Zendesk Inc. (ZEN: $75/share) – Closing Short Position – up 65% vs. S&P up 40%

We first put Zendesk in the Danger Zone in March 2018 and reiterated our opinion on the stock in January 2019, March 2020, and August 2021. ZEN earned an Unattractive rating at the time of our first report. We pointed out that Zendesk’s strong revenue growth had not created any profits, its profitability lagged peers, and its stock was significantly overvalued.

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During the 4+ year holding period, and after the recent acquisition announcement, ZEN underperformed as a short position, rising 65% compared to a 40% gain for the S&P 500. Developments over the life of the trade highlight the difficulty of picking shorts in a market awash in cheap capital.

Zendesk’s return on invested capital (ROIC) fell from -28% in 2017 to -38% over the trailing-twelve-months (TTM), and Core Earnings fell from -$115 million to -$239 million over the same time. Per Figure 1, the market had begun to ring the warning bell on ZEN, and prior to the take-private announcement, our Zendesk Danger Zone pick had outperformed the S&P 500 as a short by 11%.

However, despite a clear deterioration of the company’s fundamentals, Zendesk announced on June 24, 2022 that a private equity investor group led by Permira and Hellman & Friedman had made an unsolicited bid of $10.2 billion, or $77.50/share, which represents a 34% premium to the stock’s closing price the day prior to the announcement. Ironically, management rejected a prior bid of ~$130/share back in February 2022.

The acquisition of an unprofitable business highlights the stupid money risk, which is one of the biggest risks to any short thesis. Despite announcing in early June that it would remain an independent company, Zendesk agreeing to be acquired turned a winning Danger Zone pick into a losing pick. We’re closing this Danger Zone pick since there is little to stop the announced deal from going through, as Bloomberg reports the deal is already fully financed, and activist investor Jana Partners has since withdrawn its ongoing proxy battle.

Figure 1: ZEN vs. S&P 500 – Price Return – Unsuccessful Danger Zone Pick

Sources: New Constructs, LLC and company filings

Note: Gain/Decline performance analysis excludes transaction costs and dividends.

This article originally published on June 29, 2022.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.

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[1] Our research utilizes our Core Earnings, a more reliable measure of profits, as proven in Core Earnings: New Data & Evidence, written by professors at Harvard Business School (HBS) & MIT Sloan and published in The Journal of Financial Economics.

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