Drilling Down On What Might Be Ailing Zuora Shares

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About: Zuora, Inc. (ZUO)
by: Bert Hochfeld
Summary

Zuora shares have been under substantial pressure since the company announced its earnings on March 21.

The results by the company were actually a beat, and the company actually guided above the consensus on an apples to apples basis.

Zuora shares sell for substantially below the average EV/S metric for its growth cohort.

The company continues its dominance of providing software for the subscription economy.

The subscription economy is growing at a fairly constant rate of 20% and Zuora's growth will noticeably achieve that for some years.

Zuora: A dominant company in an emerging space - can investors live with 30% top-line growth

A couple of weeks ago, Zuora (ZUO) reported the results of its fiscal Q4. Consistent with the results compiled by many other IT companies in this past earnings season, while the quarterly results were constructive and ahead of expectations, the growth forecast for this current fiscal year was seemingly less than what some analysts and investors had hoped for. Amongst those disappointed, and with some proverbial egg adhering to his face was this writer. I had hoped that the emergence of the so-called "subscription economy" would result in long term growth for this company at above 30%. Based on my interview with the VP of IR, I have to conclude that this will not be the case - but I have also concluded that 30% growth is more than enough for me to maintain a position in this name in my portfolio.

There apparently was some confusion on the part of some investors relating to the adoption of ASC 606 by Zuora. Ironically, one of Zuora's more important offerings has been its solution that allows customers to make the change through its software. From the point of view of share price valuation, the adoption of the ASC 606 standard ought not meaningful. The percentage growth will be the same for both accounting standards and ASC 605 standard will no longer be reported. The issue in terms of share price for this company is one of growth, and the change in the accounting standard will not change the cadence of top-line expansion. In the balance of this article, I have consistently used ASC 605; next quarter, when the company restates all of its historical numbers on a retrospective, analysts will use ASC 606 and so will I.

In the wake of the guidance provided by Zuora, the share valuation has compressed by 20% or so and at this point, the shares are up just about 11% on a YTD basis, far below the appreciation of the IGV which has been up by 22% over the same period. The shares, which began trading a bit more than a year ago, are essentially unchanged over that time period and are far below their high of $34.53 set in the wake of the company's initial earnings release.

Subsequent to this share price pullback, ZUO shares have seen their EV/S valuation fall to substantially less than average for their growth cohort in the mid-high 20% range. Using a 28% growth rate comparable to what the company is currently projecting, my EV/S estimate is now below 6.4X-and that is down from a double-digit EV/S valuation when the company's shares first came public.

The company is not generating positive cash flow at this point, but it has been improving profitability on a path that is congruent with its forecast issued at the time it went public a year ago. The company had a better cash flow quarter in Q4 than it had heretofore projected. The company - not terribly surprisingly - is in the midst of acquiring a new headquarters facility and the expenses of that undertaking are such that cash flow will not show a great improvement in the current fiscal year. Excluding the facilities investment, free cash flow is improving at a planned cadence, but management reaffirmed that it would be another couple of years until the company consistently generates positive free cash flow.

Should investors take a look at this company or move on to something else? I tend to evaluate companies based on some reasonable set of expectations for growth and profitability. The fact that expectations for this company got out of hand is just an incident of its immaturity but not some impediment to its business. It has a somewhat ugly chart - although, at the current share price, the current low point seems to be holding comfortably above the prior low set in mid-December 2018. The shares are not heavily shorted - if there is a short case on these shares, I have yet to see it published.

The emergence of the subscription economy is a real trend that is hard to ignore. And subscription billing and subscription accounting are unique undertakings with substantial differences from traditional ERP technology. Zuora is clearly the leader in its space and it would seem to have a reasonable likelihood of remaining in the top position. I have added some Zuora to the accounts of my investment management clients. I may have to be patient to see the kind of returns I am hoping for. After my interview with management, I am well aware that Zuora will not be a consistent grower of greater than 30% - but I feel more than a bit satisfied about management's aspirational expectations that it can achieve 25-30% growth for many years into the future and achieve substantial profitability over the next 2 years.

The shares, based on a growth rate of just less than 30%, probably lack the potential excitement of some of the hyper-growth names on which I regularly comment - but I can use some relief from the unceasing tasks of trying to handicap companies such as Zscaler (ZS), Trade Desk (TTD), or Mongo DB (MDB). It is a matter of taste and investment objective. A little less growth, a little less reliance on high-wire performance to sustain valuation.

