Zendesk (ZEN) Stock Analysis

Date of Recommendation:       Jan 28, 2020 
Closing Stock Price:          $85.87

Zendesk (ZEN) stock should be considered for long term investment. I expect the price of Zendesk’s stock to grow significantly over the next 5 years.  This is based on my characteristics for a successful software stack company. Growth will be driven by their solid position in a large addressable market, with multiple expansion opportunities. Their product development cadence has accelerated, with several exciting new launches in the last two years. Zendesk is viewed as a leader in customer service and already supports many large-scale internet-first operations. They have a reliably growing revenue base and have demonstrated basic profitability. The leadership team is strong, led by a long-time founder and CEO. I expect the stock price to more than double and exceed $220 within the next 5 years.

Financial Overview

I have been a long time investor in Zendesk. I was introduced to the company in 2013, when I was VP Engineering at Zoosk (a dating property that nearly IPO’ed in 2014 under ZSK). We occupied the floors above Zendesk in an office building on Market Street in San Francisco (where they are still headquartered today). Like many internet-first companies, we used Zendesk’s customer support tools. Zendesk went public in 2014 at a time when many companies were discouraged from IPO’ing (ZSK included). Zendesk was one of few enterprise focused companies that persevered, opening trade in May 2014 around $16.

The stock was range bound in the $20’s through most of 2017. From October 2017 to July 2019, though, the stock tripled from $30 to just over $90. In the Fall of 2019, the software stock sell-off hit ZEN like most others, and it dropped back to $65. As we kick-off 2020, the stock has recovered and is trading at about $85 now.

I think that ZEN will break $100 at some point in 2020, and then continue the steady upward ascent that started in 2018. It should pass $200 within a couple more years and reach my target of $220 by 2024, or sooner.

My stock price projections are based on the following assumptions:

• Average annualized revenue growth of 30+% for the first 2-3 years and then dropping to the high 20’s.
• Increasing non-GAAP EPS
• Achievement of long term non-GAAP gross margin target of 78%
• Improving FCF margin

Current EV/Revenue ratio is 12.5. End of 2019 EV/Revenue ratio target is 11.6. End of 2020 EV/Revenue ratio would be 8.9, assuming 30% revenue growth, which is current consensus. EV is $9.5B on projected $814M revenue in 2019. If we assume another 30% revenue growth in 2021, and 25% revenue growth from 2022 – 2024, we arrive at about $2.7B in revenue in 2024. Within increasing profitability, a revenue growth rate in the mid to high 20% range would at least justify an EV/Revenue ratio of 10 at peak. This gives a total EV target of $27B, or about a 3x increase from today’s value.

Profitability will similarly improve over the next 2 years. The growth of non-GAAP EPS is impressive, notably higher than projected revenue growth. This combination of high revenue and earnings growth should be a powerful driver of share price.

In order to meet these assumptions, Zendesk will need to continue to maintain their product leadership, expanding their offering into enterprise customers and fending off competition. I will deep-dive on product, market and competitors shortly, but first, let’s examine a few other financial highlights from the most recent quarter.

Q3 2019 Results

ZEN released Q3 2019 results on 10/29/2019. They reported $210.5M in revenue versus consensus of $207.6M, representing year/year growth of 35.9%. Non-GAAP EPS was $0.12 versus consensus of $0.06. For Q4 2019, leadership projected $227M in revenue versus $226.6M consensus for 31.8% growth. If Zendesk over-performs on revenue by $3M again, this would add another 2% to growth. Total 2019 annual growth is targeted at 36%.

Investors will want to monitor year/year revenue growth going forward. As you can see in the chart above, annual revenue growth reported each quarter has stabilized over the last couple of years. For the longer term, we can expect the growth rate to drift down towards 30%, and this is the base analyst target for 2020. I think ZEN has a good chance of maintaining 30% growth for a few more years, and then high 20’s.

Here are some highlights from the Q3 2019 financial report:

• Paid customer count was 153,700, representing growth of about 15% over the prior year.
• Revenue increased by 41% in the U.S., 29% in EMEA, 27% in APAC, and 45% in other regions, compared to a year ago. There is obviously room for improvement in EMEA and APAC, which Zendesk is addressing through sales re-org and new strategic hiring.
• The percentage of annual recurring revenue from customers with 100 or more Support agents was 42% versus 40% a year ago. This is an important measure of “enterprise” revenue.
• The dollar-based net expansion rate (DBNER) was 116%. While this came down from previous quarters, it remains in the target range of 110-120%. Some of this decrease is explained by turbulence in EMEA and APAC from prior quarters.
• RPO grew by 55% year/year. RPO represents future revenues that are under contract but have not yet been recognized. ZEN leadership points at this metric as an indicator of growth with large customers, as those sign long term contracts.

