies. Non-GAAP operating margins are calculated using GAAP revenues and non-GAAP operating expenses. See “Non-GAAP Financial Measures” below for further information. Non-GAAP operating margins improved from 13.2% for the three months ended July 31, 2019, to 24.3% for the three months ended July 31, 2020. Our non-GAAP operating margins for the three months ended July 31, 2020, have been favorably impacted by our revenue growth outpacing headcount growth as well as moderation of operating expenses in response to the COVID-19 pandemic, including reduced travel, marketing and event spending. Non-GAAP operating margins improved from 13.2% for the six months ended July 31, 2019, to 18.7% for the six months ended July 31, 2020. Our non-GAAP operating margins for the six months ended July 31, 2020, have been favorably impacted by our revenue growth outpacing headcount growth as well as moderation of operating expenses in response to the COVID-19 pandemic, including reduced travel, marketing and event spending. Reconciliations of our GAAP to non-GAAP operating margins were as follows: Three Months Ended July 31, 2020 GAAP Operating Expenses Share-Based Compensation Expenses Other Operating Expenses Non-GAAP Operating Expenses (1) Operating margin (1.6)% 23.7% 2.2% 24.3% Three Months Ended July 31, 2019 GAAP Operating Expenses Share-Based Compensation Expenses Other Operating Expenses Non-GAAP Operating Expenses (1) Operating margin (13.8)% 23.6% 3.4% 13.2% Six Months Ended July 31, 2020 GAAP Operating Expenses Share-Based Compensation Expenses Other Operating Expenses Non-GAAP Operating Expenses (1) Operating margin (7.7)% 23.4% 3.0% 18.7% Six Months Ended July 31, 2019 GAAP Operating Expenses Share-Based Compensation Expenses Other Operating Expenses Non-GAAP Operating Expenses (1) Operating margin (14.4)% 23.0% 4.6% 13.2% (1) See “Non-GAAP Financial Measures” below for further information. Other Income (Expense), Net Other expense, net was $11 million for the three months ended July 31, 2020, as compared to other expense, net of $0.1 million for the prior year period. The increase in other expense, net was due primarily to a $6 million reduction in interest income on marketable securities as a result of lower prevailing interest rates during the three months ended July 31, 2020. In addition, interest expense increased by $5 million primarily related to our term loan entered into in April 2020. Other expense, net was $22 million for the six months ended July 31, 2020, as compared to other income, net of $7 million for the prior year period. During the six months ended July 31, 2019, we recognized a gain from the sale of marketable equity investment of $7 million gain and we capitalized interest costs of $6 million, which reduced interest expense. Additionally, during the six months ended July 31, 2020, there was a $9 million decrease in interest income on marketable securities as a result of lower prevailing interest rates, and a $5 million increase in interest expense related to the term loan. 35 Table of Contents Liquidity and Capital Resources As of July 31, 2020, our principal sources of liquidity were cash, cash equivalents, and marketable securities totaling $2.8 billion, which were primarily held for working capital purposes. Our cash equivalents and marketable securities are composed primarily of U.S. treasury securities, U.S. agency obligations, corporate bonds, commercial paper, and money market funds. In April 2020, we entered into a credit agreement (“Credit Agreement”) pursuant to which the lenders would extend to Workday a senior unsecured term loan facility in an aggregate principal amount of $750 million (“Term Loan”) and an unsecured revolving credit facility in an aggregate principal amount of $750 million (“Revolving Credit Facility”). On April 2, 2020, $500 million of the Term Loan was funded, and the remaining $250 million of the Term Loan was funded on July 13, 2020. We can also borrow up to $750 million under the Revolving Credit Facility until April 2, 2025. For further information, see Note 10, Debt, of the Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. We have financed our operations primarily through customer payments, issuance of debt, and sales of equity securities. Our long-term future capital requirements depend on many factors, including our customer growth rate, subscription renewal activity, the timing and extent of development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced services offerings, the continuing market acceptance of our services, the timing of construction of facilities in Pleasanton, California and the acquisition of additional facilities, and investment and acquisition activities. We may enter into arrangements to acquire or invest in complementary businesses, services, technologies, or intellectual property rights in the future. We also may choose to seek additional equity or debt financing. Our cash flows for the three and six months ended July 31, 2020, and 2019, were as follows (in thousands): Three Months Ended July 31, Six Months Ended July 31, 2020 2019 2020 2019 Net cash provided by (used in): Operating activities $ 157,210 $ 100,319 $ 420,893 $ 309,482 Investing activities (202,638) (320,745) (479,985) (388,100) Financing activities 70,780 57,951 570,111 61,313 Effect of exchange rate changes 771 75 506 (252) Net increase (decrease) in cash, cash equivalents, and restricted cash $ 26,123 $ (162,400) $ 511,525 $ (17,557) Operating Activities Cash provided by operating activities was $157 million and $100 million for the three months ended July 31, 2020, and 2019, respectively. The improvement in cash flow provided by operating activities was primarily due to increases in sales and the related cash collections, moderation of operating expenses in response to the COVID-19 pandemic, including reduced travel, marketing and event spending, partially offset by higher cash operating expenses driven by increased headcount. Cash provided by operating activities was $421 million and $309 million for the six months ended July 31, 2020, and 2019, respectively. The improvement in cash flow provided by operating activities was primarily due to increases in sales and the related cash collections, moderation of operating expenses in response to the COVID-19 pandemic, including