Description

Executive Summary

LegalZoom is a software company focused on legal / finance software and solutions for the SMB market. It historically has provided entrepreneurs with business formation tools to set up LLCs or Corporations and is increasing its menu of solutions to increase wallet share and drive more recurring revenues. Company is thus offering tax and legal advice, compliance solutions, and other solutions that an SMB may need.

 Since its IPO, the stock has traded down and at $15 / share, the company has a $2.9B enterprise value and is trading at ~5x revenues. There are multiple ways for the company to generate growth given i) strong unit economics of the core product, ii) strength and experience of the team, iii) leadership position the company enjoys in the sector and iv) the ability to create a legal marketplace. This could be a 25% topline grower with +20% EBITDA margins. I see 3-4x upside with this one in the next 5 years. Given the selling pressure for tech stocks, I’m going to establish a small position but aim to build a larger investment over time.

 Company Background

LegalZoom is one of the largest online providers of legal services to the SMB market. The company was founded +20 years ago and is going through some interesting evolution in the recent times that could provide an attractive investment opportunity. Company recently went public in June of 2021 at a ~$7B valuation and at ~$15 / share, has a $2.9B TEV with no debt. Company is thus valued at ~5.0x 2021E revenues.

 The company provides upfront formation services to SMBs and also provides individuals with estate planning products. The company was historically owned by Permira, where the focus was on generating cash flows to service its debt. In the couple of years leading up to its IPO in June 2021, the company was growing topline in the mid-teens.

 In recent years, the company has brought in new executives from Intuit (new CEO, COO and CTO) who have a lot of expertise in the SMB market and are focused on LT growth initiatives. Importantly, new management is focused on driving LT growth in sticky subscription products. These products run the gamut from: i) other software licenses that LZ has (e.g. compliance and registration solutions), ii) SMB solutions from its partner network (e.g. Intuit, Quickbooks, Brex and Square), iii) professional services that it has in-house (e.g. tax and certain legal) and iv) professional services from its partner network (e.g. legal network with +1,300 lawyers).

 The company has a couple of different business lines comprised of products associated with business formation that are one-time in nature (e.g. getting a business registered as an LLC or Corporation, trademark and IP) and recurring products that companies subscribe to (e.g. compliance products, virtual business mail forwarding, etc.). Company also receives revenues from business partners who can provide other services and solutions to SMBs. The company also provides individuals with estate planning services (e.g. setting up wills).

 The largest opportunity resides with the SMB side of the house and though the company has helped set up over 2.5M companies, it only has 1.3M subscribers, speaking to the room for a higher attach-rate on the recurring services. That is where new management from Intuit is coming in with three conscious growth vectors:

 -          Scaling the core business: The existing business is fairly economic. CAC payback is 90 days and with an 18 month LTV for a customer, the LTV / CAC is ~6x suggesting that there is room to meaningfully invest in GTM. Top-level management come from Intuit and come with established playbooks regarding how to economically acquire the market.

 -          Building SMB formation services: LZ is building a broader portfolio of services to help with business formation. Some of these services are one-time, others recurring. Some are provided through partners and other internally. All are aimed at creating deeper engagement with customers and increasing stickiness and LTV. Company has created in-house teams to help companies with tax solutions, which are often sought at the time of business formation. LZ also acquired a company to provide virtual business mail forwarding solutions, which should create a more continual touchpoint with the customer. LZ is also partnering with companies in the financial services sector (e.g. Brex, Intuit and Square). The benefit to LZ customers is that they can buy these partner solutions at a better price point. For LZ, instead of getting an upfront lead fee, they have a rev share with their respective partners. By consolidating their channel partners, they are providing enough critical volume such that they can really extract economics for their clients and themselves.

 -          Integrating attorneys: This is interesting since most law firms, especially the ones that work with SMBs, are fairly small organizations that don’t have a lot of resources and don’t spend a lot on marketing. LZ thus can act as a marketplace to connect lawyers with clients. So far, over 1,300 lawyers have provided over 600,000 consultations on LZ since 2011. Note that an average SMB will have +$3,000 of annual recurring legal fees. ARPU for subscriptions is ~$250 so there is plenty of headroom to gain more wallet share from SMB clients.

