Zendesk's Growth Is Driven by Large Deals and Bundling

Customer-service software provider Zendesk (ZEN) reported its second-quarter results after the market closed on July 31. The company is having success winning larger customers, which helped drive robust revenue growth during the quarter. But losses on a GAAP basis grew as Zendesk invests in growth. Here's what investors need to know about Zendesk's second quarter:

Zendesk results: The raw numbers

Q2 2017 numbers adjusted for ASC 606. Data source: Zendesk.

What happened with Zendesk this quarter?

• Paid customer accounts reached 130,300 at the end of the second quarter, up from 125,500 at the end of the first quarter and 107,400 one year ago.
• Zendesk Support gained 2,700 net new customers in the quarter, reaching a customer count of 70,500. Zendesk Chat lost 100 net customers, bringing the customer count down to 47,600. Other Zendesk products gained 2,200 net customers, bringing the total up to 12,200.
• About 38% of Support monthly recurring revenue came from customers with 100 or more Support agents. That percentage is flat compared to the first quarter, but up 3 percentage points year over year.
• The number of contracts with annual values over $50,000 rose 60% year over year.
• Zendesk's dollar-based net expansion rate, which measures annual expansion for existing customers, was 119%. That's down from 120% at the end of the first quarter, and up from 116% one year ago. Zendesk targets a rate of 110% to 120%.
• Major customers joining or expanding with Zendesk during the second quarter included Casio, Netflix, and restaurant discovery service Zomato.
• Zendesk generated $8.7 million of free cash flow, up from $4.3 million in the prior-year period.

Image source: Zendesk.

Zendesk provided the following guidance for the third quarter:

• Revenue is expected between $150 million and $152 million, up 33.9% year over year at the midpoint.
• Zendesk expects to post a GAAP operating loss between $31 million and $33 million, and a non-GAAP operating profit between $2 million and $4 million.

Zendesk boosted its full-year revenue guidance:

• Revenue is now expected between $582 million and $586 million, up from a previous range of $565 million to $572 million.
• Zendesk expects to post a GAAP operating loss between $130 million and $135 million, and a non-GAAP operating profit between breakeven and $5 million.
• Free cash flow is expected between $28 million and $30 million, up from a previous guidance range of $25 million to $30 million.

What management had to say

Zendesk VP Marc Cabi explained during the conference call that Zendesk Suite, which bundles multiple products, is one reason for the decline in Chat customers: "With the Zendesk Suite, we are accounting for that as one customer, and right now that customer only shows up in the other line. So if that customer doesn't show up in Support, Chat, Talk, or anywhere else, it shows up in the other line."

Cabi added that a price increase at the low end for Chat has pushed some customers away, but the result has been higher quality customers overall.

Cabi also commented on the average size of the large deals Zendesk signed during the quarter:

So it was up more than 60% in deal count and just below neutral. So just slightly negative on deal size. So in this quarter, we saw a lot of new business activity as part of that number, which we view as a good land-and-expand kind of opportunity for us as we go through the rest of the year.

Looking forward

Just like it did after its first-quarter report, Zendesk boosted its full-year revenue guidance while lowering its outlook for GAAP operating profit. GAAP operating expenses rose 32.7% year over year in the second quarter, expanding slower than revenue, but Zendesk's gross margin dipped by a bit more than 1 percentage point.

The company does expect to produce positive free cash flow this year, but Zendesk may still be years away from turning a GAAP profit.