Description

Summary: Zuora (ZUO) enjoyed start-up-esque valuations post it’s IPO in April 2018, but has since struggled amid headwinds and fierce competition. Like many software and Hi-Tech companies, Zuora received a flood of venture capitalist funds despite growing losses, eventually going to the public markets to raise cash and generate liquidity. However, since then:

• Sales have slowed 

• Members of leadership have been removed

• Major technical issues integrating its applications has impeded cross-selling and allowed a plethora of competitors, including large enterprise companies, to gain market share and introduce new products

• Management continues to promote the transition of many businesses to a subscription business model, but fails to demonstrate how Zuora is capturing that market. This led to an awkward moment on Q2 earnings call, when an analyst referenced a commentary Zuora did on Nike's recent announcement of a subscription line, which the CEO clarified was not an announcement of Nike's subscribing to Zuora software.

As a daily user of the software, I am somewhat disappointed in the actual product, and do not see long-term value. Additionally, without a solid path to positive cash-flow, profitability, and a lengthy and complex sales process, Zuora will not find a quick-fix, and will need to explore strategic alternatives within the coming 2 years, possibly even a sale, at significant discounts to current EV/FY Rev multiples. 

Company Description: Zuora (ZUO) is a Bay Area-based enterprise SaaS (Software-as-a-service) company that provides cloud-based software solutions to companies across various industries and geographies to enable them to launch, manage and transform their business to a subscription business model. The company, founded by alumni of SalesForce and WebEx, began operations in 2007, and has grown significantly in the past decade. During the FY19, which ended in January 2019, the company generated $235M in revenues and had 1,200+ employees. The company has never been profitable, and has an accumulated deficit of $349M on its balance sheet as of EoQ2 FY20.

The Zuora platform, known as Zuora Central, is constructed around 2 flagship products, 

• Zuora Billing, a billing tool for recurring invoices  (70-80% of revenues)

• RevPro (AKA: Leeyo), a tool acquired in 2017 for $35.2M in cash and stock, which calculates subscription revenues in accordance with newly implemented accounting standards (ASC 606) addressing revenue recognition. (20-30% of revenues) 

Zuora Central is a suite of tools and interoperates with other third-party front-end (ex. SalesForce) and back-end ERP (Oracle ledger) systems to facilitate subscription companies’ order-to-cash workflows

Source: Zuora

The company raised $250M through 2015 in 6 rounds of funding, earning a valuation of $740M. In April 2018, with only $48.2M of cash on the balance sheet, $15M debt, and a cash burn rate (free cash flow) exceeding ~$30M annually, the company underwent an IPO, raising $159.7M at a price of $14/share, higher than the original expected price point of $9-$11, giving the company a market cap of $1.44B. With the commencement of trading, shares jumped an additional 43%. 

Competition and TAM: The Company’s executives have promoted the company as “a portfolio play for the growth of the entire ‘subscription economy’ (a term coined and evangelized by the company).” A study by Zion Market Research has shown:

• TAM for subscription management software to be $3.8B in 2018 and potentially growing to $10.5B by 2025

•  Zuora controls only 6% of the market 

• Competitors include well-known software companies, Microsoft, Oracle, SAP, and Amdocs, as well as a numerous start-ups, Chargify, Recurly, Apttus, Sage, Zoho, SteelBrick (acquired by SalesForce), ChargeBee and various homegrown products 

Microsoft, Oracle and SAP dominate the ERP system landscape, and have a tremendous advantage as an end-to-end solution and scale of economies across many different product lines, whereas Zuora and other start-ups are simply a bridge or billing system between a CRM and an EPR or back-end system. Researchers have predicted that the industry is ripe for consolidation by those with deeper pockets. 

Operating Metrics: The Company breaks out its revenues into 2 parts; 

• Subscription revenue, or ARR (Annual recurring revenue)- a fixed and/or a variable amount contingent on transactional volume. 

~30% growth annually 75% margins 70-80% of revenues slowing and stagnant growth since Q1FY19

• Professional Services, such as implementation and service fees, which generally occur within the first year of a booking. 

105% growth Y/Y in FY18 due to Leeyo acq   0-(10%) margins 0-10% growth since mid-FY18 (see 4th bullet below)

Zuora has likely exhibited a total of ~30% organic growth in subscription revenue and ~10% growth in professional services revenues in the 18 months since the Leeyo acquisition. Good numbers, but not hyper-growth. 

