Zendesk: Is there light at the end of this tunnel?
Zen is defined as a religion that emphasizes rigorous meditation packages. I suppose San Francisco is a good home for a company that calls itself Zendesk (NYSE:ZEN) although the business was actually started in Copenhagen. I have used the ZEN app occasionally and truth to tell one sometimes really does need meditation skills to avoid extreme displeasure with the app.
But then again, despite having worked at or followed IT businesses most of my life, I have a difficult time with so-called personal productivity applications. I find they either waste my time or frustrate me and I need some younger friend or relative to show me how they are to be used properly. Perhaps uniquely amongst the army of SA contributors, I needed personalized instruction in how to use the blue ball to provide a link to sources of information that I use.
I was actually able to figure out the use of the bullet point icon without instruction and I considered putting in for an award. So the fact that I have cursed at and chosen to anthropomorphize the ZEN application is really not a good measure of its value to the companies that buy it or the customers that use it.
But enough personal musing. There is really only one reason to consider a company like this amongst what might be thought of as a forest of similar solutions. There are portfolio strategies, which might suggest buying a basket of these relatively small, loss-making vendors who populate the spaces of improving customer interaction with websites. For sure, not all of them will be equally successful - it doesn't happen that way and choosing between them at this stage of their evolution is hard to do with so few objective data points. The special claim to fame for ZEN is it has the highest percentage growth rate in the broadly defined space in which it competes.
The company is forecast to grow 45% this year and 33% in 2017 although given the performance in Q1 and throughout 2015, I suspect that the reversion to the mean is likely to be slower than the consensus indication. Even the Q2 forecast, which calls for revenue growth of $3.5 million sequentially seems more conservative than is warranted as Q2-2015 showed a $6 million sequential quarterly revenue increase.
When I try to write these articles, my focus is on figuring out why a company like ZEN has been a bit more successful in its growth rate than some of the other vendors who are trying to address the same potential customers. And I want to try to understand how long the period of hyper growth can last and finally I pay obeisance to the concept of finding competitive moats.
To dispose of the last matter first, it is highly unlikely that someone has made a particular discovery that will change the world and conquer the Zika virus. The product that ZEN offers and the products of many of the other vendors in the broadly defined CRM space, are all about using the web to deliver to ultimate users a more enjoyable and less stressful shopping experience. Most of the parts of these solutions already exist in one form or the other and potential competitors can put the functionality together any way they want.
Competitive moats are going to be such things as 1st mover advantage, more efficient ways of targeting buyers, the ability to execute at scale and having a management team that is capable of looking at the landscape holistically. Of course, if those are the attributes of competitive moats, which are all subjective in nature then determining the winners is pretty hard. But that being said, the purpose of this article is to try to use a screen of qualitative factors to determine the suitability of investing in ZEN for tech investors.
ZEN - If it not about Meditation, then what is it about?
Before I discuss what ZEN is, I have to say what it is not. It is not a company that has turned the corner in terms of profitability and that is probably 18-24 months away. It is not a company with a mature l business model. It is not a company that has paid more than modest attention to GAAP profitability. And it is not a company that has been economical with stock-based comp. This is going to disbar the name from consideration by many readers and investors.
The company is cash flow positive with the help of a significant slug of stock based comp. but it is also growing its deferred revenues at a rapid clip. Management has said that it is going to focus on cash flow from operations as a key target it will use in both planning its business and in evaluating results. So do not look for any emphasis on GAAP profitability in the near future.
There are observers who believe that a company such as this is doomed to come to economic ruin. The fact is, however, that almost all of the institutions and VCs that invest in this space are doing so with full knowledge of the risks implicit in investing in loss making companies. Since ZEN, and many of its peers do not burn cash, the doom scenario is unlikely.
What is harder to call is how long and to what levels, the hyper growth story can continue. Like many other companies in this space, the company has an aspirational model of 20% non-GAAP operating margins sometime after 2020. Just to be clear, such a projection most likely means that the company will not achieve GAAP profitability at its non-GAAP target model. The company's projection is that it will be halfway to its target model by 2020, which implies that non-GAAP break-even is likely at some point in 2018.
Zendesk operates within a niche of the broadly defined CRM space. Simply put, its solution is said to "help bring organizations and their customers closer together." There are plenty of prospective users who seem to want to get closer to their customers. The company has gone from 0 to a $300 million annual revenue run rate in less than 5 years. So far, there have been no quantifiable signs of a growth slowdown. Q1 showed a sequential revenue increase of $5 million or 8% from Q4. Q4 to Q1 sequential revenue growth in 2015 was 7.5%.