Analyst Coverage

While folks can debate the accuracy of sell-side analyst recommendations, these do influence sentiment towards a stock. Currently, ZEN has 18 ratings that are the equivalent of Buy and 2 Hold ratings. The two hold ratings were set in July 2019 and haven’t been updated by the associated analysts. All announced ratings since then have been positive.

Most recently, two analysts provided updates on ZEN:

• RBC maintains overweight rating, boosts price target to $100 from $81 (Jan 21, 2020). Analyst comments: “The analyst expects a bounceback quarter for the company, reversing softer trends from Q2-Q3, noting that the deals which slipped in the most recent quarter have all closed successfully. Zukin adds that his channel checks point to better domestic close rates, with greater sales morale and lower sales pressure toward quarter-end.”

• Oppenheimer upgraded ZEN from perform to outperform and set a $103 price target (Jan 17, 2020). The analyst “thinks the Sunshine platform will serve as an upside driver over the next 12-24 months.”

Product Overview

The initial Zendesk product was a customer service offering that fielded issues reported by users of web properties and powered a self-service “Help” section of those sites. This was called the Support product. Support allows customer service teams in these companies to collect, prioritize and address customer support tickets in a flexible, intuitive user interface.

Since that time, Zendesk has dramatically expanded their product offering into knowledge base, chat, forums, customer marketing, call center, analytics and most recently CRM. Their intent is to provide a full platform offering that addresses all aspects of customer relationship management. Of course, this sounds like what Salesforce (CRM) does and there is overlap. Zendesk and Salesforce started from different ends of the customer experience market. Salesforce initially focused on lead capture and pipeline management for sales people, while Zendesk focused on customer support processes. In either case, enterprises prefer to work across a single platform for all their customer management needs. Salesforce was first to market with a full solution. Zendesk just put the final pieces in place in 2019.

Also worth noting is Zendesk’s evolution by customer segment. In the early days, they focused their sales efforts on SMB and “internet first” companies. By selling directly to many of the early internet unicorns in 2010 – 2015, Zendesk was able to gain traction quickly and experienced rapid revenue growth as these companies expanded their businesses. There was even a concern voiced by analysts in 2015-2016 that this dependence on many of the non-profitable, high growth consumer internet brands for revenue might backfire, if these companies started going out of business. This didn’t happen for the most part, but Zendesk acknowledged that future growth needed to be through acquisition of mainstream “enterprise” customers.

Zendesk defines an enterprise customer as having more than 100 seats. This proxy works well, as you can imagine a larger company having more than 100 individuals in customer service. With this definition and objective in place, Zendesk was bumping up against limitations in sales to the global 2000 companies, who prefer a full solution that includes a product offering in all facets of customer engagement management. This prompted Zendesk to expand their product offering during 2017 – 2019, through internal development and acquisitions. The result is that going into 2020, Zendesk leadership feels they are well positioned from a product point of view to compete for enterprise business with larger competitors, primarily Salesforce. Whether true or not, at least Zendesk isn’t written off immediately by large customers due to a gap in the product offering. This point was underscored by the CFO on a recent analyst call, in which she specifically mentioned that a couple of large customers who passed on Zendesk in the past have re-engaged, due to the completeness of the offering.

Penetration into larger companies has been progressing gradually, as the chart below shows. Annual Recurring Revenue for the Support product from companies with 100+ agents has grown beyond 40% to 42% in the most recent quarter.

Gartner defines the space that Zendesk operates as the CRM Customer Engagement Center. This still has its roots in customer support ticketing, but has evolved into a broader system of addressing customer service in all facets of the sales process, across multiple communication channels. The definition also recognizes that customer service is evolving to drive proactive sales, beyond reactive issue resolution.

Gartner now defines the CRM CEC market as the market for software applications used to provide customer service and support by engaging intelligently — both proactively and reactively — with customers by answering questions, solving problems and giving advice. The orchestration of intelligent customer processes through a CEC application is built around a case management record and process. It may include advisory services, problem diagnostics and problem resolution, account management, insurance claims handling, servicing of banking interactions, provisioning and returns management, among other things. To be able to orchestrate the processing of customer engagements for the best outcomes in an effortless, effective and timely way, the workflow is an important component, and some organizations require intelligent business process management (BPM) capabilities. In addition to case and workflow management, knowledge — and management — of how to enrich and personalize customer engagements is crucial.