What actually happened in terms of results and future expectations

It might be well to frame the issues with Zuora shares. The company went public last spring and initially had a rather substantial run. The initial earnings release from last June, showed revenue growing at 60% and that metric was adopted by some as indicating the company's growth potential. But subscription revenues in the period grew 39%; the very substantial increase in services revenues which more than doubled was basically because in the prior year, with the merger of Leeyo, the deferred revenue write-down had led to the elimination of most of the company's services revenues from that source. In the course of the year, the Leeyo/RevPro deferred revenue balance had been rebuilt, and services revenue comparisons as reported, showed growth of more than 100%. That, of course, was not a real growth number, and over the course of the past fiscal year, services revenue growth receded dramatically

Essentially. the 60% revenue growth that was reported in the company's Q1 last year did not really reflect the reality of business growth - the company reported 39% license revenue growth in last year's Q1 and 35% license revenue growth in the just reported Q4. The 35% license revenue growth for the period was a bit greater than the company's prior forecast. License revenues reached $46.7 million in the last quarter, compared to a prior forecast of $45.5 million.

The company is forecasting that Q1 service revenue growth will be about 21%. That is up considerably from the levels reported during the course of the prior fiscal year as the impact of the deferred revenue haircut declines. As management pointed out to me in our discussion and also during the course of the conference call, looking at services bookings, shows a growth rate of 33% which is consistent with the growth in license revenues. Over time, as the impact of the deferred revenue haircut disappears, the company should see service bookings and service revenues grow at approximately the same pace as license revenues.

The company is forecasting that license revenues in this Q1 will be $48 million on an apples to apples basis, growth of just 2.8% sequentially. The limited level of sequential growth is primarily a factor of seasonal influences - this company derives quite a bit of its subscription revenue from the volume of payments processed on its platform, and those payments showed a 56% growth year on year during the last quarter and they increased by almost 25% sequentially. Zuora has tiered pricing plans and one cannot take the growth in payments volume last quarter and extrapolate some kind of revenue growth using that metric. But, certainly, it is likely that the continuation of that level of payment growth will ultimately swing expected revenue growth to higher levels than the company has currently forecast and discussed with me during our meeting. To a certain extent, the increase in transaction volume can be driven by the cadence of implementations rather than new customer acquisition. That said, full year transaction volume rose by 45% compared to 49% the prior year. Again, on an apples to apples basis, the company is forecasting license revenue growth of about 33% in Q1, compared to 35% in Q4. Basically the so-called guide-down or growth slowdown, really doesn't exist for Zuora - at least in Q1.

Overall, and again, on an apples to apples basis, Zuora is forecasting a 28% growth in license revenues for the full year. Moving from 33% projected license growth in Q1, to 28% license growth for the full year, would imply a noticeable slowdown in the cadence of new customer acquisition - the company has continued to achieve dollar-based net retention at the upper end of its forecasted band of 108-112%.

Many investors/analysts focus on the dollar-based retention metric (indeed I do myself) as an indication of the overall level of user satisfaction and growth opportunities for companies with a SaaS revenue model. Zuora, however, can have a significantly "heavier" initial sale than most other kinds of applications. Given the nature of the app which is based on changing the billing paradigm and the rather substantial customization that is required for both the billing and the revenue recognition apps, most users start out with a rather substantial installation that encompasses much of what they sell on a subscription basis. This has tended to limit the amount of upsell that is available at this point.

About a year ago, Zuora launched its Collect product which as the name suggests is a tool to help collect subscription invoices. In addition, there are numerous modules that Zuora offers with regards to billing and finance support. But the initial installation is likely to be a far greater component of revenue for Zuora than it is for other high-growth SaaS vendors.

Zuora still has a relatively brief post IPO history. Thus, I can't quite suggest that one ought to dismiss the specifics of its revenue growth forecast out of hand. But I can suggest, after a lengthy discussion with the management of this company, that there has not been any fall off in the cadence of new customer acquisition and its management is certainly not expecting to see that happen any time in the foreseeable future. I would suggest that the difference between the forecast growth in Q1 and the forecast growth for the balance of the year when it comes to license revenues is nothing other than prudence.

Zuora's cohort of its largest customers - those with ACV of greater than $100k, increased by 22 sequentially to 526, and the actual size of the average customer in that cohort has grown rather significantly as the company penetrates larger users. Management detailed a case study of NCR (NCR) in which it took that vendor about 6 years to get 10% of its volume onto the Zuora platform which resulted in an ACV for that customer rising from about $200-300k to a multi-million ACV. Needless to say, that kind of cadence isn't quite typical but it does speak to the potential the company sees in its business.

