Overview
Zendesk (NYSE:ZEN), the leader in the cloud customer experience CRM market, withdrew its full-year guidance given the ongoing uncertainties due to the COVID-19 pandemic. The pandemic is impacting a lot of its 160,000 paid customers across sizes and industries, particularly those in the ride-sharing and travel sectors. We expect a near-term contraction into Q2, which creates a possible entry point for long-term investors to pick up the stock at a bargain.
Risk: Ongoing Contractions Across the Customer Base
Q1 was a good quarter for Zendesk. The company maintained a+30% top-line growth while the gross margin expanded by ~480 bps to 78%. It also beat the guidance, though shares price was down 5% upon the Q1 earnings call as the market priced in the contraction ahead. Zendesk's Q2 revenue guidance will be below the consensus as ~20% of its customers are in the industries most impacted by COVID-19, such as travel and ride-sharing. Customers in the ride-hailing/transportation industry include Uber (UBER), Lyft (LYFT), Ola, and Easy Taxi. On the other hand, Zendesk's customers in the travel/hospitality industry include Airbnb, Skyscanner, OpenTable, Lonely Planet, Azerbaijan Airlines, Qatar Airways, and Four Seasons Hotel. Some of these customers are seeing over 70% - 95% contractions in demand, and as a response, Zendesk is moving quickly to manage the crisis by offering them various flexibilities, such as extended payment terms and a one-time discount.
(Zendesk's FCF, quarterly. source: stockrow)
To reduce further pressure on its customers, Zendesk also implemented a new policy on March 1st to invoice the customers at the renewal date instead of the 30 days prior. This change of timing severely impacted the FCF (Free Cash Flows) for the quarter. The -$15.6 million of FCF in Q1 2020 marked the first time in over four years that Zendesk recorded a negative FCF in a quarter. Within the same period, FCF has steadily improved from -$6.1 million to $15.87 million last quarter in Q4 2019, which was the highest FCF figure Zendesk ever posted in any quarter.
Catalyst: Long-Term Upside is Intact
We maintain a bullish view on Zendesk and have written about the stock a few times in the past. The company's easy-to-use product, customer-centric culture, and market leadership have made it an attractive growth story with a solid economic moat. Despite the near-term contraction that puts the company on the backfoot, the management has effectively managed the crisis by being very flexible with its customers when it comes to payment terms and pricing. The action taken so far has aligned with the company's vision as an industry leader in the customer experience space. Therefore, we continue to feel optimistic that its great culture will enable stronger wins, retention, and expansion once COVID-19 ends.
(source: company's 10-K)
Moreover, key metrics have always been strong. By the end of 2020, Revenue will be more than double from that of 3 years ago. Gross margin also consistently expands every year. The current 78% gross margin in Q1 is already ~1,000 bps higher than where it was 2-3 years ago. In Q1, the company maintained a +30% YoY growth despite the contraction due to COVID-19. The diversified customer base helped a lot in this case as there were significant increases in usage from customers in healthcare, education, government, and software. Its messaging product, in particular, continued to gain traction in Q1 as more healthcare and government institutions needed to quickly roll out a solution to handle pandemic-related use cases:
So we have seen a rise in customer service almost for many of our customers. Some dramatic rises for a large segment of our customers. We have also seen much more reliance on self-service, on automated reflection and an increase in messaging and chat conversations. We have many examples, a lot of them are in the shareholder letter, but like one customer is trying WhatsApp chat box through our Samsung platform that help people to self diagnose COVID-19 symptoms. We have another customer that have deployed self-service for government track and trade applications and our call center product, our voice products that's helping multiple healthcare providers managing medical conversations to healthcare.
Valuation
As of May 1, the shares price has dropped by ~9% from its 5-day high of ~$79 per-share. As the market prices in the near-term contraction, we believe that long-term investors should notice and take the opportunity to buy the stock at a bargain.
(source: google)
At the current ~9.3x P/S, the stock is attractively priced. For context, the stock spent most of 2019 trading at a mid-double-digit P/S. Furthermore, back when we wrote about the stock in March, it was trading at a ~12x P/S. Back then, we projected a ~$84 price target under the assumption that the company will be able to break the first billion-dollar of revenue by the end of FY 2020. As the company will guide ~5% below the consensus in Q2, we are upgrading our best-case price target to ~$80 per share.
