Zendesk (ZEN) Q1 2020 Earnings Results Review

Zendesk released their earnings report for Q1 2020 on April 30, 2020. Results were mixed – they beat Q1 estimates, but lowered revenue projections for Q2 due to COVID-19 impact on customers. The market reacted the next day by pushing ZEN stock down 5.6%, although some of that drop has recovered since then. Most analysts lowered their price targets. Zendesk leadership also retracted prior FY 2020 guidance, until they have more clarity around the duration of the COVID-19 economic downturn. Let’s take a deeper look at the results and draw some conclusions for the investment thesis.

Headline Financial Results (EPS is Non-GAAP)

• Q1 2020 Revenue was $237.5M versus $236.9M expected, up 30.9% year/year. This represents a slight beat of $0.6M, and is inline with guidance provided as part of Q4 earnings of $237-242M. Q4 2019 revenue growth was 33.5% year/year.
• Q1 Net income was $12.4M. EPS was $0.10 vs. $0.06 expected. In Q1 2019, Net income was $5.0M and EPS was $0.04.
• Non-GAAP operating income was $9.2M, representing operating margin of 3.9%. This compares to operating income of $0.6M and operating margin of 0.3% in Q1 2019.
• FCF was -$15.6M, representing FCF margin of -6.6%. This compares to 6.4% in Q1 2019. Free cash flow was impacted by partnering with distressed customers to defer payments and the previously announced change to invoice customers on their renewal date instead of 30 days prior (transitory impact on billings and cash flow).
• Q2 2020 Revenue estimate of $237-243M versus consensus estimate of $246.5M. Lower by $6.5M at the midpoint, or about 2.6%. Q2 revenue estimate represents year/year growth of 23.3% at the midpoint.
• Q2 2020 Non-GAAP operating income estimate in the range of $8-12M. This would represent an operating margin of 4.2% at the midpoint of revenue guidance. Included is $8M of COVID-19 related expense, including continuing support for employees working from home and bad debt expense.
• Pulled guidance for full year 2020, which had been published with Q4 2019 earnings results.
• Ended the quarter with cash, cash equivalents and marketable securities of $837M.

Other Performance Notes

• Non-GAAP gross margin of 78.3% for Q1 2020, compares to 73.5% in Q1 2019 and 76.7% in Q4 2019. The 4.8% improvement year/year was primarily driven by customer success initiatives and increased hosting efficiencies.
• Q1 expenses included a few unplanned items – a $6.5M allocation for employee stipends to help transition to work from home, additional cost associated with last-minute cancellation of the Relate conference and increased bad debt expense driven by customer collection concerns due to COVID-19. Lacking these would have further bolstered profitability in Q1.
• Lower Q2 revenue estimate was primarily driven by contraction in usage by customers in industries that are facing significant pressure, including airlines, retail, ride-sharing, travel and hospitality. This started at end of Q1 and is expected to continue through Q2. The CFO clarified that these sectors represent about 20% of Zendesk’s business. They are not seeing churn in these customers so far, just reduced spending. In many cases, this is because the customer has cut back on customer service staffing due to lower business activity.
• RPO (Remaining Performance Obligations) growth was strong again this quarter. RPO represents future revenues that are under contract, but haven’t been recognized. Zendesk believes that RPO growth provides a good indicator of penetration in mid-sized and enterprise customers, as these tend to sign longer term contracts, versus engaging in month-to-month arrangements. Short term RPO (realized in 12 months) increased 41% and long-term RPO (realized longer than 12 months) increased 94%. Total RPO increased 53% year/year. The leadership team is encouraged that customers are continuing to commit to multi-year contracts, even during this environment.

• DBNER was 115% in Q1 2020. This compared to 116% in Q4 2019 and 118% in Q1 2019. Zendesk leadership has published a target of 110-120% for DBNER, so this quarter’s rate is in range.
• Enterprise penetration is continuing. Percent of total ARR from customers with 100 or more Zendesk Support agents remained at 43% in Q1, inline with 43% in Q4 and up from 40% in Q1 2019.

