Zendesk (ZEN) Q4 2019 Earnings Results Review

Zendesk released earnings results for Q4 2019 on February 6, 2020.  Reaction to these results were generally positive.  The market bid ZEN stock up slightly the next day, closing up about 0.3%.  Analysts were uniform in their reaction, with 6 out of 6 analysts raising their price target and reiterating a buy rating. Projections for 2020 were on target, with room to outperform. Let’s take a deeper look at the results.

Headline Financial Results (EPS is Non-GAAP)

• Q4 2019 Revenue was $229.9M versus $227.6M expected, up 33.5% year/year.  Beat of $2.3M or about 1%.
• Q4 EPS was $0.10 vs. $0.10 expected.  Non-GAAP operating income of $11.6M, representing operating margin of 5.1%. This compares to 2.8% in the prior year period.
• FY 2019 Full Year Revenue was $816.4M vs. $814.2M expected, up 36% year/year.  Note that the original full year 2019 Revenue estimate published in Feb 2019 was $800M at the mid-point. Actual 2019 result represents over-performance of 2%.
• FY 2019 Non-GAAP operating income of $26.6M, representing operating margin of 3.3%.  2018 operating margin was 0.6%.
• Q1 2020 Revenue estimate of $239.5M at the mid-point of $237 – $242M versus consensus estimate of $238M.  Raise of $1.5M or about 0.6%.
• Q1 2020 Non-GAAP income estimate of $5-9M, representing operating margin of about 2-4%.
• FY 2020 Revenue of $1.06B at the mid-point of $1.05-$1.07B versus consensus estimate of $1.06B.  Represents growth of 30% year/year.
• FY 2020 Non-GAAP operating income of $43-53M, representing operating margin of 4-5%, compared to 2019 operating margin of 3.3%.
• FY 2020 FCF in the range of $40-50M.   FY 2019 FCF of $42.3.

Other Notes

• Ended the year with cash and cash equivalents of $693M.
• Non-GAAP gross margin of 76.7% for Q4 2019, compares to 74.3% in prior year period.  Non-GAAP gross margin of 75.3% for full year 2019, compared to 73.3% for 2018.
• Full year revenue growth in just the U.S. (ZEN’s most mature market) was 38%, while growth in LATAM was 49%. This implies that revenue growth in EMEA and APAC was lower, representing potential upside.
• Zendesk Suite, which is the bundle of Support, Guide, Chat and Talk, customer count exceeded 6,000.  Drove revenue growth and larger average deal sizes.
• Enterprise penetration is continuing.  Percent of total revenue from customers with 100 or more Zendesk Support agents grew to 43% in Q4 2019, versus 40% in Q4 2018 and 42% in the prior quarter.
• Rolled out several new product improvements in Q4 2019:
  • Launched Gather – a new product for managing online community forums for customers
  • Added integration between Zendesk Support and WhatsApp
  • Expanded Answer Bot channel coverage
  • Several incremental features and capabilities in Sunshine, the new open CRM platform
  • Launched Sunshine Conversations, a new omni-channel messaging platform
  • Integrated Sell, the Sales Force Automation tool, with the Zendesk app development framework. This allows third party developers to distribute new apps through the Sell Marketplace.
  • New capabilities added to the Guide Enterprise knowledge management product, including AI-powered content cues to prompt for new knowledge coverage
• The Sell product is being sold by the main Zendesk salesforce starting in February.
• Increased focus on enterprise sales, by hiring more account executives and solutions consultants with enterprise experience.
• Expanded partner network to include over 1200 partners, which is an increase of 50% over a year ago.  Sales from deals with partners more than doubled in 2019.
• DBNER was 116% in Q4 2019. This compared to 119% in Q4 2018, and was even with 116% in the prior quarter. Zendesk leadership has published a target of 110-120% for DBNER, so this quarter’s rate is in range and slightly above midpoint.

• RPO (Remaining Performance Obligations) growth was strong. RPO represents future revenues that are under contract, but haven’t been recognized. Total RPO at end of 2019 was up 57% over 2018, with current RPO up 40% and long-term RPO up 132% year-over-year.
• Overall customer count grew 15% year over year. For products outside of Support and Chat (the oldest products), customer count almost doubled.

Analyst Reactions

Following the earnings results, all 6 analysts who updated their coverage raised price targets and reiterated their buy ratings. The average price target for these updates is a little over $103, representing about a 19% gain over the closing price on Feb 7th.

Analyst Alex Zukin from RBC Capital issued the highest price target and shared this perspective, which I agree is foundational to the long-term investment thesis.

The analyst also believes that the company has the potential to grow its revenue by over 30% over a multi-year period given its “multiple growth initiatives to address a large market opportunity.”