Gartner Magic Quadrant for CRM CEC, June 2019

Given this landscape, let’s look at the set of Zendesk product offerings and how these have evolved.

Support

The original Zendesk product offering was Support. Per the Zendesk web site, “Zendesk Support is a beautifully simple system for tracking, prioritizing, and solving customer support tickets.” It consolidates all customer service interactions into one tool, so that customer service agents can easily reference the history with a customer. Content and workflows can be customized to handle different business types and engagement models. This is anchored in a UX interface modeled after a help desk. All customer interactions across any medium – phone, chat, email, social media, etc. – are consolidated into a single view.

A popular customer touchpoint is the little chat window that you see on most e-commerce sites now. These are often powered by Zendesk Chat and the output flows into the Support tool, providing a record for the customer service rep.

Since most customer service operations are metric driven, Support provides performance data and dashboards. These generate useful insights and customer satisfaction ratings, so that customer service managers can optimize the performance of their teams.

Customer service tickets can be initiated through email, Facebook, Twitter, or customizable ticket forms. The tool is international ready, as Zendesk does almost half its business outside the U.S. The Admin interface is available in over 40 languages. It’s also easy to collaborate issue resolution between teams within the Support tool, in the event that customer service isn’t able to address the customer issue by themselves.

Like most Zendesk products, Support product pricing is sold on a usage basis, per agent per month. There are different levels, which include various add-on services.

Guide

Zendesk Guide enables the creation of a “knowledge base” with the intent to allow customers to answer their question themselves. Guide organizes frequently asked questions, product details, policies, and more, and publishes that to the company’s web site in a CMS that is separately managed by Zendesk.

Zendesk generated a report in 2019, based on a survey of Internet users. They found that a majority of the Gen Z and Millennial population prefer to locate the answer to a question themselves, versus calling customer support. This is the opposite of Boomers, who tend to pick up the phone.

Guide provides a customer service team with the tools to create the “Support” or “FAQ” section of their web site (modeling after a CMS, like WordPress). Guide offers a WYSIWYG editor and a Google Docs importer to make the content generation process easy. It’s also optimized for search-engine consumption.

At an investor conference in December 2019, Zendesk leadership said that the Guide and Answerbot products are growing faster than other offerings. Also, they noticed an interesting trend in which the customer service agents are using this knowledge base to educate themselves and quickly retrieve answers on customer calls.

As an example of Guide in the wild, here is the Support section of an e-commerce site (boat sharing) that I know is powered by Zendesk.

Guide has built in tracking and reporting, that provides feedback on which content is satisfying users and where gaps might be. This is also integrated with the Support tool, so that a customer company can create a feedback loop of customer service inquiries generating new self-service Support content.

Chat

Zendesk Chat offers a way to connect customer service personnel with customers in realtime. This is generally applied at key friction points in the customer’s shopping experience, like the product page or during check-out. It also provides an easy way for customers to reach out with a question in a low touch way – without requiring a phone call.

The Chat service can be applied to the main customer entry points – web site, mobile app, Facebook Messenger and WhatsApp. The interface is the same for the customer service agent, regardless of channel. In order to maximize the productivity of agents, they aren’t limited to a single Chat thread at a time. Agents can switch between serving Chat threads, phone calls, emails and social media messages. 

As an example, clothing rental company Le Tote uses an automated trigger to pop up a Chat window if a customer is hanging on the checkout page. This prompt allows Le Tote to address any customer concerns at point of purchase. The outcome is an increase in conversions, which Zendesk claims can be as high as 3x.

Talk

Zendesk Talk is a cloud-based, call center solution. This allows customer support personnel to handle phone calls to the customer support line from their computer using a headset. Talk is built into the same interface as the Support product that customer support personnel are already using to handle inquiries from chat, email, etc.

As part of the Talk product, customer support teams can set up IVR (interactive voice response) trees, which provide a menu of options to accommodate different types of inquiries and call routing to the correct support teams. Talk also provides real-time queue monitoring and reporting to allow customer support managers to ensure that enough personnel are online to handle call volume and prevent bottlenecks.

Set up is extremely easy, as Talk is a VoIP (voice over IP) system. The customer support team only needs a computer, a browser, internet connection and headset. The Zendesk Talk system is further extended by providing support for handling customer communications via text message through their Text product, which is bundled with Talk. Inbound SMS and MMS message formats are supported, as well as the ability to respond with SMS. All communications are captured in the Support tool. The team can also customize a flow for text message routing and auto-responders using macros and other business automation.