Most of my time with Zuora management was spent trying to understand why the company isn't forecasting growth of greater than 30%. To synthesize what I was told - Zuora is creating a category that has heretofore not existed. The hyper growth names are essentially in a land grab mode and are replacing solutions that already existed. That explanation isn't exactly the case - at least so far as I can tell. Alteryx (AYX) and Twilio (TWLO) for examples are not replacing anything but are growing because of capabilities they offer that were not heretofore available. Management also believes that it will not get the kind of add-on revenue that is instrumental in keeping growth at iconic SaaS vendors at such elevated levels=although again, the NCR model certainly might suggest that there are potentials beyond what the company has currently forecast.

But at the end of the day, I think that the company is acting aggressively in recruiting users. I think it is reasonable to make the investment case for Zuora using a growth rate of approximately 30% - and if there are quarters that see a stronger performance they should be regarded as lagniappe and outliers at this point.

Can Zuora grow revenues at a rate above 30%?

I think the keys to seeing growth substantially exceed current company forecasts relate to increased penetration of add-ons such as Zuora Collect, a continuation of the hyper-growth seen last quarter in terms of transactions processed on the Zuora platform, and penetration of new verticals. The later opportunity can be a bit lumpy at times - it is hard to say when a vertical is ripe for Zuora's solutions and that has led to a certain level of conservative forecasting coupled with an uneven cadence of large customer acquisition.

Management suggested that several new verticals such as insurance/healthcare, Communications, and B2C are all emerging verticals that could be deeply penetrated and which could accelerate growth. But my interlocutor said it was impossible to forecast which vertical might take off in the near future. He said that the penetration the company had achieved in automotive, where 8 out of the top 10 users have adopted the Zuora platform for their extended warranty and for their remote service offerings, came as a substantial surprise to management.

As mentioned, last quarter, the company saw a 56% growth in the volume of transactions it manages. Interestingly, the company is also seeing a CAGR of almost 50% in the invoices sent by its users (see link here). Zuora tracks something that is called the Subscription Economy Index, which is produced by the company's Chief Data Scientist, Carl Gold. The latest data show that the index is climbing at around 18%/year, with growth a bit stronger in EMEA than in the US. That is about 5X the growth the companies in the analysis are generating overall. Unfortunately for third-party observers as I am, the survey doesn't turn from tracking the growth of the subscription economy, to tracking the growth of software applications that are tied to that economy. But inevitably, the strong increases in transaction volume and in processed invoices would seem likely to be leading indicators of potential revenue growth for Zuora. Based on my conversations and the specific metrics that were shared during the course of the conference call, I regard company guidance as a floor whose strength is undergirded by the visibility that comes from a rising tide of transaction volume and successful implementations.

Competition - A key part of the Zuora investment story.

I think competitive moats are one of the key elements in any investment story and that is certainly the case in considering the investment merits of Zuora. Much of my interview with management was spent on discussing the competition as they see it. While it is certainly likely that any management in an interview will focus on positive elements of their positioning, after looking at third-party discussions, I think that Zuora is really well positioned in its space.

Indeed, I came away from the discussions feeling that the company's contention that it is presenting users the only platform encompasses, billing, payments, and revenue recognition is probably reasonably accurate.

I admit that I find it surprising to see that none of the major stack vendors has a competitive offering for either billing or rev. recognition that was developed for companies offering their products on a subscription basis. Oracle (ORCL) does have an offering that it acquired when it absorbed NetSuite. Apparently, the functionality of the product was inadequate and it has essentially dropped out of the market. SAP (SAP) owns bought a company called Hybris a few years ago. Neither Microsoft (MSFT) nor IBM (IBM) has entrants in this space. According to the Forrester Wave study that I have linked here, the two closest competitors that Zuora has are goTransverse and Aria Systems.

goTransverse is a leader in a niche market for consumption-based rating and billing applications. goTransverse is said to have weaknesses in the support of electronic payments. Aria is private with revenues said to be less than $10 million. It has some notable users such as Adobe, but at its scale, it will not really be a competitor for most enterprise deployment and it lacks the breadth of the Zuora offering.

Given the competitive dynamics, coupled with valuation, it seems to me as though Zuora has a substantial opportunity to be acquired. Having a recurring revenue billing and revenue recognition capability would be a very significant differentiator for a stack vendor and the synergies in terms of both revenues and costs would be very substantial.