• 566 customers with annual contract value (ACV) => $100K as of EoQ2 FY20, an increase of 19% Y/Y and 4% Q/Q, in contrast to 42% and 27% Y/Y growth as of EoFY18 and 19 respectively. This makes up more than 88% of recurring revenue, up from 85%. 

• Dollar-retention grew to 112% in 2019 from 110% and 104% in 2018 and 2017, respectively, exhibiting the stickiness of customers and its ability to upsell. However, it has leveled off to 107%-110% in the first 2 Qtrs of FY20, below managements target of 112%.

• Exceeded $10B in quarterly invoice transaction volume for the first time during Q4 FY 2019, but has since leveled off.

• The apparent increase in professional services revenues in Q2 FY20 was a sequential benefit of seasonality, including 3 additional days compared to Q1.

Expenses are allocated between;

•  Cost of Services,
  A) subscription costs, such as could hosting and salaries of technical operators
  B) professional services, which primarily consists of salaries and other costs associated with implementation services 

•  S&M, G&A and R&D 

In the past few years, Operating Expenses have increased at a torrid pace, far exceeding revenue growth. In various filings and conference calls, management has expressed the necessity to continue investing in headcount, product O&M, and S&M spend. 

Source: Zuora

Financial Metrics: The Company has continued to post negative bottom line results despite significant growth. 

• EBITDA in FY19 was -$68M, down from -47M in FY18. Included in 2019’s number is $25M in non-cash compensation

The company has relied on significant stock-based compensation, which it does not include in its Non-GAAP operating earnings reported in quarterly press releases (See reconciliation below). This has an anti-dilutive effect on the current loss per share, but can cause dilution if the company were to become profitable.

Source: Zuora

Cash flow from Ops has continued to languish around -$25M, though the company has issued guidance slightly lower for the 2020 fiscal year. FCF has also suffered as the company continues to increase spend on various capital initiatives necessary for its product development.

• FCF guidance for FY20: ~-$40M 

• Q1 FY20 had FCF of -$3.8 million, as the company benefited from strong collection activity and some spending delays into future quarters. Q2 had FCF of -11.5M.

• The company signed a new lease agreement to move headquarters in the coming months and most of those costs are still to come H2 FY20. Excluding the $9M facility spend, FCF will likely land in the mid -$30M range, still significantly worse than FY18.

Source: Zuora

Product and Service: Akin to the well-known analogy of investing in an ice cream product only after tasting the ice cream, I’ve learned and used the Zuora platform over the past year, and found the UI/UX and back-end of the software to be extremely complicated, rigid, and full of bugs. A lot of revamping and updates are needed, and the overall product needs improvement. Customer service often directs the customer to submit ideas in the suggestion portal.

Headwinds: In its Q1 conference call, company executives expressed concerns with;

• Productivity of their sales team 

• Integration issues between their two flagship products, Zuora Billing and RevPro. 

The CEO and founder, Tien Tzuo did not downplay the issues either; “We found that the newer reps were less than half as productive as our more experienced reps… Second, part of our ability to grow within our installed base has been predicated on our ability to cross-sell our two flagship products, Billing and RevPro. However, the product integration for these two products is taking longer than expected.” As a result, the stock dropped 29% on May 31st .

The effect of these headwinds can clearly be seen in the weight of new business, and the stagnant up-sell % as depitcted in the accompanying chart. 

Source: Zuora

Management expressed hope that;

• Integration issues can be fixed near the end of Q3

• Were hesitant to express confidence in their current sales team, and projected it might take a few quarters to bring in new leadership and ramp up. 

• Due to these weaknesses, the company: 

• Lowered revenue guidance for FY20, from $289M-293.5M to $268M-$278M, (7.3M below for subscriptions and 11M below for services) 

• Reiterated FCF guidance around the -$40M mark

Q2's earnings call carried a better headline and positivity, but content was lacking. The company is slowly trying to overhaul its sales operations (though comments from the CEO in response to analysts' questions seemed to downplay the change), and has begun work on intergrating Billing and RevPro technologies and restarted a number of previously paused implementations. However, cross-selling of the products will only resume "sometime in the coming quarters." Guidance was revised modestly:

• Q3 revenue $69-71M, with $51.5-52.5M  of recurring revenue. FY20 revenue if $273.5-278M, with recurring revenues of $202.5-206M. Non-GAAP operating loss (which is adjusted to remove stock based compensation) of -$44-42M.

