I kind of like reading Charles Mizrahi’s stuff — the teaser pitches are over-the-top, of course, promising way more than they can deliver, but the companies he touts tend to also be relatively rational when it comes to things like earnings or cash flow.
For example… his pitch about Brink’s being the best play for marijuana legalization a couple years ago was awfully misleading, in my mind, but that didn’t take away from the fact that Brink’s was a pretty reasonable investment idea, with real earnings and cash flow. There was at least a little meat to chew on, it wasn’t all flash.
So when he started pitching another hot trend this week, subscriptions, in ads for his Alpha Investor (that’s his “entry level” newsletter, $79/yr), I thought I’d look into that for you today.
He has a little lead-in that’s meant to make you realize how much you’ve gradually begun to subscribe to everything in your life, how we’re all participating in this “user” economy instead of an “owner” economy, with his look at a credit card statement as the gimmick, showing the monthly payments for Netflix, Stitch Fix, Electronic Arts, Spotify, Zoom, etc… but this is basically a pitch for the fact that everything is going to subscriptions, and that it’s good for both companies and customers (customers don’t have to buy everything up front and can moderate their spending based on usage, companies get predictable and steady cash flow, which investors are generally willing to pay more for).
That’s nothing new, of course — ever since Salesforce.com (CRM) came on the scene we’ve been gradually building an investor obsession with Cloud and Software as a Service (SaaS) businesses, SaaS has been the “next big thing” for 15 years now… and we see lots of other “as a service” trends, from Mobility or Transportation as a Service (MaaS or TaaS) to Communication as a Service (CaaS) to Security as a Service (SECaaS), and there are dozens of other buzzy terms just like that… if you can make up an aaS acronym, I’m sure someone will help you popularize it.
But how does he think we’ll make money off of this trend toward subscriptions? We’ve heard plenty of pitches about cloud and SaaS companies over the years, and many of them did extraordinarily well, particularly over the past year… is Mizrahi just pitching one of those stocks we’ve seen before, or is it something new? Let’s dig in and see.
Here’s the tantalizing bit…
“In fact, scores of companies have been created across the world for the sole purpose of cashing in on the subscription revolution….
“With my top SoE stock pick, you can get your share of this exploding industry.
“In fact, this is the perfect time to jump on board. If anything, SoE’s growth is just going to accelerate.
“How can I be so sure?
“I’ve got one word for you … COVID-19.
“When the pandemic hit, America switched to a subscription model virtually overnight.
“And SoE shifted into high gear.”
He keep harping on the huge potential of this “SoE” revolution…
“Over HALF the things more than 7 billion people are using right now … things you use every single day to live your life … could be radically transformed by SoE.
“This is beyond big. It’s colossal. And the money that can be made here is mind-blowing.
“And some of our country’s richest investors know it.
“Billionaire investor George Soros already owns an estimated $79 million worth of shares in SoE.
“Warren Buffett has invested $250 million.
“And Bill Gates has injected $644 million into a company that branched out into SoE just a couple of years ago. Could its move into SoE be why he made that huge investment? No telling for sure, but I wouldn’t be surprised.”
“SoE” is just his little acronym to make things seem more memorable, it stands for “Subscription of Everything,” and I guess you can argue that we’re all heading in that direction. You’re probably subscribed to this website, after all, even if your subscription is free (if you want the better stuff, of course, we’re also happy to take your money).
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But there are thousands of SaaS and subscription companies out there, what makes this one special? More from the ad…
“SoE is not only transforming the way companies do business … it’s maximizing their sales and revenue by practically putting them on autopilot.
“And one leading company in this industry stands to profit big time.
“You know the ‘essential’ businesses you’ve been hearing about lately?
“Most of them can be found in the exact same industries that are cashing in on SoE … including my top SoE stock pick.
“Now, essential is a word that describes this breakout company to a T. It’s so essential … every other company looking to get in on the SoE revolution needs what it offers to run their operations effectively.
“Every single one of them.
“In fact, I would go so far as to say that SoE companies will struggle to succeed … or even stay in business … without the cutting-edge systems this company has created.”
Huh, OK — so it’s a service company for other subscription companies. I think I know where we’re headed here, but let’s see if he drops some more clues.
First, he lays on a little hyperbole…
“The subscription model is like turning on the spigot of a tank full of money…
“And releasing a steady stream of cash right into a company’s bank account.
“Repeat customers can be created at the click of a button … subscription fees come in month after month like clockwork … and profit margins are higher than average …
“What business owner isn’t going to crawl over broken glass to get in on this?
“None that I know of.
“Any company that doesn’t jump on board the SoE bandwagon is going to miss out in a big way.
“I would even go so far as to say…
“Businesses that reject the predictable income and loyal customers of the subscription model could find themselves bankrupt within a few years.”
