LZ - LegalZoom: A Wait And See Situation

2023-11-01 22:43:31 ET

Summary

• LegalZoom has not proved a good investment thus far since coming public in 2021.
• The company is a market leader in the online legal advice business and has significant growth potential.
• LZ valuation has come down significantly, and the stock now appears fairly valued relative to the S&P 500 and peers.
• A large insider recently sold a significant amount of stock, raising questions about the company's prospects.
• I am initiating LZ with a hold rating and want to see the company deliver on its growth objectives before considering buying the stock.

Since coming public in 2021, shares of LegalZoom.com, Inc. ( LZ ) have not been a good investment. Since inception, LZ has delivered a total return of -73.5% compared to a -0.1% total return posted by the S&P 500.

While LZ shares have proved a disappointing investment thus far, the company remains well-positioned to benefit from a secular trend toward online legal services. However, earnings have proved highly cyclical and profitability remains a challenge due to the highly competitive environment.

Company Overview

LZ is a leading online platform for legal and compliance solutions in the U.S. The company operates across all 50 states and offers formation, compliance, tax advice and filings, virtual mailbox solutions, trademark filings, and estate plans.

LZ combines technology and people to offer solutions at transparent, flat-fee prices which are often at a significant discount to traditional offline alternatives.

Transaction revenue accounts for ~35% of revenue while subscription revenue accounts for ~60% of revenue with partner revenue accounting for ~5% of revenue.

Transaction revenue is driven by new business formations and tends to be highly volatile. Subscription revenue is driven by compliance and legal services and tends to be much more stable. Partner revenue consists of one-time or recurring fees earned from third-party providers from leads generated through the LZ platform.

Highly Competitive Business

LZ faces competition from a variety of players including offline law firms and attorneys, online legal document services, legal plans, secretaries of state, tax preparation companies such as Intuit ( INTU ), and other service providers.

LZ has built its market position based on a breadth of offerings, price, brand name recognition, reputation, and customer service. However, despite being in business since 2001 LZ continues to struggle to generate profits, which serves as evidence of the competitive nature of the business LZ operates in.

The total addressable market for LZ is estimated at ~$49 billion. Currently, LZ has just 1% market share and thus the growth potential remains significant.

Historical Financial Performance & Long-Term Targets

As shown by the table below, LZ has enjoyed significant, but volatile, revenue growth over the past 3 years. Margin levels have also been highly volatile.

LZ has noted that their "long-term targets" are not projections but rather goals. That said, the company's strong Q2 2023 results suggest these may be attainable. During Q2 2023, LZ posted an 18% Adj. EBITDA margin and 22% FCF Margin, both represent significant increases from the past few quarters.

Consensus Analyst Growth Estimates

As shown by the tables below, current consensus estimates call for EPS growth of ~26% and 19% for 2024 and 2025, respectively. Consensus revenue growth estimates for 2024 and 2025 are ~9% and ~14% respectively. Thus, from these metrics, it appears Wall Street analysts are confident that LZ will be able to achieve margin improvements.

LZ Books

In August 2023, LZ launched its accounting solution LZ Books. LZ Books was launched to help customers navigate the complexities of bookkeeping and taxes.

LZ CEO Dan Wernikoff highlighted the LZ Books opportunity on the Q2 2023 conference call:

Based on a recent customer study, roughly two-thirds of our formation customers are solopreneurs, which we define as either single member LLCs or sole proprietors. Over 90% of our formation customers form with us before they consult a business tax professional and only a little over 5% have established a bookkeeping method prior to forming with us. We’ve built what we believe to be the most well-designed solution for this large market. With LZ Books, you’ll be able to create your first proposal with access to an attorney if needed, send it for digital signature go from invoice to electronic payment, download and auto categorize expenses from your bank account and even more importantly, seamlessly integrate with LZ Tax.