reduced travel, marketing and event spending, partially offset by higher cash operating expenses driven by increased headcount and the COVID-19 one-time employee bonus. We expect our business to continue to generate sufficient operating cash flows; however, if the COVID-19 pandemic worsens or is prolonged, our customers may continue to request payment timing concessions, which could materially impact the timing and predictability of our operating cash flows in any given period. Investing Activities Cash used in investing activities for the three months ended July 31, 2020, was $203 million, which was primarily the result of data center and office space projects of $67 million and the timing of purchases and maturities of marketable securities. Cash used in investing activities for the three months ended July 31, 2019, was $321 million, which was primarily the result of capital expenditures for data center and office space projects of $76 million, capital expenditures related to the construction of our development center of $34 million, a net outflow related to acquisition activity of $13 million, and the timing of purchases and maturities of marketable securities. 36 Table of Contents Cash used in investing activities for the six months ended July 31, 2020, was $480 million, which was primarily the result of capital expenditures for data center and office space projects of $126 million, purchases of non-marketable equity and other investments of $59 million, and the timing of purchases and maturities of marketable securities. Cash used in investing activities for the six months ended July 31, 2019, was $388 million, which was primarily the result of capital expenditures for data center and office space projects of $141 million, capital expenditures related to the construction of our development center of $74 million, a net outflow related to acquisition activity of $13 million, and the timing of purchases and maturities of marketable securities. These payments were partially offset by proceeds of $55 million from sales of marketable equity investments. We expect capital expenditures, excluding owned real estate projects, will be approximately $280 million for fiscal 2021. These capital outlays will largely be used to expand the infrastructure of our data centers. We do not expect to make additional investments in owned real estate projects during fiscal 2021. Financing Activities Cash provided by financing activities was $71 million for the three months ended July 31, 2020, which was primarily due to proceeds of $250 million from borrowings on the Term Loan and $71 million from the issuance of common stock from employee equity plans, offset by the principal payment of $250 million in connection with the conversion of our 1.50% convertible senior notes (“2020 Notes”) during the quarter. Cash provided by financing activities was $58 million for the three months ended July 31, 2019, which was primarily due to proceeds from the issuance of common stock from employee equity plans. Cash provided by financing activities was $570 million for the six months ended July 31, 2020, which was primarily due to proceeds of $748 million from borrowings on the Term Loan and $75 million from the issuance of common stock from employee equity plans, offset by the principal payment of $250 million in connection with the conversion of the 2020 Notes. Cash provided by financing activities was $61 million for the six months ended July 31, 2019, which was primarily due to proceeds from the issuance of common stock from employee equity plans. 37 Table of Contents Non-GAAP Financial Measures Regulation S-K Item 10(e), “Use of non-GAAP financial measures in Commission filings,” defines and prescribes the conditions for use of non-GAAP financial information. Our measures of non-GAAP operating expenses and non-GAAP operating margins meet the definition of a non-GAAP financial measure. Non-GAAP Operating Expenses and Non-GAAP Operating Margins Our non-GAAP operating expenses and non-GAAP operating margins exclude the components listed below. For the reasons set forth below, management believes that excluding the component provides useful information to investors and others in understanding and evaluating our operating results and prospects in the same manner as management, in comparing financial results across accounting periods and to those of peer companies, and to better understand the long-term performance of our core business. • Share-Based Compensation Expenses. Although share-based compensation is an important aspect of the compensation of our employees and executives, management believes it is useful to exclude share-based compensation expenses to better understand the long-term performance of our core business and to facilitate comparison of our results to those of peer companies. Share-based compensation expenses are determined using a number of factors, including our stock price, volatility, and forfeiture rates that are beyond our control and generally unrelated to operational decisions and performance in any particular period. Further, share-based compensation expenses are not reflective of the value ultimately received by the grant recipients. • Other Operating Expenses. Other operating expenses includes employer payroll tax-related items on employee stock transactions and amortization of acquisition-related intangible assets. The amount of employer payroll tax-related items on employee stock transactions is dependent on our stock price and other factors that are beyond our control and do not correlate to the operation of the business. For business combinations, we generally allocate a portion of the purchase price to intangible assets. The amount of the allocation is based on estimates and assumptions made by management and is subject to amortization. The amount of purchase price allocated to intangible assets and the term of its related amortization can vary significantly and are unique to each acquisition and thus we do not believe it is reflective of our ongoing operations. Limitations on the Use of Non-GAAP Financial Measures A limitation of our non-GAAP financial measures of non-GAAP operating expenses and non-GAAP operating margins is that they do not have uniform definitions. Our definitions will likely differ from