Slack Joins the Lagging IPO Club

Slack (WORK) just put out its first earnings report, and the market wasn't happy. Growth at the online-collaboration company has been lagging for years, and now Microsoft's (MSFT 0.37%) getting in the game in a big way.

In this week's Industry Focus: Tech, host Dylan Lewis and Motley Fool analyst Evan Niu look over the earnings report, along with Microsoft's new Teams push, and explain what it all means for Slack's future. Then the hosts discuss why so many of 2019's hyped up IPOs -- from Slack to Uber (UBER -2.03%) to Dropbox (DBX 2.34%) -- have failed to impress. Tune in to learn how private investing trends have shifted, why every new company wants to be seen as a tech player, what it means that WeWork is already slashing its IPO expectations, some big-picture context that investors need to know regarding the venture-capital market, 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 Sept. 6, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, September 6th, and we are talking about results from 2019 IPOs. I'm your host, Dylan Lewis, and I've got fool.com's Evan Niu with me on Skype. Evan, what's going on, man?

Evan Niu: Not a whole lot.

Lewis: Nothing too big? You had the birthday weekend. Anything big going on this weekend?

Niu: No. Just taking it easy after a short week since we had Labor Day holiday. A short week, but I'm still ready for the weekend.

Lewis: I'm always ready for the weekend. It's one of the beauties of taping on Friday. We get to catch up a little bit, coast into the weekend, especially now when we're recording in the afternoon. Sometimes we do it in the morning. But it's nice. We ease into things. And I like to think that if we're getting listeners listening on their way home, maybe commuting or something like that, they too are heading into the weekend. It's a nice attitude to have. Austin Morgan, our producer, has his weekend shirt on right now, and he is in full summer mode. Trying to get those last couple of days out of those shirts. 

Austin Morgan: Oh, yeah! And, this weekend, the pool's opened up for dogs. After Labor Day, closed for people, open for dogs. So I have at least one thing to do on Saturday.

Lewis: When one door closes, another one opens. Who knew? I had no idea that the dog season was starting.

Morgan: Me neither. I missed that one. One weekend only, for four hours.

Lewis: Well, there you go. You have to take advantage. Today on the show, we are going to be talking about the first quarterly results from Slack, then digging a little bit into what's been going on broadly with the 2019 IPOs, and some of the 2018 IPOs as well. A highly anticipated class of public offerings. A lot of stocks that also have not done particularly well. Really, the impetus for all this was Slack's results, Evan. The stock is down about 10% from where they were before they reported earnings. Obviously, the market was not particularly pleased with the results that Slack threw out there.

Niu: Right. This was their first earnings release as a public company. They had released their first quarter results as they were about to go public. But once they started trading, this is now the first time that they're reporting. We saw second quarter revenue come in at $145 million, which was up 58%. But now they're forecasting third quarter revenue to be up about 40%. We're seeing the top line decelerate a little bit here, which I think is a lot of what is rattling investors.

Lewis: Yeah. When you see those big growth numbers out of the gate, you get excited. The valuation that a company like Slack trades at is contingent on them continuing those results. You look at what them going down to like the 48% or 46% year-over-year range does for them for the full year, they're saying, for the full year, we're looking at growth of 51% to 52%. You go back to the previous year, 82% year-over-year growth. The year before that, 110% year-over-year growth. So this is definitely a little bit of a slowdown from what people have gotten used to seeing from them on the books.

Niu: Right, exactly. The same is true for billings. Billings this year, supposed to grow somewhere in this 43% to 47% range, down from 79% last year and 102% the year before. At the same time, deceleration is natural as you're growing your revenue base. These growth forecasts are by no means unhealthy in absolute terms. These are still some great numbers to put up. But I think the real challenge that Slack is facing is that when you're combining this directional deceleration with Slack's lofty valuation multiples, for example, even now, when they're trading close to their all-time lows, the stock is trading at 30 times sales, which is still pretty big premium compared to other peer stocks that are software-as-a-service, enterprise, collaboration, that whole group of companies. They're still at a premium. And they went public at around 45 times sales. I'm not really surprised to see that we're having some multiple compression here because they're slowing down, they started trading with such a high valuation, and now there's all these other threats coming from Microsoft. There's a lot going on here that I think is explaining why investors are a little freaked out right now.

