If you’ve been following my website for a few months now, you would know that I recommended investors purchase Zendesk shares. Soon after, we started making progress and were actually up 10% in a matter of weeks. Unfortunately, Zendesk then reported earnings. Contrary to what you might expect, the earnings were actually excellent despite the 20% drop that followed. The problem was the blockbuster announcement of their intention to purchase Momentive (the company behind Survey Monkey) for 0.225 shares of Zendesk per Momentive share. This was about 4 Billion at the time, and was around 22% of the market cap of the company. Justifiably, the market panicked on the news that their just recently profitable small-cap software stock was planning on doing a massive acquisition, in the middle of trying to scale the business. The decision is soon to be finalized at a shareholder vote, and if you still hold shares as I do, you might want to consider the following information before making your decision.
The case for the acquisition
Zendesk’s reasoning behind the acquisition is the substantial synergies associated with the two businesses combining. Momentive (primarily through Survey Monkey), offers businesses the ability to get insight into the customer reception and feedback associated with their products or services. Of course, combining this with the customer service tools that Zendesk offers could result in the best value proposition on the market for customer lifecycle management. Additionally, the deal is expected to drive over $250 million in synergies by 2025, and is likely to increase each segment’s business as cross-selling opportunities & bundling drive value.
The case against the acquisition
The reasoning behind the massive drop, aside from the massive value of the acquisition for a small company and the potential distraction comes from the fact that Momentive is simply not as high quality a company as Zendesk. Momentive boasts a revenue growth rate of around 19%, as opposed to zendesk’s 26-27%, and a net margins that are around half of Zendesk’s in the upcoming year. In addition to this, there is always significant risk with any acquisition as management’s focus can get distracted from the core business, and it is quite possible that the synergies and cross-selling opportunities do not materialize, causing the company to lose the primary reason for the purchase.
Overall Analysis
Zendesk & Momentive themselves had J.P.organ & Goldman Sachs analyze the merger and provide their opinion on the share price & growth impact. Very simply, both companies analyzed Zendesk shares to be undervalued on DCF estimates, with estimated share prices between 140 & 190. Included in the assumptions was a 5 year expected growth rate of 25% and WACC of between 8 & 9%. Meanwhile, Momentive shares were determined as slightly overvalued, with the suggested share conversion ranges putting the finalized one as optimistic (top end of the potentially acceptable range). However, the potential gains associated from the acquisition resulted in potential 10% upside from the current fair value of Zendesk shares. Unfortunately, although this might initially seem to make sense, we need to consider that these are not risk-adjusted returns and do not explain the required assumptions in order to justify these numbers. First of all, Momentive’s internal expected growth rates, used to determine the combined company’s value incorporates the belief that their growth rates will in fact accelerate, even independently, over the next 5 years. Essentially, despite growing 20-ish% for the past few years, they expect their 2024-2025 growth rate to be closer to 26%. This assumption seems incredibly optimistic for my liking and doesn’t give me confidence that the 10% potential premium is correct considering the associated risk with this growth. Additionally, it assumes that there will be substantial business acceleration & savings driven by synergies. All of this is not guaranteed, and even so, is only expected to add about a point to the expected growth rate of Zendesk as a stand-alone company.
All in all, it seems as though the Zendesk management team believes in their execution to perfection, and is factoring in virtually no risk in their ability to grow & integrate both businesses, as well as their ability to account for very optimistic projections. Personally, I am much happier just holding Zendesk as a stand-alone company and I believe that will provide the best risk-adjusted returns for investors. Of course, you need to do your own research and come to your own conclusions, but remember, every vote counts!
Comments