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

investment thesis

Zuora (NYSE:ZUO) is a leading provider of software for businesses to manage their subscription-based services. The company’s dominant position is highlighted in the image below, taken from Gartner’s 2024 Magic Quadrant for recurring billing applications. According to one study by Juniper Researchthe 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 expanded its offering to include non-recurring billing based on income as well as consumption. -based billing.

Despite a rather dim near-term growth outlook, some of its product offerings are starting to gain significant market traction. Management is exercising tight control over expenses following recent job cuts, which should support margin improvement future quarters. ZUO’s stock valuation looks attractive to me at EV/Revenue and EV/non-GAAP earnings multiples of 2.4 and 12.2, respectively. Given the company’s status as a potential acquisition target, the risk of significant downside is relatively low. I find the current risk-reward profile attractive and therefore maintain a Buy rating on the stock.

My financial highlights and expectations are at a glance

Zuora reported a solid Q2 report, with subscription revenue up 9% year-over-year to $104.1 million. Non-GAAP operating margin increased to 22%, an improvement of 1,300 basis points over the prior-year period. Despite the slight increase in 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 due to macroeconomic weakness, this indicates a slowdown ahead after the 7% ARR growth seen in Q2. On the other hand, total remaining performance obligations (RPOs) were $577 million, up 14% year-on-year, reflecting overall healthy demand.

In Q2, Zuora acquired Togai to enhance its consumption-based billing 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 coming quarters

Strong market traction for consumption-based billing

After launching its consumption-based pricing product last June, the company has seen strong growth in this area, particularly among its technology customers whose products have seen increased usage following the introduction of AI-related features. The acquisition of Togai should further enhance this product by adding metering and rating solutions to Zuora’s existing product suite. A recent customer win in the transportation industry, which was brought up on the Q2 earnings call, shows that Zuora is likely to be able to attract customers even outside the tech industry with this offering.

High upselling potential in existing customer base

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

We already have a significant 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 the revenue that they get through us, it’s a tiny fraction. So it’s a huge opportunity to expand, even if we didn’t get a single additional customer, a huge opportunity to get into large enterprises.

As further evidence of this, the company has seen ARR increase by approximately 17% year-over-year for customers in the $0.5 million and above bracket. Given the current macroeconomic downturn, which makes signing new customers more difficult, I expect management to continue to focus more on upselling the now broader product set.

Tight expense management should lead to margin improvement

As seen in its Q2 report, the company showed a strong improvement in profitability, starting with gross margins improving to 68% from 65% in the year-ago period. Operating expenses were lower compared to the prior year, despite a $7.7 million increase in G&A costs related 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 operational leverage which should lead to improved margins going forward.

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 is $1.12 billion. Management’s full-year guidance is for revenue of $459 million and non-GAAP earnings of $92 million. Accordingly, the stock is valued at an EV/Revenue multiple of 2.4 and an EV/non-GAAP earnings multiple of 12.2. Zuora’s valuation looks attractive relative to midcaps that I consider valuation relevant, such as Paycom (PAYC) and BILL Holdings (BILL). These companies are growing at low double-digit rates and have EV/Revenue multiples over 4 and non-GAAP earnings multiples over 20.

Zuora’s valuation appeals to me given the catalysts I see, which I’ll discuss in the next section. One concern I have is with the company’s high level of stock-based compensation (SBC). As shown below, although SBC has decreased significantly year over year, it still remains very high, which affects the company’s GAAP profitability.

Catalysts that could lead to further share price appreciation

The engine for a significant advantage for investors is the acquisition of the company. Reports earlier this year suggested the company was in talks involving an acquisition. Potential buyers could include private equity firms or larger public companies such as Salesforce ( CRM ) that may be interested in integrating Zuora’s capabilities into their Revenue Cloud product. In addition, Enterprise Resource Planning (ERP) players such as SAP may also be interested in improving their billing offerings. I would also point out that following its strategic $400 million 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 increasing profitability. Success in selling its new offerings to its large existing customer base could significantly increase the company’s operating margins. This will likely result in the market rewarding the company with a higher valuation multiple.

Risks to consider

Competition

Despite having a leading position in its industry, the company faces significant competition from big players like SAP as well as newer ones like BillingPlatform. One of the ways in which Zuora fights against competitive threats is by expanding its customer offering, thereby making its products more attractive and sticky. Investors should keep a close eye on how this risk develops going forward.

Lack of GAAP profitability

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

Macroeconomic weakness

The company is already seeing a negative impact due to a challenging macroeconomic context on the signing of new agreements. Continued weakness could see growth and profitability remain under pressure.

Buy ZUO stock

Given the subdued growth outlook for this year, the stock has fallen to levels where the valuation looks attractive, especially with the potential for improved profitability. The downside risk is mitigated by the company’s status as an attractive acquisition target. The favorable risk-reward profile supports my Buy rating on the stock.