Productivity company Slack is planning to go public on June 20, under ticker symbol WORK. On this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Brian Feroldi review what we know about this business, and what investors should watch out for if they're interested in those sweet, SaaS-y margins.
The guys explain: what Slack does, how it works, and why it's so profitable; how healthy the management picture looks; why Slack is doing a direct listing instead of an IPO (initial public offering); the main competitors that Slack has to battle; how price-sensitive investors might want to approach Slack's nosebleed valuation; the most important risks and trends to keep an eye on; and more.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.
This video was recorded on June 14, 2019.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Friday, June 14, and we're talking about yet another soon-to-be-public tech company. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com's Brian Feroldi. Brian, what's going on, man?
Brian Feroldi: Hey, Dylan! I am still in mourning this morning after my beloved Boston Bruins lost a heartbreaking seventh game of the Stanley Cup Finals. I guess this is what it feels like to be a Jets fan all the time.
Lewis: That's true! You know, that's a lot of shade to throw this early in the podcast, Brian, but I have to take it because the Jets are just so terrible. Man behind the glass, Dan Boyd, is just having a hoot back there. [laughs] I don't think he expected you to come out quite so hot. But you know, as a Boston sports fan, I think you guys have enjoyed a pretty good run.
Feroldi: Yeah, we certainly have. But it was an exciting game. Congratulations to St. Louis! It looks like they were partying and having a good time there. The way they played last night, they deserved to win.
Lewis: I was in Boston for five years. I think I attended three different parades while I was there. It's a lot of fun, but it's nice to see another city win one every now and then.
Feroldi: Well, I still would have preferred Boston win again.
Lewis: [laughs] Brian, the Jets are going to have their day. We're going to drop the title discussion. Dan Boyd says no behind the glass, and that's OK. We can agree to disagree on that one.
Brian, today you are on the show because we want to talk about Slack. Slack is a SaaS [software-as-a-service] company. I'm sure a lot of listeners have heard this name before. Maybe they even use the product. Because it's a SaaS company, you're obviously the guy that I want to talk to. You are like Mr. SaaS for Fool.com.
Feroldi: Hey, that's a title I'm happy to take on. I love SaaS!
Lewis: We use this product here. In fact, we were planning the show using Slack. For the unacquainted, why don't we just talk a little bit about what this company does? It's a messaging service, but it isn't as simple as your classic AOL Instant Messenger. There's a lot of functionality in there that makes it a pretty good enterprise product for companies like The Fool.
Feroldi: Yeah. Slack is a provider of cloud-based collaboration tools and services that help teams get projects done. The backstory behind this business is: A team was trying to create a product, and they were going back and forth with email, and they were just getting frustrated. When you're using email, it's easy to leave people off a chain, or if somebody else joins in, it's easy to accidentally share files that you shouldn't, or it's hard to keep track. So they created Slack as a way for them to collaborate easier. And through iterations, they developed a tool that they just felt was heads and shoulders above email. They've been rolling it out worldwide. The more organizations that adopt it, the bigger these guys grow. I know that once The Fool joined the Slack train, the number of emails that were sent internally just plummeted. It's definitely the communications tool of the 21st century.
Lewis: There's a little bit here that reminds me of Shopify, in that this is a product that was born out of some feeling of necessity. The lore of Shopify is, CEO Tobias Lutke was like: "I'm trying to build this snowboard business online. I don't really like the tools that are there to do that." Slack has basically said: "We couldn't find a good corporate communication tool. We're going to create it." That hasn't been a bad model for businesses, especially in the publicly-traded space, Brian.
Feroldi: Oh, completely! I mean, if you as the entrepreneur feel the pain of the problem you're trying to solve firsthand, and you can create a tool that solves it, that is a great model for developing a business.
Lewis: This is a fairly young company; it launched in 2014. A couple of numbers just to paint a picture on how the business looks: They boast over 600,000 organizations on Slack, 88,000 paid. This is something, like you might expect with SaaS, where there's the "land and expand" model: They are giving a free tier away for small businesses, and hoping that as companies grow, as they see the value in the functionality of the platform, they will become paid members down the road.
Feroldi: Yeah, and they have landed a lot of huge clients -- I mean, 600,000 organizations, as you said. That includes about 65% of the Fortune 100. The bulk of users here are using the free version, but they have a pretty good track record of using the free version to get their foot in the door, then upselling their customers over time.
Lewis: You look over at the concentration of customers -- something we always want to look at when we're talking about SaaS companies, or really any business in particular -- they have 575 paid companies with annual recurring revenue of more than $100,000. That group only makes 40% of the total top line. They don't have too much customer concentration there. You like to see that. There are also quite a few developers that are building integrations for Slack.