Lewis: Yeah, and when the top line dips like this, it also means that the specific inputs that go into that revenue number are showing that same deceleration. Two big numbers that stood out to me. You go over to their net customer additions, it was 5,000 for the quarter, which is the lowest quarterly figure I've seen them post in aggregate. Then, if you go to the year over year growth, that's also the lowest number they've posted. Its 37%, where it had been in the 40% and 50% range in previous quarters. The all-important number that we love to look at for the SaaS businesses, net revenue retention rate, basically their comps number for their customer cohorts, 136% year over year. That's a great number, but if you look at how they've trended over time, it's down from 138% the quarter before and 146% a year ago. So, again, more of these very impressive growth numbers coming down to reality a little.

Niu: Right, exactly. I think that's really the key here, is the direction they're heading. They're still good numbers, like you mentioned. The market was just previously pricing in even higher expectations.

Lewis: One of the important things when a company goes public is to understand that there's probably going to be some stock-based compensation coming out when you look at the financial reports. Evan, I know that with this earnings report, you specifically dug into that a little bit.

Niu: Right. That's common for all companies because it triggers a lot of these vesting requirements for all this equity they've been given their employees all this time. That's a very common thing. In this case, that's a big part of their net loss. They recognized over $300 million in stock-based compensation expenses, which are one-time events, so investors typically brush that aside. If you ignore that, their non-GAAP operating loss was just $55 million. Still losing money, but I think they're becoming a bit more conscious of trying to control their costs as well now they're getting more scrutiny as a public company. And then, another one-off item that happened this quarter was, there was a service outage at the end of June. I don't know if you remember. We use Slack at the Fool, so we were hit by this outage, too. To compensate for this, they gave out $8 million in credits to customers to make up for the service disruption, which also impacted full-year billings guidance by about $5 million. Not a huge deal, but a little blip there because they did have that outage.

Lewis: You mentioned Microsoft before. I think that as Slack gets bigger, and they start going after these very large accounts... Of their customer base, a very small portion of their customers are very big accounts -- accounts that would spend over $100,000, if I remember the metric correctly. That right now is very much Microsoft's world. They are in with Outlook at all these huge businesses. That's who Slack is going to be going after to really meaningfully grow their business. If you get in at some of the Fortune 100 or 500 companies in a really meaningful way, well, bam, that's thousands of users immediately with just that one account. Anecdotally, I've noticed over the last couple of weeks, it seems like I'm getting a little bit more of a nudge to start using Microsoft Teams. We use Outlook and we use Slack here at HQ. I have Outlook on my computer. And I'm starting to get that prompt, "Oh, do you want to sign into Microsoft Teams?" when I boot up my computer in a way that I wasn't two months ago.

Niu: I think that's a lot of the big threat that Slack is facing when it comes to Microsoft Teams and Office 365. There's a survey that came out a few months ago about how a lot of these IT executives and decision makers, who are ultimately who's making this purchasing decision, the customers, a lot of them actually really are considering ramping down their spending on Slack, and putting it back into Office 365. I think most people agree that Slack is better than Teams, but Teams is bundled in with 365, so it's little to no cost to have it on there. And if it's a good enough alternative vs. Slack, which is more expensive, even if it's better, then, for an IT executive that's really looking at their spending budget, that's a pretty compelling thing, if it's good enough and a lot cheaper. I think that that's what's the challenge here for Slack. On the call, CEO Stewart Butterfield provided a couple of examples of customer wins, like, "They chose Slack over 365 because we're the only one that can integrate with all these apps that they've developed, a lot of interoperability," it's an open platform. So, they do have some advantages there. But, I think they're pretty clearly showing that, yes, this is something to worry about. They want to address it and dispel these fears.

Lewis: Yeah. It's natural, so often we think of switching costs as being something that is very helpful for a SaaS business, where you get in there and you have customers who use the product, love the product, and become dependent on it. I think that this is actually a situation where, yes, it works for Slack, because the people that use it obviously love it. We see that net retention rate going up over time. But, in the case of acquiring new customers, that Office Outlook 365 suite is pretty sticky. If you have people that are so used to using that, it's already installed on their computers, and there's something rolled into it that is Slack-like in some way, well, some corporations might look at that and be like, "It doesn't cost us all that much more to do, and we don't have to retrain thousands of employees to use this other piece of software." I think it's a rare instance where it may work against Slack a bit.

