- KPB & Co Research
#Slack recently began trading on the New York Stock Exchange (NYSE: WORK) at a reference price of US$26.0 per share, after directly listing its shares. In the first dat of trading the stock went up 48.4% to US$38.62 per share, easing fears of a collapse in price, as a direct listing by-passes the traditional demand discovery process. In light of the aggressive move upwards to a US$19Bn market capitalization, it appears that investor appetite for this unicorn is quite strong. The strong uptake could potentially reflect the general euphoric sentiment of the times, but there is also the possibility that something fundamentally strong could be occurring. In this article we seek to do a high level size-up of the company in a bid to provide some colour on whether the hype is justified.
What Is Slack
A glance through the form S1 of slack would expose the un-initiated to terms that would make it appear that slack's business is complex. On the contrary, they have a really simple business model. Slack offers a chat room on steroids i.e. a chat room with enough functionality to allow a team to collaborate, share data, and access applications. Users send messages either directly or through channels. According to form S1:
Channels offer flexibility and can be organized by project, topic, team, or whatever makes sense for a specific task or situation. Public channels are accessible to all users within a Slack workspace. For more exclusive workstreams and conversations, users create invite-only channels. Within channels, users post messages, documents, and images and interact with other software. Users can search for information about a topic or project, find a relevant channel, join it, and easily scroll through the entire channel's history, finding messages and contextual content.
Customers are also able complete tasks that would usually involve multiple unconnected applications, using a singular interface on slack's platform. Enhanced productivity can also be achieved through the automation of tasks that could require either multiple applications or a single application.
Slack also provides users with the option of extending the capabilities that are provided within an organization, across organizations. According form S1:
Shared channels securely connect the Slack workspaces of different organizations, enabling the same level of communication and collaboration between enterprises that Slack brings to teams within an organization. Shared channels can be public or invite-only and contain all of the powerful tools and integrations of Slack along with an added layer of administrative capabilities to regulate and monitor the flow of information between organizations.
The final significant value added provided by #slack is the ability to search historical messages for interesting topics. According to the company:
Everything in Slack, including messages, posts from applications, and text content of files is searchable, so that permissioned users can tap into company knowledge and find information when they need it.
All of the functionalities outlined are packed into a simple, intuitive, and friendly user interface:
Slack offers their service in four tiers, designed based on the amount of activity that the customer is expected to engage in. The free tier serves as a tool to introduce customers to the product with the expectation that the customer will upgrade to unlock more features. The cost for Slack's standard package is about US$8.0 per active user per month, the cost for the plus package is about US$15.0 per active user per month, and enterprise packages can starts from US$18 per user per month and upwards.
The Messaging Industry
With fiscal year 2019 revenues of US$400.5Mn, Slack is still a relatively small player in an industry that is estimated at US$28Bn - according to slack. The are numerous competitors with each having different sizes and shades. Slack competes with Google hangouts, which is a part of a much larger organization that has access to a very large pool of capital, and which have prices that are lower (starts at around US$7 per user per month). Cisco spark is also another fierce competitor and is also apart of larger organization with vast financial resources. Furthermore, Cisco spark and Google hangouts have video messaging, something that Slack currently lacks. The starting price for Cisco spark is around US$12 per user per month. Facebook has also thrown its hat into the ring with their "workplace" solution, and given its over 1Bn active users they post an enormous threat. There are many other competitors, our early count puts it at well over 50, and there might be others that we are missing. The fact of the matter is that Slack is operating in a space that requires continuous product innovation, high quality customer service and speed, they really can't slack off for a minute.
slack Has A Strong Offering
On the positive side, they have a product that requires the customer to make large non-monetary commitments - emotionally and habitually. The customer has to learn how to navigate the platform, upload files, build up a communication history, create automated tasks based on the Slack API and the list goes on. This make switching cost very high, and so customer retention will undoubted be high. The price of the product is small relative to the cost that many firms face when they hire and train workers. It can cost about US$370 per month for a 8 man and or woman team, while total compensation cost for such a team could run well into a hundred thousand per month. Of Slack's 95,000 paying customers, approximately 645 pay over a 100,000 per month. A key part of Slack's competitive edge is the ability to integrate multiple independent third party apps within Slack's platform, and the ability to communicate across organizations. The company boast more than 65 companies in the Fortune 100, and more than 500,000 organizations which presents an enormous opportunity to increase stickiness due to networking effects. The more apps that are on the network, the greater the number of teams that will see value in the productivity enhancements being offered. As at January 31, 2019, slack boasts over 1,500 apps in its app directory, and it continues to grow.
Like Spotify, the over 10 million active users on the free tier part of the platform represents an opportunity to optimize on marketing spend. The company would likely have emails and other customer behavioural information which they can use to customize their marketing campaigns. In this regard the customer acquisition cost would be much cheaper than usual.
