In my last article on Zuora, Inc. (ZUO) published almost six months ago, I gave the company a neutral rating based on negative free cash flow, low gross margin, and headwinds that will be present for the next few quarters. Since publication, Zuora is up 11% whereas the S&P 500 is up almost 18%.
I am now back to check in on Zuora to see how the company is progressing. As identified in the previous article, Zuora has two main issues: delays in software integration of the two flagship products, billings and RevPro, and poor sales execution. These two issues have resulted in executive management changes.
Billings/RevPro integration – Zuora acquired Leeyo two years ago, and although RevPro has been sold as a standalone product since then, it was supposed to have been integrated with Zuora’s billing product for cross-selling purposes. But apparently, there were technical issues that have delayed the release of the combined product. The company had to put a pause on customer implementations while the issues were being sorted out. The product has now been taken off of pause and is back in the hands of some customers:
… we’ve completed the technical integration phase with a number of customers and three of them, Siemens, LivePerson and Modernizing Medicine are expected to be operationally live using RevPro and Billing in the next couple of months.
While this is important news, I believe that one should not get too optimistic here. There is no guarantee that all problems have been worked out or even discovered. The “next couple of months” could stretch into a much longer time period. Furthermore, we could be looking months down the road before the combined product is available to the general market.
Poor sales execution – Zuora has now hired a new CRO to address poor sales execution. In addition to this move, the company has restructured the sales force by realigning its sales force to focus on strategic accounts and also add personnel to improve the sales process for strategic accounts. Based on the changes that have been made, I would not expect to see improvements in sales execution for 6-12 months.
I believe that the aforementioned problems, although they have been mostly addressed, will weigh on performance probably for the remainder of 2020. I also find the negative free cash flow margin to be somewhat concerning. My feeling is that this company needs more time to demonstrate that it is a leading SaaS company worthy of investment dollars. For these reasons, I am giving Zuora a neutral rating.
When it comes to software companies, I don’t rely on traditional value factors; instead, I focus on other measures, such as the software company “Rule of 40” and relative valuation, a concept that I recently developed that compares forward sales multiple versus estimated sales growth.
Zuora’s annual revenue growth is 21%, down from its 3-year growth rate of 37%.
Free Cash Flow Margin
Zuora’s free cash flow margin TTM is -11%. It has been steadily increasing for the last two years, however.
The Rule Of 40
One industry metric that is often used for software companies is the Rule of 40. It is an industry rule of thumb that attempts to help software companies ascertain how to balance growth and profitability. There are different ways of calculating the Rule of 40 – some analysts use EBITDA and others use free cash flow margin. I use the free cash flow margin TTM.
The Rule of 40 is interpreted as follows – If a company’s growth rate plus free cash flow margin adds up to 40% or more, then the software company has growth and cash flow in balance and is considered financially healthy. In Zuora’s case:
Revenue Growth + FCF margin = 21% – 11% = 10%
The calculation comes out well below 40%, indicating that Zuora has a lot of work ahead of it in order to balance growth and profits.
I determine stock valuation on a relative basis by comparing sales multiples and sales growth to the company’s peers. I believe that high-growth companies should be more highly valued than slow-growth companies. After all, growth is a prime factor in valuation models such as DCF. Higher future growth results in higher valuation and, therefore, higher EV/sales multiple.
To illustrate this point, I created a scatter plot of enterprise value/forward sales versus estimated Y-o-Y sales growth for the 152 stocks in my digital transformation stock universe.
(Source: Portfolio123/private software)
The sales multiple in the vertical direction is calculated using the EV and “next year’s sales estimate” mean value based on all analysts from the Portfolio123 database. The estimated Y-o-Y sales growth is calculated using “current year’s sales estimate” and “next year’s sales estimate,” also provided by Portfolio123.
As can be seen from this scatter plot, Zuora is positioned well below the best-fit line, suggesting that its forward sales multiple is extremely undervalued relative to its peers, given its estimated future revenue growth rate.
The Sales/EV multiple tells me that the stock is quite undervalued, but my value assessment changes when I substitute next year’s earnings estimates for forward sales.
(Source: Portfolio123/private software)
The results shown on this second scatter plot suggest that Zuora is actually overvalued based on next year’s earnings estimates.
Summary and Conclusions
Zuora has made progress in addressing its two main issues: sales execution and product integration. The company has hired a new CRO and restructured the sales force to focus on strategic accounts. The software integration of RevPro with Zuora’s billing product is apparently back on track and is in the hands of select companies for evaluation.
I expect that it will be 6-12 months before these positive events translate into a noticeable acceleration of revenue growth. In the meantime, Zuora suffers from negative free cash flow, although it appears to be improving with time. I believe that this company needs another year to demonstrate that it is a leading SaaS contender worthy of investment. For these reasons, I am giving Zuora a neutral rating.
Digital Transformation is a once-in-a-lifetime investment opportunity fueled by the need for businesses to convert to the new digital era or risk being left behind. You can take advantage of this opportunity by subscribing to the Digital Transformation marketplace service.
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.