Zuora: Tremendous Value Play In This Subscription Enabler

Summary

• After rallying more than 30% in 2021, shares of Zuora still have plenty of upside in the new year.
• Zuora benefits from being a value-oriented software growth stock, while investors are running away from more richly valued peers.
• The company's ERP software is aimed specifically at subscription businesses. Revenue growth has been accelerating nicely over the past few quarters.
• Valuation looks modest at just ~5x 2022 revenue.
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It's 2022 now, and as I've been writing over the past few months since the tech/growth stock correction began, investors should begin the year by focusing on rotating their portfolios to value. That doesn't mean let go of all tech positions: rather, focus on tech stocks that are offering compelling growth stories but still trade at a reasonable price, to protect yourself from continued downside and the fallout of interest rate hikes.

Zuora (NYSE:ZUO) is one of the most compelling stocks in my portfolio in the "growth at a reasonable price" crowd. For investors who are newer to this stock, Zuora provides enterprise resource planning (ERP) software, which is critical to running backend operations at any company. Where Zuora distinguishes itself is that it customizes its products to tailor specifically to the needs of other subscription-based businesses.

Zuora has enjoyed reasonable momentum and strength, up ~30% over the past year and having a gentler fall in November and December when compared to some of its more high-flying peers in enterprise SaaS. Still, with Zuora now trading at ~15-20% below its October peaks, it's a good time to invest in this value stock with an eye to outperformance again in 2022.

Data by YCharts

I entered into Zuora when the stock was trading in the low-teens, but even now with Zuora trading in the high teens, I remain very bullish on this name.

Here's a refresher on what I consider to be the key drivers behind the bull case for this stock:

• Subscription-based business models are becoming dominant. Given the fact that more and more businesses are adopting this type of model, Zuora's base of potential customers has widened significantly. Zuora's uniqueness in this regard is also important to point out: companies can choose a regular ERP, but Zuora's subscription-focused solutions help to address common pain points.
• Innovation track record is strong; the product portfolio is expanding. There's virtually no other company that markets itself as a purpose-built platform for subscription companies. Zuora has also done a good job at fleshing out its portfolio of solutions, ranging from revenue management to billing tools to CPQ (configure, price and quote) applications.
• Zuora grows along with its customers. As Zuora's clients' subscriber bases grow, so does Zuora's opportunity to monetize and grow alongside its customers. The company has noted that upsells have hit a "record pace" in Q2, and highlighted several key milestones like GoPro's subscription-based storage and insurance program (a key feature of the company's planned turnaround) hitting 1 million subscribers.
• Offloading services work to partners. As Zuora has scaled, it has also been able to ramp up its third-party vendors and resellers to take on more of the unprofitable services/onboarding work that typically acts as a drag on software-company margins. Zuora's mix of subscription versus services revenue has grown over the past several quarters, helping boost gross margins and illustrating where Zuora would prefer to be at scale.
• Acquisition possibility. While I never like to base any investment decision based on high hopes that the stock will get acquired, Zuora checks off a lot of boxes for being acquired: it's small with just a ~$2 billion market cap; it offers a very unique product that many larger software companies may want to get their hands on, especially during times when organic growth is fading; and it's FCF positive.

Relative to other software companies growing their revenue in the mid-teens, Zuora also remains quite cheap. At current share prices near $18, Zuora trades at a market cap of $2.23 billion. After we net off the $203.3 million of cash and minor $2.7 million of debt on the company's most recent balance sheet, Zuora's resulting enterprise value is $2.03 billion.

Meanwhile, for the following fiscal year FY23 (the year ending for Zuora in January 2023), Wall Street analysts have a consensus revenue target of $402.2 million for this company, representing 16% y/y growth (data from Yahoo Finance). We note as well that Zuora has also released preliminary guidance for FY23 with revenue estimates of $401-405 million bracketing Wall Street's mark, plus 21% y/y ARR growth:

Figure 1. Zuora FY23 outlookSource: Zuora Q3 earnings release

Against Wall Street's revenue outlook, Zuora trades at 5.1x EV/FY23 revenue - a bargain not easily found elsewhere in the software sector.