the definitions used by other companies, including peer companies, and therefore comparability may be limited. Further, the non-GAAP financial measure of non-GAAP operating expenses has certain limitations because it does not reflect all items of expense that affect our operations and are reflected in the GAAP financial measure of total operating expenses. In the case of share-based compensation, if we did not pay out a portion of compensation in the form of share-based compensation and related employer payroll tax-related items, the cash salary expense included in costs of revenues and operating expenses would be higher, which would affect our cash position. We compensate for these limitations by reconciling the non-GAAP financial measures to the most comparable GAAP financial measures. These non-GAAP financial measures should be considered in addition to, not as a substitute for or in isolation from, measures prepared in accordance with GAAP. We encourage investors and others to review our financial information in its entirety, not to rely on any single financial measure, and to view our non-GAAP financial measures in conjunction with the most comparable GAAP financial measures. See “Results of Operations—Operating Expenses and Results of Operations—Operating Margins” for reconciliations from the most directly comparable GAAP financial measures, GAAP operating expenses and GAAP operating margins, to the non-GAAP financial measures, non-GAAP operating expenses and non-GAAP operating margins, for the three and six months ended July 31, 2020, and 2019. Contractual Obligations Our contractual obligations primarily consist of our convertible senior notes, borrowings under our Credit Agreement, leases for office space and co-location facilities for data center capacity, third-party hosted infrastructure platforms for business operations, and agreements to purchase data center equipment. We do not consider outstanding purchase orders to be contractual obligations as they represent authorizations to purchase rather than binding agreements. 38 Table of Contents Convertible Senior Notes In June 2013, we completed an offering of $250 million of 1.50% convertible senior notes due July 15, 2020, which were subsequently converted during the three months ended July 31, 2020. In September 2017, we completed an offering of $1.15 billion of 0.25% convertible senior notes due October 1, 2022 (“2022 Notes”). We are not required to make principal payments under the 2022 Notes prior to maturity. If the 2022 Notes are not converted to Class A common stock prior to their maturity dates, we are required to repay $1.15 billion in principal on October 1, 2022. We are also required to make interest payments on a semi-annual basis at the interest rates described in Note 10, Debt, of the Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. Credit Agreement In April 2020, we entered into a credit agreement pursuant to which the lenders extended to Workday a senior unsecured term loan facility in an aggregate principal amount of $ 750 million and an unsecured revolving credit facility in an aggregate principal amount of $ 750 million. The Term Loan matures on April 2, 2025, and provides for quarterly repayment in installments of the principal amount, beginning October 2020, at a rate of 1.25% of the principal amount per quarter through January 2022, and 2.50% of the principal amount per quarter thereafter. The Revolving Credit Facility may be borrowed, repaid, and reborrowed until April 2, 2025, at which time all amounts borrowed must be repaid. The Term Loan and Revolving Credit Facility bear interest at the interest rates described in Note 10, Debt, of the Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. The following table summarizes our contractual cash obligations under the Credit Agreement as of July 31, 2020, and assumes interest rates consistent with those in effect for our Term Loan as of July 31, 2020. The Revolving Credit Facility is excluded as there were no outstanding borrowings as of July 31, 2020. Payments Due by Period (in thousands) Total Remainder of Fiscal 2021 Fiscal 2022 - Fiscal 2023 Fiscal 2024 - Fiscal 2025 Thereafter Term Loan $ 750,000 $ 18,750 $ 112,500 $ 150,000 $ 468,750 Interest obligation on Term Loan 65,327 9,295 29,747 23,826 2,459 Total $ 815,327 $ 28,045 $ 142,247 $ 173,826 $ 471,209 Leases We have entered into operating lease agreements for our office space, data centers, and other property and equipment with various expiration dates. These lease agreements often provide us with an option to renew. Third-Party Hosted Infrastructure Platforms for Business Operations We have entered into noncancelable agreements with third-party hosted infrastructure platform vendors with various expiration dates. As of July 31, 2020, future noncancelable minimum payments under these agreements were approximately $466 million. Data Center Equipment As of July 31, 2020, we have entered into noncancelable agreements to purchase $110 million of data center equipment during the second half of fiscal 2021. Off-Balance Sheet Arrangements Through July 31, 2020, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in accordance with GAAP. The preparation of these condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of certain assets, liabilities, revenues, costs and expenses, and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions. 39 Table of Contents Due to the COVID-19 pandemic, there has been uncertainty and disruption in the global economy and financial markets. We are not aware of any specific event or circumstance that would require further updates to our estimates or judgments or require us to further revise the carrying value of our assets or liabilities as of July 31, 2020. These estimates may change as new events occur and additional information is obtained. Actual results could differ materially from these estimates under different assumptions or conditions. During the six months ended July 31, 2020, there were no significant changes to our critical accounting policies and estimates as described in the consolidated financial statements contained in the Annual Report on Form 10-K for the year ended January 31, 2020, filed with the Securities and Exchange Commission (“SEC”) on March 3, 2020. 40 Table of Contents