CHGG - LegalZoom Survived A ChatGPT Scare So What's Next?

2023-06-13 09:26:51 ET

Summary

• LegalZoom's Q1 earnings report showed strong performance and a strategic vision for leveraging AI, dispelling concerns about the impact of generative AI like ChatGPT.
• LegalZoom plans to use AI to streamline operations, increase efficiency, and expand demand for its legal services, with upcoming AI-enabled product releases in the pipeline.
• LegalZoom's healthy balance sheet, growing market share, and clear product strategy make it an attractive investment, despite recent share price increases.

In the week ahead of Q1 earnings, LegalZoom ( LZ ) stock mysteriously plunged. I could not find company-specific news to explain the sudden and sharp selling. Sympathy selling looked like the probable suspect. Panic selling cascaded from online learning platform Chegg, Inc. ( CHGG ) earnings where the company acknowledged taking a hit from generative AI. Suddenly, any company that processes language as a part of its core business model looked vulnerable. The accompanying panic selling in LZ made the stock even more attractive than my case for buying LZ ahead of earnings where I covered some generative AI. As it turned out, LegalZoom survived the ChatGPT scare.

The company delivered earnings that reassured analysts and investors with strong, yet conservative, guidance. Most importantly for the narrative, management delivered a compelling strategic vision for its use of AI. They reminded investors that LegalZoom has been working to leverage AI to increase efficiency and to expand demand for its legal services.

As a result, LZ surged 25.0% post-earnings and has continued pushing higher from there. At the time of writing, LZ trades near a 52-week closing high as it wrestles with resistance from the top of a post-earnings fade from August, 2022.

So what is next for LegalZoom now that the ChatGPT scare is apparently over? Interestingly, neither management nor the analysts in attendance at the conference call speculated about the pre-earnings weakness. Instead, the earnings call was all about reinforcing the messages from the previous earnings report, looking forward to new product releases, and firming guidance for the year.

The Generative AI Opportunity

The following summary comes from the Seeking Alpha transcript of the Q1 earnings conference call .

CEO Dan Wernikoff left no doubt that LegalZoom considers AI to represent an opportunity for the company: “Just as we feel good about the long-term prospects of the macro, we also anticipate growth opportunities as we begin to leverage generative AI.”

Generative AI will allow LegalZoom to streamline operations. “The most exciting opportunity we see is eliminating inefficiencies in the contract drafting and review process,” stated Wernikoff. This strategic direction came from the 2022 acquisition of Revv and a reinvestment in forms. This reminder about the acquisition signaled the company’s existing efforts to keep pace with advancing technical capabilities. ChatGPT is not catching the company off-guard.

Management further emphasized their preparation by revealing that part of their coming product releases will include AI capabilities. Wernikoff proudly reminded analysts that, “We’ve hinted multiple times that you should expect new product releases in the back half of this year that will provide clarity on our strategy with attorneys”, and then revealed “the foundation for this is a new contract and forms platform that will leverage AI.” Forms and contracts are currently under 5% of LegalZoom’s revenue (including the estate planning business). Thus, this business also represents significant upside potential. AI-enabled tools will also create new demand that is currently dormant.

During Q&A, Wernikoff provided the bottom-line about the company’s preparation for adopting new technologies: “What I don’t think everybody fully appreciates is that our whole purpose for the first 20 years of our existence has been to leverage tech to make legal services accessible.”

Wernikoff reassured analysts that, “I’ve been through these shifts a couple of times before.” He went on to explain that disruptive technologies like ChatGPT first get applied broadly and next get configured for vertical specific use. As an example he differentiated the generalized ability to scrape the internet to generate templates for terms of services versus leveraging an internal data set on small business vendor contracts and geographically based terms. Yet, he also acknowledged that “you get to a place of diminishing return eventually, and it becomes a little bit more of a long tail of smaller improvements.” The company guided to larger improvements in the next six months and then subsequent moderation.

While AI will bring new efficiencies, regulations regarding the unauthorized practice of law will preserve important roles for attorneys. LegalZoom distinguishes itself by leveraging a large ecosystem of independent attorneys. A recent courtroom incident highlighted the need for human intervention and supervision for legal work . A New York judge chastised a lawyer who submitted a legal brief which referenced non-existent legal cases generated by ChatGPT (the classic generative AI hallucination problem). LegalZoom plans to use its network of attorneys to “bridge [ChatGPT’s] shortfalls.”

Overall Guidance

LegalZoom still anticipates a recession later this year and maintains its conservative macro assumptions for the second half of the year. Yet, the company will continue its acceleration of investment in product and technology. For the full year of 2023, the company raised total revenue guidance to $630M to $650M representing a 3% year-over-year growth at the midpoint. This increase translates into adjusted EBITDA increasing to $105M. Second quarter revenue should print between $166M to $168M for 3% year-over-year growth, and adjusted EBITDA should print between $27M to $28M.

Management remains “highly confident” that LegalZoom will drive at least 15% growth in market share thanks to a new product portfolio and refreshed marketing messaging. Q1’s strong performance supports this confidence. Business formations soared 32% year-over-year to 170,000. Formations growth outpaced the market’s 4% growth according to U.S. Census data. Market share grew 27% year-over-year. Tougher comps hit in the coming quarters as the company laps the initial testing and expanding rollout of its free products.

Balance Sheet

LegalZoom continued to support its stock with share repurchases. In Q1, the company repurchased 771,000 shares at an average share price of $8.78 at a total cost of $7M. LegalZoom ended the quarter with cash and cash equivalents of $204 million and no outstanding debt. Cash and cash equivalents increased 8.0%% quarter-over-quarter.

Conclusion and The Trade

Despite earlier concerns regarding the impact of generative AI, LegalZoom emerged unscathed from its Q1 earnings release. A bearish to bullish reversal continues apace for LZ.

The company leverages artificial intelligence as an opportunity, enhancing efficiency and stimulating demand for its services. Through strategic acquisitions and reinvestment, LegalZoom is strengthening its technical capabilities to keep up with advancements like generative AI. The future looks promising with upcoming AI-enabled product releases that will transform the legal contract and forms business. CEO Dan Wernikoff’s reassurance about the company’s readiness for adopting new technologies, while retaining human legal expertise, nullified the ChatGPT scare.

Furthermore, LegalZoom’s financial performance remains solid and serves as a foundation for resiliency through a potential recession later in the year. The share repurchase program, which has spent to-date $102M buying back 10M shares, attests to a healthy balance sheet. With growing market share and a clear product strategy, LZ remains an attractive investment.

Given the recent run-up in the share price, I reduced my recommendation from strong buy to buy. This change reflects my preference to buy dips rather than chase the price higher. Still, valuation remains reasonable with a price/sales ratio of 4 which is less than half of levels from LZ’s first days of public trading. I expect the company to grow into its double digit forward price/earnings ratio , currently at 38, given the buyback and the momentum from a reduction in the net loss per share from $0.13 a year ago to $0.01 in Q1 2023.

Be careful out there!

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