Finally, Zendesk provides a 99.95% uptime SLA to meet the high availability expectations of customers. Interestingly, the Zendesk Talk and Text systems are built on top of Twilio’s infrastructure, which is a well known CPaaS provider. I cover Twilio separately in this blog post.

Like most Zendesk product offerings, Talk is licensed by customers on a monthly per agent fee. This provides customers with nice flexibility to get started for a low cost and scale usage up/down as needed.

Sell

Zendesk Sell represents Zendesk’s initial foray into a traditional CRM solution. Sell is a sales force automation (SFA) tool, which is used to improve processes and pipeline visibility for sales teams. The Sell product was enabled by Zendesk’s acquisition of FutureSimple, and its SFA product, called Base, in September 2018.

The Sell tool provides the ability to capture full customer account information in addition to what is reflected from Support interactions. The implication in this case is that Support interactions, particularly where a potential customer was intercepted by a Chat widget in the consideration phase, could be transitioned into a buyer. This represents an interesting evolution in the customer service space, in which reps can also be enabled to encourage sales, versus just responding to inbound requests. A support ticket associated with questions about product offerings can also be handed off to the sales team and tracked through Sell. By keeping all customer information in a single system, sales has a history of the prior discussions with the support team.

Companies can configure the sales pipeline in Sell to mirror their process. Like most CRM tools, they can track customer contacts through the stages towards a sale. Leads can be ranked, ensuring that high value leads get prioritized. The tool also allows users to send emails, schedule meetings, view history and even make outbound calls with customers.

Acknowledging that customers will likely use a bevy of other tools for communications, the Zendesk platform supports integrations with the most popular ones. For example, if a customer initiates a newsletter subscription on Mailchimp, this will be reflected in the Sell interface.

As you would expect, Sell also provides useful analytics to allow salespeople to track their progress. Users can create their own dashboards using a drag-and-drop interface or select from 30+ pre-built dashboards.

Zendesk provides a customer example from DYME (DiomyMed), which is a major cannabis brand provider in Canada. DYME uses Zendesk Sell, as well as Talk, Support, Chat and Guide products, as a bundle for their 300 employees.

The Sell toolset includes a number of useful productivity features for agents. They can draft and send emails directly from the tool, be notified once customers engage with those emails and maintain templates of email formats to speed up creation. Outbound calls to customers can be initiated with a click, call details are logged and recorded in the tool and agents can create and share call scripts. The agent can also communicate via SMS within the same interface. Finally, the Sell tool includes a sales prospecting feature, that provides access to over 20M businesses, 200M professionals, and intelligent lead recommendations through a partnership with Reach.

The Sell product is licensed on a per seat per month basis, like other Zendesk products. Interestingly, outbound calling is supported by Twilio as well and utilizes their pricing.

Explore

Zendesk Explore provides an analytics platform for tracking customer support success across all interaction channels, including email, chat, phone, social, etc. This allows customer service managers to examine the performance of their teams and make adjustments to optimize customer service effectiveness.

As an example, if a customer is using the Guide product with an AnswerBot, Explore allows the customer to monitor the effectiveness of each article or recommendation in resolving an end user’s problem.

Explore provides a set of pre-built metrics and dashboards, based on best practices observed by Zendesk, as well as the ability for customers to customize their own dashboards. Dashboards can be shared across the team and also packaged into communications reports (like via email) that can be send out on a schedule. They can also be exported into most most common visualization formats, or raw for import into a separate BI tool.

As far as pricing, Explore is available at a base level included in most other product subscriptions. This provides a number of pre-built reports tracking standard metrics. Customers can upgrade for $9 per agent per month to add customization, scheduled distribution and refined access controls.

Gather

Zendesk Gather is a customer community forum solution. It provides a destination for users to post comments, ask other users for advice or share their experiences. This user-generated content is made available for all users to review. The goal is to further allow users to become self-service in solving their own questions or to gather pre-purchase feedback, by making prior customers advocates and reducing load on the company’s support and sales teams.

Customer support personnel can monitor the community content, suppress inappropriate feedback and most importantly, provide additional context where needed.

The main benefits are feedback on products for the product development team to consider and a reduction in support tickets, as customers can help other customers. These benefits were highlighted by a customer testimonial from Invision, a provider of UI design software. “Thanks to our community, we’ve seen some great feedback about our product and we’ve reduced the number of tickets coming in thanks to peers helping each other out publicly.”