Feroldi: Yeah, this platform is a developer's dream tool. I mean, they have over 500,000 registered developers that are building third-party apps. The platform at this point has 450,000 third-party apps that are built into it. You love to see a thriving ecosystem for developers to get onto. Slack definitely has that.
Lewis: They are worldwide; they're in 150 countries. The big markets here are the U.S., Europe, and Japan. They have integrations from a lot of the big tech names you'd expect -- [Alphabet's] Google; salesforce[.com]; Atlassian, a name that a lot of Fools know; and Dropbox. And with the land-and-expand model, I think they've enjoyed the fact that they don't have to spend quite as much as you might expect on marketing. It's a big expense for them, but they do benefit from word of mouth.
Feroldi: Yeah. As you said, they are pursuing a "freemium" model. They use the free tool to get their foot in the door, get teams using it. And once they do hit critical mass, they do have a track record of converting those customers to paid users.
One thing that excites me about this business is, the usage metrics are very strong. I mean, the average Slack user spends more than 90 minutes per workday on the platform, and they have 10 million daily active users. This is clearly a very engaging product.
Lewis: As for how all the pricing shakes out, they have a free option, which will probably do the trick for a lot of small teams. And then they have a standard plan for small businesses that'll range from about $6.50 to $8 a month, depending on whether you do monthly or yearly billing. Slack Plus is $12.50 or $15 a month, again, depending on the billing you choose.
Brian, why don't we dive into the financials? This company, in some ways, has a lot of the markings of a business about to go public.
Feroldi: Certainly. These guys have been in hypergrowth mode for the last couple of years. When we talk revenue, we see $100 million in fiscal 2017, $220 million in fiscal 2018, and $401 million in fiscal '19. Last year, that was good enough for growth of 82% -- extremely strong. From a revenue breakdown, about two-thirds of that number is generated in the U.S., and just over one-third is generated internationally. It's nice to see both a very fast growth rate as well as a decent mix of business from an international perspective.
Lewis: The thing that has me excited, as it often does with software, is the margins with this business -- 87% gross margins in fiscal 2019. And that's actually a little higher than it was in 2017. But my gosh, you can do so much there if you have that much money flowing down to cover your other expenses.
Feroldi: Oh, completely! When you combine a very healthy gross margin with extremely strong revenue growth, it can just create magic as you move further down the income statement. From a balance-sheet perspective (keep in mind this is before they do their direct listing), $841 million in cash. They do have about $1.4 billion in convertible stock before they do the direct listing. But that stock is most likely to be converted into shares, so that will result in dilution as opposed to real debt. So it looks like a very healthy balance sheet.
Lewis: Of course, we talked about how they look like a lot of growth companies: They are losing money. They posted a net loss of about $140 million in fiscal 2019. Somewhat to be expected. I mean, you look at how this company is run -- high gross margins, but they are in growth mode. You break down exactly what's taking them negative: They have $150 million in R&D [research and development], $230 million in sales and marketing, over $100 million in general and administrative expenses. The story here is one that we see all the time in the SaaS space -- they are going out there and trying to build a big book of clients, knowing that they have a fairly sticky product, and once they get them in, they can retain them, and then ratchet that sales and marketing expense down a little bit down the road.
Feroldi: Yeah. It's also worth repeating that this company was started in 2014. It is only half a decade old, despite their size and their scale. It is not surprising to see, given their torrid rate of growth, that they are losing money. But they're basically plowing everything that they can into sales and marketing to expand, expand, expand. Given their rapid growth and their high margins, that's a trade-off that investors, I think, should be very happy with.
Lewis: The big question with a software provider, Brian, is: Do they have a moat? When you look at everything for Slack, what do you see?
Feroldi: I do think that Slack has a moat here, in a couple of ways. To me, when you use a messaging service like this, the most important moat that they have would be a network effect. As you can imagine, it's very hard to get a whole team of people switched over to a different communications platform, to get them to displace a messaging system. However, once a majority of users in your organization are on Slack, that definitely creates a network effect where if you want to communicate with people, you have to use Slack. So that actually creates both a network effect, and it creates some switching costs. I think the most telling number to highlight the switching costs is their dollar-based net expansion rate. This is a very critical metric for every SaaS company; it's a measure of customer spending from one year to the next. Slack's number came in at 143% last year. That's very telling that this company has a very deep moat.
