Zendesk: Ease Of Use And Agility To Unlock Upmarket Adoption

Summary

• Zendesk’s focus on ease of use will speed up its upmarket onboarding process as it expands its direct and indirect sales channels to drive growth.
• The revenue contribution from clients with 100+ agents increased by 300 bps YoY.
• Upmarket growth will also drive further margin expansion. Long-term RPO grew by ~1.3 times to drive ~28% of overall RPO in 2020.
• Amid uncertainty leading to various guidance cuts and pulls, Zendesk is firm with its $1 billion FY revenue guidance and ~30% YoY growth for 2020.

Overview

Since 2019, Zendesk (NYSE:ZEN) has been pushing for wider adoption of its Suite and Sunshine products from the enterprise clients. This move has been successful so far, given the 300 bps YoY increase in revenue contribution from clients with 100+ agents and solid ~36% YoY revenue growth. In addition, RPO (Revenue Performance Obligation), which represents unrecognized future revenues under contract, grew by ~57%. Much of that was driven by ~1.3x increase in long-term contracts often associated with upmarket deals. In FY 2020, the company will invest more into go-to-market areas such as sales enablement, product innovation, and indirect channels to continue to boost the upmarket growth at scale. In our view, central to the growth plan is Zendesk's ease of use and agility as a platform, which will be the key to reducing the adoption barrier at the upmarket segment.

Catalyst: Focus on Ease of Use and Agility

Moving towards the upmarket segments will allow Zendesk to both improve its retention rate and cash flow profitability due to typically longer contracts and deal sizes. Traditionally, aiming for higher-valued clients has been crucial in helping a fast-growing cloud software company like Zendesk to be on a path to net profitability in the long term. Zendesk's major move into the upmarket began with the introductions of its CRM platform, Sunshine, and its omnichannel CX platform, Suite in mid-2018. As the company ramped up upmarket clients sometime last year, the overall positioning has also shifted from Support to Customer Experience. These initiatives enabled Zendesk to not only increase the upmarket marketability but also ease of use and agility of its platform, which the CEO Mikkel Svane considers as differentiating factors during the most recent earnings call:

I do want to say that, like, a lot of our differentiation is in the agility and the ease of use of the product here that we can help our customers get results really, really quick, that we can help them change really, really quick, that we can -- that nothing that they put in front of themselves that we cannot solve and help them get results. I think that's still incredibly important to our customers because they all live in an area where customer expectations are changing so quickly.

Over the last year, go-to-market executions have been solid. Revenue has grown over ~36% - ~39% while long-term RPO increased by ~1.3x. Net retention rate has also remained solid at the higher end of the 110% - 120% range.

(source: Zendesk's earnings call slide)

Going forward, we expect this strong momentum to continue as the company focuses more on sales enablement and growing its indirect upmarket sales channel overseas. In that regard, the platform's ease of use will be more crucial in shortening the time to educate the stakeholders on the value of the product. The agility aspect, furthermore, allows for flexibility on particular deployment needs across support, sales, or other areas depending on customer expectation. Zendesk Suite, for instance, accommodates the growing demand to serve customers across channels, including chat and messaging platforms, while also offering individual pricing scheme for each feature.

(source: Zendesk)

One feature that highlights the platform's agility is light agent access. The feature enables clients to onboard additional customer support agents with limited functionality on an ad-hoc basis without paying additional per-user fees. From an enterprise standpoint, the functionality provides rich use cases while removing the adoption barriers that typically slow down the client's decision-making process during the trial.

Risk

In our view, Zendesk is not exposed to many company-specific risks in the context of its growth plan. Its current lack of presence in the international markets relative to its main competitor, Salesforce (CRM) and Freshdesk, however, can provide a bit of a challenge in replicating its upmarket strategy overseas. At the moment, the US is still both the largest and fastest-growing market with ~39% YoY growth. On the other hand, APAC and EMEA grew by only ~30% YoY despite the relatively small revenue contributions (~28% and ~10% of total revenue for both EMEA and APAC) that typically signal upside potential. As such, there is still uncertainty on Zendesk's potential growth opportunities outside the US, where the concept of customer experience CRM is relatively nascent and varies in terms of demands aside from the fierce competition.

(source: Zendesk Q4 earnings call)

The company's lack of net profitability also creates a concern for some investors. Despite its relatively strong operating cash flow profile, Zendesk is yet to generate positive earnings. Much of this was due to the share-based compensation that made up ~90% of the net loss in the last two years. We think that this is not a huge issue, however, given the sharp appreciation of its share price within the same timeframe. Before the 2020 selloff in late February, the stock price has appreciated by ~64% since January 2018.

Valuation

Within the saturated greater CRM market where Salesforce and HubSpot (HUBS) are competing for market leadership in Sales and Marketing consecutively, Zendesk will continue to own the Customer Service/Experience CRM market.

(Revenue growth, LPSN, HUBS, ZEN, CRM. source: stockrow)

Against its peers such as LivePerson (LPSN), HubSpot, and Salesforce, Zendesk's ~36% growth rate means it is the fastest-growing player in the group. The growth rate is expected to drop to ~31% by the end of FY 2020, however, as the company moves upmarket and signs more clients on longer-term contracts. We do not view this as an issue however, given the solid RPO outlook.

(Gross margin comparison - LPSN, HUBS, CRM, ZEN. source: stockrow)

What is more impressive is the company's ability to maintain its strong growth rate while expanding its gross margin by ~250 bps over the last 4 years. Only HubSpot's margin has improved more within the same period. As Zendesk onboards upmarket clients in 2020, we predict gross margin to even expand further in 2020.

(Relative Valuation. source: stockrow)

When we remove Atlassian (TEAM) as the outlier in P/S comparison, Zendesk turns out to be the most expensive stock in its peer group with a 9.2x P/S. We found this to be less surprising given its stable growth, consistent margin expansion, and solid execution in the last few years. A quick look on the earnings page reveals that the company has never missed a single revenue or EPS guidance in the last 5 years. Over the same period, the strong execution has also allowed Zendesk to be very consistent with its goal. In 2016, Zendesk announced that it aims to achieve a $1 billion revenue by 2020, which the company likely does by the end of this year as reflected by its guidance.

(source: stockrow)

We believe that Zendesk remains a highly attractive long-term buy opportunity. Considering its $1.06 billion revenue target at the end of the year and ~113 million shares, the 9x P/S gives a price target of approximately $84 per share. The recent global selloff due to coronavirus that has been depressing stock prices across sectors also creates a good entry point opportunity. Zendesk is currently trading at a ~30% discount to its pre-selloff multiple of ~12x P/S. We feel that there is enough margin of safety for investors to own the stock today.

Disclosure: I am/we are long ZEN. 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.