Intelligence is also built into the system, with search, voting features and similar post filtering. Users can create profiles, follow other users, give feedback on post quality and share across social channels. Power users can even be promoted to moderator status, allowing them to work on behalf of the community. Content display can be customized with a variety of themes or by editing CSS files. The system supports multiple languages, brands and is SEO ready for Google indexing.

Connect

Zendesk Connect allows for the configuration of proactive communications across customer journeys. This could start with follow-up communications after a deliberate user action, like sign-up or purchase, or include prompts to finish all steps in a product usage process. It could even facilitate an upsell. Messages can be generated across multiple mediums – email, text, push notifications, web widget, based on customer preferences. These can also be used to alert customers of potential issues, like shipment delays or service outages, before customers start sending in support requests.

Customers can be divided into segments around product or service types. These can then be associated with a customized communications program, with frequency capping to ensure the customer isn’t over-communicated.

Communication templates can be personalized to reflect the customer’s individual context – contact info, purchase history, etc. The system allows for conditional logic to be scripted (IF/ELSE, loops) and images to be embedded dynamically. Communications can also be associated with CSAT feedback and customized based on whether the user’s experience so far has been positive or negative.

Finally, Connect supports A/B testing of messages to allow for performance optimization. This allows support and sales teams to experiment iteratively to discover the most effective messaging content and frequency. Pricing is based on the volume of messages sent per month, on a proporational monthly fee scale.

Bundles

Many Zendesk customers subscribe to more than one of the product offerings listed above. Zendesk recognizes this and wants to encourage more of it, so they created product bundles. There are currently two promoted bundles, Zendesk Suite and Duet.

Zendesk Suite includes Support, Guide, Chat and Talk, which arguably represent the main touchpoints with customers. By bundling these products together, Zendesk claims that customers can save up to 35% versus purchasing each product individually. These products are all tied together with shared analytics, allowing the company to track their customer service performance across all channels. Zendesk published a customer testimonial from eBates, which claims they achieved a 93% CSAT score using the Suite.

The other bundle is Zendesk Duet, which includes Support and Sell. This bundle combines sales force automation and customer support in a single offering. Zendesk advertises a discount of up to 40% as compared to licensing each product separately. They cite Staples as a customer for this bundle.

Zendesk Platform – Sunshine

Zendesk Sunshine is a completely new offering by Zendesk, representing a move into a “platform” play and positioning the company to compete in the enterprise space. This is the next logical step in Zendesk’s evolution, from slotting individual customer experience product offerings to a full platform, upon which developers can build new customer experience applications.

At its core, Sunshine is described as an open and flexible CRM platform. It is built natively on AWS, which makes it cloud-friendly. I think this positioning is more about an effort to distinguish this platform solution from Salesforce, which leadership describes as a “walled garden” or “legacy CRM”. Sunshine supports import of all customer data regardless of source, which underlies its description as being open.

When it comes to the customer experience, most companies are stuck in the dark. They still use legacy CRM platforms that are hard to change and only offer a one‑dimensional view of customers.

Zendesk Sunshine represents a whole new approach. Sunshine is a modern CRM platform, built on AWS. It gives you a complete picture of the customer, using any data — from anywhere. It gives you the agility to innovate and the power to scale. Above all, it gives you the freedom to build the best customer experiences.

Zendesk Sunshine Product Description

A big part of the appeal and positioning for Sunshine is that it enables developers at customer companies to build new applications on top of the platform using languages and development tools that they already know. This is presumably a swipe at Salesforce, which requires developers to learn their proprietary framework and toolset.

The mechanics of this openness are through the use of the Sunshine API. The API is pretty well documented with working code examples in Python. The API exposes interactions with three major data types:

• Custom Objects. The standard Zendesk API already provides access to common customer related concepts, like tickets or users. However, most of these common concepts don’t extend to each customer’s own business context. The Sunshine Custom Objects API allows for the creation of new object types in Zendesk and then to populate those objects with customer data. A custom object can be just about anything – the schema is totally flexible. Examples include service contracts, catalog items or customer households. Once the object types are defined, the Custom Object API allows the user to create, read, update, or delete the objects. Finally, the user can map relationships between Custom Objects and standard Zendesk objects. These include one-to-one, one-to-many and many-to-many.
• User Events. The Sunshine API provides the ability to create events triggered by customers in an application. Events can reflect any programmatic action generated by an app, like purchases, sign-ups, visits or customer service interactions. Each event is associated with the customer who triggered the event. Once events start being collected, they can be accessed by other applications to improve the customer experience. Examples might be triggering a follow-up communication after a certain customer action or to personalize service.
• Profiles. The Sunshine profile API allows users to manage customer data across different systems. A profile consists of an identifier for a customer in each external system plus any custom attributes to describe them. These profiles can then all be associated with a single customer identity. This would allow the developer to connect customer data across multiple systems and pull that into a single view for their app built on top of Sunshine.