 Growth increased during the pandemic to +20% with +35% growth in the subscription business, which now accounts for +50% of overall revenues. Transaction revenue has also been increasing over the course of the last two years but this revenue segment will be deprioritized relative to subscription revenues. Partner revenues will likely face some near-term headwinds as the company transitions from upfront lead gen fees to recurring revenue-share arrangements. Gross margins are +65% (OK for a company selling into the SMB market) and should improve as the tech stack is upgraded and automation measures implemented. aEBITDA is expected to compress to ~10% this year as management invests in growth initiatives.

Over the LT, management hopes to be growing the company at a +24% topline rate with +70% gross margins and +30% aEBITDA margins. If the company is able to reach these goals, it will score very well on the Rule of 40 basis. Note that company is currently running at an EBIT loss of $25M every quarter as it ramps up heavily on stock-based-comp. Biggest increases in SBC are in G&A (likely to senior brass) and in R&D (to recruit top engineering talent).

 Market Opportunity

Though a leader in digital legal services (~10% of LLC formations and 5% of incorporations), the market is significantly underpenetrated. Whereas 70% of financial services are transacted online, only 10% of legal services are done online. In fact, 40% of solo lawyers don't have a website. LegalZoom estimates that its addressable market is +$45B of which the bulk resides in the SMB market. Note that ~$20B of that TAM is associated with products that are fairly newly launched (e.g. tax planning and business tax returns). The core TAM is thus closer to $20B, which is still plenty of runway for a company doing $580M in 2021E revenues.

There are some macro market changes that should be beneficial for LegalZoom:

 - New business formation has been increasing. Over the years, monthly new business formation in the US has increased from a rate of ~200k per month after the financial crisis to ~300k per month in 2019. After the pandemic, the rate of new business formations skyrocketed. Note that a lot of this increase is probably due to people setting up shop to collect PPP loans. That being said, a lot of people were laid off and had to start their own business. A lot of other people probably were working remotely and decided to set up a side gig. It’s clear that the pandemic created an atypical bump in business applications but the LT trend of business creation has been a +10 year trend.

-          Legal business innovation at the state level: The state of Arizona recently allowed alternative business structures with regards to law firms. Instead of law firms required to be owned by lawyers, companies could now employ lawyers and offer their legal services. LZ has set up a legal organization in Arizona and intends to launch legal business services to AZ SMBs, trademark services to companies nationally, and provide access to its lawyers for a monthly subscription fee. This kind of service allows LZ to create more value for its clients and more regular interaction. This could reduce the upchurn that the company faces when its clients grow and need more sophisticated services. Other states that are exploring similar types of legal firms include UT, CA, FL, WA, and NC.

 Thesis and Forecasted Performance

 -          LZ is a company with multiple ways to win. The company has historically under-invested in GTM under its PE ownership and is finally making some appropriate investments. Expansion into more subscription revenue streams with recurring utilization (e.g. virtual business mail) and higher value-add (e.g. business tax solutions) should mean stickier revenues and higher LTV.

 -          Experienced management team. Senior management team hail from Intuit and know what it takes it scale to and operate at 10x the level of the current business. Management is focused on i) increasing subscription revenues and ii) increasing LT growth profile of the business.

 -          Large and underpenetrated market: SMB market is a major opportunity and there is plenty of market opportunity for company to grow to be at least 3x the size of the current business, especially as it branches into new TAMs that are multiples larger than its previous market. Legal market is still early in the movement to online services and LZ is well situated to benefit from the movement to online.

 -          Ability to become dominant legal marketplace: Company is one of the few players of scale that can connect SMBs with lawyers. As company enters new areas of law, it can onboard more clients and more lawyers.

 In a base case forecast, I assume that the company can reach ~$1.5B of revenues in 5 years, growing topline at a +20% CAGR with subscription revenues comprising +70% of the overall revenue base. More detailed assumptions:

 -          Transaction revenues: I assume that the company is able to grow topline ~20% over the coming years through 2026 to $1.5B topline. I estimate that new business formation declines to 4M in 2022 and 2023 after the pandemic bump but then grows to 4.6M business formations / year in 2026. I also assume that LZ is able to increase its penetration of new business formations from ~8-9% to 14% by 2026. With AOV constant at $236, transaction revenue increases from $212M in 2020 to ~$360M by 2026, growing topline in the low-teens range.