At one level, what this company tries to sell is an enhanced form of e-mail focused on interactions between consumers and their vendors. The company's solution tries to improve customer service via easier communication. Just as an aside, the use of which I am frequently guilty, even the simplest e-mails will work if the customers get what they need and the best communications platform in the world is useless if the company from which you are trying to buy can't fulfill your expectations. Needless to say, I have had plenty of pleasure from inadequate customer service regardless of whether or not it was delivered from the ZEN platform.
Most Zendesk customers have customized their customer interaction platform. They really do look prettier and more professional and in these days of self-service, prettier and professional is going to be as good as it gets. Needless to say, the product offers loads of analytics and competitive analysis as part of its reporting package. Again, like the most successful companies in this space, Zendesk is building an eco-system and it has 350 apps that can be bought for use with the company's basic product. ZEN has also attempted to integrate its technology with other solutions in this space. For example, Shopify users building their e-commerce platform can readily add Zendesk as part of their shop front to organize their customer service capabilities.
In recent quarters, ZEN has pivoted to a degree from emphasizing sales to SMB customers, to sales to enterprises. It is now focused on selling to the SMB customers with a low touch, no touch model and it is going to deploy most of its sales and marketing spend both into branding and into direct sales of large deals to the enterprise market. There were some significant wins in Q1 of major customers although there were no announced 7 figure transactions.
Zendesk pricing is based on a modified form of the "freemium" model for the SMB space and something quite a bit different for its enterprise customers. There is a pricing tier that is based on a minimal set of functionality for $5/month. Most users are going to wind up spending $49/month per agent, while enterprise users are likely to wind up spending $99/month. The company also offers phone support as an additional product and it has a free product offering. Most users are going to wind up paying $29/month to get useful functionality. There are bunches of add-ons far too numerous to mention in the context of this article. The company's advanced phone product is its most recent "big thing" and it was said to have exceeded its forecast in this last quarter.
Zopim is a company that enables live chat. For those who haven't used it, live chat is a facility that allows end-users to chat through a keyboard with a customer service agent. It is lots better than being put on hold and it is cheaper for the actual customer since it enhances the productivity of CSRs significantly. In my own experience, most CSRs multi-task and take care of a few customer conversations at the same time.
Zopim was acquired by ZEN two years ago and the Zopim functionality is actually embedded in some of the ZEN offerings. Zopim Lite is included in the Zendesk user account. There are many combinations and permutations of pricing that are available to users.
The specific market that ZEN serves these days is not particularly large, but certainly large enough for a $300 million revenue company to grow significantly. The basic data on what is called the CEM space is that it is worth about $6 billion/year these days and is growing at 20%/year, one of the higher growth rates in a CRM sub-market.
Just how many software competitors are needed to help enterprises to help customers?
There are loads and loads of competitors in this space. As I mentioned earlier, evaluating this space is not about the technology per se. It is about developing solutions that are easy for customer service representatives to learn and use. It is about having all of the available communications resources available on a single platform. It is about offering support for all possible mobility platforms.
One review amongst far too many I have seen is probably worth noting, "I evaluated 5 other competing products and chose Zendesk for its reliability and scalability, In addition to exceptional customer service and outstanding training and implementation. The product is beautifully designed and intuitive to use and my team couldn't be more thrilled to have moved from managing cases in Salesforce to Zendesk."
The review highlights the ways a vendor without real technology differentiation can build a very strong customer moat. Reliability and Scalability. Outstanding customer service and outstanding training and implementation. A "beautiful" looking product and intuitive to use. Those are excellent components of a secret sauce.
This company does have a modest advantage in terms of its rankings by users but almost all of the significant vendors have someone amongst their user base who loves them. Based on the rankings and the commentary that I saw it really is not product functionality or product quality that is going to do much to change market share. ZEN may be best of breed or second best of breed but the rankings are so close that the specifics really do not matter.
Gartner recently rated Zendesk in the leader box of its Magic Quadrant which is nice, but nothing that is really earth shattering. There are 5 other vendors in Gartner's leader box and of those CRM is the highest. I would guess that very few prospective customers are making decisions based on whose technology is better. Most of the potential clients are going to make deci8sions based on subjective impressions of competitive solution as well as "feelings" of installation and support capabilities. In my opinion, ZEN is going to do just fine in such an environment.
The G2 Crowd analysis list more than 50 competitors in the space. One of the principle competitors is a company called Desk.com that was acquired by Salesforce (NYSE:CRM) in 2011. At that time, it was called Assistly. Desk is now part of the CRM service cloud so we really do not know how well it is doing. We do know that the service cloud has enjoyed one of the highest growth rates of all of the CRM clouds.
Another large company offering in the space is that of Microsoft (NASDAQ:MSFT). Microsoft bought Parture. Parture had been around for some years before the acquisition and it had started to partner with MSFT before the 2014 acquisition.