And then some more clues…
“If SoE grows like I predict it will … and becomes a $2.7 trillion industry by 2030 … my top stock pick is positioned to make a killing….
“The founder and CEO of this cutting-edge business saw this day coming years ago … long before it was on anyone’s radar.
“And he structured his company to be a part of it from the very beginning….
“You see … standard business software programs just don’t cut it for subscription companies. They’re not designed to handle recurring revenue. Not by a long shot.
“That’s why what my top SoE company offers is so revolutionary. Its proprietary systems for billing, collections, revenue management and analytics are specifically created to work with the subscription model.
“And having the right systems makes a world of difference.
“When a Norwegian media firm made the switch to this company’s platform, it doubled its digital subscription revenue in just two years.
“Yes, doubled it.
“And more than 1,000 of the biggest SoE companies in the world have also jumped on board.”
He drops some names of customers, which should help the Thinkolator…
HBO Nordic, Symantec, DocuSign, ZenDesk, Schneider Electric, Houzz, Karbon, HomeAway, The Seattle Times, Sierra Wireless France, Zillow, Trivago
And implies that somehow this company does something unique in the space…
“You see … it doesn’t matter if a company has transitioned to SoE…
“Or was created to be a subscription business from day one.
“They all need this one company’s proprietary systems to truly succeed and profit.
“That’s why this company’s stock could easily go up tenfold over the next five years….
“Look, this stock is already starting to attract the attention of big institutional investors.
“BlackRock owns over $75 million in this company.
“Brown Advisory owns nearly $45 million.
“And Vanguard Group owns more than $112.5 million in this company’s stock.”
Other clues? He does drop one bit about patents…
“You’ll learn that it has 10 patents … and 23 additional patents pending. It’ll block competitors from duplicating its proprietary systems for decades.”
So… hoodat? Thinkolator sez that Mizrahi is teasing Zuora (ZUO), which is indeed a company that helps other companies build, run and optimize subscription services.
And this is a company I’ve struggled with over the years — I don’t think I’ve ever written a full article about them, but I’ve seen the Motley Fool and others pitch the stock from time to time (it was a hot ticket right after the IPO in 2018, but came back down hard from that early hype and is back pretty close to their IPO offering price of $14), and this is what I posted in response to a reader question back in January:
“I’ve never understood Zuora, I’m afraid. It’s almost a ‘meta’ concept stock — a SaaS company whose mission is to help facilitate subscription management for other SaaS businesses — but they have clearly not posted the growth that so many in the sector have enjoyed and it’s hard to understand how their service is uniquely valuable or has a strong potential customer base given the many subscription system options out there.
“The stock is certainly undervalued on metrics like price/sales compared to many SaaS providers, though that’s because the revenue growth has been light, but I’d love it if anyone could explain to me why you expect their user base to be either very sticky and long-lived or why they should grow faster than they have or have a much larger addressable market.
“Analysts are relatively tepid on the name, their forecast of expected 10-15% revenue growth probably isn’t enough to captivate anyone in this sector, so perhaps the analysts are underestimating and the stock is just a little under the radar because they’re growing more slowly… or maybe investors, including me, just don’t get it and they have some ‘secret sauce’ that will help them reaccelerate at some point. But I’ve never been able to quite push this one over the edge into, ‘ah, that’s why I should buy it’ territory. Convince me if you can, please.”
Maybe the challenge for me is that I run a subscription business, and I have been studying subscription businesses for 20 years, and therefore I’ve been exposed to hundreds of service providers in this space. All of them say they do the same thing, manage product subscriptions and analytics and payments and email or other services, so it’s hard for one to stand out as brilliant or unique. There’s nothing magical about “subscription,” after all, but I should at least keep an open mind that maybe Zuora does this better than others — at least for larger scale companies. I had similar qualms about Zoom Video (ZM) before it had a breakout year last year, since video conferencing seemed effectively like a commodity service that lots of big companies could provide, many of them more reliably than Zoom, and that meant I missed out on that company’s incredible surge in 2020.
And I’m not against paying up for the leader in a growing space, even if the product can be somewhat commoditized. Being a leader, having a strong brand for your customers, and offering a better service does matter — I know there are dozens of companies offering cheap e-signature services, for example, but I’m still confident that DocuSign (DOCU) is holding on to its lead in that space and will continue to grow nicely. So can I be convinced about Zuora?
The company just had its investor day (presentation here), so it’s a good time to catch up with them and see if you like the potential. The company’s argument is basically that they lost their growth momentum as they scaled up the business, hiring like mad and investing in integrating their products and services and infrastructure to make things easier for their customers, and that they’re ready to start growing rapidly again.
They set financial targets for fiscal year 2025, including subscription revenue growth of 25% or more, non-GAAP subscription gross margin of 82% or more, and non-GAAP operating margin of 10% or more… all of which sounds good, though it’s hard to wait that long to get to just a 10% operating margin (and, of course, Zuora doesn’t know what will happen to change the world between now and 2025 any more than you or I do).
