Zuora: Betting On Mean Reversion (NYSE:ZUO)

I believe investors willing to look through the near-term challenges at Zuora (NYSE:ZUO) stand to be handsomely rewarded. The stock remains a key beneficiary of secular tailwinds from the rise of the Subscription Economy, which should, in turn, propel strong user growth over the longer term. Now, this isn’t a clear-cut investment case – the company currently screens below peers on conventional SaaS growth metrics, but that’s also true for the valuation. In essence, the bar is low, and even early signs of an acceleration post-COVID could drive a re-rating in the stock. Plus, with Zuora still in the earlier innings of capturing and monetizing a vast addressable market, the risk/reward strikes me as favorable here.

Data by YCharts

Transitory Weakness in the Net Retention Rate

Overall net retention rate fell to 99% in 2Q (vs. 103% in the prior quarter and 107% in the prior year). If we were to break down the impact, most of the decline was down to churn, which contributed to ~2%pts of decline. Down-sell, on the other hand, contributed to a relatively lower ~1%pt of the decline.

Source: Company Filings

On balance, I see the lower net retention rate as largely due to a tougher macro backdrop, with many smaller businesses being pushed into bankruptcy, and others substituting for cheaper alternatives. That said, I would point to several initiatives in the pipeline to help drive retention higher over time, including rightsizing initial lands with customers, as well as a refocus on verticals such as technology, media, and manufacturing, which offer higher growth potential.

Improving Execution Offers Reason for Optimism in a Difficult Environment

Developments were a bit more positive at the EBIT level, with margins reaching -2% in the 2Q (up from -10% in the prior quarter and -14% in the prior year). The better-than-expected EBIT margin expansion (Street estimates were at -10%) was largely down to greater leverage in pro services, which drove a ~3%pt increase in gross margins.

Source: Company Filings

Additional cost drivers include savings related to travel, as well as an investment shift in the second half of the year that helped drive cost savings elsewhere. While SaaS investors tend to focus solely on the top line, I believe the bottom-line beat was key this time around – ZUO’s ability to deliver margins through a slowdown in growth is a key positive, particularly if macro challenges persist. Alongside the margin beat, operating cash flow also outperformed on the back of both the improving margins and favorable working capital shifts.

Source: Form 10-Q

Progressing Well Across Underlying Growth Drivers

The company did not reinstate full-year guidance this time around (recall Zuora withdrew FY21 guidance last quarter) but did disclose lower 3Q top-line guidance. Revenue is guided to range between $74m and $75m in 3Q (~3-4.5% YoY growth), with subscription revenue expected to grow at a faster ~9-11% YoY clip. Lastly, the company is on track to be FCF neutral by 4Q, building on the positive margin progress thus far.

Source: Press Release

The short-term numbers may point toward slowing growth, but I think there is reason to be upbeat for the longer-term trajectory. Not only is the focus now on higher-growth opportunities in technology, media, and manufacturing, but also on the product side, the company is leveraging client data to build on existing offerings (e.g., business insights through its recently launched analytics product). Growing traction across new product lines will be particularly bullish for the margin profile going forward.

In the near term, though, the additional headcount needed to address new verticals creates an additional headwind for margins. But I remain confident for the longer term – execution has been strong thus far, with management noting improving sales productivity despite go-to-market changes announced in recent quarters and a difficult macro backdrop providing an additional headwind. Part of the reason for this is the shift toward a more consulting-oriented approach (vs. transactional), as well as a more holistic approach toward pitching products (as a solution set vs. separate products). The company has also leveraged its global system integrators (GSI) network more effectively of late, with GSIs increasingly taking on more implementations, which should ultimately prove accretive for margins.

Exiting COVID in Better Shape

While billings growth did falter in 2Q at -2% YoY, the slowdown was largely down to QoQ deferred revenue declines, as the company loosened contract terms to provide relief to long-standing customers. Extended sales cycles in impacted verticals also weighed on billings for the quarter.

Source: Company Filings

I expect the overhang to persist in the near term, though I like that Zuora is positioning itself to better navigate the continued macro uncertainty. Key initiatives include revised sales incentives to rightsize initial lands with new customers and set up a more consistent upsell motion, as well as an increased focus on higher-growth verticals. Early signs have been good – management cited double-digit QoQ pipeline growth, as customers increasingly look for a subscription-based solution in light of the accelerated shift to the cloud.

That said, the downbeat guide for the top line in 3Q highlights the extent of the challenges ahead, and thus, investors may need to stomach a slowing growth trajectory for now. But medium to long term, Zuora looks better positioned to capitalize on a secular move to cloud-based subscription models – a key positive, in my view.

Reasonable Valuation for a Secular Cloud Play

Zuora has been through a storm, but I think the worst is behind us now, with the business set for an eventual acceleration as the move toward a more subscription-oriented Cloud model regains momentum. Yet, the market has punished short-term growth hiccups, creating the opportunity for longer-term investors to buy into a secular SaaS growth story at a very reasonable ~3x fwd EV/Revenue multiple (a meaningful discount vs. historical averages and peers).

Going forward, I see the potential for a mean reversion trade on two fronts – a steady reversion toward a more leading SaaS multiple and a return to double-digit growth %, both of which would entail significant upside from here. Further, with expectations for the upcoming quarter appearing very conservative due to the lowered guide, I am increasingly optimistic about the likelihood of an upside surprise. Key risks to monitor include the pace of the underlying growth trajectory, developments on the macro front, and sales execution issues.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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