Sunshine represents a very forward-thinking offering from Zendesk, in that it leverages the trend by most enterprises to build their own custom software applications in order to enable better customer experiences and differentiate themselves from competitors. The idea behind Sunshine is to make customer experience data available across the enterprises’ many applications in order to deliver solutions that go beyond standard support.

As an example, Zendesk provides a testimonial from Reverb, which was recently purchased by Etsy. Reverb developers were able to connect the custom back-end that drives their web experience to their Zendesk Support toolset, in order to create a more complete view for their customer service team.

This was accomplished using the Sunshine API to create custom objects associated with the catalog and transaction items in their web site back-end.

Sunshine was launched in November 2018. At an investor conference in December 2019, Zendesk leadership said that about 2,000 customers have started using Sunshine since launch. They don’t charge customers incrementally for Sunshine usage at this point, but expect to in the future. The CFO said this could take the form of some sort of usage metering model.

Sunshine Conversations

Conversations is Zendesk’s newest product offering, announced in October 2019. Conversations allows companies to reach their customers on any communications channel and aggregate messages on different channels into a single thread. Similarly, companies can reach out to customers on whatever communications platform they prefer.

Conversations has integrations with almost every modern messaging platform, including WhatsApp, Apple Business Chat, Facebook Messenger, Twitter, WeChat, Line, SMS, RCS and more. Each of these messaging platforms maintains their own API for interaction, which would represent a major development lift for individual companies to incorporate into their applications. By leveraging the Conversations platform, customer companies need only provision an account with each of the messaging providers and then enter their credentials into the Conversations platform for that channel. Then, customer company developers need only interact with a single, consolidated API provided by the Conversations platform. This represents a huge simplification.

Sunshine Conversations is fully integrated with the Sunshine platform through the Sunshine API. That provides it with access to custom objects, events and user profiles created within Sunshine, as well as the suite of core Zendesk products, like Support or Sell. Conversations was built using the platform of Smooch Technologies, which Zendesk acquired in May 2019.

Like other core Zendesk offerings, Conversations pricing is based on metered usage. Currently, they offer published pricing for lower volume usage, which can be enabled with a credit card commitment. Larger enterprises need to work with the sales team to determine an appropriate arrangement.

At two investor conferences in December 2019 (UBS and Wells Fargo), Zendesk leadership discussed revenue drivers for 2020. In both cases, they cited an expectation for incremental growth from Sunshine Conversations, given the broader industry shift to enabling customer interactions through messaging. The Conversations product positions Zendesk favorably for this.

Product Launch Velocity

It is worth noting the speed of product launches by Zendesk over the past 2 years has been exceptional. This has rapidly expanded the core product offering beyond basic customer support. A number of these additions have been bootstrapped through acquisitions. This transformation has enabled Zendesk to be viewed as a holistic customer experience management platform provider.

Here is a rough list of product additions with launch dates and acquisitions highlighted.

• Conversations. October, 2019. Powered by Smooch acquisition.
• Gather (Community offering). October, 2019.
• Duet (Support and Sell bundle). June, 2019.
• Sell (SFA offering). November, 2018. Based on FutureSimple acquisition and their Base product.
• Sunshine (Open CRM platform). November, 2018.
• Suite (Support, Guide, Chat, and Talk bundle). May, 2018.
• Connect (Customer outreach). May, 2018.

Each of these is a major addition to the product offering, with the majority of them representing a new revenue generation opportunity.

Addressable Market

Zendesk estimates their total addressable market (TAM) to be greater than $20B by 2022. This represents the aggregate of the total spend in the several markets that Zendesk either serves now or is expanding into.

First, the Customer Service Application market (estimated to grow to $13.2B by 2022) represents Zendesk’s core product offering, including Support, Guide and Chat. Contact Center is serviced by Zendesk Talk, which is Zendesk’s call center solution. This market is projected to grow to $10.4B. Sales Applications, estimated to grow to $15.6B in 2022 represents Zendesk’s Sell application and includes future growth into CRM with the Sunshine Platform. As mentioned above, both Sell and Sunshine CRM were launched in November 2018, so these are just gaining traction now. Finally, Marketing Applications is estimated at $18.2B and is covered by Zendesk’s Connect offering, launched in May 2018. Given that half the addressable market is being addressed by products launched in the last year, there still remains substantial upside for ZEN.