Niu: Right. This is a long game. Microsoft's in this for the long game. They have this huge business, it's all enterprise collaboration. What they've been doing over the past three years is replicating all of Slack's best features, not unlike what Facebook has done to Snapchat. We know how that's going for them, as we've talked about at length. Over time, Microsoft is just going to keep doing this. They're just going to keep copying all the things that people love about Slack, then undercut them on pricing, then sell that to all of their much larger customer base as a way to chip away at Slack's popularity. Teams already has more daily active users than Slack. That doesn't say how many customers there are, but the point is, it's already pretty competitive in terms of how big it is in terms of users. So, I think that over time, yeah, they could definitely keep chipping away, and that's what they're going to keep doing.

Lewis: Shares of Slack now trade below where most people were probably able to first buy in, somewhere in the mid to high $30s. I think they're down about 20% from that point. 

Looking at 2019 in general, I've seen the phrase broken or underwater IPO more than I have at any other point following the financial markets. It seems like we have had a ton of companies go public, and then, to be honest, post pretty underwhelming results that have taken their current share price and dropped it well below the offering price, Evan.

Niu: Right, exactly. If you go back over the past couple of years, most of them are actually down, the high-profile start-ups that most people recognize as household names. For example, Xiaomi, Chinese smartphone maker, was once heralded as the most valuable start-up in the world. They went public last year, and now their shares are down like 60%. Dropbox, which famously turned down an acquisition offer from Steve Jobs, they're down about a third when they went public last year. Spotify, leader in paid music streaming, they're only down about 8% from their direct listing last year. That's just three examples from last year. If we look at this year, we have Slack, which we're talking about. They're down about 30% from when they started trading. Uber's down 25%. Lyft's down 40%. Pinterest is bucking the trend here, they're up about 25%. This has a lot of implications going forward. There's a lot of companies going public on the horizon that people are excited about. We have WeWork, Airbnb, Peloton, Robinhood, Postmates. The list goes on and on.

Lewis: What's interesting about WeWork in particular is, we've seen this very specific class of heralded unicorns go public, and beyond these valuations that seem to have been propped up a little bit by VC money, then hit the reality of the markets, and maybe some slowing growth rates, and deal with the fact that the valuation is going to take a haircut if that's happening. With WeWork planning to go public, they went from having a certain idea of what they might go public at to, according to a report this week, taking a haircut on that, and saying, "We're probably going to be looking at the lower end of the range that we were originally looking for." And that range is actually below what they were raising funds at with SoftBank just a couple of months ago. So, we're seeing this effect play out before this company maybe even goes public.

Niu: Right. A lot of these down rounds, where companies are getting valued at lower than what they were at the private markets, which is not a good thing if you're a private investor, or public investor, even. This just doesn't look good for anyone, for the valuation to come down before you even hit the public markets.

Lewis: No, you don't want to see that. We're used to that to some extent as public investors, because you can buy shares of a company and six months later get a better price on those shares because they're hitting some short-term headwinds, hopefully, and maybe you're lowering your cost basis a little bit. Venture capitalists aren't quite as used to that happening, and are probably not as thrilled. But I think it's worth unpacking why that's happening a little bit, Evan.

Niu: The most obvious explanation here is, when there's more hype around a company going public -- for example, these start-ups that have all of this brand recognition -- the more hype there is, the higher the IPO price or direct listing price, whatever the case may be. And the higher the price is, the more you're pricing in these really high expectations, and a lot of these companies are simply unable to meet these expectations once the reality hits. But there's also another bigger trend that's happening here, which is that there's been a massive boom in venture capital funding over the past five years. For example, there are a lot more funding rounds these days that are $100 million or greater. It used to be that most rounds were less than $100 million. So, the rounds are getting much bigger. And all of this venture money that's coming in, flowing into these companies, is letting these companies stay private for a lot longer than they used to be able to historically, which basically means that the venture capitalists are capturing more of the gains while the companies are in this hyper-growth mode since they're staying private a lot longer during that high-growth phase. And just like we're starting to see with Slack, growth starts to slow right when they hit the public markets. And when you combine all of these factors -- a lot of hype, lofty valuations, slowing performance -- it's just a recipe for underperformance. We mentioned Pinterest is one of the ones that's up. Pinterest was one of the least hyped of all the deals that we mentioned.