 -          Subscription revenues: Management is squarely focused on growing subscription revenues and I estimate that LZ will add 200k units in 2021 and 350k units by 2026. Total sub units increase to 2.7M in 2026, which is ~8% penetration of the US SMB market. Logo growth is thus 18% in 2021 droping slightly to 15% in 2026. Given management’s focus on increasing sub revenues, I’m assuming that ARPU increases 10% annually from $245 in 2021 to $395 in 2026. Actual ARPU increase can be much more dramatic given the company is expanding into some fairly juicy tangential services where upcharge can be material. Subscription revenues grow from $315M in 2021 to $1B by 2026 at a growth rate exceeding 25% CAGR and representing +70% of 2026 revenues.

 -          Partnership revenue: I haven’t spent a lot of time on the partnership revenue build but management has guided that near-term partner revenue contribution will be tame as smaller partners are weeded out. Additionally, subscription elements of the partner revenues may be incorporated into the subscription revenue-line. I’m conservatively estimating that partner revenues stay flat in the forecast period.

 Assuming the company can perform to this forecast and reach ~$1.5B in revenues with +20% topline growth rates and reasonable EBITDA profitability (management is targeting +30% aEBITDA margins), the company can realistically be valued at 6-9x revenues, in line with historical averages. Under such scenarios, there is the chance to generate a 2.8-4.2x gross MOIC in a 5-year timeframe.

 Investment Approach

The company recently went public in June of 2021 and has since been trading down. After pricing an IPO at ~$28 / share, the stock increased to ~$40 / share before trading down to ~$15 / share in the last month. The stock has appeared to have found some stability around the $15 price point.

 There isn’t a lot of volume in this stock and only 1M shares typically are traded per day. If we look at the chart below, the company was caught in a market downdraft from Sept 7 through Oct 4 and without any news flow, fell from $35 to $24 in that timeframe. The stock took a 20% drop on Nov 10 when it announced the acquisition of Earth Class Mail, a provider of virtual business mailboxes. That may have also been a function of the wider markets as the NASDAQ traded down from Nov 8 through Nov 10.

If we look at the NASDAQ, there has been a sharp drop in January when rate hikes hit tech stocks. LegalZoom has held up relatively well at the $15 price point even accounting for i) the drop in tech shares and ii) the expiration of the IPO lock-up at the end of December 2021. This suggests to be that there is some support to the stock at this price point right now. There are 7.6M shares sold short, representing 3.7% of shares outstanding and 9% of the float.

 So far in 2022, tech stocks are taking a beating as the market is focused on rate hikes, which increase the discount rates associated with future cash flows. A lot of high-growth stocks have fallen to earth and there is a lot of selling pressure in the market today. It may make sense to either i) establish a small position now since the stock is priced well and has found some trading support or ii) to wait for the tech selloff to abate before beginning to establish a position.

 Risks

-          Pricing pressure – LegalZoom’s primary business is around business formation where they assist entrepreneurs with state filings for LLCs and Corporations. The cost to file in a state varies but ranges from $300 / filing in Texas to $50 in states like Hawaii. There are companies that offer free fillings and some companies such as ZenBusiness, charge only $39 on top of a state filing fee (LegalZoom charges $79 on top). More competition could emerge in this area and states could lower filling fees, which would pressure LZ’s business. LZ needs to launch new and stickier products in order to offset this risk.

 -          Management turnover – New management from Intuit is a net positive but as with any change, it can be disruptive. There have been some management turnover in recent quarters and sentiment on Glassdoor is not great at a 3.6 rating. Overall, new management is a good thing since the C-level team at LegalZoom have scaled Intuit, where they ran a business 10x the size of LegalZoom.

 -          Tech debt – Company has been around for 20 years and under ownership by Permira, was focused on optimizing cash flows instead of investing for growth. Company is in the process of investing in itself and will work its way through the tech debt but it is an issue for the time being.

 -          New product launches – Given potential pricing pressure in the core business, there is a need to get new product launches right. New team is seasoned and focused on some sensible initiatives but this is a risk since a lot of the new products are relatively untested. 

Catalyst

No near-term catalysts for this company. Recognition of value will likely occur over time as company performs and unlocks the market opportunity. As new product launches gain traction, investment gets de-risked and stock should re-rate.