3 Reasons Slack Will Prove the Naysayers Wrong

The market has not been kind to Slack (WORK +0.00%) this year; its stock is down more than 45% from its high in June. With 20% of the available shares short, the company has its fair share of naysayers. But there are three reasons this software-as-a-service (SaaS) communications platform will succeed despite the naysayers and its high valuation.

1. A product with strong appeal

Customers love Slack. That can be seen by the fact that existing customers spent 36% more for the product than they did a year ago. Also, the number of customers has grown to more than 100,000 paying users, up 37% from the previous year. Then there is the fact that daily active users topped 12 million, and they spend an average of 90 minutes a day using the tool.

The platform appeals to all types of organizations: families, nonprofits, tech companies like Splunk, or high-end-retailers like Cole Haan. Large customers seem to be especially attracted to the software's feature set despite the alternative of Microsoft Teams, which comes free when bundled with Office 365. Organizations spending more than $100K annually grew at a 75% rate last quarter over the previous year, and 65% of the Fortune 100 are paying customers. These growth stats have resulted in 58% year-over-year revenue growth last quarter and 51% projected revenue growth for the full year.

But users liking a product doesn't guarantee its success.

Users love the software, but does Slack have what it takes to be a good investment? Image source: Getty Images.

2. Innovation and integration make customers stick around

In 2019, the company spent a hefty 39% of its revenue on research and development. In addition to in-house activities, more than 600,000 third-party developers have registered on the platform and built over 500,000 custom applications. Many of these customizations are built by a customer's information technology teams to improve employee productivity.

Shopify created functions inside of Slack to give employees quick access to critical data such as problem ticket status, customer metrics, or data center statistics. Customer-specific functions like this cement the platform's status as the "must-have" application for office workers.

Additionally, there are more than 1,800 general-use applications available on its app store. These applications provide seamless integration to common calendars, video conferencing, project tracking tools, or even HR software. These integrations make it so that users don't have to leave Slack to retrieve data, coordinate with colleagues, or act on critical workflows.

All of these integrations and custom hooks to internal applications increase the switching costs for customers, making it hard for them to leave.

3. Leadership has a wealth of relevant experience

A strongly integrated platform that attracts loyal customers is a must, but Slack also needs a solid leadership team in order to thrive in this competitive industry.

This isn't CEO Stewart Butterfield's first time starting and running a company -- it's actually his fourth. After his first start-up, Gradfinder.com, was sold in 2000, he started Ludicorp. When Ludicorp determined its primary online gaming product would never be profitable, it managed an amazing pivot and created a cloud-based photo-sharing service called Flickr. It was wildly popular and was bought by Yahoo (now owned by Verizon). Butterfield joined the established search engine organization but left after a few years for start-up No. 3.

The new company, Tiny Speck, was another attempt at producing an online multiplayer game called Glitch. During the development process for the game, Tiny Speck built an internal communication tool called Searchable Log of All Conversation and Knowledge, or SLACK for short. The cloud-based game didn't survive, but the communications platform did, and it was released to users in 2014.

Butterfield's unique career path has provided him valuable leadership experience and a network of talent. He's built an impressive team of experienced software executives in key leadership positions.

Source: Slack's Leadership webpage.

A CEO who's graduated from the school of hard knocks that is backed by a team with start-up knowledge and large-organization experience should be a winning formula to grow the company. But even with all Slack has going for it, investors might still be staying away from the stock.

The elephant in the room

The price-to-sales ratio (P/S) is a common tool to compare valuations of growth companies. Slack's P/S ratio of its market value over the trailing 12 months of sales is a lofty 23.5 compared to Nike at 3.5 or even software giant Adobe at 12.6. This high valuation means that if there's a quarter in which results don't meet market expectations, the stock will likely take a hit. Although it's still high, this ratio is now more in line with some of Slack's fast-growing SaaS peers like Atlassian (P/S of 23) and Okta (P/S of 27).

Another metric that doubters point to is Slack's poor performance on the rule of 40 test. The growth component of that formula is significantly offset by negative profit margins driven by notable spending on marketing, research and development, and stock options. This spending can be viewed as necessary for Slack to grow and compete with deep-pocketed competitors like Microsoft. With $785 million in cash and marketable securities, the company is well-positioned to fund its growth into the future.

A recent Barron's article about Slack points to bullish sentiment among some market analysts and hedge fund managers, who believe that fears over the competition are overblown and the market opportunity for this superior product is huge. An analyst from William Blair thinks that, with the stock trading in the low $20s, investors getting in at this price and operating with a five-year investing horizon could be rewarded with market-beating returns.

Given that Slack has only released one earnings report to the public so far, what lies ahead is far from certain. This stock may not be for everyone, but investors who believe in this much-loved SaaS communication product could do well by investing a little bit now and watching as this story plays out.