But interestingly, they get more detailed on their “deliverables” too — we’re told that…
“Zuora also introduced three new KPIs to monitor its progress with the objective of meeting these targets by the end of fiscal year 2025:
- Annual recurring revenue (“ARR”) growth of 25% to 30%
- Net Dollar Retention (as defined by current period ARR compared to prior year’s ARR from existing customers) of 112% to 115%
- “Rule of 40” (as defined by the sum of subscription revenue growth rate plus free cash flow margin year-over-year) of 40% or more.”
We see that “KPI” term thrown around a lot lately, probably just because there are more MBAs running investor relations departments — if it’s new to you, that acronym stands for “Key Performance Indicators.”
And if they hit those numbers, it will be impressive, and would mean that the investments they’ve made in the business over the past couple years really paid off.
Will they? I don’t know. They certainly had a great idea early on, and realized the power and wide-ranging applicability of the subscription business model before a lot of other businesses, and they have posted strong growth… even if it has been a shadow of the growth rates that companies like Salesforce.com or Zoom have posted as subscription businesses.
The key will be building up the annualized recurring revenue, and right now they think that number will grow 17% in this just-begun fiscal year (which is FY22 for them), so that’s a near-enough timeframe to take it somewhat seriously, and while for some reason that number is not identical to ARR, it’s basically the same thing, and they grew subscription revenue at 17% for the full year last year, too.
The number they shared in their forecast with their quarterly update in March was subscription revenue of $275 million for this year (they also have services revenue that’s not “subscription”, so the total forecast is revenue of $336 million). They also expect to roughly break even on a cash flow basis this year, so should become profitable and start growing earnings over the next year or two.
What do we pay for ~15% growth in ARR?
If they keep their customers and keep growing at 15-25% for the next several years, that puts them in a similar neighborhood to Avalara on the growth front (though AVLR is currently seeing revenue growth slow down to that level, while Zuora would be accelerating to that level). Avalara also provides a back-end service that is tightly integrated with the core business and a hassle to deal with on your own (tax compliance, in Avalara’s case), and one where there is competition that’s less specialized, though they’re growing a bit slower (AVLR was at 35% last year, expected to be in the 20%+ range for the next few years), and Avalara’s gross margins are better.
I’ve been willing to pay 15-20X 2022 revenue forecasts for Avalara because of the stickiness of the product and their ability to tack on new compliance products in the future, partly through successful serial acquisitions. The businesses are obviously not the same, but when I think of Zuora’s potential in the context of a company like Avalara, and block out in my mind some of my inner skepticism about how challenging the competition might be, I think it’s appealing enough that I might be willing to pay 10-15X sales for the company… particularly if their restructuring is going to enable them to get their revenue growth reinvigorated, as they clearly believe. Where would that put us?
Well, as luck would have it, investors don’t really trust Zuora after they hit a bit of a stall over the last year or so… so if you use those assumptions it puts the stock in pretty reasonable “buy” range. 10X their forecasted 2022 ARR would be $2.5-3 billion in market cap, and Zuora sits right now at a $2 billion market cap at $16.50. That means there’s some rationality in assuming the stock has a chance to double from here over the next year or two if they do post those 20% top-line growth numbers and reassure frustrated investors that they are still relevant and growing.
What are the odds of that? Well, I’m not sure… but because the share price assumes very low growth I decided, after weighing my skepticism today and looking through their new investor materials, to place a little wager on their turnaround taking root over the next year or so. I bought some out of the money call options for both next May (at $25) and January of 2023 (at $35). In total, those add up to about 0.1% of the portfolio — so in “possible loss” terms it’s kind of like buying a little 0.5% entry position with a 20% stop loss, with potentially levered returns if it turns out that Zuora can really turn it on again from here. I’m a little skeptical, but those Zuora folks are pretty good evangelists for their potential, the stock is inexpensive relative to near-peers because of past growth disappointments, and it seems worth the risk. I guess you could say that I’m now partially “talked into” the Zuora story.
There’s a good “about” page on Zuora’s website that gives a timeline of the company’s development, so that might help to give some background if it’s new to you. Not many analysts cover the company, but those who do are still feeling quite “meh” about the shares — they expect 10% revenue growth this year and 15% next year, with a profit of a couple cents a share coming through next year, and their average price target is… right about where the stock now stands, at $16.60. They have an odd fiscal year, so their first quarter FY22 earnings announcement likely won’t be coming for another month or so, in the first week of June — so you’ve probably got plenty of time to think it over before there’s any big news.
Worth your money? That’s your call. Do let us know what you think with a comment below.
Disclosure: of the companies mentioned above I own shares of DocuSign, Electronic Arts and Stitch Fix, and call options on Zuora. I will not trade in any covered stock for at least three days, per Stock Gumshoe’s trading rules.