Zuora: Rising Margins, Potential Catalysts Make It Attractive (NYSE:ZUO)

Investment thesis

Zuora (NYSE:ZUO) is a leading software provider for businesses to manage their subscription-based services. The company’s dominant position is highlighted in the image below, taken from the 2024 Gartner Magic Quadrant for Recurring Billing Applications. According to a study by Juniper Research, the subscription-based economy that the company serves is valued at $593 billion and is expected to grow at a 14% CAGR through 2028. In recent years, Zuora has also broadened its offering to include non-recurring revenue based billing as well as consumption-based billing.

Despite having a rather muted near-term outlook for growth, some of its product offerings are beginning to gain significant traction in the market. Management is exercising strict control over expenses following the recent workforce reductions, which should support margin improvement in upcoming quarters. I find the valuation of ZUO shares attractive at EV/Revenue and EV/non-GAAP earnings multiples of 2.4 and 12.2 respectively. Considering the company’s status as a potential acquisition target, the risk of significant downside is relatively low. I find the current risk-reward profile appealing, and therefore maintain a Buy rating on the shares.

Financial highlights and my expectations looking head

Zuora reported a solid Q2 report, with subscription revenue increasing 9% year over year to $104.1 million. Non-GAAP operating margin grew to 22%, a 1300 basis point improvement versus the prior year period. Despite slightly raising full year revenue and adjusted FCF expectations to $459 million and $82 million respectively, management lowered guidance for Annual Recurring Revenue (ARR) growth from 9% to 6%. Likely stemming from macroeconomic weakness, this points to a deceleration ahead following an ARR growth of 7% seen in Q2. On the other hand, total Remaining Performance Obligations (RPO) was at $577 million, up 14% year-over-year, which reflects healthy demand overall.

In Q2, Zuora acquired Togai, to enhance its consumption-based billings product, and also acquired Sub(x) to add AI capabilities to its subscription offering for media companies. I will now outline the key factors that I believe will drive the company’s performance in the upcoming quarters

Strong traction in the market for Consumption-based billing

Following the launch of its Consumption-based pricing product in June of last year, the company has experienced strong growth in this area, especially among its technology customers whose products have seen increased usage following the introduction of AI-related features. The acquisition of Togai should further improve this product, by adding the metering and rating solutions to Zuora’s existing product suite. A recent client win from the transportation industry, which was brought up on the Q2 earnings call, shows that Zuora is likely to succeed in bringing on clients from even outside the technology industry through this offering.

Large potential for upselling into existing client base

As shown in the image above, the company has a large opportunity to upsell its products into its existing client base. Speaking about this at a recent investor conference, the company’s CFO highlighted emphasized this potential, noting:

We already have a sizable percentage of our customers that are already on SAP (SAP) and Oracle (ORCL) and yet if you look at the fraction of the revenue, of revenue that they do through us, it’s a tiny fraction. So it represents a huge opportunity to expand even if we didn’t get a single additional customer, huge opportunity to go into large enterprise.

As further evidence of this, the company saw ARR grow by approximately 17% year over year for customers in the $0.5 million or greater cohort. Given the current macroeconomic drop which makes signing new customers more challenging, I expect management to continue to focus more on upselling its now more broader set of product offerings.

Strict expense management should lead to margin improvements

As seen in its Q2 report, the company has shown a strong improvement in profitability, starting from improving gross margins to 68% versus 65% in the prior year period. Operating expenses were lower compared to the prior year, despite a $7.7 million increase in G&A costs relating to legal fees and acquisition related expenses. Given that management has now optimized the company’s cost structure following the workforce reduction, I expect the business to demonstrate good operating leverage that should lead to improving margins ahead.

ZUO stock valuation

At the current share price of $8.50, Zuora has a market capitalization of $1.3 billion. With a net cash position of $180 million, its enterprise value stands at $1.12 billion. Management’s full-year guidance points to revenue of $459 million and non-GAAP earnings of $92 million. Consequently, the shares are valued at an EV/Revenue multiple of 2.4 and an EV/non-GAAP earnings multiple of 12.2. Zuora’s valuation appears attractive versus mid-cap peers which I consider relevant for valuation, such as Paycom (PAYC) and BILL Holdings (BILL). These companies are growing an low double-digit rates and have EV/Revenue multiples above 4 and non-GAAP earnings multiples above 20.

Zuora’s valuation is appealing to me, given the catalysts I see, which I will discuss in the next section. A concern I have however is related to the company’s elevated level of stock-based compensation (SBC). As shown below, though SBC has reduced significantly year over year, it still remains very high, which impacts the company’s GAAP profitability.

Catalysts that could drive further share price appreciation

The driver for significant upside for investors is the company getting acquired. Reports from earlier this year suggest that the company is involved in discussions involving a buyout. Potential buyers could include private equity firms or larger public companies such as Salesforce (CRM), which might be interested in integrating Zuora’s capabilities into their Revenue Cloud product. Additionally, Enterprise Resource Planning (ERP) players like SAP may also be interested in enhancing their billing offerings. I would also point out that following its $400 million strategic investment in Zuora in 2022, private equity firm Silver Lake still maintains a seat on the company’s board.

Another catalyst, albeit to a lesser extent, is the company’s rapidly improving profitability. Success in upselling its new offerings to its large existing client base could significantly enhance the company’s operating margins. This will likely lead to the market rewarding the company with a higher valuation multiple.

Risks to consider

Competition

Despite having a leading position in its industry, the company does face significant competition from large players like SAP as well as newer entrants like BillingPlatform. One of the ways in which Zuora is countering the competitive threats is by broadening its offering to clients, thereby making its products more appealing and stickier. Investors need to closely watch how this risk develops in the future.

Lack of GAAP profitability

Despite demonstrating solid non-GAAP margins above 20% and generating strong FCF, Zuora is still unprofitable on a GAAP basis. This is mainly explained by the high SBC expenses which I previously highlighted. However as I noted, SBC appears to be coming down, and I expect that the company will be close to achieving GAAP profitability by Q4.

Macroeconomic weakness

The company is already seeing a negative impact from a challenging macroeconomic backdrop on signing new deals. Continued weakness could see growth and profitability remaining under pressure.

Buy ZUO stock

Given the muted growth outlook for this year, shares have dropped to levels where the valuation appears attractive, particularly with the potential for improved profitability. The downside risk is mitigated by the company’s status as an appealing acquisition target. The favorable risk-reward profile supports my Buy rating on the shares.