Description

Summary

ZUO is a long with 30%+ upside in the next 12 months and ~70% over 18-24 months. It is a “category creator” SaaS business with sticky products and participates in the upside from its customers’ growth, which will drive compounding of subscription revenue growth at 30% y/y for at least the next 3 years. The Street doesn’t appreciate ZUO’s ability to keep adding new customers or greater upsell/cross-sell in its installed base, resulting in top-line estimates that are too low. ZUO is also underearning from doing most of its own customer implementations and spending heavily on S&M, which will change as SI partners offload more low-margin services and sales efficiency improves. Operating margins will improve faster than Street estimates and get ZUO to FCF breakeven by H2 FY21 (YE 1/31/21), a year earlier than management’s guidance. Q120 earnings in late May and ZUO’s first Investor Day in early June should be positive near-term catalysts against conservative guide and a lowered buyside bar, signaling a good setup for bulls. As ZUO beats numbers and proves it can reach the “Rule of 40” over time, its NTM EV/RR of 10.0x should hold and roll forward. We use 8.5x EV/RR on our FY23 subscription revenue for a price target of $37.

Background

ZUO is a B2B SaaS vendor that lets companies set up and maintain recurring revenue subscription models. It provides a system of record and billing software that sits in the middle of a company’s CRM and ERP to process transactional data from subscription models like user activations, churn, ARR, MRR, ARPU, etc. The software is designed to act as a central hub for this data and is compatible with various general ledger, payment gateways, tax, and CRM applications. ZUO’s contracts are generally 1 year in length and dollar based retention should settle in the 108-112% range over the long term per management.

ZUO has 2 flagship products, Zuora Billing and RevPro, and all customers subscribe to at least one. Billing lets customers set up multiple custom pricing models, manage invoices, and automate the order-to-revenue process. RevPro is a subscription accounting and revenue recognition tool developed through the acquisition of Leeyo in May 2017. Importantly, management sees only a ~10% overlap today between Billing and RevPro customers, so cross-sell has been minimal. Management also believes all customers will eventually subscribe to both but notes the buyer persona and sales motion are different for each. Billing is a strategic digital transformation sale because it provides a holistic view on the recurring customer relationship. This often needs C-level involvement and can be a lengthy sales cycles of 6-9+ months. RevPro is a relatively easier sale to a company’s controller because it’s based on regulatory compliance (ASC 606 or IFRS 15), which is why audit partners like PWC have driven ~25% of new RevPro lands in recent quarters.

ZUO generates subscription revenue by charging customers a fixed monthly fee for access to Zuora and a variable component based on volume. When a customer signs up, it pays the fixed fee (usually billed quarterly or annually) and subscribes to a “block” (usage tier) of minimum commitment for how much transaction volume it will need Zuora to process. Customers have to buy more blocks as they scale their subscription business, which results in more fees paid to ZUO. Pricing is structured so the initial block has a fixed invoice amount with an overage fee, so the customer knows upfront how much volume will require buying a higher tier instead of paying a lot of overage on a per-transaction basis. Customers can upsize their minimum block whenever it makes sense and ZUO participates in the underlying volume growth of its installed base. This is structurally a very good business and has similarities to the success-based model used by Demandware (acquired by Salesforce.com in 2016), which earned both subscription fees and a take rate based on e-commerce GMV flowing through its platform. ZUO’s subscription revenue is >70% of total revenue carrying 78% gross margins, with management’s goal of 80%+ over the next 3-5 years. Professional services (PS) revenue is the remaining ~30% and is managed to breakeven gross margin. ZUO has a relatively heavier mix of PS because of its heavy initial land, and it doesn’t want to risk a bad customer experience by handing clients off to SIs who haven’t yet built robust Zuora practices. Management says this is slowly changing though as Zuora increasingly becomes an industry standard.

