Zuora – Accelerating Growth Makes This An Interesting IPO

Zuora (ZUO) has gone public in an offering which has seen healthy demand. In fact, shares are trading at levels nearly twice the value being attached to the business in the preliminary offering range ahead of the IPO. Strong demand has doubled the attached valuation from a billion to two billion.

Valuation multiples have risen to 12 times trailing sales and 10 times annualised sales based on the Q4 revenue numbers, which is quite high, but could be justified as growth is accelerating to more than 60% on an annual basis. In fact, I would have loved to buy the shares at $10 or even the IPO price of $14 per share, yet at $20 per share I find that expectations have risen quite a bit, a bit too much for me.

A Cloud Subscription Business

Zuora is a cloud based subscription business which aims to overtake the role of traditional ERP systems and software systems. These software programs were perfect in a world focused on “products” but are showing deficiencies in a world which is shifting towards a “subscription-based” business model.

Zuora was founded back in 2006 as it envisioned the emergence of the subscription-based economy. This vision has proven to be correct as the company has ramped up sales quite quickly. With the customer count approaching the 1,000 mark, it is very comforting to see an acceleration in revenue growth in percentage terms.

Core of the offering is the Zuora Central Platform. This is complemented by the portfolio of SaaS products of the business allowing for billing, collecting and insights, as it has an App marketplace business as well.

The Offering

Initially, in early April, Zuora aimed to sell 11 million shares at a range of $9-$11 per share. After raising the preliminary offering range another time, shares were finally priced at $14 per share, as the offering brought in $154 million in gross proceeds. Following the IPO, there are 103.5 million shares outstanding which at the offer price values the company at $1.45 billion. Included in this valuation is a net cash position of $33 million, which values operating assets at $1.42 billion.

Shares jumped to levels at, or slightly above $20 per share on their opening day, implying that operating assets are valued just above the $2.0 billion mark.

I find this valuation rather steep given the operating performance of the business. Zuora reported revenues of $92.2 million in the calendar year of 2015 (which really ended on January 31, 2016) on which it reported an operating loss of $48 million. Revenues were up by more than 22% in 2016 to $113 million as the company reduced operating losses to $39 million.

Growth has accelerated in a significant manner as revenues were up by more than 48% in 2017 to $167.9 million. This resulted in operating losses increasing to $46 million, although they are coming down on a relative basis of course. Based on the trailing numbers, valuation multiples are quite steep at 12 times sales.

While expectations are elevated, the growth trends are very reassuring. Sales were up nearly 27% in the first quarter of 2017 as growth accelerated to 44% in the second quarter. The operating progress was even more impressive in the second half of 2017 as growth came in at 57% in the third quarter and even hit 62% in the final quarter of the year.

Easy Avoid For Me

It is very clear that I am quite impressed with the growth of Zuora, and the accelerating growth trends. While the company now trades at 12 times trailing sales, multiples contract to 10 times if we annualise the fourth-quarter revenue numbers.

Nonetheless, these sales multiples are quite high, despite the strong growth, as operating losses are still showing up. Ironically enough, the same companies which might face the biggest competition from a name like Zuora over time, such as Oracle (NYSE:ORCL) and SAP AG (NYSE:SAP), might be among those most interested in a name such as this. We have recently seen that big names are willing to spend big bucks to defend or strengthen their leadership position, just look at the deal which Salesforce.com (CRM) did with MuleSoft (MULE) as the latter got taken out at a roughly 15 times multiple.

Given the accelerating growth profile, I would be quite comfortably to pay a 6-7 times sales multiple which corresponds to a valuation of $12-$14, more or less in line with the preliminary pricing indications and the actual offer price. At current levels around $20, shares are valued at a rich price in my book, although I will not rule out that Zuora becomes a real success given the accelerating growth trends. Upside can come from a potential takeout, as well as continued or even accelerating sales growth, combined with operating leverage. Of interest is that CEO and co-founder Tien Tzuo held key roles at Salesforce.com in the past, with potentially warm ties left to this business and Mr. Benioff.

Real downside risks can emerge if sales growth slows down or operating leverage fails to materialise. Other risks include the dual share class structure, giving owners of the common stock no effective ownership, as well as the reliance on a key number of staff. Unless shares visit the mid-teens, I am maintaining a cautious/neutral stance at these levels.

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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.