Slack: Overfull Valuation Taking Its Toll

About: Slack Technologies, Inc. (WORK)
by: Gary Alexander

Shares of Slack have lost more than 10% after the company released its first-ever earnings report since going public.

Slack's price performance has only seen downward trajectory since its first day of trading. At the time, Slack shares were worth north of 33x forward revenues.

The company's Q2 revenue growth decelerated sharply to 57% y/y, down from 67% y/y in Q1.

Despite Slack's steep decline since going public, the stock still trades at a steep >20x forward revenue multiple.

Slack's (WORK) public debut was all the rage earlier this year, but barely one quarter into its existence as a public company, the once-proud unicorn is tanking. Slack has shed more than $5 billion in market value since it went public in a direct listing in late June, falling in a consistent down-trend and following the trajectory of other highly-anticipated IPOs like Uber (UBER) and Lyft (LYFT). Losses were aggravated after the company released a dismal Q2 earnings report, and now Slack is back near the $26 "reference price" that it set immediately prior to its public debut.

Data by YCharts

The question for investors now: is Slack a "buy the dip" situation, or does the stock have further to fall? In my view, it's the latter. Slack benefited from a lot of hype going into its IPO, selling a compelling story that Slack was disrupting the future of work-based communication. In reality, Slack is up against a slew of competitors from the likes of Microsoft Teams (MSFT) and Microsoft Skype, various workflow/collaboration tools like Atlassian (TEAM), new entrant Workplace by Facebook (FB), as well as old-fashioned email and text chains.

Slack's furious growth rates in its S-1 filing were something of a "teaser rate." In FY19, Slack's revenues grew at a compelling 88% y/y rate. In Q1, that fell to 67% y/y, and now in Q2, Slack's growth rate has crumbled to 57% y/y. Of course, a >50% y/y growth rate still classifies Slack as a "high-growth" company, but this level of growth is already well-priced into Slack's buoyant valuation.

At present share prices around $27, Slack still trades at a hefty market cap of $13.81 billion. After netting out the $841.4 million of cash on Slack's balance sheet, the company is left with an enterprise value of $12.97 billion. This represents a generous multiple of 21.4x EV/FY20 expected revenues based on the midpoint of Slack's updated revenue guidance of $603-$610 million (representing 51-52% y/y growth, and a slight uptick versus a prior midpoint outlook of $595 million or 49% y/y growth):

Figure 1. Slack updated FY20 outlook Source: Slack Q2 earnings release

Very few companies are worth paying >20x forward revenues for, and certainly not companies that are facing such heightened deceleration risks. Slack's huge losses are another significant problem - on a pro forma basis, even after stripping out the impacts of Slack's substantial stock compensation to executives, Slack's operating losses nearly doubled this quarter, growing at a faster pace than revenue growth. Despite these risks, Slack is trading at one of the highest valuation multiples in the software sector, right alongside names like Atlassian (TEAM), Anaplan (PLAN), Coupa (COUP) and Zscaler (ZS):

Data by YCharts

It's difficult to imagine Slack's valuation multiple expanding any further than it already has. The Slack bubble is bursting, and investors should be careful to avoid the fallout. Continue to stay on the sidelines on Slack until a better price avails itself.

Q2 download

Let's now examine Slack's second-quarter fallout in greater detail. The company's earnings summary is shown below:

Figure 2. Slack 2Q20 earnings results Source: Slack Q2 earnings release

As previously mentioned, Slack's revenue growth showed weakness this quarter, sliding to 57% y/y growth and hitting $145.0 million, though that's still slightly higher than the $141.3 million (+54% y/y) that Wall Street analysts had expected. What's perhaps more concerning, however, is that Slack's Billings growth rate has persistently lagged behind its revenue growth rate - a reliable forward indicator of continued deceleration.

Slack billed $174.8 million in the quarter, representing a 52% y/y growth rate in billings - five points slower than revenue growth.

Figure 3. Slack Q2 billings Source: Slack Q2 earnings release

We note as well that Slack reported its slowest-ever growth rate in paid user counts this quarter. Customer growth slowed to 37% y/y this quarter, down five points from Q1, while net customer adds of 5k this quarter were the slowest over this six-quarter stretch of time:

Figure 4. Slack customer trends Source: Slack Q2 earnings deck

Slack has attempted to defend some of its weakness this quarter by attributing revenue losses to a service-time disruption in Q2, which triggered a substantial rebate to customers. Per CFO Allen Shim's prepared remarks on the Q2 earnings call:

[We had a] $8 million onetime revenue headwind from credits issued in the quarter related to service-level disruption in the quarter. Our uptime was 99.9% or 3 nines in the quarter. But this was below our commitment of 99.99% or 4 nines. Service-level disruption of this magnitude is unusual for us. Compounding the financial impact of the down time was an exceptionally generous credit payout multiplier, and our contracts dating from when we were a very young company. We've adjusted those terms to be more in line with industry standards while still remaining very customer friendly. We do not expect a revenue impact of this magnitude again."

Absent this $8 million revenue kickback, Slack's top-line growth this quarter would have been nine points stronger, or 66% y/y. Still, this excuse doesn't fully explain why Slack's net adds were so low this quarter (did service disruptions frustrate some customers so much that they ended up cutting Slack?) - nor does it give us confidence that this widespread service outage doesn't have any long-term impacts on Slack's brand, despite the company's insistence that Slack doesn't expect this type of revenue impact going forward.

We note as well that alongside slow net new customer adds, Slack reported a two-point loss in net dollar-based retention rates; in fact, retention rates have been sliding for each of the past five quarters:

Figure 5. Slack customer retention trends Source: Slack Q2 earnings deck

Slack's profitability story was similarly lacking. Huge losses have been an ongoing topic ever since Slack's direct listing, but margins got even worse in Q2, with pro forma gross margins shedding one point to 87%, and pro forma operating margins losing three points to -35%. Pro forma operating losses ballooned 71% y/y to -$51.5 million.

Figure 6. Slack margin trends Source: Slack Q2 earnings deck

Slack's guidance isn't reassuring on this front either. For Q3, Slack is projecting pro forma EPS of $-0.08 to -$0.09, one to two cents worse than Wall Street's expectations of -$0.07; for the full year, Slack is guiding to -$0.40 to -$0.42, worse than Wall Street's mark at -$0.40. Amid decelerating revenue growth and slowing customer counts, we'd expect Slack to make up for it with profitability gains, but this is unlikely to happen.

Key takeaways

Slack's disappointing growth is a reflection of the hyper-competitive nature of its product niche. A plethora of companies are competing in the work communication space, and though Slack enjoys plenty of support from Silicon Valley startups, offerings like Microsoft Teams - with its native connection to Microsoft Office applications and workflows - may make more sense for customers that are already deeply embedded into the Microsoft ecosystem. Slack's significant service downtime in Q2 - and the potential ripple effects that may have had on customer retention - is another red flag.

For a stock trading at >20x forward revenues, Slack is laden with risks. In my view, shares will continue on their sliding pattern until they hit a bottom at a low-teens forward revenue multiple. My price target on Slack is $19, representing a valuation multiple of 14x EV/FY20 revenues and 30% downside from current levels. Steer clear and invest elsewhere for now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.