Wall Street Loves Workday, but Doesn’t Understand Subscription Businesses

Workday had a monster IPO last month, pricing well above the top of its range and closing its first day with a pop of nearly 75 percent, and Wall Street seemed to respond well to the company’s first quarterly earnings report on Wednesday.

Founders Dave Duffield and Aneel Bhusri have been around long enough to know that this is simply a beginning, and they also know that as much as investors love subscription businesses, Wall Street has a fundamental misunderstanding of how to accurately value them.

In the last few years, a new business model has taken hold — it’s happening in music (Spotify), transportation (Zipcar), consumer goods (Shoedazzle), and, of course, in the software industry with the dominance of the cloud as the preferred model for consuming applications. But even while the Subscription Economy has taken hold across multiple, multi-billion dollar industries, investors, analysts and investor media continue to miss the fundamental differences between product and subscription companies that make their financial measurements just as different.

  • Subscription businesses are about building and monetizing recurring customer relationships, not about building and shipping units for discrete one-time transactions.
  • Subscription businesses are forward-looking, not backward-looking. The health of the business is in what it is likely to make this year, the next year and the next, not what it has shipped, earned and spent in the past period.
  • Subscription companies operate on recurring revenue and recurring expenses and therefore care about recurring profit, not operating profit.

Just think about it. We all know that if Bob is willing to give you $100, while John is willing to give you $100 a year for the next eight years, John’s offer is much more valuable. In the same sense, subscription businesses should be a more attractive investment than traditional one-time sales models. With a subscription revenue model, each year you start off with a known revenue level, versus having to chase every dollar of revenue, each year, from ground zero. Whereas in the traditional model, you invest in R&D, cost of goods, and sales & marketing with the hope of generating future revenue, in the subscription model, revenue from customers you have already acquired can be used to fuel future growth.

Regardless, most investors and analysts still look at EPS and P/E ratios when evaluating subscription companies, even though they are essentially worthless metrics in the Subscription Economy. Take this commentary from Morningstar’s Rick Sumner around Workday’s IPO:

Workday is now among the most richly valued of recent cloud computing IPOs, with a valuation of 22 times trailing sales in the last twelve months. IT software company ServiceNow, which went public in June, was valued at roughly 14 times during the time of its IPO, while e-commerce platform provider Demandware was valued at 17 times. “Workday can grow when it’s smaller, but the question becomes when they get in excess of a billion in revenue, can they still bolt on this high growth rate to justify its valuation?”

I know what Dave and Aneel are in for. Take my experience at Salesforce.com — arguably the first company to popularize a publicly-traded subscription business. I started as employee No. 11, and was part of the executive team through the IPO in 2004 until I left to start Zuora in 2008. During that time, we spent a lot of time and energy educating Wall Street investors and analysts on the vast differences in SaaS company performance from a traditional software company. Many remained fixed on the P/E ratio, and could not fathom investing in a company trading — at that point — 200X future earnings. Inside Salesforce.com, we knew that operating profit was essentially meaningless to measuring our value. (Honestly, as an investor, I would ding a subscription business that brought operating profit to the bottom line, seeing it as a signal from the company that it is cutting Sales and Marketing spending because it can’t efficiently acquire new bookings.)

Fast forward eight years. SaaS as a category has overtaken traditional software because it is a fundamentally better business model for the customer and the vendor. Even Oracle and SAP are attempting to change their mix (spoiler alert: they will fail). Yet in eight years, Wall Street seems to have learned almost nothing. And with the Subscription Economy growing in communications, media, consumer services and more, you would expect that Wall Street analysts would finally have a better handle on the metrics that do matter.

For example, the most important financial statistic for valuing Salesforce.com is buried as a footnote on page 11 of its FY 2011 annual report — “Select off-balance sheet accounts” — $2.2 billion in unbilled deferred revenue. But that’s not a GAAP metric, so it’s not reported. You won’t see it on a balance sheet. You won’t read it in an earnings release. And you won’t hear a CFO talk about that on an earnings call.

Zuora often discusses the three metrics that matter when valuing any SaaS business. We believe that Annual Recurring Revenue (ARR) drives everything. A company’s Growth Efficiency Index (GEI – the sales and marketing expense needed to acquire new dollars of ARR), retention rate, and recurring profit margin (how much non-sales and marketing dollars are spent on servicing existing ARR) tell you far more than profits. But not a single one of these metrics is disclosed in GAAP financials. That’s a disservice to the companies, to analysts and to individual investors.

The other day, I saw that Salesforce.com’s P/E ratio had reached 666. Chat board posters were making half-joking calls for widespread selling with the sign of the beast at hand. But unless better metrics are made clear for investors, they may as well depend on the science of the Dark Ages for next quarter guidance. The Subscription Economy is here, and it is here to stay. It’s time that Wall Street finds a way to institute new measurements of subscription companies based on the financial statistics that actually reflect its health, value and future prospects.

Tien Tzuo is CEO of Zuora, a subscription-billing company based in Silicon Valley. Previously, he was the chief strategy officer and chief marketing officer at Salesforce.com.


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