Click here to read Part 1 of this series: https://www.investinggurukul.com/post/is-zuora-a-multibagger-in-the-making-part-1
Zuora Stock Analysis ($ZUO)
Financials & Valuation:
SaaS companies spend a lot of money on product, sales and marketing to acquire customers. All these expenses are captured in the income statement during that quarter. Unlike traditional firms that tend to collect most of the payments upfront, SaaS firms receive payments in installments. Revenue is subscription based and is realized through MRR – Monthly Recurring Revenues. MRR is sales revenue which is received as payments month on month from all existing customers. The more the number of customers, the better it is for companies to realize more revenues in the long run.
Since SaaS firms are not profitable, they are not valued on Price to Earnings. Instead, they are valued on a multiple of revenues. Typically, the valuation is between 5-15 times ARR (Annual Recurring Revenue). Companies that grow higher than expected growth rates trade at even more than 15 times. This valuation method might change in the future when this industry matures. For example, ServiceNow is growing at a CAGR of 40% over the last 5 years. It is trading at 18 times sales.
Default Public SaaS Multiple - 6X Sales:
As SaaS companies trade at ‘x’ times sales, let’s try to find out the right valuation multiple for Zuora. Between 2008 and 2015, median valuation multiple for public SaaS companies was in the range of 2X to 9X sales. In the last 5 years, median valuation multiple has been hovering between 6x to 10x sales. Since SaaS companies have evolved and grown rapidly over the last 5 years, we can consider the last 5 year data to find out the right multiple. As a conservative estimate, let’s take 6X sales (lower range) as our default multiple.
As of Oct 2019, Median SaaS valuation multiple for public SaaS companies is at a historically high rate now - at 9X.
Sales Growth Multiple:
Zuora’s revenues come from two different channels - subscription revenues and professional services revenues. Subscription revenues are pure product led revenues where customers are charged for product usage. Whereas, professional services revenues are revenues that come from providing IT services.
📷
Median growth rate for public SaaS companies is around 30% in the last 8 years. Zuora has shown stupendous growth between 2016 and 2019. It has grown at a CAGR of 36.22% from $92.18 million to $235 million in 3 years. Markets provide a premium for companies that are growing faster than their peers.
Hence, Zuora commands an additional valuation of ====> 2X ===> 8X (6+2)
Last One Year Growth Multiple:
Three year data provides an idea about the company’s historical growth rate (we only have 3 year data). Last one year data provides an overview of existing revenue run rate. Zuora has cut its ARR guidance for financial year 2020 from $289-293.5 million to $268 to $278 million. Markets didn’t appreciate this. Since then, Zuora’s stock price has been languishing at the bottom. There are two primary reasons for this.
Delayed Product Integration: Zuora has two flagship products - Billing and RevPro. Part of the strategy is to cross-sell RevPro to customers who use Billing. But there has been a delay in integrating the two products. The tech team has been unable to complete product integration within stipulated time. Hence, it has led to several quarters of poor growth.
Sales Execution Challenges:
Though they continued to invest in sales teams, they were unable to convert a lot of new deals. The new sales reps, who joined Zuora, were not as efficient as the old ones. So, there is a conscious effort to improve the productivity of new sales reps. They revamped the sales training process and tightened each step of the sales process to improve execution. Besides, they reorganized the sales team as mentors started to work closely with new joinees.
And the sales formula has to be changed as well. When Zuora started, subscription billing was considered as a ‘good to have product’. Zuora sales reps have to evangelize and educate customers about the need of a billing solution. But the situation has changed now. Customers are aware of the need of this product. Hence, Zuora is shifting from an evangelized sales approach to a focused sales approach. They have split the prospects into different categories - beginners who have no knowledge about subscription billing, users with in-house systems and users who have worked with third party tools. This is expected to drive revenues in the future.
They continue to work with global system integration partners like Deloitte, PWC, Accenture, E&Y. They have also hired a new head of sales who is expected to lead the sales team towards a different growth trajectory.
Though Zuora’s growth rate is poor in the last one year, what is interesting to note here is that the company is attracting marquee clients in the last few quarters like Kia, Chrysler, Caterpillar.
