Can You Guess The Best Tech IPO of 2014? (Hint: Shares Rallied 98%)

2014 was an active year for tech IPOs and the top performer is a relatively unknown company -- cloud provider Zendesk (ZEN)Thus far in 2014 shares of the helpdesk software company skyrocketed 98% from the opening IPO date price and over 150% from the original IPO pricing of $9.

Never heard of Zendesk? You're not alone!

Fool Tech Analyst Nathan Hamilton fills in the blanks on the seven year old SaaS provider that is making inroads against entrenched leaders like Salesforce.com (CRM -0.18%) , while also touching upon why the company's valuation of 15 times trailing twelve month sales is not as rich as many would assume.

Sean O'Reilly: We're talking the top performing tech IPO of 2014 on a tech edition of Industry Focus.

[INTRO]

TGIF, everybody! I am Sean O'Reilly with the one and only Nathan Hamilton. How are you, Nathan?

Nathan Hamilton: I'm good. We're doing our first tech Industry Focus, so I'm excited.

O'Reilly: I feel like this is the first of many awesome shows for Industry Focus.

Hamilton: Yes. We've been doing Where the Money Is for some time, but we decided to switch it up. Let's get a different name in there.

O'Reilly: Put a different label on.

We're nearing the end of December, end of the year, and we wanted to take a look back and look at the top-performing tech IPOs of 2014 because this has been one of the hottest performing tech IPO markets since the tech bubble of 1999-2000.

First and foremost, before we dive in there, solve the riddle for us. What is the top performing tech IPO of this year?

Hamilton: We've got to get our shockers in a line.

O'Reilly: Have I heard of it? Have I not heard of it?

Hamilton: Yes, it's a company called Zendesk.

O'Reilly: I have not heard of it.

Hamilton: They're not a new ...

O'Reilly: How big is it?

Hamilton: It's around a $1-2 billion market cap.

O'Reilly: Okay, so it's not like ...

Hamilton: Yes, but specifically the IPO details; hit the market in May, up almost 80% since that timeframe. The IPO priced at $9 per share. Obviously it's done pretty well since then.

O'Reilly: Right. Cool. When did they public? Because I really don't remember these guys.

Hamilton: May.

O'Reilly: In May, OK. You're going to have to forgive me; I'm not exactly the biggest tech guy in the world. What do they do?

Hamilton: For the more technical people out there, they're a cloud SaaS company. For the less technical people ...

O'Reilly: They get sassy with the cloud, or ...?

Hamilton: Well, "Software as a Service" is what it's referring to.

O'Reilly: Okay. No, I knew that!

Hamilton: Look at it this way; they provide helpdesk software. A perfect example is, say you and I go into business together and we start a consumer-facing company that sells widgets -- who knows, whatever.

To have our help center or support desk, we would have to buy the infrastructure, get the server set up, all the routers; every piece of infrastructure to get our customer service department set up. Essentially, Zendesk provides this as a cloud-based platform.

It's a lower-cost alternative for, say you and I starting a business. Really, when it comes down to it, it just speaks to a lot of different trends in tech, where you've got cloud ruling everything from images to Software as a Service, Platforms as a Service, and so forth.

O'Reilly: They're definitely an enabler of consumer-facing businesses.

Hamilton: Yes, no doubt.

O'Reilly: The average Joe and Jane, they're not going to run into Zendesk.

Hamilton: Well, it depends. There are a lot of companies, say industrial companies that work internally, where they use Zendesk's platform say for ticket management. A tech support desk may use it internally.

It's not always 100% consumer-facing, but it's more managing every aspect of some sort of relationship within a company, or maybe externally with customers.

O'Reilly: What's their value offering? Our widget company, for example; why would we use Zendesk over, I don't know, getting a guy that used to run one of these things to just help us set it up and just figuring it out on our own?

Hamilton: It's cheap and easy.

O'Reilly: Okay, so it is cheaper?

Hamilton: Absolutely, no doubt about it. If we look at cloud platforms and Software as a Service, that's really the intent, to offer a cheaper model.

If you look at us starting up our company, it costs a lot of money to buy servers. It costs a lot of money to buy all of that infrastructure to set up our customer service or ticketing management; any sort of help desk platform.

O'Reilly: Got it, OK. Do we have any really good, big-name examples that they helped out?

Hamilton: We do, yes. If you look over the website, you'll find a lot of different companies they work with. If you look at their actual growth as well, they added 3,000 subscribers in the most recent quarter.

O'Reilly: Oh, wow.

Hamilton: That's up to almost 50,000, which if we look back a few years ago was 10,000 customers, so kind of exponential growth in customer accounts.

O'Reilly: For sure, yes.

Hamilton: But we'll point out one company ... or I don't know if we can call it a "company" specifically, but an organization. My hometown football team, the Denver Broncos, used Zendesk to create their helpdesk. If you look at it, the company provides some details on how the Broncos set up their helpdesk, and essentially did this within a few hours.

If you look back 10 years ago ...

O'Reilly: That would take our widget company weeks.

Hamilton: Exactly. Probably even longer than that, because you have to set up all the contracts, relationships. This is a lower-cost model.

If you look at the other value proposition of it, I mentioned simple. If you look over their platform and you try and understand what they're doing, they're trying to make it as simple as possible to use. That's why the Broncos could set it up in a few hours.

O'Reilly: Got it, OK. Peyton Manning has been doing a lot of Papa John's commercials. Do you think he'll be doing commercials for Zendesk now?

Hamilton: We'll see!

O'Reilly: Obviously they've got a great value offering. They're cheaper and way faster than anything anybody could do.

