"The entire $80 trillion economy is up for grabs", wrote Tien Zuo, the founder and CEO of Zuora (NYSE:ZUO) in his book Subscribed. So confident is he in the unbounded viability of the subscription model that he would challenge his colleagues over dinner to name businesses that could not adopt it. It was said that during such conversations, even that as disparate as the supply of cement was concluded to be amenable to this transformation.
Factual or hyperbole, an investment decision should never be made based on total addressable market alone. One ought to examine if the company has a distinct and lasting competitive advantage in serving the market. Despite that, an investor would only be able to participate in any gains of this mega trend if operations are sound and shares are suitably priced. Having examined Zuora against these factors, I conclude that it does not make for a good investment at today's price.
Tip of the Iceberg or Subscription Bubble?
Impressive statistics and forecasts abound on the scale and speed at which the subscription model is taking root. McKinsey and Company found that the subscription ecommerce market has grown by more than a 100% a year between 2012 and 2017 (McKinsey). The stock market, a supposed great aggregator of crowd wisdom, is also conferring substantially higher multiples on subscription-based companies vis-a-vis their peers, reflecting a comparatively higher expectation for prospects. Adobe, a company that began to make the shift to a subscription strategy in 2011, has a P/E ratio of 50 now versus an average of 18 then. Businesses from industries as diverse as air travel to heavy equipment have all jumped aboard the bandwagon; with more on the way. One wonders if the ongoing quest for cloud gaming could also turn video games wholly to being subscription-based and if the PlayStation 5 and Xbox Two would be the last of the consoles. In this view of things, it does seem like we could be at the innings of a major shift.
Yet consumers are already lamenting subscription fatigue. They are saturated with a myriad of services that they are making monthly payments for and which they are barely able to keep track of. Dropbox (NASDAQ:DBX), Netflix (NASDAQ:NFLX), Spotify (NYSE:SPOT), Stitch Fix (NASDAQ:SFIX), and Blue Apron (NYSE:APRN) are but some of these services that are making incursions into every facet of their lives. Waterstone Group found that 84% of consumers grossly underestimates the recurring payments that they are making (Waterstone). A common gripe has also been that previously free services are now hidden behind paywalls and one-time fees are replaced with unpalatable recurring charges. While that might sound like things are good for business, the reality is something else. The stickiness of consumers to such services is next to nothing, while enterprises are themselves contending with their own slew of them. Companies are rhythmically forking out cash for services like Git Hub, Amazon Web Services, Shopify, Photoshop, and Slack etc. While the larger ones certainly have higher thresholds, one wonders how many more of these could consumers and SMBs swallow.
Harking Back to 2000
Subscription services could, in limited ways, play out the way the dot com companies did at the turn of the millennium. Certainly, they are not new. In fact, newspaper industry lore has it that the first paperboy was hired in 1833 to deliver papers to the homes and offices of subscribers. Yet catalysed by technology, it is revolutionizing the way people consume and companies operate. Much like what the World Wide Web did two decades ago. In 2000, businesses from florists to pet shops were fervently hopping aboard the hype train and latching on the internet to offer their services. Many were spending heavily to gain market share while making significant operating losses. Those that added "e" in front of their names or ".com" at the back quickly saw the value of their companies surge. Noteworthily, this took place on the back of tax cuts and low interest rates following the waning of inflation in the U.S.
The state of affairs today is rather similar. Businesses ranging from those that offer Bible study lessons on one end, to shoe polishing services on the other, are shifting to subscription-based models. Many are spending heavily to build scale while making large losses. Tax cuts and dovish monetary policy has flooded the market with capital and many of those that are going public are valued at high multiples of revenue while remaining unprofitable.
If history is anything to go by, subscription-based models will remain a mainstay, but drastic consolidation and belly-up businesses could be on the horizon. Already, we are seeing signs of that with Blue Apron now a penny stock, Hasbro retreating from its foray into subscriptions and MoviePass's stocks down 99% on a split-adjusted basis.