Looking at the growth opportunity another way, you can see how Zendesk leadership is aligning their product offerings against current addressable market areas and the areas of focus they see for future growth.

Competitive Landscape

Obviously, Zendesk isn’t the only player in these addressable markets. They have established a leadership position in their core customer support application space. This was the area of focus going back to the company’s founding and the primary offering at the time of the IPO in 2014.

However, as they expand into adjacent addressable markets, they will have to compete more aggressively with established players in each. Call center leaders include RingCentral (RNG) and Five9 (FIVN). Marketing applications are dominated by Adobe (ADBE). And, of course, the gorilla in CRM is Salesforce (CRM).

Gartner includes Zendesk in its Magic Quadrant for the CRM Customer Engagement Center (CEC). The definition and requirements for this market have evolved over the past couple of years, particularly as expectations from customers around digital channels have increased. Gartner now defines the CRM CEC market as “the market for software applications used to provide customer service and support by engaging intelligently — both proactively and reactively — with customers by answering questions, solving problems and giving advice.”

Zendesk is positioned as a leader in Gartner’s magic quadrant. Given that the other players in the leaders quadrant are many times larger (Microsoft, Oracle, Salesforce), this is quite an accomplishment.

Feedback from Gartner included the following points for Zendesk:

• Cited as having the fastest growing customer base.
• Highlighted strength as a SaaS solution.
• Called out rapid product innovation. Referenced several new product launches in past year.
• Strength in application of AI based solutions. “Zendesk offers practical AI-based capabilities in a number of ways. Its Answer Bot intelligently surfaces knowledge articles and supports chat engagements. New content is intelligently proposed and made easier to create. Customer sentiment is leveraged during an engagement to change outcomes.”
• Recognized that Zendesk is “the only vendor in this Magic Quadrant to provide native voice support.”
• Cautions on Zendesk lacking depth in industry-specific solutions. This may be a future opportunity for Zendesk to build out industry vertical solutions, or rely on Partners to do so.
• Noted that few customer implementations have over 500 seats.
• Mentions that there has been a “notable increase in the number of Gartner enterprise clients in the past year asking about Zendesk’s pricing and contracts, especially their complexity, and alternative models.”

When asked about competition on analyst calls, Zendesk management references Salesforce (CRM) most often. They frequently cite a few factors that they feel differentiate the Zendesk customer engagement offering from larger, “legacy” competitors, like Salesforce and Oracle:

• Ease of Implementation. Zendesk customer companies can plan to bring their solutions online in weeks with their own resources, versus engagements of 12-18 months with competitors supported by third-party consultants (global SI’s).
• Lower TCO. Zendesk claims that their total cost of ownership is much less than competitors. This is likely due to lower licensing costs and lack of third-party consulting to install. Also, they claim that the cost to companies is more predictable. This is due to the per seat/agent licensing model, with published fees and understood incremental usage.
• Open, modern architecture. Competitive offerings are described as “walled gardens”. This refers to the fact that competitive products are built and hosted on proprietary platforms and frameworks. This is addressed by Zendesk with the open platform design of Sunshine, in which all data and functionality is controlled by APIs and apps can be written in whatever framework is preferred by developers.
• Developer-friendly motion. While Salesforce and Oracle have legions of developers who are “certified” in that platform, Zendesk is positioning Sunshine as not requiring a certification, allowing developers to work in their preferred toolset.

Zendesk leadership sees the three vectors below driving incremental growth over the next few years – an expanding TAM due to addition of CRM capabilities, rapid product innovation as evidenced by new offerings launched in last 2 years and momentum with enterprise customers.

Customer Mindshare

For Q3 2019, Zendesk reported 153,700 paid customer accounts. This increased about 15% from the prior year. Looking at reported customer growth by product type, we see about a 10% increase in customer count for the core Support product over the prior year. Chat customer count actually appears to have flatlined. At the same time, we see a significant growth in “other” Zendesk products, growing over 100% year-over-year. This presumably includes many of the new products launched in the last two years, which is encouraging relative to future growth.

Further evidence of growth in multi-product customer adoption can be found in the deck from the 2019 Investor event. We see substantial growth in customers with more than 3 products over the prior 2 year period.

Zendesk provides a very useful list of customer case studies on their web site. It is a worthwhile exercise for interested investors to read through these, as they provide a lot of insight into customer use cases across the spectrum of industries and customer size. There are many recognizable customer labels listed with detailed case studies: Airbnb, Uber, Squarespace, Black and Decker, Yext, Birchbox, One Medical, Veeva, LendingClub, Bill.com and the State of Tennessee. You can also filter by product type. I was surprised to see the number of customers on Talk (call center solution), as I assumed call center would be difficult to penetrate. Newer products, like Sell, Connect and Gather have a few customers highlighted, so there is room to grow.