• Reiterated FCF guidance around the -$40M mark.

Over the past 2 earnings calls, management seems to have tapered its original approach regarding guidance numbers, from a more aggressive outlook to a more conservative/"beat the number" methodology, which seems to have succeeded with the stock rising 7+% post the earnings release. Management continues to rely heavily on non-cash compensation, and attempts to focus on non-GAAP adjustments, which should worry any investor expecting EPS-positive at an point.

Valuation: From a fundamental standpoint, Zuora has many negative attributes:

• Large GAAP and Non-GAAP losses despite sales growth

• BVPS of ~$1.50, few tangible assets (typical for SaaS companies)

• Its inability to achieve the Rule of 40,  a benchmark in the SaaS universe

• Flat to decreasing gross and net margins, which is a death-cross for SaaS companies
  
  Source: Zuora

• 9-12 months sales process

• market expectation for constant rapid growth creates tremendous volatility on stock (see NYSE: BOX & NEWR)

• few products without an ability to spin off more porfitable units

The crux of growing SaaS companies' valuations lies in the sales trajectory, usually valued as an EV/FY revenue multiple, and the hope that scale will bring the company to [increased]

profitability. The nature of subscription businesses allows a relatively accurate short-term projection based on the run-rate +/- a growth adjustment. With a sales overhaul ongoing,

Zuora will not significantly surpass its run rate, which calculates to $~278M, in line with the upper-end of guidance, and a sub 20% Y/Y revenue growth. Not something to write-home

about for a non-profitable SaaS company.

☞ Sales headwinds, and a more competitive landscape with new product offerings by Oracle Monetization Cloud and SAP Hybris, does little to justify even the sub-median EV/Revenue multiple the market has given Zuora.  Additionally, Zuora’s inability to scale questions management’s “land and conquer” strategy.

☞ Management has not expressed a timeline or path to profitability, but has focused instead on achieving CF-positive in the next 2 years, which seems almost unrealistic based on trends. I believe the headwinds and inefficient spending will bring continued poor results and negative FCF margins. The company will likely turn to non-cash compensation, on top of the 15M+ options and RSU, whcih represent more than a 10% dilution, that are already outstanding and the $60M dollars of unrecognized compensation that will hit over the next 3 years, to keep cash flows up. 

☞ In the long-term, without the possibility to raise cash or IPO, the company will have to seek strategic alternatives, potentially even a sale to a bigger software firm who can reduce expenses through synergies and scale. However, that will only come at a significant discount to the current multiple.

SaaS Market Outlook:

In the past few years, with a plethora of software companies going public, and “Cloud” becoming a household term, EV/Revenue multiples have risen to historical highs. In the appendix, I’ve included a few articles and studies addressing the overall market. 

Redpoint VC partner, Tom Tunguz rightfully noted, “The variance of valuations has exploded. Variance of the forward multiple has increased from about 3x to about 7.6x in the last six months. It’s another way of saying that multiples have expanded at the upper end of the spectrum quite significantly. The most attractive companies have become much, much, much more expensive relative to their peers. If a stock had a big multiple 12 months ago is very likely that the multiple has expanded by 50% or greater since then.”

Suprisingly, there are still some well-known and profitable names, such as Adobe (ADBE), SalesForce (CRM), and RealPage (RP) that trade at relatively realisitic multiples. Its companies like Zuora, whose trajectories have faltered, that cannot sustain the multiples given to them, and experience tremendous whiplash in response. 

As of 6/5/19

Risks:

• Due to a dual-class share structure, management, pre-IPO shareholders, and company founders control shareholder voting, and can potentially block an activitst takeover.

• CEO and founder, Tien Zuo, is well respected and has been pitching the change to 'subscription economy' for a decade.

• Mark Benioff, founder of SalesForce, owns a 3% share of Zuora, as one of the original investors, and can complicate potential M&A activity.

Catalyst

Sales-team overhaul and Technical issues with product.

Increased competition

Consistent negative cash flows, making management's 2 year window nearly out of reach.