Zuora provides a cloud-based software on a subscription basis that enables any company in any industry to successfully launch, manage and transform into a subscription business. It offers 4 core products which in essence, helps customers execute complex processes which they are unable or unwilling to do in house. Zuora Billing and Zuora RevPro are that which get its customers' foot in the door. The former automates billing schedules while managing prorations stemming from changes in subscription plans. The latter ensures compliance to accounting standards. Once in, Zuora tries to upsell the others. Zuora CPQ (Configure, Price, Quote) allows businesses to easily configure complex and changing deals to meet the unique needs of their customers while Zuora Collect automates dunning and credit card retry processes to maximize collection success.
That Zuora is offering solutions for every major need in a market where stickiness is high makes for a compelling case. However, it has many competitors offering the same suite of services - billing, collection and revenue recognition - jostling for market share with it. Recurly, Chargebee, Chargify, and Aria are but some of the more prominent ones. It should perhaps give initial pause to any investor when a young company, with barely a moat and nary any earnings, is priced at a substantial multiple of sales.
Primus Inter Pares
Yet, there is, in fact, something exceptional about the company. Its founder and CEO Tien Zuo, and by corollary, Zuora, is synonymous with the subscription revolution. Known also as the Chief Evangelist of the revolution, he is seen by many as the person whose vision it first was and who is now "converting" the world. Key in "subscription economy" on Google or YouTube and you would see a multitude of interviews and talks given by him in heralding the advent. Ever the consummate salesman he even has a book published to accelerate the shift. Zuora conducts yearly conventions on the subscription economy, counting among its attendees; big names such as Ford (NYSE:F), Caterpillar (NYSE:CAT), and Fender. Further, the company has an enticing pitch while providing numerous guides to convince and aid would-be customers in making that shift. Even Tien's questionable assertion that business schools are no longer relevant was likely made to generate measured controversy and awareness for the Zuora brand. All these serve the purpose of creating a water-tight association between Zuora and the subscription economy, conferring it, top-of-mind awareness and elevating it as primus inter pares in a market where no one has a distinct advantage.
Conventional wisdom suggests that the first mover who creates a new market and educates customers is susceptible to copycats leeching off his efforts and replacing him with a better product/service. However, having satisfied customers aside; Zuora's products are deeply enmeshed within their core infrastructure. This makes switching costs high and customer churn unlikely. In fact, between fiscal years 2016 to 2018, they reported having lost only one customer with ACV that is above $100 000. Further, it has also been found that educating customers is an important service differentiator which can build trust in a firm (B Eisingerich, J. Bell).
While one ought to be doubtful of the staying power and sustained proliferation of most subscription-based businesses, Zuora's unique position within this space warrants a deeper examination. Some may balk at the uncertainty and the lack of information available to value such a young company operating in this new industry. However, I am convinced that this is exactly where opportunities lie.
The usual way most would value a SaaS company is based on a multiple of a certain metrics, derived from the relative growth rate or competitive position of the firm in an industry. Annual Recurring Revenue "ARR", Customer Acquisition Costs "CAC", Billings, Churn, Life Time Value "LTV" are but some of those used alone or in several permutations of each other. However, I would apply a DCF analysis as I see the market as more expensive than it is cheap, and hence, would rather make decisions based on an absolute value.
Adjusted Operating Income
The CAC ratio suggests the number of years in renewal required for a customer to pay off his acquisition costs, following which it would contribute fully to operating expenses and profits after deduction of COGS. However, to arrive at an appropriate cash flow for projection, there is a need to amortize the CAC through the expected customer lifetime to reflect the accruement of benefits throughout that period. This would have no effect on current period cash flow as the capitalized portion would be accounted for in Capex.
