Zuora focuses in on subscription leaders as Q2 results reveal churn

Growth at Zuora stayed on track during Q2, according to the subscription business vendor's results released yesterday after market close. But a rise in churn and the company's continued cautious outlook failed to please investors, who punished the stock today in the midst of across-the-board tech declines, wiping almost a third off its value. Neverthless, yesterday's earnings call saw Zuora CEO Tien Tzuo maintaining his characteristic ebullience about the prospects ahead in the subscription economy, despite the challenges of COVID-19:

Six months into the COVID crisis, more companies are waking up to the power of the subscription business model. Many subscription companies aren't just proving to be resilient. They're actually thriving ...

In fact, our next Subscription Economy Index Report to be released shortly will show that while the S&P 500 companies saw revenue contract at an annual rate of 10% last quarter, Zuora customers included in the report actually expanded at a rate of 12%.

To back up the assertion, he cited several examples of Zuora customers that had quickly spun up new services in response to new patterns of demand post-COVID, including news publisher The Seattle Times, industrial manufacturing giant Honeywell, Foxtel-owned Australian sports streaming service Kayo Sports, and a leading auto manufacturer preparing its launch of electrical vehicles.

He also highlighted Zuora's support for customers that have seen sudden surges in subscriber numbers, including guitar maker Fender, which has seen soaring demand for its online guitar classes — online education has become a new subscription growth area — and video conferencing provider Zoom, whose spectacular growth has become a stock market sensation. Even while growth has soared, Zuora's automation of the billing process has helped these and others cut the time it takes them to send out bills anywhere from 40-95%, says Tzuo.

As just one example, Zoom is actually getting all their bills out faster today than six months ago, despite the growth that they've experienced, which I think is pretty amazing. Because of our history and our data, we can now actually apply AI techniques to continuously optimize performance and throughput.

Could do better

But despite all this success, Zuora could be doing better still, he conceded: "Given that our market is expanding, I do believe our growth can be better." While the quarter came in ahead of expectations, some metrics faltered. Topline numbers were:

• Total Q2 revenue was $75.0 million, up 8% on the same quarter a year ago. Within that figure, subscription revenue was up 15% to $58.3 million, while professional services revenue fell 13% to $16.7 million, as implementation work either declined or shifted to systems integrator partners.
• GAAP net loss was $20.1 million, or 27% of revenue, compared to a net loss of $20.8 million, or 30% of revenue a year ago. The non-GAAP equivalent was $0.2 million, improved from $9.5 million a year ago. Savings in T&E and cost benefits from virtual events contributed to improved margins.
• Net cash from operations was $3.8 million, versus a negative $8.9 million a year ago, with free cash flow close to breakeven at negative $0.7 million. Zuora ended the quarter with $179 million in cash and cash equivalents.
• Zuora again declined to offer guidance for the full year, and expects revenue to remain in the $73-75 million range in Q3, with the non-GAAP loss from operations around $5 million.

While the topline numbers exceeded analyst predictions, there were some concerning trends in customer numbers. The number of customers spending over $100,000 annually — which accounts for 90% of Zuora's business — crept up to 645, just two more than at the end of Q1. But within that figure there were 35 new customers, which implies a loss of 33 others. New CFO Todd McElhatton explained that this was one of two factors that led to a significant drop in the average value of customer contracts:

We saw a number of customers leave our platform due to business failure, bankruptcy and M&A. As a result, dollar based retention decreased to 99% compared to 103% in Q1. This was our highest level of churn, more than twice our historical average.

Elaborating further, McElhatton said that "M&A and product fit" were the leading causes of customer churn, which contributed around two thirds of the decline, while downsizing of contracts, in many cases to provide relief to customers impacted by the effects of the pandemic, contributed around a third. But he indicated that this was likely a blip rather than a sustained trend: "We believe this was our toughest quarter for churn."

Focus on core verticals

There are some changes in sales strategy afoot to counter these headwinds. First of all, Zuora will focus in on the strongest verticals for subscriptions — high tech, media and manufacturing. McElhatton explains:

These companies are growing much faster pace than our other verticals. We started this transition at the beginning of the fiscal year and the results are beginning to show. However, this is a multi-quarter journey.

Secondly, the introduction of add-on capabilities such as Audit Trail, Sandbox and Analytics provides more scope for upsells to existing customers.

Finally, McElhatton suggested that the sales team had oversold some customers in the past, anticipating ambitious volumes that some customers had struggled to achieve. Sales incentives have now been adjusted "to right-size our initial deals with customers," he says.

Answering analyst questions, Tzuo said some churn comes from customers who find growth in subscriptions doesn't match expectations, and who therefore revert to managing subscriptions manually.

Our sweet spot is really companies that have some level of volume and some level of complexity into their business ... historically, we might have signed up a few customers at aspirations, but just for whatever reason, it didn't work out for them. Those are the ones that you're going to see really move towards a more manual-based model.

But he also emphasized that demand remains strong from the growing number of companies that want to use subscriptions to build closer relationships with their customers:

It's not a surprise that RFPs are up year-over-year, demand is up over year-over-year.

We're trying to make sure, though, that we're focused on generating this pipeline to three core verticals that we know are where the growth is going to be in the short term — even as we pursue the leaders in other industries that want to be the first movers in their industries into the subscription economy.

My take

Zuora must feel that the timing of its earnings release has a jinx on it. Six months ago, its Q4 results coincided with the market falling precipitously as the enormity of the COVID-19 crisis sank in. Zuora's stock was punished for announcing the departure of its longstanding CFO and a slight miss against analyst expectations. Today, its Q2 results just happen to coincide with the market dropping from a speculative high, and again its stock price — which had had a run-up in advance of the results — gets whipped.

All the same, as we observed in our coverage of the Q4 results, Zuora has had some growing pains over the past year and a half as it has moved upmarket to serve larger customers and deliver much bigger projects. As today's results show, the past few months have been a tough market for that kind of sale, however attractive the subscription model may be proving. As Tzuo says, Zuora fits best where the subscription requirement is complex and high-volume scaling, and those deals remain hard to find and to close. But the company remains well placed with its current product set and market focus to succeed. Even though investors are finding it hard to hold their nerve, Zuora's leadership quite rightly continues to focus on the long game.