Lewis: Yeah. I think that this is compounded a little bit, too, by the fact that so much of the tech zeitgeist is, "look at TAM, worry about everything else later." So, focus on total addressable market, get these businesses that scale incredibly well, and then, over time, bring down your sales spend, bring down your marketing spend, they will become profitable, hopefully. It depends on the business model here. But, when that is the goal, the customer acquisition growth is going to fuel a lot of the valuation. And when that number starts to dip, when it starts to decelerate a little bit, you get closer and closer to the point where the business really starts to need to make money instead of just acquire new customers. And we haven't seen that a lot of these businesses have been able to prove they're able to do that.

Niu: Plus, a lot of these companies aren't even tech companies, in my opinion. Everyone wants to be a tech company because tech companies tend to get higher multiples and better valuations. WeWork, it's just a real estate, subleasing play, but they call themselves a tech company. I remember reading this thing where they said that they used machine learning and AI to figure out when to make coffee in the morning. Which is like, what?! [laughs] Why do you need AI to tell you when to make coffee in the morning for your people that are renting the space from you? That's just an example of, it's a stretched comparison to say some of these companies are tech companies, but they all want to make that argument so they can justify these valuations.

Lewis: I think it's important for investors to understand the size of the business that they're buying into when they buy shares. If you're looking at share price, you will miss market cap. There are some folks out there that have looked at big tech as an example. If you're looking at Apple, Microsoft, Amazon, sure, those have been great stocks to own over the last couple of years, but these are companies that trade between $850 billion and $1 trillion. It's going to be hard for them to double. It's going to be hard for them to triple. If you're looking at stocks in the $2 billion to $10 billion range, it's much more likely that they are going to put up pretty killer returns over time, just because of the law of large numbers. And I think that holds also for a lot of these companies that have gone public in 2018 and 2019. For them to have valuations of $20 billion, $30 billion, in the case of Uber going public at $80 billion, that is immediately putting a company within the hundred most valuable businesses on the major U.S. exchanges. It's a lot harder for them to go and double at $80 billion because they waited so long to go public, rather than a software company that debuts at $3 billion.

Niu: Right, particularly when, for a lot of these companies, the fundamentals just haven't caught up to the valuations that they were able to get in the private markets. When they go public, the fundamentals aren't there yet.

Lewis: Yeah. I think the important thing for people to remember, Amazon IPO-ed at $438 million back in 1997. The largest company on the U.S. market at the time was GE, with a valuation of somewhere between like $200 billion and $220 billion. So, a tiny portion of the most valuable company on the publicly traded markets at that time. You look at Uber, $80 billion valuation, some of the largest companies on the market were trading at $900 billion to $1 trillion. That's 8% of the most valuable business out there. So, when you start looking at those larger companies, yeah, it's just going ot be more difficult for them to live up to those valuations. It'll be a little bit more difficult for them to double or triple the way that you might expect some of the major tech companies of the past have been able to do.

Niu: Makes me wish I was a VC.

Lewis: [laughs] Yeah. That's a wholly different world, private investing. We've talked a little bit about equity crowdfunding on the podcast before, but that asset class is still closed off to folks like you and me, Evan.

Niu: Actually, some of my family members are venture capitalists, which is interesting. I have some interesting conversations with them sometimes. 

Lewis: I bet. Yeah, that must be a really fun Thanksgiving dinner.

Niu: [laughs] Good family reunion small talk. 

Lewis: We'll continue to check up on these IPOs as they give us some quarterly results. Maybe we'll do a little year in review as we get closer to the end of 2019. We'll save the discussion for then, though. Evan, thanks for hopping on today's show!

Niu: Thanks for having me!

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. There's also all this bonus content on our YouTube channel, tons of stuff from the podcast as well as some videos we make specifically for 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 Austin Morgan for all his work behind the glass today! For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!