Since Zuora’s trailing twelve month growth rate is 22.08% which is less than the median growth of public SaaS companies, valuation multiple has to be reduced by -1X ===> 7X
Sales Growth vs COGS Growth (CAGR)
Though Zuora’s historical growth rate is superior, more than 25% of revenues come through professional services. This is an unprofitable segment. It involves activities like system integration, data migration, training etc. Since the share of professional services is high, it is impacting the company’s margins. When we compare sales growth against COGS growth, it is negative. Hence, Zuora’s valuation has to be reduced because of this. If they can grow subscription revenues more than professional services revenues, it might lead to an increase in Zuora’s gross margins. Till then, it might not trade at high valuations.
📷
Most of the public SaaS companies have a gross margin of 75%+ but Zuora’s gross margin is poor at 50%. Unless Zuora focuses on improving it’s subscription revenues and reducing it’s professional services revenues, it is difficult for Zuora to command a premium valuation in the market.
Valuation multiple has to be reduced by -2X. ===> 5X
Net Retention Rate:
Net Retention Rate is a key metric which is used to understand the performance of a SaaS company. It gives you an indication of how the company has fared without the addition of any new customers. Company’s performance in selling more features/products to existing customers and reducing churn leads to an increase in revenues without new customers. According to a survey by forentrepreneurs.com, it is 4X cheaper to upsell to existing customers than acquiring new customers. It is 9X cheaper to retain existing customers than acquiring new customers.
Net Retention Rate =
[Last Year ARR + Expansion MRR (Upgrades) - Downgrades - Churn]
Last Year ARR
A net retention rate below 100 indicates that downgrades and churn are higher than upgrades from your existing set of customers. A SaaS firm with NRR below 100 is extremely unhealthy. Zuora’s net retention rate is above 100. It went up to 112 in 2019. But in the recent quarter, it has fallen down to 106. Billing solutions are extremely complex. Hence, customers tend to remain sticky and churn is expected to remain low. As these clients grow, they tend to transact more. Zuora’s pricing is charged as a percentage of total payments processed. Hence, upgrades will continue when Zuora’s clients grow their revenues. As retention rate is fluctuating, we can assign a 0.5X valuation for it’s current NRR of 106.
Zuora’s customer base has gone up from 327 in 2016 to 619 in 2019. It is growing at a healthy rate. What is interesting about Zuora’s client base? Zuora is primarily focused on enterprise customers. It has 619 customers but 526 out of 619 ie) 85% of customers have an ARR (Zuora calls that as ACV) of $100,000. B2B enterprise customers in SaaS tend to stay for a longer horizon when compared to SMB or B2C space. Hence, these customers are expected to remain sticky and this should improve cash flows going forward.
NRR of 106 commands an increase in Valuation multiple by 0.5X. ===> 5.5X
Sales & Marketing Cost vs Revenues:
SaaS companies targeting SMBs and mid-market customers tend to spend a lot of money on marketing and R&D but less on sales. Enterprise customer focused companies like Zuora have to spend on expensive sales professionals and sales teams. If the focus is on a specific vertical, marketing expenses would be less. Since Zuora is expanding horizontally across multiple sectors like media, publishing, auto, manufacturing, utilities, technology, e-commerce etc, they also spend a lot of money on marketing.
Sales Efficiency Index is used to measure the effectiveness of sales and marketing spend. It is the ratio of new revenues generated to the total amount spent on sales and marketing.
Sales Efficiency Index = New ARR generated for the Period .
Sales & Marketing Expenses for the Period
In 2019, Zuora had an efficiency index of 0.67. It indicates that, for every $1 spent on sales & marketing, the company has been able to generate $0.67 of revenues. It has gone up from 0.37 in 2016 to 0.75 in 2018 and then to 0.67 in 2019. As the company continues to grow, this index will eventually reach 1. And Zuora will move towards profitability (still a long way ahead). Since customers are acquired across different financial years, a cumulative approach will give a good picture. Cumulatively, Zuora has an efficiency index of 0.55 which is on par with the median efficiency index of public SaaS companies.