ZUO was founded in 2007 by Tien Tzuo (current CEO, employee #11 from Salesforce.com) and 2 former WebEx employees. The idea was to monetize the rapid proliferation of subscription models by both emerging startups and incumbents across industries. ZUO has trademarked the term “Subscription Economy” and Tien can be a little too promotional at times in hyping his book “Subscribed”, which talks about how every business has to build an “as-a-service” to future-proof itself. Despite the occasionally goofy self-promotion, we find Tien to be honest, intelligent, supremely confident, well-aligned with shareholders, and most importantly a very skilled salesperson, which is essentially everything you need in a great enterprise software CEO. By branding ZUO as a thought leader on subscription models, Tien and his book have helped evangelize customers and made the sales motion easier in a largely greenfield TAM. Our work in speaking to competitors and SIs suggests the TAM is realistically somewhere between $7-10bn, with management quoting $9bn as a subset of a broader $40bn ERP market. This implies ZUO is only 2-3% penetrated today.

Competitive Landscape

Competition is hotly debated, but our research indicates ZUO has first-mover advantage and that isn’t likely to change soon. The lazy bearish argument we hear a lot is that traditional ERPs will eventually compete or the reason they haven’t yet is because this is a small TAM that’s not worth chasing. The reality is doing what Zuora does is difficult and ERP incumbents do have a small market presence already, but they haven’t been able to scale precisely because it is a tough problem to solve efficiently. Legacy solutions from SAP and Oracle, which we find have been cobbled together through a hodgepodge of in-house R&D and acquired tech, are clunky, have a poor UI/UX, consume too many resources (need to constantly ping a system to track real-time subscriber activity), suffer from downtime frequently, and haven’t gained traction due to years of underinvestment in both product and distribution. From an architecture standpoint, traditional ERP was designed to handle episodic transactions and not recurring customer relationships. The tech stack to automate subscription activity (constant upsells, deactivations, add-ons, etc.) and the sales culture/talent to effectively sell such software are fundamentally different and not easily replicable by legacy vendors.

Many startups like Chargify, Chargebee, and Recurly play in the space, and Stripe has recently made some noise with its subscription billing offering for SMBs. However, our work shows that these players aren’t gaining as much traction as Zuora especially in the high-end enterprise segment and will probably never profitably serve large customers. Companies that have been in the market a little longer like goTransverse and Aria (has ADBE as a customer and is the closest competitor per Forrester research) have also not scaled well given what we view as inferior tech. We attribute ZUO’s moat to best-in-class tech, ease of use, thought leadership position, public company status that has elevated its legitimacy, and frankly Tien Tzuo’s ability to tell a good story and his deep understanding of effective sales technique through the SFDC pedigree. We don’t believe meaningful competition will emerge over the next many years, particularly because doing so now would require too many investment dollars to catch up to ZUO while also being comped to ZUO’s financial model (won’t help VC exit valuations), which will be profitable in the next few years. Moreover, once Zuora lands with a customer it becomes entrenched in the workflow of a subscription model. This is mission-critical software that is unlikely to go through a rip-and-replace.

Stock Opportunity / Debate

ZUO is up a mere ~17% YTD in a tape where many mid-cap SaaS names have ripped. The stock is also down 67% from its peak in June 2018. Having gone public only in April of last year, ZUO is a busted IPO now trading at <6.0x FY21 EV/S on consensus sales despite long-term top-line growth guide of “25-30% over 3-5 years, 20-30% forever” (per IR). We think this is cheap given our understanding of ZUO’s moat and how early it is in penetrating its TAM with undeniable secular tailwinds from the end market’s growth.

A noisy fiscal Q419 print in late March ignited debate on ZUO’s top-line growth runway, driving stock volatility. First, Q4 billings were in line with consensus. Given the stock’s 30%+ rally YTD into the print, expectations were simply too high and in-line billings are never good enough for recent IPOs. Customer count growth in the ACV >$100k bucket decelerated to 27% y/y from 30% in Q3. Since these customers represent >85% of total ACV, investors are confused as to whether this implies ZUO is structurally decelerating toward its long-term growth algorithm of 25-30% so quickly after going public. Further, ZUO’s fiscal year ends on 1/31 and it didn’t adopt ASC 606 until 2/1, resulting in guide being given on both an ASC 605 and 606 basis. Adjusting for a Q1 headwind of $1.5mm from 606, subscription revenue growth was guided to be down sequentially. On a y/y basis, top-line growth guide also came in lighter on both subscription and total revenue lines for Q1 and FY21, even excluding the 606 headwind. The guidance has caused a lot of confusion, with bears believing ZUO may be facing competitive issues or a lack of demand while bulls think the guide is simply conservative. Shortly after earnings, news that a share distribution was required by the LPs of Benchmark, one of ZUO’s VCs, also put technical pressure on the stock. In just a few days following the Q4 print, ZUO went from $24 to <$20. The stock has rebounded only very slightly since, giving us an attractive entry point.

