Zuora: A Case Of SaaS-Ception
- Zuora is a relatively new IPO since April, and it has performed quite well.
- Zuora's management is not trying to capitalize on some fad; it created the fad.
- Based on some issues with the scalability of its business model, the difficult path to profitability, and, on top of this, a rich valuation, Zuora is not a buy.
A SaaS (software-as-a-service) business trying to help businesses become SaaS business? Talk about SaaS inception! When I first heard about Zuora (NYSE:ZUO) in its successful April IPO, I was very skeptical. It seemed like a company trying to take advantage of the SaaS hype. But the story is a little more interesting than that superficial judgment.
Though subscription revenue has been accelerating and Zuora has a valid business, I am not convinced this company is a buy, based on business quality relative to valuation.
A World Subscribed
CEO and founder, Tien Tzuo, was the 11th employee at a small startup on Sand Hill road, named Salesforce.com (CRM). There, he was the first Chief Marketing Officer, building the billing system, then later, transitioning into a strategy role. After his 9 years at, what is now the biggest, most well-known SaaS company in the world, he started Zuora in 2007.
He even termed the phrase "Subscription Economy" and, recently, wrote a book on the power of subscription business models. So, it is fair to say Mr. Tzuo is not just trying to profit off of a fad-craze. He practically started the craze.
The Business and Financials
Zuora sells subscriptions to enable any company in any vertical to launch, manage, and transform into a subscription business. ERP (enterprise resource planning) software programs fail to capture the nuance and complexity of subscription models. This is where Zuora comes in. Its flagship products are Zuora Billing and Zuora RevPro. But the main platform is called Zuora Central, which allows companies to transform into SaaS businesses by managing pricing, order, payments, metrics, and accounting.
The company has more than 950 customers, including 15 of the Top Fortune 100 enterprises. It also estimates that its market will grow at a CAGR (compounded annual growth rate) of 35% to $9.1 billion by 2022. Plus, it believes it can disrupt a portion of the $40 billion ERP market.
Source: Investor Presentation
In the latest quarter, the number of customers with an average contract value of over $100,000 increased to 441. It is clear this company is selling to large enterprises rather than SMBs (small-to-medium businesses).
This creates a slight scalability problem. In the company's prospectus, there is a direct quote pertaining to this,
"Deployment is often a complex process involving secure data migration and the establishment of new processes, requiring a dedicated team during deployment."
This translates into high services revenue rather than just subscriptions. The problem with this is the margins. Subscription margins usually can end up in the 70-90% range, but services revenues are typically negative or very small.
Source: Investor Presentation
This is because Zuora needs to pay technicians to help these enterprises implement the software since it is a complex process. Ironically, the whole draw of SaaS businesses was to get away from the license and maintenance model that software embodied for so long. It seems funny that the company to SaaS-ify all business ends up looking a little like a maintenance-service model.
Granted, the majority of Zuora's business is still subscriptions, but the real growth has been in the services.
Source: Investor Presentation
For instance, if you look just at the fourth quarters, you can see that the services went from $6 to $15, a growth rate of 150%, whereas the subscriptions went from $25 to $35, or 40% growth. 40% growth is certainly not bad, but it is not very consoling as an investor to see the services side of the business grow larger as a percent of revenue. This means gross margin is at about 56%, which is a far cry from 80% or so gross margins in SaaS businesses like Zscaler (ZS) or Okta (OKTA).
Plus, operating margins and free cash flow are actually worsening. Non-GAAP operating margins went from -22% last year to -27% this past quarter. Similarly, free cash flow margins went from -12% to -19% year over year. But this is not surprising since the services side of the business grew so quickly.
One more important note on this business dynamics here. In May 2017, the company acquired Leeyo software, which gave Zuora the RevPro software. In the last three quarters, since the acquisition, subscription revenue has actually accelerated, as you can see in the chart above. This would normally be an awesome sign, but the timing of the acquisition suggests that the subscription accelerating is due simply to the integration of Leeyo. Normally, revenue accelerating is always a great sign, but I think less so when it is a direct result of an acquisition.
This all means that the valuation should naturally be lower.
Zuora's market cap is $2.9 billion with $207 million in net cash. Therefore, the enterprise value comes out to $2.7 billion. TTM (trailing twelve months) sales come out to $167 million. Simple division suggests ZUO is trading for 16x sales. The high-end of 2019 guidance is $223 million, signaling 34% revenue growth, which is still almost a 12x forward sales multiple. Subscription guidance of $159 million for 2019 also suggests that subscription will stay constant at 70% of revenue.
Frankly, valuation is a risk for Zuora based on the fundamentals. But Zuora has a much more existential risk. The whole company is based on the premise that every company needs to have a subscription model. It could turn out to be true, that the evolution of the internet could build a world where people don't need to own anything but can just more efficiently use resources and services on a subscription basis. But Zuora's business is SaaS-ifying incumbent businesses that are trying to catch up with the times. Smaller businesses likely won't use Zuora, and bigger businesses will be resistant to change. At a high view, it seems difficult for Zuora to be a multi-bagger one day based on market size and possible penetration.
For Zuora's sake, I hope I'm wrong and that it becomes a huge success. Well, a $3 billion company is already a success in most people's books. However, from today's price, I can't recommend Zuora based on some issues with the scalability of its business model, the difficult path to profitability, and, on top of this, a rich valuation.
Zuora seems to be helping some companies get with the times, but all things considered, I won't be buying this name anytime soon.
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