A final name to mention is RightNow. At the time of the acquisition which cost Oracle (NYSE:ORCL)$1.5 billion, RightNow had a leading customer service cloud. At the time of the acquisition, Oracle paid $1.5 billion for the company, which was about 6X the run rate of revenues. RightNow may have been the only public software company that ever called Bozeman, MT home. Today, RightNow is now part of the Oracle Service Cloud and its performance gets lumped in with all of Oracle's SaaS offerings.
There has been a significant convergence in the overall space between CEM and all the other functionality needed to work with web based businesses. There clearly are far too many alternatives to supply the same basic solutions. I think consolidation on a massive scale is relatively inevitable. But figuring out who might get consolidated and at what price is something far beyond either my knowledge or skill set.
Are there any specific catalysts for the stock? Why buy it now?
ZEN shares have been on the typical path of the share price performance of most other IT vendors. The shares made an all-time high of just above $27 in December and then fell 47% to make a low on February 9, 2016. After that, the shares rallied back above their old high where they now stand. The company twice had beat the prior quarterly earnings and revenue consensus over that span.
The shares were up the 10% the day after earnings in February and up 4% in May. ZEN's performance over all was more volatile than that of the IGV software-technology index, but over the last 6+ months the index and ZEN got to the same place. The day that ZEN rallied 10% after earnings, the IGV rallied 4%. In May, when ZEN rallied 4%, the IGV showed a 1.5% gain. Earnings mattered, but not all that much-the course of the market and the tech stock market overall, has been far more significant in determining share value changes over the last 6+ months.
Clearly, one specific catalyst is going to be merger-mania. CRM, MSFT and ORCL have runners in this race. Adobe (NASDAQ:ADBE) is a peripheral competitor and could certainly be considered as a prospective purchaser. IBM (NYSE:IBM) has an entry in the space called Silverpop. Silverpop is far less popular and is considered less functional than Zendesk. It would certainly be a useful strategy for IBM to buy its largest direct competitor in the space and it is possible given the fragmentation in the space that anti-trust might not be a major issue.
Remedyforce, yet another competitor if one stretches definitions of this space, is owned by BMC, now private. Remedyforce has a far lower rating than does Zendesk and far lower customer satisfaction rating. While there is functional overlap between the two products, for the most part they are sold differently and to different groups of potential customers. I wouldn't be shocked to see Remedyforce/BMC make a bid to acquire Zendesk.
There is a pretty extensive list beyond these of potential acquirers. Further afield, but certainly possible would be companies such as Facebook (NASDAQ:FB) and Amazon. (NASDAQ:AMZN). Indeed, FB recently did a deal with ZEN in which FB Messenger can be used as part of an overall ZEN solution.
ZEN has a current market cap of $2.5 billion so presumably a deal could be done at $3.5 billion. I do not know if anyone might buy ZEN. I do know that a potential acquisition is likely part of the share price dialogue.
At $3.5 billion, the EV/S is beyond the valuation level at which most deals are getting done but in this latest feeding frenzy it is possible that potential consolidators will step up simply to have their own entry in this space and one that is best regarded with the highest growth rate as well. So I would put merger speculation on my list of potential catalysts.
There may be some commentators who bewail the current valuations in the software space. There are others who are unhappy that software companies are willing to pay up for companies that don't achieve earnings or a meaningful level of free cash flow and who use lots of stock based comp in their earnings presentation.
At the end of the day, those concerns, valid though they may be in the abstract, are more or less like King Canute lecturing the tide. The potential consolidators know all about stock based comp and cash flow. This would be a small acquisition if it happened so the dilution would be scarcely noticeable to many. But more important, with interest rates so low and liquidity so flush, companies find a strong incentive to buy operating assets as opposed to paper.
The valuations in the M&A space are a strong reflection of what happens when the Fed and other central banks become concerned enough such that ignore parts of their mandates. Governments and banks, even in countries that lack truly representative institutions, are going to be more responsive to threats to growth than towards potential threats of inflation. As the saying goes, don't fight the Fed, and decrying high valuations for takeovers is a bit like that-or so I think.
I might put speculation about the earnings release for the current quarter. Most managements these days have proven to be quite restrained in giving forward guidance. They believe that the macro environment is such that they do not wish to extend themselves. The current revenue estimates and their concomitant earnings estimates for Q2 and likely beyond, appear on their face to be designed to be beaten.
The sequential growth forecast simply is less in dollars than the company has been achieving despite the continued "investments" in both product and in sales capacity. So, the potential for a beat is pretty high and the market may, to a greater or lesser degree, be anticipating a beat.