Why Now?

We think there is a high probability of a beat/raise on the upcoming Q120 print, with our work suggesting a sequential downtick in subscription revenue isn’t likely. Looking at TTM subscription billings, the toughest comp is in Q1 and compares get several points easier sequentially as the year progresses. This is particularly important because every quarter management discloses how much processed transaction volume flows through Zuora Billing, and in Q4 that number saw the largest q/q and y/y increase since it was first given for Q118. We think this is a leading indicator for dollar based retention, which could potentially expand in the near term vs. Street modeling it flat/down in FY20. Higher retention would support beats to subscription revenue. While H1 professional services revenue comps are tough from lapping the one-time glut of customers implementing 606 last year, management has been proactive about messaging this. We think once the tough Q1 comps are out of the way, management will be more confident in raising guide and suggesting further momentum in the remaining quarters. The Street is modeling within the guidance range (including the q/q decline in subscription revenue) and given sustained weakness in shares since the last print, we think even just a small beat on top-line is enough for the stock to work. Overall, the lowered bar on guide, favorable positioning (limited hedge fund ownership, fairly high short interest relative to market cap), and an undemanding EV/S multiple provide a good tactical setup for longs into Q1. We also think the company’s Investor Day during the Subscribed user conference on 6/5 could be an incremental catalyst as management may provide more detail on go-to-market initiatives, including progress with the SI ecosystem.

Differentiated View

Street coverage is sparse and the few covering analysts don’t do a good job of dissecting ZUO’s model given no real incentive (smaller cap stock, relatively low trading volume, no marquee HF ownership). MS (rated Hold) is the most detailed in its analysis so we use their model as an overall benchmark for sellside expectations. The lazy modeling and lack of attention to fundamental drivers create the scope for differentiated estimates.

Breaking Subscription Revenue Down by Customer Segments Highlights 25-30% Long-Term Growth Opportunity

A key part of the bear case is that ZUO serves a lot of low-ACV subscription-based Series A/B startups. Given structurally higher churn in this segment, bears think a slowdown in startup land is going to derail ZUO’s long-term growth of 25-30%. Making some reasonable assumptions shows that the delta between high-value customers (defined by ZUO has those with ACV of $100k+) and small customers is quite large, which also means small ones become a lot less meaningful to growth as ZUO continues to grow its ACV base. This is especially true now because management has indicated it is more focused on landing large customers today than earlier in ZUO’s history.

In Q419, management reported that ZUO earned “over 85%” of subscription ACV from customers spending ACV of $100k+ (we’ll call this “enterprise”) and $169mm of subscription revenue overall in FY19. Using an assumed ACV contribution of 86% (exact % unknown) as a proxy for subscription revenue generated by large customers and the 526 large customer count number disclosed at the end of FY19, we estimate that ZUO generated $145mm in subscription revenue from enterprise in FY19. This implies the average enterprise customer spends >$300k per year on Zuora. We further estimate there were a total of >1,100 customers in FY19 (ZUO no longer discloses total customer count), implying there were ~470 customers spending <$100k ACV (we’ll call this “mid-market”). Our implied mid-market segment revenue is $24mm for FY19, suggesting these customers spend ~$40k per year on average.

The above shows our customer growth assumptions. In order to account for 1) the increased focus on enterprise (though at a slower rate y/y); and 2) the possibility of slowing momentum in mid-market, we model differential growth rates that we believe reflect underlying demand in the respective segments. Our work speaking to SIs suggests it is reasonable to assume that ZUO can grow to ~1k enterprise customers by FY23, which would imply enterprise is still growing at 15% y/y by then.

