Enterprise communication platform operator Slack (NYSE:WORK) made a splashy debut on Wall Street in 2019. Slack stock rose from its $26 IPO price to above $40 on its first day of trading. But, alongside a handful of other headline-making tech unicorns, Slack has come crashing down.
Today, WORK trades hands just over $20, about 25% below its IPO price and about 50% below the stock’s first-day opening price.
Why the huge drop in Slack stock since its strong IPO? The company hasn’t quite lived up to the hype.
Specifically, Slack popped in its IPO because most investors were betting on the idea that the company would become as commonplace in the enterprise workplace as email. But its numbers since then have failed to support that idea and growth has meaningfully slowed amid escalating competition. Suddenly, it looks like Slack won’t be as commonplace as email. As investors have reassessed their long-term outlooks based on this less rosy reality, WORK stock has dropped.
Is a rebound in the cards? Maybe. But I don’t think so. Here’s why.
Headwinds and Tailwinds Will Offset in 2020
When you look at Slack’s fundamental 2020 outlook, you have a mixed bag of headwinds and tailwinds.
On the tailwinds side, corporate spending on things like Slack will increase in 2020. That’s because the global economy is finally in a good place. In 2018, the global economy was hit hard by tightening central bank policy. In 2019, the economy was hit hard by rising trade tensions. But, in 2020, central banks are easing monetary policies and U.S.-China trade tensions are also easing, so the global economic landscape will stabilize for the first time in two years.
Against that backdrop, corporations across the globe will up their spending on things like enterprise software. One of the more attractive niches in that vertical? Enterprise communication software, like Slack. Consequently, Slack should sustain healthy customer and spending-per-customer growth in 2020.
But, on the headwinds side, you have rising competition and slowing growth trends. Of note, Microsoft’s (NASDAQ:MSFT) Teams offering has generated a lot of buzz and gained significant traction in the enterprise communication software market recently. Teams also has a big advantage over Slack in that it can integrate seamlessly with Office 365 and Outlook, which are sizable value props to larger companies that have already established Office’s suite of products as the norm for workflow processes.
As Teams has gained momentum, Slack has lost some. Customer growth rates have dropped from 50% exiting 2018, to 30% toward the end of 2019. Revenue growth has followed a similar slowing growth trajectory. Escalating Teams competition will only accelerate this slowdown, and largely offset improving macroeconomic tailwinds in 2020.
Slack Stock Is Richly Valued
All things considered, Slack stock is richly valued for a company that is staring at a mixed bag of tailwinds and headwinds.
Slack will end 2019 with about 110,000 paid customers. There are about 3 million businesses with 10 or more employees in the United States and European Union. A healthy majority of those 3 million businesses will eventually adopt cloud-based enterprise communication software. From this perspective, Slack still has a ton of room left to grow.
But, Slack is only adding about 5,000 new customers every quarter. That’s because: 1) the transition away from email has been very slow as many companies still value email communications, and 2) competition in the enterprise communication software landscape has intensified, so Slack isn’t winning over every customer that runs into the market.
Neither of these trends will change course anytime soon. Consequently, for the foreseeable future, it is likely that Slack continues to add about 5,000 new customers every quarter.
At the same time, average spending per customer will rise too, as Slack wins over bigger customers with more employees. Gross margins should remain strong in the near-90% range given that pricing isn’t a huge issue in this market. Moderating expense growth and continued spending-per-customer growth will allow for positive operating leverage. But, the company will simultaneously have to maintain large marketing and product development spending to offset competitive threats.
Putting all that together, Slack reasonably projects as a big (but slowing) revenue grower over the next several years, with sizable (but not significant) upside margin drivers.
My modeling suggests that this growth framework gives Slack visibility to do about 80 cents in earnings per share by 2025. Based on a 35-times forward earnings multiple — which is the medium-term average forward multiple for application software stocks — and a 10% annual discount, that implies a 2020 price target for Slack stock of $19.
Bottom Line on WORK
Slack is a fine growth company. But, it’s not a great one, because sizable competitive risks have slowed this company’s growth trajectory, and will likely continue to do so for the foreseeable future.
Considering these risks, WORK stock is richly valued here and now. If shares drop considerably below $20, the price will start to look right. Until then, it’s probably best to watch this one from the sidelines.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
