LZ - LegalZoom: A Case For Buying Ahead Of Q1 Earnings

2023-05-02 06:37:04 ET

Summary

• A recent upgrade for LegalZoom supports strong quant ratings and an apparent bearish to bullish reversal in the stock.
• A successful transition to the subscription model is one key tenet of the investment theme.
• Improved profitability is another key tenet of the investment theme.
• Google search trends indicate potential upside in business formations that could in turn generate an upside revenue surprise, especially if business conditions have not deteriorated as much as expected.
• Conditions look good for taking a small risk in buying stock just ahead of Q1 earnings.

LegalZoom, Inc ( LZ ), a provider of legal services and solutions, got my attention after an upgrade from JMP to market outperform from perform created a technical breakout for the stock. The price action formed what might finally be a long overdue bottom for LZ. The sustainability of this breakout depends on the success of a pivot to a freemium model bolstered by subscription over transaction services. I took a closer look at the earnings report, especially the conference call , to assess the prospects for LegalZoom to navigate the coming challenges of a potential economic slowdown/recession. I decided that starting purchases ahead of earnings is worth the risk.

Strategy

LegalZoom has a three-point strategy developed by the current CEO after joining the company:

• Scaling the core operations for business formations – up 61% since 2019.
• Creating an ecosystem of subscription services – revenue up 73% since 2019.
• Introducing integrated experts.

The company is “building the product experiences that…can help businesses better succeed at the time of formation and beyond, especially during this economically challenging time.” Efficiencies and investments have facilitated the creation of the ecosystem of subscription services. At the same, LegalZoom is reducing costs associated with fulfilling LLC transactions. LegalZoom is also expanding its product and service offerings like expert-assisted LZ Tax attorney-assisted trademarks. The competitive market means LegalZoom must always look for ways to innovate.

Financial Performance

While the LegalZoom portfolio looks attractive, the company’s financial performance is underwhelming in this moment of economic challenges.

LegalZoom reported 3% year-over-year growth in total GAAP revenue even as transaction revenue declined by 10% year-over-year. Subscription revenue offset that decline with 13% year-over-year growth. Seemingly, this mix was expected as the company transitions to a subscription model using a freemium offering to promote new customer acquisition. A successful transition to the subscription model is a key tenet of the investment theme. However, current macro-economic pressures are slowing the business formations key to LegalZoom’s growth. For now, the company is leaning on its ability to take share through the attraction of freemium plans and partnership deals. LegalZoom achieved its largest share gain over the last two years. Still, the company expects continued anemic revenue growth of 2% in 2023. The freemium product should be accretive to revenue after this year.

Gross margins will likely decline slightly from higher filing fees as a percentage of revenue from the rollout of the freemium product. The company is rationalizing marketing spend and expects improved marketing ROI to generate a 16% margin this year, up from 10% in 2022. Margin guidance for Q1 is 11%. Improved profitability is another key tenet of the investment theme.

The Competition

I was really intrigued by the possibilities with LegalZoom increasing market share at a time when the Census data shows business formations slightly down in Q4. The company talked a little about its various efforts across SEM (search engine marketing), SEO (search engine optimization), and social media ads. The search trends for LegalZoom seem to support a sustainably robust competitive position. There also could be a small upside surprise on the horizon for business formations based on the search trends for “how to start a business” and “how to form a business.”

Search interest in “how to start a business” ticked upward notably after the pandemic starting July 2020. Baseline interest has remained higher than adjacent pre-pandemic years. A recent uptrend in the lower volume search on “how to form a business” signals a subtle improvement in overall interest in business formations. This search interest is now at an all-time high.

LegalZoom performs exceptionally well in brand SEO. The next two charts show LegalZoom sits far above a host of its closest competitors. However, this year’s apparent seasonal rise in search interest is not as strong as the prior year. This small decline could be the result of lower brand media spend. Still, LegalZoom’s competitors do not appear to benefit from this seasonal effect. The company has a lot of room to find efficiencies in its spend.

Generative AI (ChatGPT)

Is generative artificial intelligence ((AI)) competition for LegalZoom? An analyst asked this question during the earnings conference call. Management went straight from the general technology to the specific implementation in ChatGPT:

“I think we could leverage ChatGPT as a way to enable our experts to be more productive. I mean if you think about – if you consider a law firm in the role of a paralegal, in a lot of ways what we try to do as an expert platform is be a paralegal for our attorneys. And the function of getting and summarizing data is sort of tailor-made for that and helps the expert be much more efficient. So that’s a good example of how we might leverage it.”

At the same time, management dismissed the potential for generative AI to improve the user experience for the government sites used for licensing and certifying business formation: “…I don’t believe the government will adopt as quickly as we can. And so the Secretary of State sites probably won’t get as much innovation out of ChatGPT. So net-net, I think it’s a tailwind.”

I think this is something to watch closely. I want to see the specifics of these tailwinds in coming earnings reports. The recent implosion in Chegg ( CHGG ) from its students’ sudden interest in and use of ChatGPT is a cautionary tale for any business sitting in the path of generative AI’s advance. Companies like CaseText are already finding innovative ways to use generative AI to support the work of attorneys.

LegalZoom exists to “democratize law.” Legal and regulatory requirements can be difficult and outright onerous for individual and small business owners, at the same time hiring attorneys can be prohibitively expense for even routine legal matters. A generative AI implementation that guides applicants through the tangled web of government sies could be a major innovation and disruptor. However, given the costs of mistakes and poor guidance, I believe LegalZoom is correct in concluding that there is a very long road ahead before governments adopt these tools.

There are other ways LegalZoom could use generative AI to innovate in its business:

• Automate routine legal tasks, such as document review or contract drafting.
• An AI platform as a shared service to support attorneys that sign up with LegalZoom.

What To Look For In Coming Earnings

While LegalZoom shows a lot of promise, execution risks of course exist. Accordingly, I am watching a few key points besides tracking actual performance versus guidance (which I hope is very conservative):

1. Revenue and demand growth: Is there any potential for upside surprises? Management said that it had yet to see signs of a recession they expect to unfold in the last half of the year. If those signs continue to lag, then perhaps some upside revenue surprise could emerge from stronger than expected business formations.
2. Margins, costs, and profits: Is the rationalization of marketing spend impacting customer acquisition negatively? The year-over-year decline in brand search interest could be a negative instead of a confirmation of more efficient marketing.
3. Balance sheet: Is the company continuing to purchase shares while hover at such a steep discount? In Q4, LegalZoom repurchased 3.6M at an average $8.66/share at a total cost of $31M. The company is working with an authorization to repurchase $150M in shares. That amount is 9% of the current market capitalization.
4. Strategy: Is the freemium rollout continuing as expected? Surprisingly, the company expects it to be revenue-neutral this year. Is this guidance still on track?

The Trade

As I mentioned earlier, LZ broke out above resistance thanks to a timely upgrade. The resistance from the 200-day moving average ((DMA)) transitioned to providing support for the pullback from the gap up response to the upgrade. I accumulate shares into this pullback. I am assuming “this time is different” given LZ’s prior breakouts failed at 200DMA resistance while the 50DMA was still in a downtrend. Now, the 50DMA is trending upward.

Stock Chart

I also like the Quant Ratings in total. While valuation and profitability have low ratings, I expect both to improve in due time. The Quant Rating is a strong buy, and LZ rates an A+ on growth.

If my buy thesis is wrong, the price action should quickly reveal my error with a fresh breakdown below important support levels. However, I plan to hold on under the assumption that over a longer timeframe, LZ is making a bearish to bullish reversal with the current turn since the Q4 2022 earnings report.

Be careful out there!

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