Zendesk: At Nosebleed Highs

Summary

• Zendesk has soared to all-time highs above $45 in 2017, appreciating more than 30% amid a broad market tumble.
• The company was buoyed by a recent announcement that it crossed a $500 million run-rate for the first time, effectively ensuring that it will exceed Q1 guidance.
• Revenues are expected to grow 30% y/y this year.
• Shares look prohibitively expensive, however, at 7.7x forward revenues as loss margins continue to run high despite the growing revenue base.
• Zendesk faces mounting competition in the service center SaaS space.

Zendesk (NYSE:ZEN), the customer-service software company, has been riding on a wave of fortune lately. The company is plowing on toward a $5 billion market cap, putting it far above the pack of average high-growth software companies. Since its IPO in 2014, original investors have made 5x on the company's starting IPO price of $9 - not a bad return at all for holding the stock a couple of years.

Year to date, Zendesk has gone up an astounding 33% versus a loss of -3% for the S&P 500:

ZEN data by YCharts

By all means, some of Zendesk's gains are well-deserved. The company has seen massive revenue growth and become a powerhouse in its space. For the unfamiliar, Zendesk provides a cloud-based software program that helps enterprises set up customer service portals. Its flagship offering, Zendesk Support, is the industry-leading application for handling customer service tickets. A screenshot of the agent interface, taken from Zendesk's website, is shown below:

Figure 1. Zendesk interface

Source: Zendesk.com

But despite Zendesk's recent success, the vaulting stock price begs the question: is Zendesk overvalued? With a few precious exceptions, as SaaS companies grow larger, the growth begins to decelerate quickly and the stock is suddenly no longer worth double-digit revenue multiples as it was back in the days immediately post-IPO. Despite the fact that Zendesk is a fantastic company with strong potential, its valuation at the moment has reached beyond the fundamentals and is due for a pullback.

Growth on the cusp of deceleration, with profits far from sight

Here's a look at how Zendesk's growth trajectory has fared over the past five years:

Figure 2. Zendesk income statement

Source: Zendesk 10-K

In FY17, the company grew revenues 38% y/y to $430.5 million. Don't get me wrong: that's tremendous growth for a company of its size, but the valuation (which we'll discuss shortly) essentially already prices in that growth.

Where the risk comes into play is if Zendesk begins to decelerate its revenue growth faster than expected. The company has historically had a strong track record for beating expectations, but it's not uncommon for software stocks to falter at this stage. Box.com (BOX), for example, plunged after reporting fourth-quarter earnings last month when its guidance implied just 20% growth in FY19 (calendar year 2018) versus the 27% growth it produced in FY18. With forward revenues of approximately $600 million, Box is at about the same scale (only slightly larger) as Zendesk is now.

Thankfully for bulls, Zendesk surprised to the upside (but only slightly) when it gave FY18 guidance of $555-565 million in revenues, implying 30% y/y growth at the midpoint. This is an eight-point deceleration from its growth rate in FY17. This might be good enough for Zendesk's investors and its covering Wall Street analysts, but the same rate of deceleration (seven points) is what caused Box to topple. Of course, 20% growth and 30% growth are different things, but extrapolating this rate forward, it won't take long for Zendesk to falter to the 20s - especially with its product becoming increasingly saturated and up against serious competition.

Zendesk recently put out a press release announcing that it had crossed the $500 million annual revenue run-rate ahead of announcing Q1 earnings. This implies that Zendesk's Q1 revenues will be at least $125 million versus its guidance for $125-127 million in revenues. That's good news, but for how long can this good fortune prosper?

And despite revenues more than quintupling over the past five years, Zendesk still generated a GAAP operating loss of -$114.6 million in FY17, or a -26.6% operating margin. The company did generate $25.7 million of free cash flow, so at least that's respectable - but note that this represents an FCF margin of just 6%. Dropbox (DBX), on the other hand, generated a 28% FCF margin; Salesforce.com (CRM) generated 21%.

Competition lurks in the open

And speaking of Salesforce.com: Zendesk faces quite a bit of competition from the cloud SaaS king, which last year produced 28% y/y growth in its Service Cloud product to $789.3 million. That makes Service Cloud almost twice as large as Zendesk; and next to the original Sales Cloud offering, Service Cloud is Salesforce's next-largest product. It also benefits from being natively connected to the rest of the Salesforce platform for large enterprise customers that deploy multiple offerings. This isn't a trivial benefit - it makes sense to connect CRM (customer relationship management) data natively to customer service functions.

One particularly cool feature of Service Cloud that Zendesk doesn't natively offer is Field Service Lightning, which allows a Salesforce Service Cloud user to dispatch field agents (such as an installation professional) from within the application in response to a query.

Salesforce aside, Zendesk also faces plenty of other competitors. Jira Service Desk, an offering by fast-growing SaaS company Atlassian (TEAM), is another growing contender. ServiceNow (NOW) is another titan in the space, which like Salesforce offers connectivity to a suite of other software tools.

Last month, Twilio (TWLO) also announced the launch of Twilio Flex, which provides an "out-of-the-box", cloud-based customer contact center. Zendesk is actually a partner of Twilio Flex, and a customer can opt to use both offerings - with Zendesk powering the front-end interface and the Twilio network facilitating the communications between service agent and customer. But an enterprise company with a large in-house developer team can bypass Zendesk overall and use Twilio's more bare-bones offering that's meant for self-customization.

Of course, Zendesk is still a customer favorite and a powerhouse in the service SaaS space. It's been named a Gartner leader for several years in a row, an honorific that carries weight with IT buyers. However, it would be a mistake to think that cloud giants like Salesforce and ServiceNow, as well as more lean upstarts like Twilio, won't have an effect on hamstringing Zendesk's future growth. Zendesk doesn't have total ownership of the market it's playing in.

Valuation doesn't reflect deceleration and competition

Zendesk's nosebleed valuation at approximately 8x forward revenues no longer seems to fit its 30% growth profile. In the high-growth software space, 30% is about average, and a more average revenue multiple lies somewhere between 6x and 7x forward revenues. Without the earnings profile or free cash flow to justify a multiple premium, Zendesk looks expensive, especially as the valuation seems to be unconcerned with the potential deceleration and competitive pressures previously discussed.

Here's a look at where Zendesk trades relative to other cloud software companies in the ~$500 million revenue range:

ZEN EV to Revenues (Forward) data by YCharts

Zendesk isn't bulletproof, though its valuation would seem to suggest that it is. Even the slightest misstep from the company - whether it be an earnings miss or disappointing guidance - can send a negative shockwave to a company so richly valued.

Though I still consider Zendesk to be a best-in-breed software company with a rare longevity and good potential, I don't think its status as a Wall Street darling can last much longer. While the company's high growth makes it difficult to be overly negative on the company, at $45 a share, Zendesk is at best a hold. I'd count on the company flattening down to a valuation of 6.5x EV/FY18 revenues at some point this year, implying a price target of $39.

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.