Zuora Has Upside Potential But Risks Exist, Hold (NYSE:ZUO)

Investment Thesis

Zuora (NYSE:ZUO) is a cloud-based software company that aims to help traditional businesses transition into a subscription-based business. The recent FY24 results were decent, although growth was certainly not that impressive as there were multiple issues such as unexpected churns and continued issues of longer sales cycles. While the firm is trading at a discount, I do think there are risks to consider. Therefore, I would rate the company as a hold for now.

Financials

Zuora’s FY24 total revenue grew 8.8% YoY to $431 million, mainly driven by new customer acquisitions and increasing transaction volume and expansion in product adoption by existing customers. Although, growth was down from 15% in FY23, which was attributed to a few main reasons, including reduced IT spendings due to macro uncertainty, longer sales cycle in larger deals, customers churn, as well as project delays and cancellations. Therefore, the company has shifted to smaller deals, which brings in smaller ACV, and therefore, leading to slower growth. The Net Retention ratio has remained relatively stable, declining just slightly from 108% to 106% in FY23, indicating that existing customers are increasing spendings.

Gross profit grew at a faster rate at 17.4%, resulting in gross margin expansion from 62% in FY23 to 66% in FY24. Eyeing profitability, driven by workforce reductions, operating losses have improved substantially by 66% YoY to $64 million in FY24, and operating margin improved from -47% in FY23 to -14% in FY24. During its 4Q23 earnings call, management said that the reduction in headcounts would not affect its go-to-market strategies and sales execution.

Projected Growth

I forecast the company to achieve a 3-year revenue CAGR of 6.9%, generating $527 million of revenue by the end of FY27. I firmly believe this target is quite achievable. I’ve taken into account the anticipated reduction in revenue growth as management transitions focus towards smaller ACV customers. While this shift is expected to result in a slight decline in revenue growth going into FY25 to FY27, in which I have factored in a slight decline in revenue increments, this, however, also means shorter sales cycles and more predictable growth moving forward. However, as with other companies, there could be execution risks that may hinder its growth, such as how the unexpected churn of its 2 large customers have impacted Zuora’s growth. In those cases, my projected growth may not be achievable, and the decline in growth may be more pronounced.

It is important to note that Zuora’s growth has been underwhelming to shareholders even before the macroeconomic hits, where the firm was only growing at a mere 5Y revenue CAGR of 14.85%. The key issue lies in that Zuora has no control throughout the long sales cycle as customers may take a longer time to evaluate ROI and a transition to subscription-based often involves complex configurations and significant changes to customer’s existing processes.

Zuora’s balance sheet consists of total cash of $514 million and a long-term debt of $359 million. FY24’s cash flow from operations now stands at negative -18 million, compared to -20 million a year ago. Based on its current negative cash flow, the company has a cash runway of roughly 8 quarters, which explains why Zuora has shifted to profitability due to potential risk to the balance sheet.

Valuation

Currently trading at EV/Sales of 2.6x, Zuora is trading at significantly below its peers, according to the list provided by Seeking Alpha. Note that while some peers here do not directly represent a direct competitor to Zuora, they are however subscription-based businesses and provide a rough approximation of where Zuora’s valuation stands. It is not difficult to understand why Zuora is trading at a discount since its growth is below the average growth of 20.81%, and the market continues to anticipate continued below-average growth rates in the next few years. Additionally, it is still loss-making, resulting in discount valuation. Using my 3Y revenue CAGR of 6.9%, the firm will trade at forward FY27 EV/Sales of 2.1x.

With the current valuation standing at 2.6x, I see limited downside potential, considering that future growth is unlikely to encounter significant fluctuations, given that fiscal year 2024 signifies a return to a more stabilized environment for Zuora. However, any issues related to sales execution, unexpected churn, particularly among large enterprises, or prolonged decision-making by customers regarding the adoption of its solution, revenue will further decline at a faster rate and the path to profitability may be delayed. This would introduce additional pessimism, leading to further contraction of the multiple. Let’s not forget that the firm has roughly 8 quarters of cash runway, and the key lies in attaining profitability as quickly as possible. For these reasons, I would rate Zuora as a hold for now.

Conclusion

In conclusion, Zuora’s recent performance underscores its efforts to navigate challenges in the subscription-based software market. While FY24 exhibited decent growth, concerns linger regarding issues such as unexpected churn and prolonged sales cycles, prompting a strategic shift towards smaller deals. Despite this, the company’s focus on profitability and margin improvement is evident, reflected in its financials.

Looking ahead, my projected growth indicates a steady but moderated trajectory, factoring in the transition to smaller Average Contract Value (ACV) customers. However, execution risks loom, particularly concerning unexpected churn and prolonged decision-making by customers. These factors could accelerate a decline in growth and delay the path to profitability, impacting valuation multiples.

And while Zuora’s current valuation at a discount relative to peers suggests limited downside potential, but with roughly 8 quarters of cash runway, the imperative for Zuora lies in achieving profitability swiftly. Therefore, considering both upside potential and associated risks, I will rate Zuora as a hold for the time-being.