As a final point, Zendesk is building a strong developer motion. This is primarily driven by their new Sunshine Platform offering and its embrace of an open, developer-friendly model. The Platform offers extensive documentation and well-structured APIs that allow developers broad capabilities to customize data objects, user profiles and events to mirror activity at their businesses.

Leadership

Zendesk is founder-led, which is one of my characteristics for determining winning software stack investments. Mikkel Svane founded Zendesk with two other individuals in 2007 and has driven the company’s growth since then. He also led the company through its IPO in 2014. I have met Mikkel and find him to be a great leader with a strong vision for the space.

Other highlights from the management team are listed below. In the past year, there has been an emphasis overall on building out the sales leadership to better position for enterprise sales, as well as expanding product development.

• Elena Gomez, CFO. Elena has been the CFO since 2016. Prior to that, she held various finance leadership roles at Salesforce.
• Norman Gennaro, President of Sales. Joined Zendesk in January 2018 to lead all sales efforts. Prior to Zendesk, he had accumulated almost 20 years of experience leading teams at both AWS and Oracle.
• Shawna Wolverton, SVP Product. Joined in December 2018. Previously was SVP of Product at Salesforce for 15 years.
• Jeff Titterton, CMO. Jeff joined in 2017. Prior to that, he led various marketing functions for Adobe. Jeff has been behind the successful efforts to build enterprise awareness for Zendesk. I worked with Jeff in 2010-2011 at another company and found him to be exceptionally creative and growth-oriented.

Risks

While I think the opportunity for Zendesk to grow over the next five years is significant, investment in ZEN has some risks that we will need to monitor.

The Dollar Based Net Expansion Rate (DBNER) has been dropping over the past couple of quarters.

The DBNER was 116% in the most recent quarter, a two point reduction from 118% a year prior. While not a huge change, the trend is downward. Zendesk leadership addressed this in the Q3 2019 shareholder letter by stating that their target range for a “healthy” DBNER is 110-120% and that sales execution challenges in APAC and EMEA have impacted this. As I have mentioned in past articles, I prefer companies with a DBNER over 120%. However, given the size of ZEN’s revenues (over $800M for 2019), it is reasonable to assume that DBNER will decrease over time. ZEN management is confident that they can maintain the healthy range between 110-120%. Investors will want to monitor this rate over the next several years, particularly as new products come online, which we would expect become drivers of new revenue.

Enterprise penetration is another trend that investors should monitor. I think that Zendesk has positioned itself well to make a run at larger accounts and compete with Salesforce and Oracle. This is driven by additions to the sales leadership team with enterprise sales experience and the recent achievement of a “complete” CRM product portfolio. The CFO mentioned on a December 2019 analyst call how large companies that had previously passed on Zendesk are looping back. Even Gartner touched on this in the 2019 Magic Quadrant analysis. While noting that “only a small percentage of Zendesk’s customers have 500 or more seats”, they have observed a notable “increase in the number of Gartner enterprise clients in the past year asking about Zendesk’s pricing”. This report was published in June 2019, so we can expect further interest since that time.

With perceived enterprise momentum, sales growth into larger companies (greater than 100 and then 500 seats) will be critical to Zendesk’s revenue growth past $1B.

In order to be a worthwhile investment for the next 5 years, we need Zendesk revenue to grow past $2B and approach $3B annually. As Zendesk leadership shared in their recent investor presentation, this will be dependent upon growth of the Sunshine Platform, which implies enterprise adoption, and then the engagement of Partner practices around customer service. The Partner ecosystem, particularly garnering attention from the global SI’s, will be a big driver of larger customer sales.

Going Forward

Overall, I am bullish on Zendesk and think an investment in ZEN stock should appreciate meaningfully over the next five years to a target of $220. I am not setting as aggressive a price target on ZEN, as I have on some other companies, but also view its trajectory as more reliable. Given its revenue growth in the 30% range and increasing profitability, I view ZEN as a “safe” bet on secular trends behind digital transformation and the inherent investment by traditional enterprises into customer experience improvements. Zendesk is positioning itself well to continue to capitalize on this movement, with rapidly expanding product offerings, a new platform strategy and a strong leadership team with a foundation in enterprise service. Zendesk will hold another investor day at its Relate conference in March 2020, which should provide more insight into the long term strategy.