Buy Zendesk As New Services And Larger Customers Will Drive Growth (NYSE:ZEN)

Buy Zendesk As New Services And Larger Customers Will Drive Growth (NYSE:ZEN)

Recent Updates

Zendesk, Inc. (ZEN) recently reported Q2-20 results, with quarterly revenue of $246.7m (up 27% YoY) ahead of CapIQ estimate of $240.5m. Second-quarter EPS was also ahead of expectations, reaching $0.14 vs. CapIQ estimate of $0.10.

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The company saw healthy demand from both smaller and enterprise customers, offsetting the weakness seen in their midsize clients. Net dollar expansion rate dropped to 111%, lower than historical values but still in line with the 110-120% projected by management in a stable economic environment. Given the company’s exposure to small and mid-sized customers, the drop in retention rate is likely macro-driven and the value should drift back as the economy slowly recovers from COVID-19. GAAP gross margin came in at 75.1% for Q2-20, up 470 basis points YoY; non-GAAP gross margin was 78.2%, up 360 basis points YoY. Gross margin expansion was largely driven by the constant optimization of cloud resources. Operating margin expanded by 14 percentage points, mainly driven by gross margin expansion and prudent expense management.

Despite the positive quarter, Zendesk saw its price drop as much as 11.4% after the announcement, as investors raised concerns on the company’s ability to continue growing in this new economic environment. According to the company’s Q2-20 press release:



We believe our financial performance will continue to be impacted by uncertain and highly disrupted global economic conditions. Many customers continue to face end-market demand challenges and we are seeing higher levels of contraction compared to historical trends (source)

The stock quickly rebounded and is now up almost 24% YTD at the time of writing.

For Q3-20, management expects revenue between $250m-255m (20% YoY growth at the midpoint), with non-GAAP operating income between $10m and $14m. While Zendesk will continue to provide guidance only on a quarterly basis, management expects free cash flows to be positive during the second half of 2020, with FY2020 FCF projected to be neutral to slightly positive as cost-cutting initiatives are realized. In 2015, the company set the ambitious goal of reaching $1bn in total revenue by 2020; five years later and despite the current economic environment, management is still optimistic they will reach this goal.

In June 2020, for the fifth year in a row, Gartner named Zendesk a leader in its famous Magic Quadrant for the CRM Customer Engagement Center.

Opportunity Summary

Key catalysts include:

  1. The company is expanding upstream to larger customers while still offering free trials and compelling solutions for SMB clients.
  2. Zendesk doesn’t compete directly with salesforce.com (CRM) or Microsoft (MSFT), as the overlap remains small at the moment.
  3. The company keeps expanding its offering by introducing new solutions and cross-selling new products to existing clients.

Key risks include:

  1. While overlap with big tech names is still small, as Zendesk continues to move upstream, it is likely to face intensifying competition.
  2. As the company is moving upstream, the move could cause Zendesk to lose focus on its SMB customer base.
  3. Zendesk might struggle to have a higher dollar-based retention rate as SMB customers tend to have higher churn than enterprise customers.
  4. As Zendesk faced execution issues in 2019, problems could continue through 2020 and beyond.

Investment Thesis

Zendesk is a leader in the customer service and engagement software space; the company was founded with a focus on simplicity and the aim to provide a faster and better customer support than existing solutions. In recent quarters, larger customers drove more than 40% of annual recurring revenue, and enterprise clients are generally stickier than SMB customers.

The company has been successful in the typical land and expand strategy, as Zendesk usually lands a client with one single service (or a limited number of services) and then expands its offering by cross-selling additional services to existing customers. Support remains Zendesk’s largest solution, with around 80% of revenue coming from existing customers. The company has a substantial market opportunity ahead, as management estimates a total addressable market of around $20 billion:

Source: Zendesk’s Investor Event Deck

Competition includes tech giants like Microsoft, salesforce.com and Oracle (ORCL), but the target market is large enough and competitive overlap remains relatively small, and Zendesk can successfully carve its own niche by simply providing quality services at a reasonable price to larger SMB customers.

Zendesk offers a variety of applications that integrate with one another and with other popular and legacy applications through APIs. Its flagship product is Zendesk Support, which helps companies tracking and resolving customers’ queries across various departments. Other key applications include Chat, Talk, Guide, Explore, Sell, and Connect (Support, Chat, Guide and Talk are often offered as a bundle as well). The company also launched Sunshine in 2018, a CRM platform with development tools that allows clients access to customers’ statistics and tools for further customization. Prices go from $5 per agent per month for the most basic version of Support, while the Zendesk suite is priced at $149 per agent per month for the enterprise version (for the annual subscription term; monthly subscription term comes in at $179).