What might happen, however, is that management speaks a bit more forcefully than it has to date with regards to a path to profitability and to significant cash flow generation. So far, Mikkel Svane, company CEO has said that "we have set an ambitious goal to reach $1 billion in revenues by 2020 and expect to reach profitability along the way to that goal." Mr. Svane has also spoken that "this shows our disciplined approach to scaling our business" in referring to the 780 basis point improvement in operating margins on a year on year basis posted in Q1.
To reach $1 billion in revenues by 2020 is going to require changes in trajectory from those that are part of the current consensus. Just simple math is such that the company would have to have a CAGR of 35% between now and 2020 to achieve its goal. Usually CAGR's re comprised of higher growth in the initial periods and lower growth over time-law of large numbers.
The company's current expense ratios are such that there ought to be substantial leverage, particularly at a sustained 35% growth rate. Last year, the company's expense ratios included sales and marketing at 54.5%; R&D at R& D at just below 30% and G&A at 23%. If the company management really wants to exert "discipline" in their spending it isn't that hard to imagine a scenario in which profitability comes sooner and reaches higher levels than is currently anticipated. And that, if it is even hinted at, would be a significant catalyst to drive these shares. At the very least, this company is in transition to a more enterprise focus with larger deals. And the company is focused on a "low touch, no touch" model to acquire small business accounts. Those two items alone might help improve the S&M expense ratio.
I think that it hardly going to come as a surprise to readers to find that valuations for ZEN are high. In a very low growth environment, there is a premium for growth. In a world that has seen a marked acceleration in consolidation activity within the IT space, investors - or read speculators if you prefer - will speculate about the probability of this vendor or that vendor being consolidated.
Is SHOP a better consolidation than ZEN. Not something that can be readily determined. Is ZEN a better investment based on some DPV analysis than HUBS. It really is a function of what kind of growth rate assumptions that are made. HUBS has a consensus full year estimate for 42% growth and ZEN has a 45% estimate for full year growth. Neither number is likely to prove all that sacrosanct.
I expect that both vendors will produce more upside surprises. SHOP is a clear winner in the growth rate derby for this year at 69% and for next year as well. If pushed, I think SHOP is a better value but not by some huge disparity. There isn't such a yawning gap in valuation between these three vendors that recommending one compared to the other is some straightforward quantitative exercise.
For the record, ZEN currently has an EV/S of 7.5X based on the 2016 revenue consensus estimates of 12 analysts. For 2017, the ratio is 5.6X. The company has no earnings and hence there is no P/E estimate. It would be a significant achievement, but one that seems realizable for the company to reach non-GAAP profitability by the end of 2017. ZEN is modestly cash flow positive at the present time.
It generated $20.2 million in operating cash although it spent more than that on stock based comp. Free cash flow was essentially zero in 2015. The company was essentially break even on a free cash flow basis in its Q1 which compares to the year earlier cash burn of about $10 million in Q1-2015.
ZEN does not forecast any cash flow measures. The company is now forecasting a GAAP net loss of $111-$112 million compared to $84 million in 2015. With stock based comp forecast to increase to $80 million, compared to $52 million last year, it seems likely that estimates for cash flow and free cash flow will show moderate progress when compared those metrics in 2015. So, a valuation based on free cash flow yield will not be terribly useful at this point. This is an early-stage company and traditional valuation metrics aren't going to work.
- ZEN sells customer interaction software that is primarily used to automate the resolution of customer complaints.
- ZEN's revenue growth is higher than that of its current competitors in the space. Growth rate estimates are almost certainly too low for both 2016 and 2017 in light of the company's $1 billion 2020 revenue aspiration.
- The company is beginning to focus far more on its enterprise class customers than on the SMB customers that have been its mainstay to this point. It now has a global footprint and can handle the requirements of large multinational companies.
- The overall customer care space is a crowded one and one that is ripe for significant additional consolidation. At the moment, more than 50 vendors compete in this market
- The company has recently engaged 3 new senior executives both to manage its transition to selling to the enterprise and to provide the executive infrastructure necessary to reach a $1 billion run rate.
- The company has a relatively high EV/S valuation and this may preclude a short-term deal to be acquired. On the other hand, the chatter about mergers in this space is deafening and some of that chatter will roll into Zendesk's valuation.
- The company appears to have the strongest product on the market today according to extensive survey data and it has announced a plethora of new functionality most recently advanced voice. In addition, the company has a significant partnership arrangement with FB.
- The company has recently been showing a bit of operating leverage. It has been increasing non-GAAP operating margins by about 800 bps annually. Its current expense ratios are so high that there should be plenty of runway to accelerate margin improvement.
These shares are not for everyone as I have been at pains to explain. But the combination of rapid growth, a path to profitability and a market space that is ripe for consolidation make this an investment that well may produce positive alpha.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.