The world we live in is slowly transitioning away from a culture of ownership to one of access. What does that mean? Instead of owning a car, having access to an autonomous one -- via an app -- will suffice. Or even simpler: We no longer have to buy movies or DVDs, we just need a subscription to Netflix.
The real-world ramifications for everyday folks are enormous: no more hoarding, and sharing helps drive down costs.
But there are more-obscure changes behind the scenes. Billing, collecting, and recognizing revenue in ways that meet regulations are fundamentally different for subscription-based businesses. Enter software-as-a-service (SaaS) stock Zuora (NYSE:ZUO) -- a new IPO that offers a host of solutions to help businesses make this transition.
A rough start in the public eye
Zuora has only been a public company for seven months. In that time, its shareholders have endured a lot. The stock went from a $20 IPO and soared to as much as $37 per share in short order.
Since then, however, Wall Street has continuously punished the company -- even after relatively strong earnings reports. Today, the stock actually sits slightly lower than when it made its debut, trading below $20.
There are a few important caveats, however. Foremost, institutional investors and insiders own just 39% and 10%, respectively, of the stock. That means that the other half is owned by individual investors like you and I.
There were also only three analysts on the most recent conference call. For perspective, SaaS giant Salesforce had eight on its most recent call. Bottom line: This is a stock that is under-followed by big-money players.
This isn't uncommon for small companies like Zuora -- and it's not inherently a bad thing. But it does usually equate to a stock prone to volatility that can be easily influenced by a few larger shareholder making big moves.
For short-term investors, this can be scary. For long-term investors, it's just noise. If you want to follow me by investing in Zuora, be sure you're in the latter camp.
The most important metrics
Right now, Zuora isn't profitable and doesn't produce positive free cash flow. For a company that trades for 10 times sales, that can be scary.
But for me, there are only three metrics worth watching: subscription revenue growth, dollar-based retention rate, and clients with annual contracts of over $100,000. Let's break those down, in order.
Zuora gets the bulk of revenue from subscriptions. But it also gets revenue from helping to on-board customers. It's important to get this on-boarding right, but it's low-margin and isn't nearly as important in the long run. Just as important, it usually skews overall revenue growth. Here's what I mean:
An undisciplined look at overall revenue is alarming: Growth has slowed from 60% to 33% in just three quarters! But a more nuanced -- and long-term -- view shows the exact opposite: Subscription revenue growth has actually trended upward since going public.
Next, we check out dollar-based retention rate (DBRR). What this measures is how much money Zuora collects from the same subset of customers from one year to the next. By factoring out the effect of new clients, this tells us how good Zuora is at keeping clients and up-selling them on new products.
When customers sign on with Zuora, they usually start with its legacy product: billing. As companies train their employees on Zuora and start relying on the software to store their data and process their business, they become accustomed to it. Switching costs -- financially, in terms of retraining, losing data, and headaches in general -- become very high. Because DBRR is above 100%, it shows that Zuora is retaining these customers and benefiting from these high switching costs.
But Zuora is more than a one-trick pony: It also offers Zuora Collect, Zuora RevPro, and Zuora CPQ -- which helps configure tailored quotes. Because the DBRR is consistently above 100% and accelerating, it means customers are adding these services. Not only does this make switching costs even higher, but these sales are also made with little sales or marketing spend -- as these customers are already in the Zuora ecosystem.
Finally, we have customer accounts over $100,000. Here's how that metric has fared recently.
It's worth noting that the 504 figure is only through the first nine months of 2018. By the end of the year, it will likely be even higher. As it is, this represents 30% growth in such contracts from the same time last year.
The takeaway for you, the investor
None of this means that Zuora's stock is a sure bet to move up. No stock is. Management needs to keep a close eye on its cash balance (currently $175 million with no debt) and make sure the company is free-cash-flow positive before that balance starts running low. For perspective, over the last nine months, free cash flow was negative $10.6 million.
But the long-term trends are still very much in Zuora's favor. As such, I will be purchasing (more) shares when Motley Fool trading rules allow -- bringing my allocation in Zuora to roughly 2% of my real-life holdings. If you're interested in a small but quickly growing company with a powerful moat via high switching costs, I suggest you consider doing the same.