Subscription business models are the future. Or so we are told…

To be sure, subscription businesses have inherent advantages. They “know” how much they are going to sell next month. Therefore, they can plan their cost structures around fairly predictable anticipated sales. Further, they are more durable than many business models because inertia/switching costs tend to result in subscription renewals. Importantly, software subscription services should benefit from operating leverage at scale. Thus, they are potentially desirable investments. Hence the current research project: Zuora.

Zuora provides a software billing solution to companies that are launching subscription services. Scuttlebutt suggests the offering is quite good and customizable. Customers see value in Zuora’s offering because subscription services have billing nuances that most billing systems aren’t equipped to handle.

Think of the NY Times as an example. There are many different customers, all subscribing to a number of products, signing up at different times. Traditional billing solutions, designed for discrete transactions, cannot handle that load. Zuora built its business specifically to address these issues and remains focused on them. As a complimentary offering, Zuora also offers a revenue recognition software solution that helps customers accurately account for the revenues they earn (which isn’t always easy given length of terms, renewals, changes, etc).

The company’s sales strategy involves “landing and expanding.” That means they try to acquire a customer and then (a) sell that customer a more robust billing solution, (b) try to cross sell the revenue recognition solution to customers using Zuora’s billing solutions (or vice versa), or (c) a combination of the two. Importantly, this strategy requires large upfront investments. Sales cycles are lengthy, the product must be designed and tested for specific use cases, and good sales reps cost a lot of money. Therefore, sales efficiency and distribution are key to scaling quickly and obtaining a defensible position in the market. While there are less expensive billing solutions on the market, Zuora’s product has proven to be a good fit in the enterprise market.

Importantly, it seems as if Zuora’s product is sticky among the larger customers they serve. The company consistently increases the amount of customers billing over $100,000 in annual recurring revenue. That said, the company’s sales growth has slowed this year and there are questions around how quickly the product will scale.

Zuora seems to have a realistic, forward looking vision about future business models. Their theory of the case is businesses, enabled by IoT, will collect data on how their products are used. Those businesses will then offer users of their products subscription services as supplements to existing business lines. The theory is supported by a recent Barron’s article featuring Honeywell. See Footnote 1. Zuora will also benefit from increasing subscription businesses such as DAZN, FT.com, the Guardian, etc. See https://www.zuora.com/our-customers/ for a list of customers and case studies. But can Zuora serve these customers profitably?

Historical Financial Results

Zuora’s CEO, Tien Tzuo, recommends benchmarking SaaS businesses by subtracting cost of goods sold, general & administrative, and research and development costs from sales in order to determine “Recurring Profit.” Then, he suggests viewing sales and marketing expenses as “growth.” Using his own suggestion, Zuora’s historical financials don’t show recurring profit margin expansion:

Admittedly, there are timing differences between the costs Zuora incurs and the revenues it recognizes. For instance, the company has been growing revenues in excess of 30% per year until this year. Undoubtedly, they hired expecting more robust growth than they achieved. Therefore, their existing cost base is almost certainly too bloated relative to their revenue base.

Moreover, the company is highly likely to be erring on the side of over hiring so they don’t hinder growth. As of today, the perceived appropriate strategy is to acquire as many customers as fast as possible. Therefore, Zuora would be foolish to forego sales because of insufficient support. That said, it’s not certain that Zuora’s anticipated growth materializes and/or the cost base “right sizes.”

An Accounting Tangent

Accounting under GAAP penalizes enterprise SaaS businesses relative to traditional capital intensive businesses. Traditionally, a growing company in a capital intensive business would capitalize a portion of its growth spending. Only later would that company depreciate the spend on the income statement. Consequently, a traditional income statement did not capture “growth” capital spend.

Conversely, enterprise SaaS businesses have the opposite problem. These business are capital intensive, but they require human, not physical, capital. GAAP does not allow companies to capitalize human capital expenditures. Consequently, the current cost structure is fully captured but the revenue stream associated with these costs is not. SaaS income statements are further penalized because revenues are recognized as they are earned. This puts more pressure on the income statement relative to traditional businesses.

For illustrative purposes, let’s assume Zuora was selling a discrete product for $100 with 70% gross margins. The income statement in the quarter of sale would capture revenues of $100 and gross profit of $70. However, Zuora is actually selling that $100 product for $8.33/month. Thus, a quarterly income statement shows sales of $25 ($8.33 * 3) and gross profit of $17.50. Therefore, the entire cost to support and implement the product sale is in today’s income statement but only a fraction of the product sale is captured.

All that said, the income statement is not useless. At a minimum, it’s a relatively reliable picture of how Zuora’s costs have grown as the business grew. These dynamics have led to a cash flow negative company, despite $19.6mm of stock based compensation over the past 6 months.

The Future, Not The Past, Is What Matters

All of the above is interesting. Zuora’s vision of the world is interesting. It’s interesting to think of the potential business lines a connected world could create. It’s also interesting that a public company, with an allegedly incredible business model, continues to lose cash despite ~7% of its expense base being non cash share based compensation. Further, it’s interesting that the company has generated larger and larger losses as its business grows. But, what’s more interesting is Zuora still trades for $1.5Bn, or ~48.1x “recurring profit” before sales and marketing expense. Why?

The answer lies in the market’s expectation that this business is scaleable, has a long runway, and will generate predictable cash flows over time. If that happens, Zuora is going to be a cash machine in the future. Therefore, Mr. Market is assigning a high valuation because he believes Zuora is on the left side of the image below:

Mr. Market may be correct. That said, it’s difficult to handicap the odds because searching historical transcripts, presentations, and filings for “unit economics” and “contribution margin” returns no results. More importantly, the historical income statement doesn’t show evidence of R&D or G&A leverage. Therefore, Zuora’s ability to scale is more theoretical than tangible.