• Leadership spent a lot of time on the analyst call talking about the impact of COVID-19 and how Zendesk is working with customers to support them. It is clear that customers in certain industries have experienced severe business impact. In these cases, Zendesk is trying to “do the right thing” by providing these customers with extended payment terms or one-time discounts. The focus is to maintain customer retention through this period, with the expectation that usage will pick up after the situation improves. This drove the shortfall in anticipated revenue for Q2.
• Highlighted strong activity in messaging channels enabled by Sunshine Conversations. Feel that this reflects user preferences for moving conversations off of the phone.
• Emphasized that many customers want fast time-to-value in this environment and are eschewing large software installations, at least for now. Favors Zendesk’s low touch on-boarding and agility.
• Have implemented expense reduction activities, including dialing back on hiring. However, the CFO did mention that sales hiring was strong in Q1 and she is confident that Zendesk has sufficient “quota on the street”.
• Rolled out several major product improvements in Q1 2020, coinciding with the virtual Relater event in March.
  • Support Suite. Bundles Support, Guide, Chat and Talk into one offering, focused on customer support organizations, allowing for cost savings over licensing each product individually. Layers on extended messaging integration with social channels (WhatsApp, Messenger, WeChat, LINE, etc.) through Sunshine Conversations. Messaging is woven into a common UI, providing a single omni-channel view of all communications with customers.
  • Sales Suite. Supplements Zendesk’s stand-alone salesforce automation product, Sell, by adding Chat, Voice and Reach. Sales Suite allows inside sales teams to pick up prospective customers from initial contact on their web site or mobile app and guide them through product selection to concluding a sale. The conversation can move from chat to voice, text or email easily, with all interaction history displayed in the same interface.
  • Sunshine Platform Improvements. Sunshine is Zendesk’s new CRM platform, native to AWS. It provides a foundation of API’s and data storage upon which enterprises can aggregate all of their customer data and build better engagement experiences. Zendesk announced pricing for Sunshine and moved it into GA in Q1 – now it can be monetized, separate from other product offerings. They also added three new capabilities to the platform – Custom Events, Unified Profiles and the AWS Events Connector. Custom Events allow enterprises to model any customer interaction, like a shopping cart addition, product delivery or a return. Unified Profiles can model all information about a customer, usually aggregated from multiple business management applications, like point of sales, loyalty, installation and training. The AWS Events Connector provides a universal data import/export tool to facilitate integration with other business management applications. 
  • Introduced the Remote Support Bundle, designed to help customers manage customer service activities with a physically distributed team. Offers a collaboration add-on, Explore analytics, training credits and workforce management tracking.  Available to existing customers at the Pro or Enterprise Support or Support Suite levels for free for six months.
  • Developed significant content like webinars, virtual community meetups and other virtual events to provide organizations with best practices on how to operate customer service in the new COVID-19 environment.
• Highlighted the following customer additions or expansions in the quarter:
  • Discord. Communications app for voice, video, and text. Popular with gaming and education communities. Invested in Zendesk Support, Gather, Guide and Answer Bot.
  • 7-Eleven. International chain of convenience stores. Appears to be using the Support product for servicing franchisees and their employees.
  • Calm. Most popular app for meditation and sleep assistance with 80M downloads. Uses Zendesk Support and Guide.
  • Alfa-Bank. Largest private commercial bank in Russia with 23,000 employees and 723 offices in 7 countries.
  • Dallas Morning News. Daily newspaper for Dallas – Ft. Worth, TX.
  • LG Electronics – Alabama. Customer service division for LG’s North American market. Offers technical and customer support for appliances, consumer electronics and wireless communication products.
  • Zoom. The popular video collaboration service.
  • Teachable. Online course creation platform that has generated over $300M in revenue and served 18M students. Added Zendesk Chat seats and turned on Answer Bot to handle an 80% increase in customer service volume.
  • Landbot. No-code chatbot builder with clients like MetLife, L’oreal and Uber. Used Sunshine Conversations to power their chatbots for WhatsApp and the web sites of several crisis relief organizations.
• Overall customer count grew to 160,600, up 10.3% year/year. For the newer products outside of Support and Chat (Zendesk’s oldest products), customer count increased by 46% year/year to 36,100. This is encouraging as it represents the future growth vector for Zendesk.

• Commented on involvement of global SI’s in new deals. Leadership said some partners brought them quick-win deals where companies were looking to make rapid changes to their customer service posture. Zendesk was able meet the need. As market conditions improve, leadership thinks that partners will continue this motion.

Analyst Reactions

Following the earnings results, six analysts provided updated coverage ratings. The ratings were split between Buy and Hold equivalents. The average price target for these updates is a little over $80, representing a 10.3% increase over the closing price of $72.55 on May 1st.

Interestingly, after Q4 results in early February, analysts all set Buy ratings and an average price target of $103, with the highest price of $115 from RBC. What a difference a pandemic can make. This does provide some perspective into future potential, if Zendesk and the broader economy can get back to some normalcy.

Date	Analyst	Rating	Price Target
5/1	Stifel Nicolaus	Hold	Lowered from $85 to $75
5/1	UBS Group	Neutral	Lowered from $88 to $80
5/1	RBC	Outperform	Lowered from $90 to $85
5/1	Jeffries	Buy	Raised from $80 to $85
5/1	Piper Sandler	Neutral	Maintained $76
5/1	Oppenheimer	Buy	Raised from $73 to $80

After earnings results, Piper Sandler downgraded Zendesk and maintained a price target of $76. Analyst Brent Bracelin provided this commentary.

Piper Sandler analyst Brent Bracelin downgraded Zendesk to Neutral from Overweight with an unchanged price target of $76. The analyst sees rising execution risks over the next two quarters and a more balanced risk/reward after the 20% share rebound in April. He remains bullish on direct to consumer secular drivers for Zendesk longer term, but prefers to wait for more signs of customer stability before adding to positions.