Lewis: That number has slid down a little bit over the last couple of years -- 170% in 2017, 150% in 2018. Those are unsustainable net revenue-retention-rate numbers. A good SaaS company might be in the high 110s or 120s. Over time, I think this number is going to come down. Don't be spooked too much if it does. But I think it does speak to how strong their offering is. One of the things that really solidifies the fact that the switching costs are high for me is: Brian, did you know that SLACK is actually an acronym?
Feroldi: I did not, actually.
Lewis: SLACK stands for Searchable Log of All Communication and Knowledge. That's what the company name is. And the reason for that, if you start using it is, wow, everything is here. There are files here, there are announcements; we use it all the time at The Fool to do companywide announcements. If you have a question about a policy, and you need to find it, it's there in Slack. Once you have all that information in there, people that are added to the platform can come in and access it if they're part of those channels. That's a really hard thing to rip out of a business once it's embedded.
Feroldi: Yeah, totally. Again, Slack was created because the team was having trouble with their own internal communications. One thing that happens with Slack all the time is you can build channels, and include team members based on projects. You can add and subtract people as they move in and out of the organization. Those that are new can basically look back at the history that has been communicated and quickly get up to speed and have access to all the files information. That's a very different experience than if it was all done the traditional way, which would be via email. That's really the big selling prop to get Slack's foot in the door.
Lewis: All right, Brian, as is the case with a lot of growth companies, this is a TAM [total addressable market] story. Slack is throwing some pretty big numbers out there as to what enterprise communications might look like.
Feroldi: Yeah, this company believes that its total addressable market, as it exists today, is worth about $28 billion. There's also reason to believe that that number could grow. I mean, this company calls out, say, remote work, distributes teams as really a facilitator of increased need for communication. I mean, this is very similar to the story that we were discussing a couple of weeks ago when we were talking about Zoom -- $28 billion is a huge number when compared to the $400 million that it pulled in last year. So the TAM here is quite large.
Lewis: Of course, with that TAM, they are not the only company in this space going after that big sticker figure. There are smaller players that are in slightly different verticals of communication, like Zoom. There are also some pretty big names out there. I mean, you can't talk about corporate communication enterprise software without talking about Microsoft, and I think Google as well.
Feroldi: Yeah, those companies certainly have the resources and the know-how to build a Slack clone, or really come after that market. But it's not like there haven't been other messaging services that have existed for business until Slack came along. So the fact that Slack has grown so quickly, has the brand name, and has created those network effects, I think, is what should allow them to continue to thrive in the space that they have. But like any SaaS company, competition is worth investors keeping their eyes on.
Lewis: I do want to put it out to listeners here, we use Slack, and I really see the value of it. I didn't quite get it early on. It just seemed like instant messaging. But now, the company seems so essential to what we do at The Fool that I want a better sense of what the competition looks like. So, listeners, if you use any enterprise messaging software that is not Slack, maybe some integration with Microsoft Outlook or something like that, give us a heads-up, because I don't have a good sense of what that market looks like and I'd love to get a better one, especially on the user-experience side. Slack seems so good at what it does. I'm sure there are other names out there, and I'd love to know what your experiences are.
Brian, let's talk customers for Slack for a minute. We talked about the land-and-expand model -- people coming in free, and then hopefully getting them to upgrade down the road. Slack spent a pretty decent amount of money acquiring people. Does that feel sustainable to you?
Feroldi: I mean, this company is five years old. We should absolutely expect them to spend heavily on sales and marketing. Their sales and marketing numbers have been growing very quickly -- $233 million in the last fiscal year, which is a very sizable number. Once they get their foot in the door, the network effects and switching costs become so high that that is completely what investors should want to see. So it is very expensive, oftentimes, to get companies to adopt any SaaS product. But once they're there, they can be a golden goose that just lays eggs for years. That's a number that I think investors should be OK with at this point, and they should expect it to grow.
Lewis: I saw an estimate from a third-party vendor, they ballparked [that] about 80% of Slack's customers would still be paying users five years out. I think at that number, you start to feel pretty good about some of those acquisition costs. If that number was lower, you'd have to worry a little bit about how much they're laying out versus what they're actually bringing in, in the lifetime value. But it seems like they're striking a pretty good balance there.
Brian, I know one of your favorite things to look at when we're talking companies is management and the company culture. You always dig into Glassdoor. What did you find there?
