LZ - LegalZoom: EBITDA Margin To Continue Expanding As Business Productivity Increases

2023-07-21 06:43:32 ET

Summary

• I expect EBITDA margins to expand due to productivity gains and top-line growth as the economy recovers.
• LZ's freemium business model should drive gains in market share, and the incorporation of generative AI should enhance its forms and contracts portfolio, providing a growth driver.
• Risks include the potential for the freemium model to disrupt LZ's ability to increase margins if the conversion to paid users doesn't take off as expected.

Overview

I recommend a buy rating for LegalZoom (LZ) as I expect margins to continue expanding as LZ reaps the benefit of productivity gains and also top-line growth when the macro gradually recovers. This is a reiteration of my buy rating for LZ previously, in which I believed margins should improve over time given management's cost-optimization strategy and the expectation that guidance was quite conservative.

Macro recovery to support growth

To broaden the base of potential subscriptions, management has rolled out a free product option since 2Q22. As the name suggests, it is a free product that reduces the psychological barrier of adoption. This enables LZ to "land" a new customer easily - which I deemed as the toughest part of the entire customer acquisition cycle.

Recalling management's words at the Raymond James Technology Investors Conference in December 2021:

"the way to think about a freemium model could be as simple as, we will do the registration for free, and then here are the things you need to start your operations, if you're ready to start your operations, which will be fee-based. But that in and of itself would open up the top of the funnel pretty considerably for people who are extremely price-sensitive"

The operating environment today has put a lot of businesses into the "price-sensitive" category, in my opinion, and LZ's freemium business model should help it gain market share as it would fare relatively well against a paid solution. While these new adds from the freemium model might be loss-making today (no revenue), I expect it to help drive growth once the macroeconomic environment improves as these users would require more services (related to operating the business) from LZ that are fee-based.

This was evident in LZ's 1Q23 results, where its new business formations increased by 32% y/y to 170K, which was higher than the 4% growth in US business applications measured by U.S. Census data during the same period. This suggests that LZ gained ~28% market share. With LZ's freemium model gaining traction, I anticipate a steady flow of new business formations in 2Q23, though management has dampened my enthusiasm by expressing caution that they anticipate the second half of the year will still be vulnerable to a recession.

In spite of my confidence in LZ's continued market share expansion, I think it's important to keep in mind that LZ's growth in the second half of the year will appear weaker than in the first half of the year because it will face the higher comp in 2H22 where it benefited from the initial expansion of rollout of free products. However, in the long run, I anticipate that LZ's organic growth profile will improve as a result of a combination of an improved macro backdrop and the continuous traction in the freemium model.

Generative AI is a tailwind

Management is actively engaged in exploring and considering the use of generative AI, which is now widely prevalent. During the recent earnings call, they discussed the challenges related to replacing licensed legal professionals with AI, both from a technical and regulatory standpoint. They also highlighted the complexities of navigating the ecosystem in this regard. Management praised the benefits of cutting-edge technologies and emphasized that LZ has been dedicated to leveraging technology for the past two decades to make legal services more accessible to everyone, with a particular focus on meeting the needs of underserved Americans without access to legal counsel.

To address this goal, management has informed shareholders that they can expect further updates on the company's strategy in 2H23. During this time, they plan to incorporate ChatGPT and generative AI technology into their existing portfolio to enhance the capabilities of the current attorney network.

Here are my thoughts on generative AI impact on LZ. While generative AI like ChatGPT allows the typical user to find legal terms and other related data easily, I don't see this as a threat to replacing a licensed legal professional. Before dwelling on this, take a step back and think about it. All sorts of legal information can be easily found on the Internet, however, individuals still seek formal aid from a legal professional. Why? Because knowing and applying are two different things. An individual might know what the law is but not know how to effectively apply it in different situations or scenarios, which is where a licensed legal professional steps in.

Management has also framed up the generative AI's positive impact on the business as well. According to the FY22 earnings transcript:

"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"

A prime area that I think LZ will see immediate results is in the forms and contracts portfolio. Since there are many standard and repetitive procedures (in filling up forms and contracts), I believe that LZ will benefit from incorporating generative AI to further enhance this portion of the portfolio. In a recent earnings call, the company's management stated that forms and contracts contribute less than 5% of revenue and highlighted the recent investments made to revitalize these offerings after a 10-year investment hiatus. Therefore, I believe that generative AI is a benefit for LZ because it enables the company to further improve this segment of the portfolio, thereby providing yet another growth driver.

In the coming quarters, I expect management to provide more information on this, which should instill more confidence in investors that are worried about generative AI impacting the business.

Expect margin to improve

LZ reported 1Q23 adj EBITDA of $21.9 million, which translates to 13% margin that is $5 million ahead of guidance and 2% ahead of consensus on margins. I believe this is the result of LZ growing marketing efficiencies as a result of the transition to freemium (which requires lesser marketing efforts as they are inbound leads driven by the opening up of top-of-funnel, attracting price-sensitive users) and the continued emphasis on automating processes (source: 1Q23 earnings call). I think it's great that LZ is putting effort into improving productivity, as this will allow them to process orders more quickly (think of it as increasing the utilization rate on a fixed asset; the incremental orders carry a high incremental margin). It's encouraging to hear that management recognizes there's room for improvement in the company's operations and is committed to taking the steps needed to achieve their goals.

Valuation

Using consensus estimates, I value LZ at $16.76. I expect LZ to meet FY23 guidance, despite my belief that management's guidance seems conservative given the performance in 1Q23. Growth should start to inflect to a low- to mid-teens level as I expect the macroeconomy to gradually recover. LZ trades at 3.7x forward revenue as of the time of writing. This is a premium to peers' median forward revenue multiple of 1.47x. I think LZ deserves this premium given its expected growth premium of low- to mid-teens vs. peers' median growth of low to mid single digits.

LZ's peer group includes other commercial support service players such as CBIZ ( CBZ ), Korn Ferry ( KFY ), First Advantage ( FA ), ZipRecruiter ( ZIP ), Huron Consulting Group ( HURN ), Kforce ( KFRC ), ASGN ( ASGN ), AMN Healthcare Services ( AMN ), and ManpowerGroup ( MAN ).

Risk

The downside of a freemium is that it might disrupt LZ's ability to increase margin as the conversion to paid users does not take off as expected, or takes longer than expected. This will impact the margin improvement equity story that investors (like myself) as looking forward to. Delay in margin/profitability improvement will likely put pressure on the stock.

Conclusion

In conclusion, my recommendation remains a buy rating for LZ. I believe that LZ's EBITDA margin will continue to expand due to productivity gains and the positive impact of a potential macroeconomic recovery. LZ's freemium business model should drive market share gains, and incorporating generative AI will further enhance the forms and contracts portfolio, acting as a growth driver.

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