Our subscription revenue assumptions are above. Our research indicates: 1) subscription revenue per customer is likely to accelerate in FY21 due to ZUO disclosing that it has started landing more customers at higher initial deal sizes over the last 12 months; 2) recently landed customers we spoke with are also accelerating their spend on Zuora faster than older cohorts (the compound effect of #1 and #2 is likely to show up by FY21); and 3) management thinks it’s not unreasonable that enterprise grows to >90% of total revenue within the next 3 years.

Finally, our ACV build is above. The boxed area shows our assumptions in forecasting enterprise and mid-market ACV mix. We also break out ACV from existing customers vs. new customers. The most important takeaway here is that ZUO makes most of its money from customers’ expansion over time, with existing customers contributing >80% of ACV in FY19. Given our view on the relationship between posted invoice volumes on Zuora Billing and subsequent uptick in dollar based retention, we think the strength in newly landed customers at higher initial ACVs plus their pace of accelerated spend is likely to keep retention at the higher end of the long-term guide for 108-112% through FY23. We have additional conviction in this assumption due to management’s claim that in Q4, add-on products started comprising a bigger percentage of existing customer bookings vs. transaction volume upsell. Further, we believe the ~10% overlap between Billing and RevPro makes cross-sell an important growth vector for existing customers as well. Given the various expansion paths we see, we think ACV growth for existing customers can sustain at nearly 30% per year over our projection period. Overall, the combination of our assumptions has ZUO building to >$500mm in subscription revenue by FY23, at which point it is still growing 28% y/y but understandably decelerating from today’s elevated ~35% level.

PS Is Likely to Be Less of a Margin Headwind in Future Years

Above are management’s intermediate (3-5 years) and long-term margin frameworks, which were given during ZUO’s IPO roadshow. Management has said they’ve been conservative about baking in any benefit to the intermediate margin structure from SIs taking on more PS implementations. Our work shows that assuming no benefit isn’t realistic because SIs are slowly building Zuora practices that will allow for consolidated gross margin upside to be realized faster than the Street expects. On the Q319 call and the MS TMT conference in February, management said RevPro is seeing uptake by audit consulting partners and 25% of all new RevPro deployments are originating from this channel. While it’s still early in realizing the same traction with Billing, management has called out Deloitte Digital as a leading SI for implementations on this side. Our conversations with Deloitte Digital and a few other SIs have indicated that it is still extremely early to see leverage from the partner channel for Billing, but it wouldn’t be a stretch to assume that PS revenue could mix down to ~20% of total ZUO revenue over the next several years. Our forecast assumes that PS revenue contributes ~$115mm (only 18%) to total revenue by FY23.

While our model assumes ZUO is able to offload some PS revenue to the partner channel, we conservatively leave PS GM flat at a breakeven/loss level through FY23. This probably isn’t realistic because the corollary to SIs assuming some PS volume is that they also take on the lower-margin revenue streams within PS. However, we don’t have reliable data today on what PS margins for services retained at ZUO could look like over time. As a thought exercise, however, we looked at Workday’s PS margins as a possible proxy. WDAY’s PS GM improved from ~7% in FY12 to 15% in FY17 before it decided to reinvest in customer support, which has driven it back down to 9% in its latest fiscal year. While we acknowledge that ZUO will never have SI practices built to the same scale as WDAY and will likely have to retain some critical mass of low-margin PS revenue, the possibility that PS GM could trend up into positive territory represents unmodeled upside to our estimates. Below is our P&L down to the non-GAAP gross profit line, which shows our belief that non-GAAP total GM can hit 65% by FY23 vs. 55% in FY19.

S&M Efficiency Should Continue to Get Better Over Time

ZUO measures its S&M efficiency by dividing TTM non-GAAP S&M spend by the change in TTM subscription revenue. Management calls the resulting ratio the “growth efficiency index” (GEI), with a lower number being better. This is effectively a way of looking at CAC or sales productivity. Management has stated that it intends to keep GEI flat to down sequentially going forward, which it has done through FY19 per the below. However, the sellside has decided to give the company no credit for managing sales efficiency and is oddly modeling both a top-line growth deceleration and a spike in GEI in FY20, which then moderates only slightly. We believe this is a very significant misunderstanding of how ZUO’s model works (and most high-quality SaaS models in general). Assuming GEI would balloon to >2.5 in FY20 (per MS model) relative to the 1.9 seen in FY19, we’d expect significant beats to subscription revenue guide in FY20. However, MS is modeling in-line revenue and drastically worsening GEI, with this trendline continuing through FY22. We think our estimates are more accurate particularly in light of the commentary around momentum with larger customers recently, which our checks suggest should continue for some time. This would result in the GEI denominator getting bigger even if the numerator does. Per below, we conservatively model GEI staying relatively flat in the near term and then modestly improving through FY23.