Feroldi: This company has two co-founders. One of them is Stewart Butterfield, who is currently the CEO. Very glowing reviews for him on Glassdoor: I see a 97% approval rating. The company itself gets 4.7 stars out of 5. Clearly, this is a culture that has a beloved leader. Butterfield owns slightly more than 8% of total shares outstanding before the direct listing. The other co-founder is a guy named Cal Henderson. He is the CTO at the organization. He owns about 3% of the business. Combined insiders in general own 46% of total shares outstanding. Given the high approval ratings [and] the high inside ownership, I think this is a thriving company culture with a great management team.
Lewis: Are there any big red flags that you see with this business? I mean, we are so glowing so far in our review of this company. I think it's good for us to take a step back and figure out what could go wrong here.
Feroldi: Sure. I always like to check about a number of things. Is it a penny stock? In this case, no; it is a multibillion-dollar organization. Is there any excessive customer concentration? No -- 88,000 paying customers, so that's not an issue at all. The industry itself, I think, does not face any long-term headwinds. I think that there are clear tailwinds behind this business, given increased remote work, and working with teams from various parts of the world. This business, from what I can tell, does not rely on any outside forces for its success.
Another factor we haven't touched upon is stock-based compensation. In fiscal 2019, stock-based compensation was $23 million. That is before the company direct-lists, and it's very common for that number to rise substantially after a company has come public. But that is a number that is very low in the grand scheme of things.
Overall, if I was to come up with any sort of knock against this business, I would just say that they are not yet profitable. They are not yet producing free cash flow. But in total, I think there's a lot to like here.
Lewis: As an investor, I think the biggest risk may be the valuation. You know, it is going to be tough for them to live up to the numbers that I am seeing right now. We talked about how they've got just over [$400 million] in trailing 12-month-revenue. The number I have seen for their direct listing is $17 billion as a valuation, which would put them at roughly 37 times trailing sales [Editor's note: Numbers are rounded]. There's a lot of different philosophies about IPOs, Brian. At a valuation like that, there are bound to be some hiccups here and there. It may make sense to hang out on the sidelines a little bit.
Feroldi: Yeah. If investors were interested in this, I mean, the numbers that we've seen out of some IPOs recently are just insane. We talked about Zoom, what a high-quality business we both thought that was, on our last show. That's been a sensational IPO that currently trades hovering around 70 times trailing sales, which is just such a nosebleed number. By comparison, Slack at 37 times sales could be viewed as a bargain, even though it's completely ridiculous when viewed through a normal valuation lens.
If listeners are interested in this, one technique that we always expound on is to buy positions in thirds: Buy a small sliver upfront, and then just wait and see. See how the company acts as a public company when they have a number over their head. Does the management change? Does the dilution get crazy? There's no rush in buying IPOs, is the advice I would give listeners.
Lewis: Yeah. This is a great-looking business. The problem here is that everybody knows it. It is no secret. It's a well-known company, and it's getting a ton of press with all of the normal outlets that are covering the market, so you're going to be paying a hefty premium for this business. If it isn't prohibitively expensive for you to do so, and you really like the company, just buy a couple of shares. Then you can track it over time, build that position, as you get a better sense of what management wants to do, how the numbers look quarter after quarter. I'm going to be putting it immediately on my watch list, but probably not buying shares in the first month or so that it's publicly traded.
Feroldi: That's exactly the same thing that I'm going to do. I think this is a great business. There's many reasons to be optimistic about the long-term potential here. But I am personally not going to be in a rush to pull the trigger on this stock right when it comes public.
Lewis: The company is planning to list its shares on June 20, and it will be under the ticker symbol WORK. We're choosing our words carefully throughout this show, Brian, because this is not an IPO; this is a direct listing. The TL;DR -- the quick takeaway on that -- is Slack is not going to be raising money by taking the shares public, they're really just allowing for shares to be traded. There's a lot more nuance to it, but I think it's fair to leave it at that.
Feroldi: Yeah. And kudos to them for getting such a great ticker symbol, right? WORK -- gotta love that.
Lewis: Yeah, I had to double-check that. I thought it was taken. Like, you're telling me Workday doesn't have that one locked down? Come on! But, yeah, I guess they managed to finagle it.
Feroldi: Well-done to them!
Lewis: Well-done to them, and well-done to you! Thanks for hopping on today's show, Brian!
Feroldi: Dylan, you know I love talking about IPOs, especially of SaaS companies. Always happy to be here!
Lewis: All right, listeners, that does it for this episode of Industry Focus! If you have any questions or you want to reach out and say "Hey," you can shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes, or catch videos from the podcast on YouTube.
As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Dan Boyd for all his work behind the glass today! For Brian Feroldi, I'm Dylan Lewis. Thanks for listening and Fool on!