The company acquired its first 10,000 customers through search engine marketing and, since then, it has gradually expanded its offering, making it more suitable for larger SMB customers. In 10 years, the company went from 4,850 paid customers account in 2010 to 157,000 accounts as of January 2020:

Source: Zendesk Investor Presentation – CEO note

Today, more than 40% of Zendesk’s AAR in any quarter comes from clients with more than 100 customer service agents. Interestingly, even if enterprise customers (500 or more employees) continue to rise in Zendesk’s revenue mix, the company still offers free trials of its software.

Zendesk benefits from high switching costs, primarily due to:

  • Time and expense necessary to implement a new software package. A major implementation will likely take several years.
  • Indirect costs associated with new software implementation, such as lost productivity as customers move up the learning curve on the new software.
  • With every software change come operational risks, which include the risk of losing valuable data, slower project execution and operational disruption.

Once customers start using one of Zendesk’s software, they are locked in an ecosystem of software products that work seamlessly together. Given these high switching costs, customers tend to change software providers only if strictly necessary and Zendesk has been extremely successful in capitalizing on its competitive position, as switching costs have historically helped the company to grow its top-line while maintaining a healthy dollar-based expansion rate. In any quarter, 80% of revenue comes from existing customers, while dollar-based net retention rate has been 115-120% over the last several years.

High switching costs, a history of strong top-line growth, large addressable market and a unique position in the larger SMB customers space make Zendesk a company worth considering.

Business Overview

Zendesk is a software development company that provides SaaS services to SMB and enterprise customers.

Source: S&P Capital IQ

Its flagship product, Zendesk Support, provides clients with the ability to track, prioritize and solve customer need across multiple channels. Other services integrate perfectly with the Zendesk Support platform and include Zendesk Chat, Zendesk Guide and Zendesk Talk:

  • Zendesk Chat is a live chat software that helps organizations to quickly connect with clients.
  • Zendesk Guide gives companies the opportunity to provide clients with articles and forums.
  • Zendesk Talk is a cloud-based call center software that provides phone support between organizations and their clients.

Together with Zendesk Support, the company offers the Zendesk Sell platform, which is a CRM software that complements the company’s aim to offer an overall better customer experience. Other products include: Zendesk Sell Suite which provides Sell and Chat plus other features, Zendesk Gather which gives companies the ability to provide customer service though online forums, Zendesk Duet, which includes both Support and Sell for a single price, Zendesk Sunshine, a CRM platform that allows companies to gather and integrate data collected through other Zendesk’s services, and Zendesk Sunshine Conversations, a messaging platform which helps companies reaching customers through social media messaging. Finally, with the Zendesk Support Suite bundle, the company provides access to Support, Chat, Talk Guide and Sell for a unique price.

Almost all revenues are coming from subscription fees, which mainly include fees from Zendesk Support and, to a lesser extent, from Talk, Guide, Chat and Sell. Subscription fees are recurring revenue which are usually non-refundable, regardless of the actual use of the service. Subscription revenues are affected by:

  1. Number of customer accounts
  2. Number of agents
  3. Type of plan purchased by customers

Revenues are recognized over the term of the agreement, beginning on the date the service is made available to customers.

Source: Q2-20 Shareholder Letter

As of June 30, 2020, the company had 164,200 paid customer accounts, including around 84,100 paid customer accounts on Support (which remains the company’s core offering), 40,600 paid accounts on Chat and approximately 39,400 paid accounts on other products. As of June 30, 2020, net dollar-based retention reached 111%, and management sees a possible further decline in the metric as the company continues to grow its top line and add larger paid customer accounts.

As of Q2-20, more than half (52.9%) of total revenue are coming from the United States, with the EMEA region representing 27.9% of total revenue:

Source: Zendesk’s 10-Q report, June 2020

As the company keeps moving upmarket to serve large enterprise customers and deliver more complex solutions, it is expected to offer longer-term contracts, thus increasing its remaining performance obligations (RPO). RPO is a key operating metric, as it represents future revenues that are under contract but have not yet been recognized. In Q2-20, both short-term RPO and long-term RPO were impacted by a reduction in average subscription length, driven by uncertainty of economic conditions following COVID-19:

Source: Q2-20 Shareholder Letter

In May 2019, Zendesk completed the acquisition of Smooch Technologies Holdings ULC, a developer of messaging technology, for a total consideration of $72 million. In Q2-20, the company finalized the accounting procedures and recognized a total Goodwill of $58.3 million generated from the transaction:

Source: Zendesk’s 10-Q report, June 2020

The company is in a solid financial position, with safe balance sheet and improving margins. Capital has historically been allocated to growth and acquisitions (with a handful of deals totaling around $150 million), with no buybacks or dividends on the horizon. Zendesk currently has $997.3m Cash and Equivalents available and around $1.2bn in interest-bearing debt (including capital leases). In June 2020, the company issued $1.15bn in convertible senior notes at 0.625%, maturing June 15, 2025.

