Slack: Strong Short Opportunity On Earnings

Summary

• Slack is unprofitable, will still be unprofitable in the near future, and only bolstered by hype.
• The underlying business model lacks barrier of entry and differentiation.
• Earnings will be a reality check for those holding the stock, and I recommend playing it in the short direction.
• Looking for a helping hand in the market? Members of Exposing Earnings get exclusive ideas and guidance to navigate any climate. Get started today »

We usually do not run earnings trades on stocks with little data, so I write this with the warning that this trade is more speculative than most of my earnings plays. I am shorting Slack (NYSE:WORK) into earnings. The data I do have support the trade, and my thesis on the company itself is bearish.

WORK is reporting its fourth quarter earnings on March 12. Whether it rises or falls, one reliable aspect is that, as per my backtests against expected movements (as measured by the average movement of a stock in the market), WORK underreacts to news. That is, earnings will be more slowly priced in than usual (read: compared with other stocks), implying that we can ride post-earnings drift.

Still, on the short side, I would suggest taking profits sooner than later. WORK’s investors are strongly bullish on this stock and constantly looking for dip-buying opportunities. You can see in its chart that the company has remained relatively unscathed during the recent correction.

Work has risen against the SPDR S&P 500 ETF (SPY). (Source: Stockcharts)

Building a Markov chain on WORK’s price action is illuminating. A Markov chain with states {up, down, white, black} - the former two indicating WORK opening higher or lower, respectively, and the latter two indicating WORK ending higher or lower, respectively – is shown below, with transition probabilities displayed connecting the states. You can see that in the past month, the dumb money (read: those trading at the open) has always bought the dip:

(Source: Damon Verial; data from Tiingo)

The smart money is not buying the dip. This does not mean they are not bullish, though, as you can see that 80% of the time the smart money is buying with momentum. Still, the smart money is engaging in slightly more selling than buying, yet the stock remains bolstered by the overwhelming bullishness of the smart money – aggressive dip-buying at the open.

This buying pattern is often seen in hype (or glamour) stocks. Indeed, WORK is a hype stock, as its price is entirely based on hope for future profits, the company being unprofitable. Most analysts do not expect WORK to become profitable in the near future, either:

(Source: Simply Wall St)

Even if investors are buying the hype, I don’t think the valuation is justified in light of Slack’s lack of differentiation. While the CEO claims the company to be a novel type of technical tool, services similar to Slack have been around since I first began using the Internet, back in the 90s (e.g., IRC). Slack's advantages (e.g., clean conversation threading, team notifications, etc.) over its current competitors are few and cannot be sustained, should other companies decide to copy them.

In addition, chat apps tend to come and go, being hype-driven themselves. Remember ICQ and AIM? They too provided novelty at one time but were eventually replaced by apps with staying power – those that were built with clear barriers to entry (e.g., Skype, positioning itself essentially as the telephone of the Internet).

Previously using Slack myself, I no longer use it. I find myself on Discord instead, which I admit is better than Slack. Still, I would not invest in Discord even if it were public. I wonder, too, if apps like Discord or Skype will soon be replaced by novel technology. Those that stay around tend to be bought out by mega tech corporations (e.g., Skype and Microsoft) and thus supported as well as integrated with a company that already has staying power; a chat app is unlikely to be a moat that supports an entire company.

WORK investors are banking on an office chat app becoming profitable in light of free, better, and easier alternatives. Slack’s popularity is in part because it filled a need other chat apps could not fill. It replaced previous chat apps due to its internal search engine and chat history, but those functions now exist in Slack’s peers (e.g., Discord).

In addition, I wouldn’t be surprised for Slack’s focus on office productivity to bite itself in the ass. Anyone who has used Slack need only think about how much time is wasted through notification spam and through, ironically, its ease of use (How many “hey” messages without content have you received from your co-workers, resulting in waiting with no response, which then results in you responding to find out what your co-worker wanted in the first place?)

I believe others see what I do, which is probably why the short percent is so high (currently 24% of float). The interesting thing about WORK is that it is in a constant state of battle between aggressive shorts and aggressive dip-buyers (supported by their smart-money momentum buyers). I think the reality wakeup call is earnings, when the company must publicly state that it is not profitable and nor does it predict itself to be profitable.

WORK is relatively new to the market, so speculators are not too concerned with negative earnings so long as the company has potential. But as more earnings reports go by, investors will be in a war of attrition – “When are profits coming?” can only be asked a number of quarters before the clear answer, “never,” becomes obvious. With the market becoming bearish, I see investors having even more reason to ditch WORK in favor of safer holdings once earnings shows again that WORK cannot produce a profitable business.

Here’s my play:

1. Sell Mar27 $26.50 call
2. Sell Jan21 ’22 $13 call
3. Buy Mar27 $25.50 call

If you don’t like short calls, go with long puts:

Buy Mar20 $27 put

Happy trading!

Analyst’s Disclosure: I am/we are short WORK. 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.

Comments

[Wanderer39]

the big risk to Slack is offices going cheap/free for internal messaging services. Without a doubt Slack is peoples preferred inter office chatting platform and is much better than its competitors. Teams being free within office 365 is the biggest risk. However I think we will see companies invest more in chat services with the shift to more remote working (especially with the Coronavirus).