Further complicating the equation is every period showing “recurring profit” growth (though at a lower margin) corresponds with an even larger increase in sales and marketing costs. Bulls will argue the sales and marketing ramp is rational because this is race to get an installed base. Skeptics will argue it’s a structurally cash flow impaired business model. What is the truth?

Grow Now, Prosper Later

There is merit to the strategy of racing to acquire customers in an enterprise software business. Thus, the bull argument cannot be summarily dismissed. That said, the bear argument also cannot be summarily dismissed; Zuora not only hasn’t generated cash but also supports a healthy valuation. See Footnote 2.

As discussed, enterprise SaaS companies benefit from switching costs. What is the probability that a company is using Zuora to run its billing for a successful subscription business line? In order to make that decision a company like the Financial Times would need to:

• (a) have enough pain with the current billing solution to consider switching,
• (b) get comfortable with a competitor’s product,
• (c) be willing to migrate billing systems and risk some sort of customer disruption (remember, the hypothetical company invested a lot to acquire those customers so disrupting the experience is a serious potential risk); and
• (d) actually make the switch.

It’s obviously possible for companies to switch, but it isn’t easy. Moreover, Zuora charges ~50bps on transaction volume. How much savings can a company capture by switching to a competitor? That competitor would need to be able to economically offer savings, guarantee a seamless transition, and close the sale. That is a tall order. So, grow now and harvest later!

Growing now and harvesting later is exactly what Zuora is trying to do. So it continues to aggressively pursue deals that look like:

A problem, however, is Zuora’s “recurring profit” margin, coupled with its sales cycle leads suggests the business economics are closer to the orange line below than the green line. And that matters. A lot.

For illustrative purposes, lets compare the Run Rate 7/31/19 financial results (above) to the year ended 1/31/19. Zuora discloses a net revenue retention rate of ~112%. Therefore, company’s 1/31/19 sales base of $168.8mm would result in $189.1mm of sales. The $100.8mm of sales and marketing exepenses deliver the “growth” of $13.6mm of new business. That $13.6mm generates ~$2.0mm of “recurring profit.” That is not an incredibly exciting return on sales spend. Please note that the actual run rate business at 1/31/20 should be substantially larger than the run rate business at 7/31/19 and this example is very imperfect. However, the example directionally demonstrates that Zuora’s business is not growing like a weed and realizing incredible unit economics. It must be noted the time period in this example also covers some sales execution issues. But, the example is useful to show this business, while priced like a Ferrari, may actually be a Honda.

Growth Persistence

Justifying Zuora’s current valuation requires a long time horizon and some creativity. In the words of Shomik Ghosh:

“In enterprise software, valuations are mostly quoted as revenue multiples. Companies are said to be valued at 15x NTM revenue or 10x NTM ARR. These again are proxies for eventual free cash flow generation. However, they’re necessary because building a discounted cash flow analysis early on in many of these company’s lives would have so many assumptions on it that the analysis would effectively be useless.

So what are the proxies commonly used for valuation? They include revenue growth, gross margins, LTV/CAC ratios, S&M efficiency, churn, upsell, runway, TAM, market share, etc. An exact same business with the exact same metrics will be valued more highly if it has 2 years of runway versus 1 year as the longer runway allows more time for growth and eventual higher free cash flow generation at steady state.” See Footnote 3.

Zuora is almost certain to continue growing sales given the business model and infancy of the product offering. As shown below, ~50% of firms with sales between $0-325mm can grow at or above 10% per year for 10 years (note there is some survivorship bias as some firms don’t last 10 years).

That said, other than faith, it’s hard to see how Zuora’s sales growth results in operating leverage. Further, the speed of growth over the long term and capital allocation is questionable. There’s something offensive about an organization spending $75.0mm of run rate R&D to support $202.7mm of run rate sales (regardless of how understated sales are). How does a company with only two real products need that kind of R&D investment? And, with $139.9mm of R&D investment over the past 4 years shouldn’t Zuora have more than 112% revenue retention if their end market is growing so much? While Zuora needs to iterate its product, this R&D spend (a) seems extreme and (b) could be better spent on an even bigger sales team to accelerate scaling.

Conclusion: Too Hard

Given concerns with Zuora’s capital allocation, it’s very difficult to determine the company’s steady state economics and the path to get there. There are so many intertwined variables that a model does more to serve as confirmation bias than an objective forecast of the future. Moreover, there’s nothing tangible that shows this business and/or management team is scaling.

There’s a strong desire to assume all this spending is rational. After all, very smart people (a) work at Zuora and (b) support the company as investors. Moreover, Zuora has a visionary concept of the future. Further, scuttlebutt suggests the product is good. All that said, investing isn’t rooting for a sports team. There is real money on the line. Given the lack of visibility into terminal economics, this business is better to let others wager on. Some bets are best observing from the sideline.

2. According to Bloomberg there are 4,371 companies in the US and Canada that are classified as communications, consumer discretionary, consumer staples, and technology. Of those only 731 have a market cap in excess of $1.5Bn. Of that 731, 602 are free cash flow positive. Those sectors were chosen because they have reasonably good businesses in them (as opposed to energy and materials). Within the technology subset, there are 1,530 companies, of which 272 have market caps equal to or greater than Zuoras. Of those 272, 221 are cash flow positive. None of these numbers mean anything, per se. However, they do demonstrate that Zuora is among the most highly valued companies in the investable universe. That said, this is a pond worth fishing in because successful tech companies tend to produce the preponderance of value within the sector.