Zendesk: Good Business Model But Expect Some Volatility

  • Zendesk delivered good first quarter results that beat on both top and bottom line expectations.
  • Most of the company’s growth metrics are showing healthy trends.
  • Zendesk, however, is still burning through a lot of cash while its losses are widening.
  • Zendesk’s shares are at high risk of becoming very volatile due to these factors especially if the company’s growth slows down.
Zendesk Stock Analysis

One year after its May 2014 IPO, cloud computing customer help desk Zendesk (NYSE:ZEN) reported results for its first quarter fiscal 2015. Zendesk finished the quarter with revenue of $42.23 million, up 72.3% Y/Y, while the company’s net loss shrunk 56% from $0.45 during the prior year period to $0.25. The results managed to beat consensus analysts’ expectations and Zendesk shares popped 7%. Zendesk shares are down 5.8% year-to-date, but 63% up since its IPO.

It’s easy to classify Zendesk as just another young and rapidly-growing SaaS and CRM company. The company, however, sports a rather unique business that investors should try and familiarize themselves with.

Zendesk Business Model

Zendesk supplies help desk software that helps companies to easily manage their customer service functions using a variety of channels including social media channels, online chat, phone, and email. Zendesk also runs an active online community discussion portal for its customers. Just like typical SaaS companies, Zendesk offers its software on a subscription basis. The company said during its latest earnings call that paid customer accounts had hit ‘‘more than 57,000,’’ a healthy 33.5% Y/Y growth compared to the prior year period.


Source: Zendesk

The fact that revenue growth has continued to outpace customer growth is a good sign that Zendesk is incrementally making more revenue per customer, as well as winning more high-end customers. The company has been winning more big accounts--Zendesk reported that the percentage of customers with 100 or more seats rose from 21% during the previous year’s comparable period to 25% last quarter. These are large customers such as Airbnb, Groupon (NASDAQ:GRPN) and Uber, as well as rapidly up-and-coming startups such as Airpnp (an app service that lets people rent out their restrooms!)

Zendesk New Sales Channels

Zendesk predominantly uses its online channel to reach out to customers. But, the company has been increasingly looking for new sales channels. One is the company’s live chat service that it deployed via Zopim, a company that it acquired last year. The acquisition appears to be very strategic in hindsight when you consider that close to 50% of Zendesk’s paid accounts use the service.

Zendesk introduced an ‘‘Embeddables’’ offering during the fourth quarter of fiscal 2014. These are a set of development tools that help customers to embed things like calls, knowledge base, and live chat into their native mobile applications from Zendesk’s website. The new service has seen a healthy uptake, with 3,000 customer accounts adopting it in the first three months after its launch. Forrester Research says that Embeddables is one of the 3 new CRM trends that hold the most promise.

Zendesk’s commitment to continuous innovation has helped it rank as a niche player in Gartner’s magic quadrant of CRM customer engagement.


Source: Gartner

Rapid International Expansion

Zendesk has been very aggressive in its international expansion efforts. The company has been rapidly moving into new markets especially in Europe and Asia. The company’s paid accounts in its Asian market grew 50% to 4,000, significantly faster than elsewhere. As a result, about 46% of the company’s revenue comes from international markets, which is a healthy balance for a young growth company (many growth companies such as Twitter (NYSE:TWTR) and Yelp (NYSE:YELP) have close to 80% of their revenue coming from the U.S.). This will of course mean bigger FX headwinds for Zendesk as long as the dollar remains strong, but it’s a small price to pay for the long-term health and sustainability of the business.

Zen Customers

Growth Comes at a Cost

Zendesk appears to have very good growth runways, especially given how the company has been able to successfully tap international markets when still at an early growth stage. Having a much more global presence allows a company to compensate weaker growth in one region by stronger growth in another. Zendesk is also recognized for its innovative CRM solutions, which are helping it grow its revenue per customer at a very healthy clip.

But, all this growth and innovation has come at a price. Zendesk has seen its operating loss expand from $10.259 million during the prior year period to $19.168 million, implying 86% growth, much faster than the company’s top line growth. This is never a good sign. What did the company in was R&D costs (31.4% of revenue) which jumped 156%, while sales and marketing expenses (55.4% of revenue) grew 63.8%.

Meanwhile, Zendesk’s stock-based executive compensation (24.2% of revenue) jumped a massive 461%. The huge jump probably has something to do with the company going public so it’s not very likely that it will keep growing at that clip. Nevertheless 24% of revenue doled out to company executives as stock-based compensation is simply profligate. After years of observing many SaaS companies including Salesforce.com (NYSE:CRM), I have come to the conclusion that companies do not necessarily become less generous with their stock options as they mature. Salesforce’s stock-based compensation is still above 10% of revenue despite the fact that it’s now almost a fully mature SaaS company with annual revenue in excess of $5 billion. Most tech companies rarely pay out more than 3% of revenue as stock-based compensation. Long-term Zendesk investors can only hope that the company will not go down that road.

But my biggest gripe with Zendesk is the fact that the company has never been free cash flow positive. The company posted free cash flow of ($12.18 million) in fiscal 2012; ($7.77 million) in fiscal 2013 and ($27.59 million) in fiscal 2014. During the last quarter, Zendesk posted free cash flow of ($8.55 million). It’s easy to argue that the company is burning so much cash because it’s still in the rapid expansion stage. But, checking the historical free cash flow trends of CRM companies such as Salesforce and Pegasystems (NYSE: PEGA), among other companies, reveals that most had healthy and positive free cashs flow when they were at a similar growth stage as Zendesk currently is. This suggests that Zendesk’s business model is perhaps to blame for the high cash burn rate.

It appears as if Zendesk has been using up most of its available cash in R&D as well in its expansion efforts. At the moment, this seems to be working well since the company’s top line growth is still way above the industry average. The company, however, issued full-year revenue guidance of $192 million-$195 million, which implies 52.4% Y/Y growth. That would be a pretty dramatic slowdown given that the company’s top line grew 76% Y/Y in fiscal 2014. I’m pretty sure that the market will be willing to give Zendesk a get-out-of-jail pass for its losses, but not if its top line growth shows a sudden slowdown.

Bottom Line

I think that Zendesk is a company with a lot of growth potential and I admire its aggressive international expansion efforts. I’m, however, not very comfortable investing in companies at this stage of growth simply because they tend to have too many moving parts which results in excessive volatility in their shares. Zendesk is burning through a lot of cash, and has guided for what appears to be a pretty dramatic slowdown in growth during the current year. I will wait for the market’s verdict at the end of the year and then take a position if the shares tank (which I suspect they will).

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