Estimates

Putting our various assumptions together, below are our estimates vs. the Street (MS model). We are modeling fairly significant beats to subscription revenue, while our total revenue beats look less meaningful. Again, this is because we believe the Street has not factored in any offloading of PS to SIs while also being too conservative on subscription revenue. Our variant assumptions on margins also pull forward the FCF breakeven point to FY21, a year earlier than guided. FCF starts to build meaningfully in FY22 in our model.

Valuation

ZUO is currently trading at 7.0x our FY21 subscription revenue and compresses to 5.3x by FY22, which we believe is too cheap especially since we assume top-line growth can accelerate in FY21. NTM EV/RR on our estimates is 9.4x, while Street numbers imply 10.0x. We anchor our view on valuation to our estimate of when ZUO achieves FCF breakeven (FY21) as we realize that software companies tend to see EV/S multiples expand once they demonstrate that they can generate positive FCF. Our model assumes that ZUO reaches the Rule of 40 (total revenue growth + FCF margin) by FY23, or 4 years out. Given that we can model a path to the Rule of 40 over our forecast period and looking at where peers generally trade in the year they become FCF positive, we believe that ZUO should trade at a 10.0x EV/RR multiple. This implies that the current NTM multiple implied by the Street will hold, which we think is logical if ZUO executes and beats Street numbers. Using 10.0x EV/RR on our FY21 subscription revenue gives us our 12-month price target of $28 (+33%). Looking 18-24 months out, we assume some natural multiple compression given top-line deceleration from today and use 8.5x EV/RR on our FY23 subscription revenue for a $37 stock (+76%). If we’re wrong, we assume a slight haircut to consensus NTM EV/S and use 6.5x on Street FY20 total revenue to get a $19 stock (-10%). Overall, we see sufficiently asymmetric risk/reward to believe we have a margin of safety in being long ZUO. Our valuation summary and key model metrics are included in the Appendix.

As a final comment on valuation, we’d be remiss if we didn’t state that ZUO could be a strategic acquisition target. Without speculating too much, Marc Benioff owns ~4% of the equity (he was a Series A investor) and our management checks indicate he loves Tien Tzuo and would want him back at Salesforce if it were possible. Could Zuora be CRM’s foray into financials (maybe “Subscription Cloud”) or an add-on to Commerce Cloud? We obviously don’t know but wouldn’t completely dismiss it. However, we think a more logical buyer is WDAY. Its acquisition of Adaptive Insights last summer illustrates its commitment to building out its “financials in the cloud” strategy. In any case, we don’t underwrite an acquisition scenario and frankly aren’t sure what ZUO would be acquired for given takeout premiums and multiples just seem to go higher by the day. That said, our intuition and scanning a list of recent precedents tells us Tien would only sell for a double-digit EV/S.

Risks

·         Zuora is expensive software: Being best-in-class means a premium price tag. While we believe Zuora is the market leader, sales cycles could potentially elongate if customers’ evaluation period is too long while they look at “good enough” competitive solutions that might be priced lower.

·         Traditional ERP suddenly decides to get its act together: We have often wondered what the corp dev guys are doing at ORCL and SAP because they seem to occasionally spend inordinate sums for growth assets but then undermonetize them. But assuming this changes and ORCL, for instance, decides to buy a low-end competitor and plug it into NetSuite’s distribution network, it could be problematic for ZUO especially given ORCL’s long enterprise client roster.

·         Tough comps and seasonal fluctuations in billings: As with most high-growth software companies, earnings setups are usually tricky due to y/y comparisons. Compounding the problem for ZUO is the heavy land for new customers, which sees the regular slippage of deals out of one quarter and into another as well as an occasionally higher mix of annual billing terms in certain quarters.

Appendix

Catalyst

Earnings, Investor Day (6/5)