There’s no doubt: tech stocks had been extremely overheated since the start of the pandemic, and some level of pullback was long overdue. In 2020 and 2021, investors piled into tech thinking it was the only business that was safe from harm – after all, tech is taking over the world! But rising rates in 2022 and a growing fear over valuations have dealt a blow to some of the best-performing deals of recent years.
In many cases, however, the hindsight has gone too far. Into this bucket falls Zendesk (NYSE:ZEN), one of Silicon Valley’s major success stories of a software startup that eventually grew into a large and profitable giant. A leader in customer service software, Zendesk’s stock has fallen around 40% in the past year, while losses in January alone were nearly 10%.
I myself issued a warning about Zendesk around the middle of last year when the stock was trading closer to the $130 range. At the time, I cited valuation issues as the main driver of a potential pullback for Zendesk, and since then the stock is down about 30%. Now however at new current levels I am more willing to buy the rebound on Zendesk and am upgrading my position on Zendesk to to buy.
Two factors explain the recent pessimism about Zendesk. The first, of course, is the stretched rating I mentioned earlier. The recent correction, in my view, largely supports this risk. A quick check of where Zendesk is currently trading: At the current share price near $95, Zendesk is trading at a market cap of $11.52 billion. After clearing the $1.54 billion in cash and $1.11 billion in debt on Zendesk’s most recent balance sheet, the company got the enterprise value is $11.08 billion.
For the upcoming FY22, Wall Street analysts expect Zendesk to generate $1.69 billion in revenue, representing a healthy 27% year-over-year growth (data from Yahoo finance). According to this revenue estimate, Zendesk is trading at just 6.6x EV/FY22 turnover – a major departure from when Zendesk traded at a low teenage multiple throughout the pandemic.
The second reason for Zendesk’s stock overhang is its proposed acquisition of Momentive Global (NASDAQ: MNTV), better known by its original name – SurveyMonkey. The case was announced at the end of October. SurveyMonkey, of course, is a survey software tool that many consumers are familiar with. Over the past few years, the company has changed its name to Momentive to better reflect its growing move toward enterprise software and employee/customer experience tools.
In my view, Momentive’s product portfolio and corporate change present a perfect opportunity for Zendesk, but several activist investors have spoken out against the acquisition. One of the main reasons I’m not concerned about the acquisition is that it’s an all-stock deal, at a ratio of 0.225 Zendesk shares per Momentive share. Currently, shares of Momentive are trading at just ~$17, only ~18% of Zendesk’s levels, reflecting low confidence in the deal being signed, at least on current terms. Still, I think Momentive’s decline in value alone gives Zendesk the opportunity to acquire over $500 million in annual revenue (much of which is recurring, thanks to Momentive’s new enterprise offerings) at a pretty attractive price, as Momentive’s market cap is currently just under $2.5 billion. Either way, once the confusion over this deal clears up, I believe it will remove a major hurdle for investors and allow them to focus on Zendesk’s fantastic standalone fundamentals.
The bottom line here: I think very few new risks have materialized for Zendesk. I view the possibility of a Momentive acquisition as accretive to Zendesk’s scale and ambition to reach $3.5 billion in revenue by 2024 (compared to the roughly $1.7 billion it should achieve in 2022). Investors should view this as an opportunity to buy a fantastic growth stock at a steep discount.
Let’s now review Zendesk’s most recent third quarter results to support the fact that on a stand-alone basis, Zendesk’s organic business growth has been phenomenal, and continued strong quarterly performance should be able to to help sentiment in this stock recover once the irrational tech selloff cools. down.
The third quarter revenue summary is shown below:
In the third quarter, Zendesk grew its revenue at a blistering 32% year-over-year to $347.0 million (a very rapid pace of revenue growth for a company that topped a year-over-year revenue scale above $1 billion), beating Wall Street expectations of $335.4 million (+28% y/y) by a respectable margin of four points.
One of Zendesk’s major recent business goals has been to focus on selling to enterprise customers, which it defines as customers that generate more than $250,000 in annual recurring revenue (ARR). To do so, it has largely focused on sales of its multi-product solution Zendesk Suite, which has proven popular among enterprise buyers who want a one-stop-shop tool to manage multiple customer needs. Suite now represents a quarter of Zendesk’s overall ARR, up dramatically from just 16% in Q2.
Additionally, Zendesk’s contribution from enterprise customers (>$250,000 ARR) as a percentage of its total ARR has increased to 37% and has also steadily increased each quarter:
Enterprise customers are more favorable for two reasons: their large size and relative slowness to change internal operations and software make them much less likely to opt out than smaller enterprises; while providing Zendesk with a “land and expand” opportunity to sell more products or expand into different departments of the company.
Unsurprisingly, Zendesk’s focus on selling the higher-priced overall Suite solution led to a slight drop in Zendesk’s customer base, which fell to 111.8,000 total customers this quarter. The company expects this slight downward trend to continue through 2022, although I think the fact that it’s mostly low-value customers turning around and the fact that Zendesk’s growth continues to being strong will make this a problem for most investors.
Also note that Zendesk’s greater business diversity has also paved the way for improved net revenue retention rates. In Q3, the company achieved a net retention rate of 122%, indicating that the typical Zendesk customer increases their spend on the platform by 22% the following year. This metric, too, has seen a gradual upward climb:
Zendesk also posted a whopping 82% pro forma gross margin in the quarter, up three points from 79% in the third quarter a year earlier and among the best of most enterprise SaaS peers. However, pro forma operating margins fell by a slight two points to 8%, driven by the increase in R&D expenditure and sales and marketing costs.
We note, however, that with pro forma operating margins of 8% and revenue growth of 32% year-over-year, Zendesk technically sticks to the “Rule of 40” definition of a business, which puts the emphasizing that its forward earnings multiple of around 6.6x looks very cheap. Zendesk has also generated $112.4 million in free cash flow with a rich 12% margin in the past three quarters year-to-date, compared to light cash burn a year ago.
Key points to remember
In my opinion, Zendesk represents an incredibly attractive rebound opportunity. I’m not that concerned about the impending acquisition of Momentive, because I think the fact that it’s an all-stock deal pegged to the falling stock prices of both companies means that Zendesk can now buy the company at a much more favorable price. With 30% y/y, Zendesk is now a bargain. Hold this for a bounce up to the ~$120 range.