The bottom line here: fundamentally, Zuora is achieving on all the key metrics investors need to see. Growth is picking up steam post-pandemic, the company is well-capitalized with slightly above breakeven free cash flow, and it continues to grow and expand its product portfolio. Given the current discount in its valuation, investors would be wise to jump in for a 2022 rebound.

Q3 download

Let's now go through Zuora's latest third-quarter results in greater detail. The Q3 earnings summary is shown below:

Figure 1. Zuora Q3 resultsSource: Zuora Q3 earnings release

Zuora's revenue grew 16% y/y to $89.2 million in the third quarter, beating Wall Street's expectations of $88.9 million (+15% y/y). More importantly, we note that total revenue growth accelerated one point versus 15% y/y growth in Q2, and just 9% y/y growth in Q1 - illustrating a post-pandemic recovery in growth for the company.

Moreover, when we look at subscription revenue only, Zuora's underlying growth rate is actually stronger. Subscription revenue growth of 19% y/y indexed above the total company growth rate - and part of the reason here is that Zuora has been offloading its professional services work to third parties, which is a common playbook for growing enterprise SaaS companies. Given that Zuora's gross margin on services is less than zero, this shift is a highly margin-accretive one.

In fact, the company's more favorable mix of subscription revenue (83% of current Q3 revenue, versus 80% in the year-ago quarter) has been a big driver in bumping up Zuora's overall company pro forma gross margins to 66%, up four points versus 62% in the year-ago quarter. Within that, subscription gross margins also ticked up two points to 79%, reflecting greater economies of scale.

Zuora notes that bookings sourced by systems integrators/resellers have grown 130% y/y, representing what I consider to be a "free" source of sales growth for the company. Zuora is also deepening its partnership with Microsoft (MSFT) to integrate its products directly into Microsoft Dynamics (the cloud-based Microsoft ERP, which can be a great way for Zuora to break into the Microsoft installed base. Per CEO Tien Tzuo's prepared remarks on the Q3 earnings call:

Finally, on a dollar basis, bookings from SI-influenced deals in Q3 grew by over 130% year-over-year.

Beyond our SI partners, we're also starting to expand our ecosystem of strategic technology partners. Now you may have seen early in Q3, we announced an exciting collaboration with Microsoft. We'll be working to integrate our products into Microsoft Dynamics. So, users of that product can also use Zora. We'll also be taking advantage of Microsoft Azure platform, as well as Power BI to drive more innovation and value within our own products for our customers.

Over time, we expect this will open up the opportunity to connect further into the Microsoft ecosystem as potentially a new distribution channel. It's still early days, but we are very excited about the potential of this collaboration."

From a go-to-market perspective, Zuora's chief objective remains to focus more on upmarket sales. In Q3, the company signed 10 deals with ACV north of $0.5 million, up from 6 such deals in the year-ago quarter.

As regards profitability, pro forma operating margins held relatively flat - clocking in at a virtually breakeven -1% loss this quarter, versus a 1% profit last year. The gains in pro forma gross margins were effectively offset by additional investments that Zuora has made into product development and sales - though, given the upside we've seen in Zuora's growth and the continued expectation for ~16% y/y revenue growth in FY23, we won't begrudge Zuora the extra spend needed to get there.

Key takeaways

Rising interest rates and investor pessimism toward momentum and growth continue to pose a major threat to most tech stocks as they did in November and December. Zuora, however, eschews these risks by being a much smaller, value-oriented SaaS play. A mid-teens growth profile, essentially breakeven pro forma operating margins, trading at a ~5x revenue valuation is quite a steal in today's market - stay long here.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of ZUO either through stock ownership, options, or other derivatives. 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.