Slack’s DPO, or Direct Public Offering, is coming up on June 20th. Among the cloud software companies to take their ventures public, Slack may be the favorite in Silicon Valley. When it comes to the workplace, frequent communication is essential. It has been established that using email for constant communication and projects isn’t sufficient, and Slack has emerged as a better alternative. Slack is an effective service as it helps boost productivity and team workflow. For customers, the cost of the paid product is balanced by the time team members save by removing partnership friction like lost files and long email threads. Due to Slack’s fan base, there will be plenty of product bias motivating Slack’s DPO stock holders.
Recently, I had warned that cloud software is expensive at the moment, and in terms of the price-to-sales ratio compared to the dot-com era, we are currently setting new valuation records. NASDAQ broke past its December lows and surged higher with cloud software in the lead, with some cloud software stocks soaring by 100% or more. This is a substantial return compared to the 13% on average recorded by FANG stocks during the same period.
Over the past two years, IPOs for cloud software companies have been rewarding to investors. PagerDuty, Okta, Twilio, Zoom and a few others have not disappointed. Thus, Slack being a cloud software company, is likely to see shares trade higher, as well. It is worthy to note that Class B shares are trading privately between $21 and $31.50 since the start of the year. The average price stands at $26.38, which is 142% higher than the previous valuation of $7 billion in August last year.
It is worthy to note that not all cloud software companies have recorded gains over the past few months. Zuora recorded disappointing earnings, which saw its stock penalized by 30% as the price dropped from $20 to $14 on May 31st. As always, proceed with caution and tight trailing stops.
Although I am a huge fan of Slack, the stock still has some issues that need to be addressed. One critical problem is that direct listings usually come with a certain degree of risk due to the lack of a lock-up period. Spotify serves as a reference for the risks involved with a direct listing with shares publicly available at $165 and now trading at $140 despite a historic tech rally. Slack’s financial records indicate that the number of paid users are on the decline, even though they are getting more customers spending over $100,000 for subscriptions. In an ideal situation, the two metrics would both be on the rise. The overall dollar retention for the company is strong, although it is banking on the fact that it is still a young company which launched its product five years ago. Thus, this implies that Slack’s retention rate is not an apples-to-apples comparison to other companies in the cloud software niche before their IPOs.
Slack’s Product is Impressive
The first advantage the company has is an excellent working product in a high-growth niche. The company has a loyal customer base and was known as the fastest-growing SaaS startup ever in 2017.
Slack’s Direct Listing is Risky
The company is not looking to raise funds and has decided to go for a direct listing instead of the usual IPO. With DPOs, company insiders initially sell their shares, and there will be no lock-up period. The absence of a lock-up period increases the risks involved with this stock compared to regular IPOs, which usually have six-month lock-up periods. When Spotify was at $185 in September, I wrote the price was too high at $185. It has not recovered since December lows.
In my opinion, Slack should not go for a direct listing as the company should focus on raising funds due to the high level of competition it is facing from Microsoft Teams. At the moment, Microsoft is in the lead, per Gartner and a few other sources. Secondly, Slack is working with other collaborative cloud software products such as Atlassian and Oracle, who have the resources to copy Slack’s messaging system.
While Slack’s 10 million customer base is good, it is also faces competition from startups, such as Asana and quite a few others. Thirdly, a look at the company’s financial records reveals that its cost of user acquisition is not improving as the company has spent 50-60% of its revenue on sales and marketing over the past two years. If this figure doesn’t improve, then Slack will need to raise funds to expand its customer base.
Slack’s Financials Need More History
According to Slack’s prospectus report, the company’s financials are decent enough to satisfy most growth investors. Slack had recorded a revenue jump from $105 million in 2017 to $220 million in 2018 to $400 million in the year ending Jan 31st, 2019, representing an increase of 110% and 82% respectively. Its international market is steadily growing as sales abroad accounted for one-third of the company’s revenue. Meanwhile, net losses have remained flat over the past three years, ranging between $138 million and $146 million.
The prospectus states that their net losses have been declining in terms of percentage due to the revenue growth surpassing the operating expenses. Although this is true, the decrease in operating expenses was achieved after the company reduced R&D funding instead of sales and marketing. Compared to their revenue growth, we can see that the cost of user acquisition is still the same with sales and marketing as it stands around 64% of the company’s revenue in 2018 and 54% of the revenue so far this year. As I mentioned above, Slack needs to spend more on research and development if it wants to remain competitive in the cloud collaboration sector.
Slack’s Updated Prospectus
Earlier this month, on June 3rd, the company published an updated prospectus. The new release didn’t indicate any improvement in their net losses although their revenue went up by $134 million in the last quarter compared to the $80 million recorded in the same quarter the previous year. As the revenue went up, so did the net losses. In the last quarter, net losses recorded was $38 million, which is higher than the $26 million reported in the same quarter of 2018.
The updated prospectus revealed that the company had seen an increase in customers that pay over $100,000. However, there is a decrease in the overall number of paid users, from 9,000 to 7,000 in the current quarter. Thus, there is a divergence of growth as the total number of paid users are decreasing while customer accounts with over $100,000 are on the rise at 24% compared to the same quarter last year. More quarterly earnings reports would be needed to help determine which direction the company is heading.
Slack Has a Solid Net Retention Rate
In its S-1 filing, the company included limited vital metrics. However, they provided their net dollar retention rate, which usually reveals the percentage revenue from current customers that were retained from the previous year after considering upgrades, downgrades, and churn. To calculate net dollar retention, use the following formula;
Beginning of period revenue + upgrades – downgrades + churn = y with y divided by beginning of period revenue
For a dollar retention rate above 100%, it implies that the growth from the existing customer base is higher than the losses. However, if it is below 100%, then downgrades and churn have surpassed the growth recorded by a company.
A Net Retention Rate of 143% for Slack means the company is in good standing, and outperformed many other cloud software IPOs. As I mentioned at the beginning of this analysis, Slack is made up of power users and has a loyal brand following, which resulted in its healthy retention rate.
Notably, Slack has a shorter history since it launched its product in 2014. Its competitors mostly started their working products ten years before their IPOs. Usually, the longer the period to an IPO, the lower the retention rate for a company due to customer stabilization.
In the current macro environment (which could change in the next two weeks depending on rate cuts, etc.), Slack will make a good trade due to brand appeal, early traction, and the overall strength of the cloud software space at the moment. Slack is good at boosting their finances by reducing R&D funds and maintaining their user acquisition levels year after year. For a long-term investment, I will have to wait and see if the company’s net losses improve and if they can show that a direct listing is the best thing for the long-term growth of the company rather than the best interest of the insiders. In the case of Spotify, the direct listing method was unfavorable at the opening price
(even for the likes of George Soros who bought high). Despite that, when compared to Spotify, Slack has stronger fundamentals and will probably be a very hot DPO.
The total addressable market for cloud collaboration currently stands at $24 billion. Couple that with one or two strong quarterly earnings and Slack could move from a good short-term trade to an excellent long-term holding. Follow me for updates on Slack.
These are my opinions as a tech analyst and not to be used for financial advice.