During the launch, we’ll also be providing free unlimited access to a CPA through the product to introduce and promote the value of our highly vetted network of accountants. LZ Books reaches across all our strategic pillars, our first strategic pillar is to scale the business and LZ Books represents a new customer entry point for LegalZoom. LZ Books can serve an SMB that formed with us already or someone who has not yet formed, but is looking for a simpler lower-priced alternative to today’s bookkeeping solutions.

LZ will be competing directly with QuickBooks, which is owned by Intuit and thus it will be interesting to see how quickly LZ is able to gain share given a well-entrenched leader. Moreover, the success or failure of LZ Books will shed considerable light on the degree of competitive advantage LZ has given that it is often the first touchpoint when individuals start a company.

Valuation

LZ trades at ~22x forward earnings compared to ~17x for the S&P 500. While LZ has the potential to grow earnings faster than the S&P 500, LZ experiences much higher earnings volatility. Moreover, as shown by the chart below, LZ has not been profitable since becoming a public company.

INTU is arguably the most relevant comp while I also view Wix.com ( WIX ) as relevant. LZ is trading at just a modest discount to INTU and in line with WIX. Given INTU's market-leading position in the do-it-yourself tax advisory business and a strong history of profitability, I believe this discount is warranted.

LZ is trading cheap to its historical average forward P/E but, given the company's relatively short public history, this is mostly a reflection of the fact that the stock price is trading at the low end of its historical range. Thus, I do not view LZ as highly attractive relative to its own historic valuation given the previous overvaluation of the stock.

Large Secondary Stock Sale

In early September 2023, a large LZ shareholder sold 14 million shares (representing ~7% of shares outstanding) via an underwritten public offering at a price of $10 per share. In addition to the public share offering, LZ repurchased ~4.7 million shares from the same shareholder for $9.55 per share. An existing shareholder, Technology Crossover Ventures agreed to acquire an additional ~2.1 million shares from the selling shareholder at a price of $9.55 per share.

Prior to the announcement of these large sale sales by a large stockholder, LZ shares had been trading at $11.3 per share and thus the selling shareholder was forced to accept a large discount to the stock price to get the deal done.

Based on public SEC filings , the stockholder is LocusZoom, LLC which is an entity controlled by Permira Funds. In total, Permira registered ~38 million shares for potential sale which means additional share sales may lie ahead. Permira became LZ's largest shareholder in 2014 when LZ was a private company.

While a large sale of stock by one of the company's biggest holders is generally not a positive event due to the asymmetrical nature of information. I am encouraged by the fact that Technology Crossover Ventures increased their stake as they were already one of the company's largest shareholders (14.3 million shares as of June 29, 2023). Moreover, private equity firm Francisco Partners continues to be a large shareholder owning ~28.6 million shares or ~15% of the outstanding shares as of June 29, 2023 (the last time their holdings were publicly reported.)

Q3 2023 Earnings Preview

LZ is expected to report Q3 2023 results on November 7, 2023. Consensus estimates call for the company to report EPS of $0.09 per share, which represents a year-over-year change of +80%. Revenues are expected to come in at $160.09 million, which represents a 3.7% increase on a year-over-year basis. In addition to focusing on the top and bottom line figures, I believe market participants and analysts will be highly focused on the LZ Books rollout. Given the recent weakness in LZ stock due to the large secondary sale in September, I believe shares could move sharply higher if the company reports a better-than-expected quarter.

Conclusion

LZ represents an interesting secular growth story that may have significant runway given the large addressable market (~$49 billion) and current market share of ~1%. However, the legal services market is highly competitive and LZ has struggled historically to generate positive profit margins.

Recent results have been encouraging and the company has aggressive long-term financial goals. Consensus estimates call for relatively high levels of earnings growth over the next few years suggesting Wall Street is confident that LZ can deliver.

LZ valuations appear reasonable compared to the S&P 500 and INTU given the growth potential.

I am initiating LZ with a hold rating as I prefer to wait and see how the company performs after the recent share sale by a large insider. Moreover, I want to see how the company's LZ Books rollout goes and if recent margin improvements can be sustained.

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