Enterprise subscription management software is pretty boring. But the world is shifting from purchase to subscription. Every company now wants “continuous customer relationships” and consumers love subscriptions. In many ways, the subscription economy isn’t new. Even cars were often leased versus bought but they were still treated as an asset. Companies like Zipcar took it to a new level of all service.

Sellers like subscriptions because it gives them more predictable revenue and consumers like to avoid making large purchases and prefer smaller, predictable and cancellable subscriptions.

Some of the key drivers for this trend in business stem from four main drivers (according to Forrester):

  1. Everyone wants stickier customer relationships. That demands a move away from “one and done” transactions and to models that keep the customer more locked in and coming back for more. For example “family plans” have caught on with service providers because it makes it much, much harder to change since it requires everyone in the family to change which is a major hassle.
  2. Products are now connected. Thanks to the IoT trend everything is full of sensors and “smart” which require ongoing monitoring and updates. This opens up lots of business model innovation for companies which demands new types of billing to go along with them.
  3. The cloud enables subscription and usage-based revenue models. In most developed (and many semi-developed) areas the cloud is ubiquitous and the general expectation for any cloud-based offering is that it will be sold on a subscription basis.
  4. Data-driven customer care and business insights. If a customer walks away with a one-time purchase your opportunity to collect data and learn how to build a relationship is nil. But if they are linked by a recurring subscription they can be monitored based on usage, engagement, and sentiment. The data can be used to provide better service, product innovations or improvements in interfaces and packaging.

Large enterprise software companies have already gone down this road – Salesforce (CRM), Workday (WDAY) and Adobe (ADBE) are all leading corporate examples. Almost everything in the cloud uses a subscription-based model.

Zuora (ZUO) is an enterprise-scale solution for companies wanting to offer a subscription-based business model. Their revenues have grown substantially in the last two years ahead of their IPO. Their loss from operations has remained high however at ($35-45M) per year for the last three fiscal years (their FYE is January.)

(As usual we have the ZUO IPO slide deck available but also did a full transcript of the ZUO IPO roadshow if you really want detail.)

In total ZUO generated $133M in operating losses to build a $168M revenue business. This is due in part to the general SaaS model but it’s a bit worse for ZUO because their system is a truly “enterprise” which makes it harder to implement than other offerings. That’s also why the company has a fairly high portion of revenue from professional services.

One odd thing about the ZUO P&L is that sales and marketing expense growth isn’t really the major culprit in the steady losses – major increases in both R&D (good) and G&A (not so good) have contributed a good deal to the growth in expenses and blunted any potential margin expansion from the increased scale of the company.

Below is the ZUO revenue growth model. The first 2 are typical “land and expand” for a SaaS company but the volume-based growth is an extra kicker for them. Note that some customers reject this pricing model if they can because they view the volume charges as a “tax” on their growth. But it’s a common-enough model in business to be accepted most of the time.

Two key metrics are customers over $100K/year and dollar-based retention. Zuora gets paid via subscriptions and also with a share of “processed transaction volume” which gives them some “skin in the game” in helping their customers grow.

Gross margin is 77% and will move into the mid-80’s as professional services becomes a smaller portion of total revenue. (Professional services are run as a break-even business.)

Operating losses have improved from 49% of sales in FY16 to 21% of sales in FY18. Management declined to provide a long-term target model for the company, leaving investors to infer one from comparable companies. Some “comps” we think are appropriate for ZUO include Coupa Software (COUP) and Apptio (APTI) on the enterprise application side and Twilio (TWLO), Cloudera (CLDR) and MuleSoft (MULE) on the infrastructure side.

The ZUO IPO has priced fairly aggressively at $14, the original range was $9-11. I opened for trading at $20 which is not very attractive relative to our $24 IV.

Competition

This is an area we may do some more work on post the IPO and as the company gets closer to having stock coverage. Zuora makes it seem like they have little or no direct competition in their space. This is at least partially true. However, Forrester had SAP positioned much higher than we expected when they evaluated the vendors in this space in 2015. It’s true this is a bit dated so we will be going back in to see if ZUO has extended their lead or whether other vendors may be catching up.

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