Free cash flow margin has historically been in the mid- to upper-single digit range over the last several years ($18.2m TTM FCF) and it is expected to gradually improve as the company keeps growing its top line and its EBITDA margin (expected to reach 13.2% by FY2022).

Management

Co-founder Mikkel Svane has served as CEO since 2007; the other two co-founders are Alex Aghassipour (Chief Product Officer) and Morten Primdahl (who served as CTO until 2017). The founders successfully scaled Zendesk from the startup phase through its IPO and continue to operate the company today. In 2016, Elena Gomez joined as the company’s CFO; prior to this, she held different financial leadership roles at salesforce.com.

Management has successfully allocated capital to scale the business, with occasional small acquisitions. Management’s compensation consists of base salary, cash performance bonuses and long-term equity incentives, with incentives based on revenue growth, operating margins, bookings and individual performance assessment (Zendesk’s management compensation is in line with compensation programs of peers).

Estimates And Valuation

Analysts are expecting Zendesk to reach $1.57bn revenue (24.3% CAGR from FY2019 to FY2022) and $206.96m EBITDA by FY2022, with EBITDA margins significantly improving versus FY2019:

Source: S&P Capital IQ

Zendesk has historically traded at a premium to big tech names like Microsoft and salesfoce.com, but in recent months the gap looks much smaller than before:

Source: S&P Capital IQ, proprietary research

Zendesk currently trades at 12.5x LTM EV/Revenue, roughly in line with public comps:

Source: S&P Capital IQ, Finviz, proprietary research

As size reduces, comparables seem to trade at a slightly lower multiple. Taking public comps with EV<$15bn as a reference and assuming a valuation range between 12.8x and 15.8x LTM Revenue, relative valuation shows a 15% upside to current levels ($98.24 at the time of writing):

Source: proprietary research

Stock performance has been quite variable across public comps, with 1-Yr return going from 1.1% for Slack Technologies (WORK) to 364.0% for DocuSign (DOCU). Median LTM EV/Revenue for companies with 1-Yr returns >50% reaches 21.6x; looking at comps with similar 1-Yr performance to Zendesk (up 24.2% over 1 year), we get the following:

Source: S&P Capital IQ, Finviz, proprietary research

Looking at the relative valuation of similar 1-Yr performers and similarly sized companies, Zendesk appears to be fairly valued to slightly undervalued and represents a solid investment at current levels:

Source: S&P Capital IQ, Finviz, proprietary research. Note: average Wall Street analyst price target is $108.78, 10.7% upside at the time of writing.

Key Risks

Zendesk does business with customers of all sizes, but for the moment, SMB clients still represent its key segment. This poses a couple of operational risks:

  1. Given Zendesk’s customer base, the company could be overly exposed to macro trends as SMB will likely be affected more than large enterprise customers by the current economic environment. However, the company is slowly starting to target larger clients, and more than 40% of total revenue are now coming from businesses with more than 100 clients.
  2. SMB customers are less sticky than enterprise customers, thus having a negative impact on Zendesk’s churn rate (note, management does not disclose churn). In Zendesk’s case, this negative effect could be amplified as most sales are monthly rather than annually.

Even though Zendesk is not directly competing with big tech names, targeting bigger clients will inevitably bring increased competition from the likes of Microsoft, salesforce.com and Oracle.

Moreover, as Zendesk keeps expanding to large customers, the company will likely have to expand its sales and servicing headcount to deal with more complex requests. SMB customers are usually more willing to go the “self-service” route, enterprise customers require a much higher level of service.

Appendix: Consolidated Financial Statements

1. Condensed consolidated statement of operations

Source: Q2-20 Shareholder Letter

2. Condensed consolidated balance sheet

Source: Q2-20 Shareholder Letter

3. Condensed consolidated cash flow statement

Source: Q2-20 Shareholder Letter

Disclosure: I am/we are long CRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


Originally published on Seeking Alpha

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