Before we dig into -- because I am curious about the valuation and if they're actually making any money -- are they profitable? How does that look?

Hamilton: It's a common IPO, so we can assume right now their operating income and earning's negative. They recently did go cash flow positive, which for an IPO, not every IPO can do that. The company is approximately seven years old.

If you look at their guidance and so forth, they're guiding for around $123 to $125 million in revenue. That's up from the low hundreds. I believe it was $111 million in the most recent fiscal year.

O'Reilly: That's not a huge jump. What's going on there?

Hamilton: They're adding customers. Maybe the growth has slowed a little bit, but if you look at it ... looking at the valuation of the company, if you look at it on paper it says 15 times sales. Anybody looking at that valuation says, "Whoa."

O'Reilly: Whoa.

Hamilton: "No. Pump the brakes. It's a really rich valuation." But you have to take into account what the company is. Ultimately, SaaS companies are subscription-based revenue companies.

O'Reilly: That's what I was going to ask, was their competitive position. How big the moat is, but also do they get legacy revenues? Because that can actually get really good for somebody down the line.

Hamilton: Yes, and that all plays into the valuation. If you look at it, they're not the first company to come into this market. There's Salesforce.com; huge market cap company, rules the enterprise space for helpdesk software and customer relationship management platforms as a whole.

Zendesk has more of a simplified platform, and they do want to take, obviously, some of Salesforce's business, but look at Zendesk; seven year old company, it's all about subscription revenue. If you look at subscription revenue, what the revenue is now is not a representation of what it will be in the future.

A lot of the revenue is back-end loaded. If you look at it, "Okay, 15 times sales based upon the last 12 months," that's a picture of where sales are today. That's not a picture of where the sales are going to be in the future.

Zendesk is growing pretty rapidly -- like I said, the customer accounts that they're gaining. No doubt that's a rich valuation. It's an IPO, up almost 80%. But it's not a true representation of the valuation as a whole.

O'Reilly: How does this lead into ... it sounds like this company's a competitor to Salesforce.com, so they're starting to get a little ... how does this speak to the broader trends in the tech industry and where they're going, toward outsourcing this sort of thing? What's going on?

Hamilton: If you look at outsourcing as a whole, cloud services, that's a trend. We've talked a lot about Amazon (NASDAQ: AMZN) and AWS, Microsoft (NASDAQ: MSFT) cloud platforms. It's all a lower-cost play to get a business running.

What I find most interesting about it, just looking at broader trends in tech over the last decade and where things are going to the future, there's a saying among engineers or programmers that "The user is always right."

If your grandmother were to hop on Zendesk and can't use it, it's not that she's wrong. It's because they haven't been able to create a platform that's easy enough to use that anyone can learn to do it.

If you look at where this comes from, we can kind of trace it back to Google (NASDAQ: GOOG) (NASDAQ: GOOGL). Google's algorithm, one of their founding factors is they mentioned, "Our search algorithm, if it doesn't deliver the right result, it's not because the user's wrong. It's because we aren't doing a good enough job of interpreting your search inquiries."

You back that up to Apple (NASDAQ: AAPL), Apple's iOS operating system. The whole draw of it is it's easy to use.

O'Reilly: Very, very simple, clean, crisp.

Hamilton: That's why Apple has been able to become as popular as it has.

O'Reilly: Awesome, OK. Very good. Real quick, just diving into the financials of the company, what do we have?

Hamilton: As I mentioned, guiding for about $123-125 million in the fiscal year. Cash flow positive -- barely cash flow positive -- so I don't think it's anything they can hang a hat on and say, "This is a big milestone" for them.

But if you look at the company in the most recent quarter, they actually under-invested in head count. They're growing fast enough where they're trying to invest more in growing the head count because as a company grows rapidly, you obviously need the employees to help that growth.

O'Reilly: Right. Is there anything there on the balance sheet ... because obviously one of the conventions of GAAP accounting is you have to report revenue as earned. How long are these contracts? How does that work? Can you paint kind of a picture there?

Hamilton: I don't know how long the contracts typically extend for, but one important factor to watch is going to be the retention rate because you've got a subscription model. Bringing, say our new business on as a customer for Zendesk ...

O'Reilly: Right, they want us for 10 ... however long.

Hamilton: They want a sticky customer so one thing to focus on is, what is the company's retention rate? One metric that the company uses to measure this is dollar retention rate. It's essentially looking at, one year from now ... say in the most recent quarter about 123% is their dollar retention rate.

Say $123 compared to the year before, $100 from the customer. It shows that they're growing; they're bringing the customers in, upselling them, retaining them, and able to increase that revenue over the longer term.

O'Reilly: Awesome, and we keep selling our widgets and they keep helping us sell them.

Hamilton: Hopefully.

O'Reilly: Awesome, very good.

Hamilton: Billion-dollar business, we IPO, and then become rich.

O'Reilly: Perfect, yes. Then we retire to Hawaii.

Hamilton: Exactly.

O'Reilly: There you have it, folks. That is the top performing tech IPO of 2014.

Now, before we go, we talk a lot about high growth dividend stocks on Industry Focus, and Motley Fool co-founder David Gardener has a checklist, believe it or not, of six different things that he looks for in growth stocks to invest in.

He's been doing this extremely successfully for over 20 years now, so if you want to access David's checklist to act as a filter between what might make a good tech growth stock to invest in, send us an email to [email protected] and we'll send this free checklist over to you. Once again, that's [email protected].

For Nathan Hamilton, I am Sean O'Reilly and this is the tech edition of Industry Focus. Thanks for listening, and Fool on!