Slack: Strong Potential, but Shareholders Won’t Be Rewarded

Despite an enticing narrative, shareholders face declining revenue growth rates and an overvalued stock.
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Slack’s (WORK) - Get Report direct listing earlier in 2019 has seen its share price fall by approximately 40%. What’s more, during the same time period, the S&P 500 has gained close to 6%.

Even though Slack is positioning itself as a disruptive and much-needed new platform for enterprises, the reality is getting in the way of this highly compelling narrative.

Investors are not likely to get rewarded by investing at this valuation. Here’s why:

The Growth Narrative

Slack seeks to solve pain points in users’ communications. Slack assists people, applications and data in working together rather than in silos. Slack proclaims that customers who were previously using Microsoft’s (MSFT) - Get Report Office 365 and having to integrate their often custom-built packages are adopting Slack’s stack instead.

Further, this time last year, Slack had just 32 customers on more than $1 million in annual recurring revenue contracts, whereas more recently the number has jumped to 53.

During the quarter, Slack launched its Shared Channels category. This allows for two different companies using Slack to share data and message each other, with administrative control and compliance functionality.

Slack’s CEO Stewart Butterfield is hoping to create network effects, where customers call on partners to come onto Slack’s platform. Butterfield asserted that Slack’s runway is long and that Share Channels, even though only launched mid-way through the most recent quarter, is already seeing huge adoption with Slack’s customer base.

Strong Growth Rates Are Slowing

Notwithstanding the upbeat tone of the recent earnings call, the facts are pointing in a different direction.

At the start of fiscal Q1 2020 (calendar 2019), Slack was growing its revenues at 67% year-over-year, but its latest guidance for fiscal Q4 2020 ending in January is pointing towards a more subdued 42% revenue growth rate, likely due to the progress that rival Microsoft Teams has been making. Why is this a problem? 

Because, if a high growth company sees a decline in its growth rate of more than 25% during a twelve-month period, this immediately brings up the question of how does Slack look over the next twelve months? Even with a milder deceleration rate, Slack’s revenue growth rate is likely to end up pointing towards mid 30s%.

The multiple investors will be willing to pay for Slack is proportional to its revenue growth rate. In other words, if Slack’s recurring revenue business model points towards a steady and predictable mid-40s% growth rate, an investor will be happy to pay more for it than for a company that may or may not be growing at 35% year-over-year. The more certain the growth rate, the larger the multiple, and vice-versa.

Valuation – Nil Margin Of Safety

For now, investors have been all too happy to embrace Slack’s growth narrative and not pay much heed to its lack of a path towards profitability. Slack is incurring a huge GAAP loss as it continues to ‘’educate’’ customers along their digital journey.

Indeed, investors should minimally question why despite seeing huge increases in stock-based compensation expenses and growing GAAP losses, there appears to be a declining growth rate?

Slack peer group comparison

The table reminds readers of just how highly valued this sector finds itself. Understandably, the tailwinds in this space are strong. But this sector is unlikely to be a winner-take-all scenario. Furthermore, paying up more than 20x sales for a significantly unprofitable company does not leave much upside for new shareholders.

The Bottom Line

Slack has a lot going for it, and it may succeed in carving out a strong niche amongst large enterprises. But when this stock is so richly-valued, new shareholders are not likely to be rewarded for deploying their savings into the stock. Avoid Slack’s stock for now.