Operationally, Slack has Big Advantages
The company has a gross margin that has averaged approximately 86.0% for the last 3 years. For the three month period ending in March 31, 2019, gross margins averaged approximately 87%. This super high gross margins indicate that the company uses a small amount of resources to create and distribute its services. Given the nature of the business, the biggest cost the company faces would likely be people and managed cloud services of which Amazon Web Services is a major part. Today, Slack has relatively large overheads owing primarily to the large marketing expenses (46% of total operating expenses) that is needed to accelerate sales growth. As the company gets bigger it will gain operational leverage resulting in, sales and marketing, research and development, and general and administrative expense getting smaller relative to sales, and company profitability accelerating. The efficiency of the company's operations can be seen from the amount of sales per worker. The company has approximately 1,664 employees, leading to sales per worker of US$239,952.0 which is slightly higher than the average of around US$220,000 per worker for enterprise software companies.
Growth Has Been Phenomenal, Long RunWay Ahead But Industry Uncertain
Slack has been putting up solid growth in revenues over the last 3 years. The number of paid customers grew by 2.5X to 95,000, while the amount of revenues grew from US$105Mn to US$400.5Mn - a 2-year CAGR of 95%. With a US$28Bn addressable market there will likely be many opportunities to grow well into the billion dollar sales club.
Just how big the company will get depends on a number of uncertain variables, and so it hard to tell the future exactly. The industry is already quite fragmented with numerous small competitive services out there, at the same time there are quite a few players with deep pockets that can go on the offensive at any time. The barriers to entry is not significantly large as the biggest problem would be customer acquisition costs, which given the size of the venture capital industry globally customer acquisition should be easy to fund. In this context, it is possible that there might be more competitors entering the industry in the future. It is also possible that the Slack can become an acquisition target at the right price, should any one of the deep pocketed competitors see a need to expand aggressively in this space.
Liquidity and Capital Structure
The company continues to lose money but is also well capitalized. In the fiscal year that ended in 2019, the company lost US$154.2Mn from operations, almost US$10Mn worse than the year before. The three month period ending in March 2019 saw an operating loss of US$38Mn relative to a loss of US$26.Mn for the same period a year earlier. The company used cash of US$41Mn to fund it operations in fiscal 2019, and US$20Mn to invest in the business making it a total of US$60Mn to operate the business. Given the run rate for the quarter, it appears that the amount of cash used will increase during the current year. On the other hand the company has cash, cash equivalents and marketable securities of approximately US$792.7Mn, which gives them close to 10 years of wiggle room assuming the current cash burn rate holds true. In essence the company did not need to go public now.
Slack's Capital Structure and Liquidity
management team incentive
Naturally as a founder led company, the management team will be intrinsically motivated to see their company do well. The CEO and co-founder Stewart Butterfield has been with the company since inception and has significant skin in the game not only from an emotional sense, but also from a financial sense as a significant part of the his net worth is tied to the stock. All the other members of the management team has turned over control of their shares to Stewart Butterfield which is a sign of trust. The other executives are also compensated in way that encourages performance. According to the company:
On March 23, 2016, we entered into an offer letter with Mr. Frati, who currently serves as our Senior Vice President of Sales and Customer Success. The offer letter provides for Mr. Frati's at-will employment and an annual base salary of $420,000, target bonus of $280,000, and an initial RSU grant, as well as his eligibility to participate in our benefit plans generally. Pursuant to his offer letter, we also provided Mr. Frati with a one-time signing bonus in the amount of $250,000, and we agreed to provide Mr. Frati with reimbursement of his moving expenses, up to a maximum aggregate amount of $75,000.
On March 9, 2014, we entered into an offer letter with Mr. Shim, who currently serves as our Chief Financial Officer. The offer letter provided for Mr. Shim's at-will employment and an initial annual base salary of $200,000 and an initial stock option grant, as well as his eligibility to participate in our benefit plans generally. Mr. Shim is subject to our standard confidential information, invention assignment and arbitration agreement.
Shareholder Voting power
Institutional shareholders with 5% or more in terms of ownership such as Andreessen Horowitz, Accel, Social Capital, and SoftBank together with the management team controls 52.4% of voting rights, while other shareholders control 17.6%. The public will control approximately 30% of the voting rights through class A shares that will issued. In this type of situation the public will not have a lot of sway over the future of the company.
Data Privacy and Security
One of the biggest threat to this business is data privacy and security. The nature of the platform requires the company to handle billions of megabytes of conversational data, business's customer data, business's trade secrets and many more. If the company were to suffer a hacking of any material scale, the damage to the brand could be enormous. At the same there are many hungry dogs on the side lines waiting to eat. An early glance at the manage team does show that it not quite deep as yet, possibly because the business is sub-scale. This is an area that will have to be addressed in the future.
In closing, Slack is definitely poised to do well in the future, but there will likely be challenges. They have more than enough capital at their disposal to invest in the research and development and capital goods needed to catapult to company forward. They have also ramp marketing expenses quite aggressively and it has paid off in terms of aggressive sales growth. With the strong liquidity on the balance sheet, they have the capacity to keep the sales fly wheel going. While the company is clearly a good business, the issue of valuation is much harder to determine. The company continues lose money and there are no easier comparison the make with companies that are already publicly traded. In addition, the industry is a very fragmented with potential threats coming from many different angles, and from very potent incumbents. All in all we believe that investors should take a wait and see to this ticker.