TheFly, May 1, 2020

On the upside, Jeffries maintained a Buy rating and raised the price target by $5. Analyst Samad Samana provided this commentary.

Jefferies analyst Samad Samana raised the firm’s price target on Zendesk to $85 from $80 and keeps a Buy rating on the shares. The company’s Q1 revenue and operating margin beat consensus but billings missed, mostly due to an expected invoicing change, Samana tells investors in a research note. Further, Zendesk’s Q2 guidance for 23% revenue growth was better than feared, adds the analyst. Samana is impressed the company can still deliver over 20% growth in Q2 and believes its valuation “remains reasonable and attractive.”

TheFly, May 1, 2020

My Take-aways

• Revenue deceleration for Q2 is nearly 8%.  Granted, the COVID-19 situation explains a lot of this, but I will want to see this recover going into 2H20 to keep the investment thesis intact.  Looking at a couple of comparable software names that have reported, NOW wasn’t noticeably affected in forward guidance and outperformed after earnings. TEAM lowered next quarter revenue guidance by 2.5% (about the same amount as ZEN). TEAM’s customer distribution by size more closely mirrors ZEN’s.
• Profitability measures continue to improve. Saw 480 bps increase in gross margin and 360 bps increase in operating margin year/year.  FCF went from positive 6.4% to -6.6%, but I think this is explainable by previously announced change in invoice timing and extending payment terms for distressed customers.  For Q2, Zendesk expects 4.2% operating margin, which also includes $8M of COVID-19 related expenses.
• Customer additions are progressing at about the same rate, reflecting that competitive position is intact. Revenue shortfall was attributed primarily to usage contraction versus churn. Customer growth in new products of 46% is 4x overall customer growth rate.
• RPO growth was a positive highlight. The year-over-year increase of 53% is indicative of signing larger, long term deals with enterprise customers. The fact that RPO growth rates significantly exceed revenue growth bodes well for future revenue realization.
• Since Conversations is expected to drive meaningful revenue in 2020, the surge in messaging traffic and uptake of Sunshine Conversations is encouraging.

Risks and Items to Watch

In addition to comments above, investors should keep an eye on the following items.

• DBNER slipped one point to 115% in Q1.  Will likely be lower in Q2.  I’d like this to stay in the higher end of management’s 110-120% target.
• Expense reduction activities could limit future growth, if they persist for more than one quarter. CFO mitigated this for Q2, saying that sales hiring in Q1 was strong and that she is comfortable with the current quota allocation. A prolonged slowdown in R&D spend would similarly risk product velocity.
• While product expansion has been rapid, I will want to see meaningful traction in new products.  Sunshine is a huge bet and encroaches upon CRM territory traditionally owned by Salesforce. Zendesk’s competitive positioning is that Sunshine emphasizes flexibility, openness and time to value. While a big opportunity, Zendesk will need to execute an effective go-to-market strategy over the next year.

Investment Plan

Zendesk’s projections for Q2 could have been better, but I understand the rationale with the COVID-19 situation. I can accept usage contraction from distressed customers as a plausible explanation for the Q2 revenue guide. The continued improvement in profitability, even with some unforeseen costs, is encouraging and might represent a bit of a silver lining. RPO growth also provided support for longer term revenue growth. With that said, Zendesk will need to get back to a 2020 revenue growth target in the high 20% range. Assuming the COVID-19 situation improves in 2H2020, the key investment consideration will be to look forward to 2021 and anticipate whether Zendesk can return to 30% revenue growth. If achieved, along with further profitability optimization, these would drive meaningful share appreciation within 12 months.

To model out the optimistic case, if 2020 revenue can grow 27-28%, that would translate to about $1.04B. Adding another 30% for 2021, would yield $1.35B. For 30% revenue growth and assumed operating margin of 5-8%, forward EV/Rev could reach 10. The forward EV/Rev ratio is about 8.5 now and hit 10 in February, after Q4 earnings. That would imply an enterprise value of $13.5B or 60% over the current value of $8.4B. Stock price would be around $120, versus about $74 now.

In the pessimistic case, revenue grows 25% on average in both 2020 and 2021 and profitability maintains. The revenue estimate for 2021 would be $1.275B. Assuming a forward EV/Rev of 8 (reduced for revenue growth), enterprise value would be $10.2B, or 21% higher than today, for a share price of about $90. Of course, prolonged economic downturn from COVID-19 would put even this model at risk.

Overall, I am maintaining my 5 year price target of $220. Investors can review my prior analysis of Zendesk for the full investment thesis. However, given the uncertainty in the current environment, I will be watching ZEN performance closely over the course of 2020. I may trim my personal ZEN allocation in the near term and apply that to an entry in one of my other recommendations. If the optimistic case appears to be materializing, I may then add later in 2020.