The Recurring Revenue Space

Zuora talks about its future being inextricably linked with that of the so-called subscription economy and, of course, that is the case. When looking at the market, the subscription economy has a couple of major elements. One of those is the billing aspect - Zuora's core technology. The second significant technology is that of revenue recognition. Zuora bought what was considered to be the leading vendor in the space, Leeyo, in 2017 and RevPro is now a significant component of the company's offering. As mentioned earlier, the company is now selling something it calls Collect which is essentially an application that users deploy to dun subscription customers.

I have linked here to an article on the size and growth of the subscription economy. Just how valid is this study? It is probably representative of much of the research that is currently available. It suggests that the overall subscription economy is growing around 20% - some components grow faster in given quarters and years - but the overall growth cadence is around 20%. Zuora will grow faster than that basically because users will continue to adopt specialized billing platforms as part of their move to subscription revenue models and because users will move more of their total subscription commerce to the Zuora platform. Further, the cross-sell opportunities for both RevPro and for Collect, will drive growth faster than just the overall growth of the subscription economy.

There are many other studies and many anecdotes that can be readily accessed by readers on the web that discuss the growth of the subscription commerce market but they simply don't have a holistic view of revenue so I haven't chosen to link to them. Nowadays, Burger King offers a coffee subscription for $5/month and Ikea is starting to offer what it describes as a furniture subscription. Every week, Zuora sends interested parties a new subscription use case. There are services that allow one to subscribe to fresh fruit and vegetables. The breadth of offerings - both in this country and abroad - that can be obtained via subscription is staggering. It seems fair to suggest that the growth rate of subscription commerce will rise at rates several times traditional sales for some years to come. While Zuora is not likely to achieve the kind of hyper growth that companies such as Zscaler and MongoDB are enjoying these days, the longevity of its growth is perhaps several years greater than the period of hyper growth to be seen for the most rapidly growing companies in the IT space. I now subscribe to 3 products myself: water, toothbrush heads, and aspirin and I am apparently a slow adopter of the trend.

I think in evaluating Zuora shares, it would be reasonable to use a growth rate of 30% with some potential upside and better visibility for a longer growth rate than competing assets in the IT space.

Valuing a relatively unique property.

It is obvious that investors and commentators have been disappointed by Zuora's operational performance and guidance. At this point, several weeks after the earnings report, I am a little baffled as to why that might be. The chart is quite ugly and the shares seem to be under some selling pressure with the shares continuing to lose ground both absolutely and relatively on some days of relatively elevated volume. As mentioned earlier, the shares, now selling for an EV/S of less than 6.4X are amongst the cheapest in the growth cohort of 25-30% and are far below the best fit line that we calculate. For that metric. Just as a contrast, ZUO shares are selling at about the same EV/S ratio as VMW and PTC, despite having double the expected growth of either company.

Part of the issue is one of profitability which is growing, but not perhaps fast enough to suit some investors. As mentioned earlier, part of the issue with regards to profitability remains the deferred revenue haircut which has had a very substantial impact on services gross margins. Overall, operating expense rose 6.6% sequentially in this last quarter. Operating expenses grew by 46% in Q3 year over year and by 36.5% year over year in Q4. This moderating growth in operating expenses is such as to lead me to believe that the company will be able to achieve its break-even goals, at or ahead of the schedule, it presented during its IPO road show.

The company achieved a strong increase in deferred revenue last quarter on a sequential basis. Much of that has to do with annual billings and a higher level of deferred revenues generated by the increase in transaction volumes. Calculated billings growth on a percentage basis grew a little slower in Q4 than in Q3. Some of that relates to the deferred revenue haircut and more of that relates to seasonality. That said, the company is not expecting that billings growth will diverge substantially from the percentage growth in reported revenues in fiscal 2020 and beyond. Overall, revenue growth metrics for Zuora are going to be well above the growth in economy-wide subscription revenues looked at holistically, although there are likely to be some quarterly ups and downs in the specifics of various revenue metrics.

No doubt there are readers and investors who would like to see Zuora achieve higher percentage growth than the company forecast. And I imagine, that at the margin, that will happen, although I have engaged my analysis using 28% 3-year growth. But last quarter was not one of missed expectations or a blown forecast or any kind of guide-down. The current growth expectations, as published by 1st Call, which call for revenue growth of less than 25% both this year and next year are likely to be noticeably exceeded. Last quarter's results were such that essentially all analysts raised their forecast and I have every reason to believe that the same result will be seen this quarter. Overall, the quarter was one in which the company modestly over attained, but perhaps not enough to satisfy traders - and in this case that includes this writer - who might have expected more over attainment in the wake of very positive analyst previews. I think there is significant positive alpha in store for these shares.

Disclosure: I am/we are long ZUO. 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.