[TheShort]

For what it's worth, I've worked at 3 places that is on O365 and has Teams as part of their subscription. All three decided to use Slack instead

[David Jackson]

@Damon Verial -- fantastic call on $WORK's earnings.

What do you prefer about Discord to Slack?

[Damon Verial]

Thanks. To answer your question:

For one, Discord is just more fun than Slack, which feels like a corporate product made by business executives. Discord feels like it was made by hackers. Second, the voice chat quality is much better than Slack's, obviously making it more useful for certain tasks and server types. I'm in a scam-baiting discord, and it's set up to where anyone can run a live scam bait call, while others listen in. As a lot of these calls are being run through VOIP and phone number spoofing programs, connecting (usually) India to the US, I'm quite impressed that the voice quality is so high. Finally, the revenue model will allow Discord to not only remain free (and ad-free) but also secure (as in users won't have to worry about their data being sold or privacy being breached).

@David Jackson

[David Jackson]

Thank you!

[1GMD]

Nice call

[Medici]

WORK is going to fly on the work from home spin tied to their earnings call. Shorting it is a bad idea.

[SG-account]

In the longer term, I don't see Slack managing to convert enough unpaid users, whether enterprise or SME, to justify its current market capitalization valued on a DCF basis. There is nothing outstanding about the technology that makes it a "must-have"; as the author noted, Discord and many other free alternatives are available and widely used.

At this valuation, cloud companies need to have a truly "killer" product to justify sharply negative earnings/lack of earnings leverage, and the revenue deceleration/decline in paid customer adds & billings per customer shows that the vast majority of users see no reason to convert to paid accounts. If those conversions don't happen, the company will continue to fail to show a path to profitability, as users will simply choose to use multiple collaboration services on an unpaid basis. The decline in net retention rate highlights the fact that paid customers don't see the product as useful enough to implement it across their organizations, while startups will continue to use Discord and alternatives in lieu of paying for Slack's paid features.

However, the company should be able to perform well with regard to revenue and guidance beats in the short term, as large enterprises, especially those already using Slack, see it as a simple, if not perfect, tool for remote collaboration. Eventually, a superior alternative should emerge, but Slack has enough short-term stickiness and moat to do well for the next year or so.

I don't think the fundamental technology is good enough for Slack to ever become a "must-have" and for the company to be able to substantially cut operating expenses while continuing to grow above 30% CAGR on a five-year forward basis (in contrast to companies like TEAM and AYX which have shown the ability to generate profits along with strong revenue growth, while DDOG looks like a a company that is able to generate revenue growth along with meaningful operating leverage). There are better short opportunities out there in SAAS/security without the significant short interest (PLAN, ZS in particular).

[SAZ318]

forget the prospects of the company.... like it or not it beat earnings estimates in the last 2 Qs. So if you want to advise on option earnings play, we need to look at techincals, not fundamentals. It may not have positive revenue, but may still beat estimates, and with that the stock price will (should...) rise. With the work-from-home dynamic happening now, and its history to beat earnings estimates, I would guess movement opposite from your assumption, i.e. it will beat earnings and make a small to medium jump in price.

[haikman]

I LOVE stupidity. It's how we traders and investors make big money.
Gary and Ed Wedbush at Wedbush Securities started WORK
with a $14 price target and that morning was the trading low all time for the stock.
Now, you have this short who says to ignore the paradigm shift of working from home
and to short one of the biggest beneficiaries of this new work style.
Good luck my friend. Ill sell you my WORK stock at $32-38 ON FRIDAY
after earnings are released.

[BlkFame]

Do you prefer your crow sauteed or grilled? Like they say, there's always a clown on the other side left holding the bag. LOL

[Damon Verial]

@BlkFame Misguided people aren't clowns. Nor are narcissists, the ignorant, those of low IQ...

Though I have never met one, I believe that the "Clown" is a profession deserving of respect.

Everyone else is just losing money for silly (but not funny) reasons.

[abecoffman]

I am extremely bullish on Slack. I work for LinkedIn so we get Teams for ”free” from our parent company. When they tried to roll it out to R&D there was very nearly a revolt. Suffice to say, we still use Slack.

Your entire premise about communication apps is flawed and naive. The entire backbone of Facebook is built on messaging. You can build powerful tooling directly into these applications.

The communication norms are still developing, hence the “Hey” messages. Less noisy behaviors can be encouraged through design.

Slack has powerful lock-in and massive network effects as well. Short at your own risk.

[WWG1_WGA_Q]

The Market as a whole is tanking & presenting all with the opportunity to buy stocks at lower prices or $$-cost avg. down. That would be a wise choice for many investor's. Holding WORK & will acquire a few shrs on any nice substantial dips,

[GameKing13]

Wow you are a very brave and courageous person for shorting a stock this week. Wow.

[Damon Verial]

I wrote this article one week ago. There is publishing lag. @GameKing13

[919_Investor]

After dipping down from 29 do you feel $work is still a short? looking at the tape there seemed to be some buying into the end of a horrible tape

[Wanderer39]

I bought Slack when it dropped to $17 this week. I’d be curious where this stands in the authors mind now since Slack like most other stocks took a big hit.

At $17 I can see Slack being an acquisition buy for Amazon or Apple.