- Following pressure from an activist investor, Zendesk is up for sale.
- There are many potential acquirers, but for the purpose of this thesis, I consider six which could considerably expand their customer engagement suite through a deal.
- Out of these, if one looks beyond advertisement revenues to the less glamorous office productivity tools, Google should be the one to benefit the most from an acquisition.
- For this purpose, a comparison with Microsoft helps to identify the margin benefits that Zendesk's digital customer experience tools could bring to Google's cloud segment.
- Based on recent M&A data in the IT industry and the Twitter purchase by Elon Musk, I consider that Zendesk has the potential to produce another 13% upside.
For a growth stock with an operating loss, Zendesk (NYSE:ZEN) has been performing remarkably well since February while the wider IT sector as symbolized by the Vanguard Information Technology ETF (VGT) fell by over 10%. This good performance is mostly attributed to the company potentially constituting an acquisition target following pressure from one of its activist investors.
Scanning the industry for a strategic deal whereby another IT customer experience ("CX") company makes the acquisition, I came across the following six contenders:
- Adobe with its Customer Experience Platform
- Salesforce with its Customer 360 Service Cloud
- Oracle with its Customer Engagement Cloud Service
- SAP with its Customer Engagement Center
- Microsoft with its Dynamics 365 Customer Service
- Google with its Customer Engagement Engine
The aim of this thesis is to identify the best contender and I start by elaborating on the reasons why Zendesk constitutes an attractive buy.
The attractiveness of Zendesk
Two years ago, in order to fight the pandemic, social distancing measures were implemented. This resulted in new ways to provide customer service, namely through the use of digital channels like the internet and smartphones, with Zendesk taking advantage of the shift to enhance CX through rapidity and simplicity.
As a result, year-on-year revenue growth has improved from 26.8% in the second quarter of 2020 to 30% in Q1-2022. Furthermore, by expanding its main help desk product with additional product options which were quickly adopted by customers, Zendesk optimized platform usage, thereby improving gross margins, with the trend likely to continue with the release of the Zendesk Suite, which combines support, guide, chat, and talk in one package. Thus, driven by traction from Zendesk Suite, the Net expansion rate increased to 121% in Q1 signifying that the company is getting 21% more revenues from its existing client base when measured over a one-year period.
On the other hand, GAAP EBIT (operating) margins have been negative since 2019 with the operating loss accelerating in 2021. There has been no improvement in Q1 due to higher headcount with no letdown in Q2 as the IT labor market grows tighter. In these conditions, despite growing rapidly, it is hard for Zendesk to make profits. Now, with rising interest rates come higher borrowing costs and the company held $1.3 billion of debt at the end of 2021, or an amount approximately equivalent to 2021's revenues. In these circumstances, it is understandable why shareholders were not agreeable to the $4.5 billion purchase of Momentive (MNTV).
Still, despite its profitability dilemma, Zendesk's revenue guidance of $1.685 billion to $1.710 billion for 2022 remains very high. Thus, with an enterprise value of $14.49 billion, it becomes attractive for companies looking to scale rapidly in current morose economic conditions.
The potential acquirers
First, Adobe (ADBE) is a creative software company whose products include Illustrator, PDF, Creative Cloud, and Photoshop. These address the content creator market, but its interest in acquiring Zendesk could stem from the fact that it has expanded into CX. However, there was a report that Adobe is not interested, and this could be related to its lower cash position as shown in the table below. For this same reason, I did not include ServiceNow (NOW) in the selection.
Second, there is Salesforce (CRM) which has a larger cash pile. The company provides CX solutions in a SaaS format and its platform offers Customer 360, a cloud-based application that helps businesses create and maintain customer relationships. Acquiring Zendesk would help it to expand its customer base considerably, but higher debts may deter shareholders to vote for an acquisition.
The growth rationale would make sense for SAP SE (SAP) too as it also has CX-related products, but with its higher debt load and currently focused on mitigating deteriorating conditions in its Eastern Europe markets, M&A activities may be the least of its priorities.
Pursuing further, mostly known for its databases, Oracle (ORCL) proposes CX cloud solutions too, for enabling a comprehensive view of customers in real-time. Some will remember that it tried to acquire TikTok back in 2020, but, taking into consideration its high debt load, the acquisition covered only 12.5% of the company in a deal worth about $2.5 billion. This figure is six times less than Zendesk's value.