Stitching together data from the S-1 and 10Qs, and amortizing the sales and marketing expenses, I derive the adjusted TTM operating income below. To be conservative, I approximated the customer lifetime of Zuora to be 5 years and amortized the relevant costs accordingly. B2B SaaS customers typically have low churn rates, but Zuora had next to no churn in the preceding three years. Using even a nominal rate of 1% annually would suggest a customer lifetime of a hundred years. While R&D expenses ought also to be capitalized and amortized, I did not have to adjust for it as Zuora had already done that in preparing their statements using an amortizable lifespan of between 1 to 3 years.
I then derived the adjusted reinvestments of Zuora. Of note, I capitalized the Sales and Marketing costs to reflect the long customer lifetime and the lasting advantage that it is conferring on the Zuora brand. Consequently, its amortization was added back so as to not double count the cash outflow. Also, I included normalized acquisition costs as they are significant external investments which do not occur yearly. Zuora has negative adjusted operating margins and would need to tap on existing cash to fund these reinvestments. If margins do not improve, they would likely have to incur additional debt or offer equity to remain a going concern.
(Source: Created by Author using Data from S1 and 10-Q)
Free Cash Flow
The cloud-based billing market is expected to have a CAGR of 21.6% through 2026 (Reuters). Zuora also expects to cannibalize the ERP market due to its incompatibility with the subscription economy. As Zuora has been growing at upwards of 30% in previous years and considering its leading position in the market, I used a rate of 35% in projecting subscription revenue. Professional service revenue is derived from the provision of assistance in implementing Zuora's products. They are primarily earned only in the customers' first year of subscription. Therefore, I expect it to decline as a percentage of revenue with time. Using the average size in the past 3 years as a gauge, I input a blended proportion of 25% of revenue in the next 3 years and 20% thereafter. 20% corresponds to an average customer lifetime of 5 years.
The cost of providing subscription services stems heavily from data centre and hosting charges. It varies with revenue earned and has averaged 25% of that over the past 3 years. However, as Zuora is a young company that can reasonably be expected to reap economies of scale as it grows, I applied a percentage of 20% - in line with mature SaaS companies - in projection. The cost of professional services comprises employee compensation and overheads and has historically been close to that of corresponding revenue for Zuora. I approximate it to be 100% of revenue each year, similarly, a size aligned with mature companies in the market. I did the same for other expenses by considering Zuora's historical statistics and that of matured SaaS companies.
(Source: Created by Author using Data from S1 and 10Q)
I used a high terminal growth rate of 7% as Zuora's central thesis lies in the world being only at the beginning of the shift to a Subscription Economy. Above-average growth should, therefore, accrue beyond the near term. While one would sometimes peg this rate to the growth rate of the economy, Zuora is not a mature company that is dependent on economic expansion for discretionary expenditure. It is changing the way things are done and there is little reason why this should even remotely be in tandem with economic growth. I applied the CAPM in calculating the cost of equity. Despite its limitation, it is parsimonious and more complex models have not proven to be a better estimate of cost of equity. With that and other inputs derived from market data and Zuora's financial statements, I arrived at an intrinsic value estimate of $6.
(Source: Created by Author using Data from S1 and 10Q)
While empirical, a DCF model requires the subjective inputs of an analyst based on his judgment and estimates of the unknowable future. As such, I see it apt to conduct a simulation to observe how might share prices vary with changes to these estimates. I simultaneously varied the key inputs within the range below and repeated that for 5000 iterations. Simulated share prices are observed to take on the shape of the log-normal distribution curve, with current prices already close to the tail.
(Source: Created by Author)
Therefore, I conclude that the risk-return tradeoff is asymmetrical against the interest of an investor at today's prices. While the cloud billing market is indeed growing at a rapid rate, the margins are thin. There are 15 competitors (Gartner) that are in there today and the economics suggest that it is unable to accommodate all of them for the long term. Sustained negative cash flow would likely lead to consolidation and perhaps then, with greater margins on a larger revenue, would a price level of today be justified.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.