Should Investors Be Worried by Zuora's Big Drop?

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Shareholders of newly IPO'd Zuora (NYSE: ZUO) had to blink twice to make sure they weren't seeing things last week. After the company announced impressive fiscal second-quarter 2019 earnings and a guidance raise on Friday, the stock was down as much as 19%.

As someone who recently bought shares of the company, I was worried something disastrous had happened. After reading through the earnings report and listening to the conference call, though, I can confidently say that's not the case. In fact, it's an opportunity for long-term investors interested in a software-as-a-service (SaaS) play that's helping companies transition to the "subscription economy."

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Zuora earnings: The raw numbers

Before we dive into why I think the market is overreacting, let's take a look at the headline numbers for Zuora:

Metric Q2 2018 Q2 2017 Growth
Revenue $58 million $39 million 47%
Earnings per share* ($0.13) ($0.47) Loss narrowed 72%
Free cash flow ($7.3 million) ($9.6 million) Loss narrowed 24%

There are a few vital details to unpack from what you see above. First and foremost, as a newly public company, Zuora's share count has ballooned -- almost quadrupling -- over the past year. Spreading the second-quarter's loss over more shares versus the prior year helped drive the 72% EPS improvement shown in the table above. If we were to normalize earnings by simply looking at net income, we would see the company's non-GAAP loss actually expanded 10% to $13.7 million during the quarter.

That said, it's more instructive to look at the company's subscription revenue. Service revenue -- which is the only other cohort -- isn't a major moneymaker for the company. It simply pays for Zuora to help its clients onboard to its namesake software. While subscription revenue growth slightly trailed overall growth -- clocking in with a 44% jump -- it's still impressive. More importantly, gross subscription margin expanded 272 basis points to 78.1% -- after backing out stock-based compensation.

And the company is showing impressive leverage as well, as operational expenses grew slower than overall sales growth:

Expense Category Q2 2018 Q2 2017 Growth
Research and development $12.6 million $9.5 million 33%
Sales and marketing $23.9 million $17.9 million 34%
General and administrative $7.7 million $5.3 million 45%

Put those three pieces together and operational expenses rose 35% to $44.2 million for the quarter.

The competitive moat remains wide

But two additional metrics really demonstrate the strength of the company's report. The first is that Zuora now has 474 clients with annual contract values (ACVs) of over $100,000. That's up 96% from the end of 2015 -- and it's 33 more high-value clients than the company had just last quarter.

If it looks like growth is moderating, it's important to note that the 2018 figure is just for the first half of the year. If the company continues growing its roster of high-ACV clients at least 25%, it could reach almost 520 by the end of the year.

Equally important, the company's dollar-based net retention rate kept steady at 112% for the quarter. This may be the single most important metric for investors to watch. That's because it means that current clients are not only sticking around, but adding more of Zuora's tools over time. This not only helps the company increase high-margin software revenue, but also lowers customer acquisition costs -- as upselling current clients is a lot cheaper than luring new ones into the company's ecosystem.

All these factors alone are enough to convince me the market's reaction is short-sighted. While it's true the company isn't yet profitable, it's following a very clear playbook of spending money early to lock customers in for the long haul. And as management once again highlighted in its conference call, it's not just tech companies that are using Zuora to set up and track a new subscription model -- even lawnmower makers are making the move.

Looking ahead

In the company's earning conference call, founder and CEO Tien Tzuo said that the company expects to continue doing well throughout the year. Below, I've offered up the midpoint of guidance for the rest of the year.

Metric Q3 Guidance Q4 Guidance
Revenue $58.8 million $60.2 million
EPS* ($0.135) ($0.02)

While the market might be worried about a stock trading for over $3 billion while not being profitable -- and losing money via free cash flow -- I believe this is an opportunity.

With over $180 million of cash on hand and less than $10 million of long-term debt, the company's in excellent financial shape. The momentum it's showing gives me confidence that things are headed in a positive direction, and that I should consider adding even more shares moving forward.

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Brian Stoffel owns shares of Zuora. The Motley Fool owns shares of Zuora. The Motley Fool has a disclosure policy.