Hence, Zuora commands an additional valuation for Sales Efficiency Index of 0.55 ====> 0.5X ====> 6X
Total Opportunity Size:
As of 2019, Subscription Billing industry has a market size of $4.4 billion. This industry is expected to grow at a CAGR of 15% from 2019 to 2025 and reach $10 billion. Companies have traditionally followed a fixed price business model as they sign a one time deal with their customers. This trend is slowly changing as companies are moving towards subscription based payment collection method. The impact is not just seen in software but it is clearly visible in other industries like auto, manufacturing, media, telecom, publishing, retail etc. There is also a strong behavioral change in the way customers purchase products. Users subscribe to online magazines, OTT platforms, media streaming etc. on a monthly basis.
Though the opportunity size is not as big as a $40 or $50 billion, the number $10 billion is still huge. And Zuora is the leader in this space and is expected to capture a significant market share. It has already signed a lot of new clients such as Chrysler, Kia, Caterpillar. There are exciting times ahead. Hence, an additional 1X can be added to Zuora’s valuation multiple.
Additional Valuation ====> 1X ====> 7X
Free Cash Flow:
SaaS companies are typically rewarded for growth irrespective of the company’s profits and cash flows. Because companies can reinvest cash on product, sales, marketing and customer success to generate more profits. As long as companies grow fast, investors don’t mind negative earnings and cash flows. But several established public SaaS companies (like ServiceNow, Zendesk) are cash flow positive.
In Zuora’s case, cash flows are negative. For some customers, Zuora collects 1 to 3 years of payments upfront. Hence, we can see that operating cash flow is improving each and every year. Since Zuora is still young after its IPO, we can remain neutral on Zuora’s cash flows and add nothing (0X) to its valuation.
Additional Valuation ====> 0X ====> 7X
Zuora can be valued at 7X sales
📷
Conservatively, Zuora can be valued at 7X sales. Zuora’s trailing twelve month ARR is $269 million (As of Q3’ FY20). At this multiple, Zuora’s fair market cap is $1887.9 million. Hence, Zuora’s fair market price comes to around $16.69. At current market price ($14.77), Zuora looks undervalued.
Where can Zuora’s stock price go from here?
Pure Sales Growth:
Subscription billing industry itself is expected to grow at a CAGR of 15% and reach $10 billion. Hence, one can expect Zuora to clock at least 15% sales growth per annum for the next 5 years. At this rate, Zuora should achieve an ARR of $542.46 million by 2025. Since Zuora is a leader in this segment, we can expect the company to show better growth rates. If they achieve a CAGR of 21% over the next five years, Zuora’s market cap could reach $5 billion at a market price of $45.13 (2X returns from current price levels). Another black swan event that could reward shareholders is acquisition. At around $1.5 billion market cap, Zuora is a perfect acquisition candidate for large enterprise companies who are looking to enter the billing space or planning to strengthen their presence in this space.
Note: I didn't include employee stock options which might reduce this target price a bit.
Sales Growth + Other Metrics:
At 21% growth rate, without any change in other metrics, Zuora’s fair market price can reach $45.13 at 7X. It is an easy 2-bagger from current price levels. In order to command a premium, Zuora has to focus on the following factors:
Improve Gross Margins and focus on increasing subscription revenues instead of the unprofitable professional services revenues (1X to 2X)
Net Retention Rate has to go up. NRR of 119+ indicates that the company has a superior business model with sticky customers. If NRR increases, it can increase valuation multiple by another 1X
Sales & Marketing Efficiency Index - for SaaS companies, this index is expected to go towards 1 in the long run. It indicates that the company is moving towards profitability. A higher index leads to a higher valuation (another 0.5X)
Free Cash Flow is the heartbeat of any business. If Zuora can generate positive free cash flows (at least 5% of revenues), then the business becomes healthy and market will add a premium to it (2X)
If Zuora ticks all these boxes, then no one can stop Zuora from becoming a megabagger. It can easily trade at 13-15 times sales. At this multiple, Zuora’s fair market price would be between $84 and $100 (or even higher than that).
While all other stocks are going up in this bull market, Zuora is still languishing at the bottom. It seems to be a great opportunity at current price levels. As long as Zuora grows its revenue without any other metric improvement, one can buy Zuora with a target price between $36 and $45. Click here for part 1
Disclaimer: The author of this article holds shares of Zuora. Hence, his views may be biased. Please do your own due diligence before buying the company’s shares.