Alex Zukin, RBC Capital, Sourced from TheFly

My Take-aways

• RPO growth was particularly impressive. The year-over-year increase of 57% is indicative of signing larger, long term deals with enterprise customers. The fact that RPO growth rates significantly exceed revenue growth estimates bodes well for revenue outperformance in 2020.
• While revenue growth is still strong, Zendesk is continuing to improve operating margins. In 2019, operating margin grew over 2% from 2018. Similarly, estimates for 2020 call for another 2% growth in operating margin, approaching 5%. I appreciate the steady improvement in profitability while continuing to invest in product growth.
• Gross margins are increasing, growing 240 basis points (2.4%) year-over-year. This is helping operating margin and indicates continued expense optimization as Zendesk scales.
• Growth in customer counts for new products (outside of Support and Chat) was very impressive, nearly doubling year-over-year. These customer counts are approaching the total for Chat and half of Support. To me, this is a positive indicator that Zendesk can launch new products and create fresh revenue streams. This growth in new product penetration combines nicely with the DBNER to provide support for overall revenue growth going forward.
• Zendesk Suite adoption is encouraging – reaching 6,000 customers. Since Suite includes Talk and Guide, in addition to Support and Chat, it demonstrates traction outside of the core products. Also, Suite will continue to drive larger new customer deals and DBNER on customer upgrades.
• Management provided several more teasers around the Sunshine platform. They are implying that discussions with customers regarding Sunshine adoption are going well and provided some example use cases. Sunshine is currently not monetized, but will be, in 2020. This could provide further revenue upside. At the Zendesk Relate conference in March, management is hinting at more announcements regarding Sunshine.
• The pace of product innovation is impressive. Two entirely new products were launched in Q4 (Gather and Sunshine Conversations), along with meaningful enhancements to several existing products. Given that new products are necessary to fuel incremental revenue growth, it is refreshing to see rapid progress here.
• Management highlighted their new messaging capabilities, following on the acquisition of Smooch and launch of Sunshine Conversations. They feel that messaging will represent a new paradigm for customer service interactions and hint at high demand for the Conversations offering going into 2020. This focus on messaging is smart, as we are seeing indicators from other software providers, like Twilio, that consumers prefer to engage over this channel.
• Sales execution issues from prior quarters in EMEA appear to have been addressed, by firming up sales leadership there. Similarly, APAC is getting the same focus. Given that EMEA is back on track, we can conclude that a similar approach applied to APAC would represent some upside for 2020.
• Growth in the partner network was strong with a significant increase in partner-sourced deals in 2019. Management also spoke to this on the earnings call. SI’s tend to be engaged by larger enterprises as part of broader digital transformation efforts. So, partner network growth reinforces the enterprise sales motion.

Some Items to Watch

While Zendesk’s Q4 2019 results were encouraging, investors should monitor a few items going forward in 2020.

• DBNER needs to stay in the target range of 110-120%, preferably above 115%. For the past 2 quarters, DBNER was 116%. Maintaining this range in 2020 will provide support for high revenue growth allowing time for new products to ramp up.
• Sunshine is a huge bet and encroaches upon CRM territory traditionally owned by behemoth Salesforce. Zendesk’s competitive positioning is smart, as they emphasize openness and flexibility. However, it isn’t hard to imagine a meaningful response from Salesforce to counteract this. Sunshine could either drive meaningful incremental revenue growth for many years, or sputter out of the gate.
• We see slowing customer growth in Support and negative growth in Chat, so continued customer adoption of new product offerings will be critical to maintaining high revenue growth going forward. While the pace of new product launches is impressive, if these don’t gain sufficient traction, that will represent a headwind to sustained revenue growth.

Investment Plan

Overall, ZEN’s results met my expectations and I am maintaining my 5 year price target of $220 or more. Investors can review my prior in-depth analysis of Zendesk for the full investment thesis. At a base level, I agree with RBC Capital’s summary. By continuing their product expansion and enterprise sales motion, Zendesk is well-positioned to maintain 30% revenue growth for the next several years. In parallel, profitability is continuing to increase. This means that investors can expect market cap to scale proportionally to revenue growth, as ZEN’s current EV/Revenue ratio of 12 could be maintained. Compounding revenue growth of 30% over 4-5 years would result in about a 3x increase in stock price. ServiceNow (NOW) provides a blueprint for this – at over $3B in annual revenue growing just over 30% and increasing operating margin, NOW has maintained an EV/Revenue over 12 for the past 2 years (spiked up to 19 currently). Given that Zendesk is also dominating its core market of customer support and rapidly adding new product lines, I think it is reasonable for investors to expect a similar trajectory.

ZEN management is building up anticipation for some exciting product announcements at the Zendesk Relate conference in March, including an analyst meeting on March 4th. I will provide further updates coming out of that event.