As for cash-rich Microsoft (NASDAQ:MSFT), it has a large and expanding enterprise cloud services business with Azure and Office 365. It also has Dynamics 365 Customer Engagement and a potential deal with Zendesk would significantly enhance its competitive position with respect to Adobe, but a deal makes more sense for Google.
The case for Google
While Google (NASDAQ:GOOG) (NASDAQ:GOOGL) has been able to grow revenues by 23% in the first quarter of 2022, it has missed earnings estimates. This can be attributed to advertising revenues obtained on YouTube not rising as per expectations due to advertisers cutting down on spending as well as tough competition from the likes of TikTok. The company is certainly addressing the problem, but, while most people's attention is glued to advertisements, there is another area where the search engine giant is facing strong competition, namely for its office productivity tools grouped into Google Workspace collaboration.
Workspace whose revenues are bundled with those of the cloud segment grew by 44% to $5.8 billion in Q1-2022 on a year-over-year basis. However, the segment suffered from an operating loss of $931 million. As per the executives, there has been solid growth (in terms of seats) for Workspace, but this business, which includes applications like Gmail, Docs, Drive, Sheet, Slides, etc as per the table below is facing strong competition from Microsoft with its Outlook, Word, Excel, etc.
Another source confirms that Google no longer constitutes a competitive threat to Microsoft's productivity applications despite the fact that both companies have basic (starter) plans priced at $6.
Furthermore, as shown by the acquisitions of cybersecurity play Mandiant (MNDT) which I covered some time back, Google seems to be more focused on improving security for its cloud business. However, it is also urgent to address the competitive threat to office productivity, this time in a bid to improve profitability.
For this purpose, there were some hints during the first-quarter earnings call that the company intends to innovate more in the Google Workspace product pipeline in addition to some of the recent developments like introducing new collaboration features for integrating Google Meet directly into Google Docs to support hybrid work. Now, integration is an area where historically, Microsoft has performed better and this is evident by the efficient way it has ported its desktop applications to the cloud, resulting in better margins as shown in the table above.
In addition, the software giant has Dynamics 365 which is an advanced CRM system, and integration with Microsoft Outlook makes it possible for users to easily track emails, contacts, and activities. This increases clients' productivity further. Now, the search engine giant does possess a Customer Engagement Engine available on Google Play which helps businesses to increase loyalty. It also proposes AI tools too. However, these are not as advanced as Dynamics 365 in terms of breadth of integration with applications in the industry.
Valuations and key takeaways
Now, integration, by enabling more automation between applications coming from different suppliers rather than having developers manually develop interfaces, results in better profitability. In this respect, adding Zendesk's products to its portfolio will increase Google Cloud's current revenues of $5.82 billion by about $1.7 billion, or 29%. Equally important, with Zendesk's gross margins of 79% and Google's existing sales channels, there should be considerable savings on marketing for a combined entity. Ultimately, this would be beneficial to the bottom line and help to change Google cloud's loss-making status.
Moreover, a bespoke CX suite like Zendesk, fully customized to Google's needs can also increase traction for Google's powerful ecosystem of ads.
As for valuations, with an EV/Sales multiple of 8.6x, Zendesk looks overvalued with respect to the IT sector, but for M&A activities it is important to look for precedents. For this matter, considering February 8's closing price of $100 and adding a premium of 20% to 25% based on data from recent M&A activities in the IT industry, I come up with a target price of $120-$125. I specifically consider February 8 as, during that week, Zendesk had rejected a bid to be acquired for around $127 to $132 per share in an all-cash transaction.
Interestingly, with Elon Musk's bid for Twitter (TWTR) made at a 38% premium over the pre-deal share price, the stakes may have gone higher and Zendesk could be valued at $138 (100 x 1.38) which would represent a 13% premium over the current share price of $122.Thus, this high-growing company is a buy.
Finally, after considering six suitors, I consider Google to be best placed to profit from a potential acquisition, but, the company is a "hold" in this uncertain economic environment due to its dependency on advertising revenues. This said there may be acquisition interest from private equity, but I do favor an industry-level consolidation, especially during this period of high inflation and rising interest rates when Zendesk's fast-growing revenues can contribute to making Google cloud profitable.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
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