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The Valuation of Slack Stock Looks Too Frothy

There’s a lot to like about Slack (NYSE:WORK) stock, but, given the company’s huge valuation, I’d recommend that investors  avoid Slack stock for now.

Huge Growth, High Margins, Top Clients

As others have noted, Slack is growing very rapidly, and its margins are very high. From 2018 to 2019, the company’s revenue nearly doubled, jumping from $220.5 million to $400.5 million. And, as another InvestorPlace contributor, Laura Hoy, recently pointed out, its gross profit margin in its third quarter was a very impressive 86.3%.Given the company’s high gross margin and gigantic revenue growth, it’s only a matter of time until  it becomes profitable.

Moreover, as Hoy also pointed out, Slack has compiled an impressive customer list. Among the companies using Slack’s collaborative products are IBM (NASDAQ:IBM) and Uber (NYSE:UBER).

And importantly, since Slack allows employees based in different locations to effectively collaborate with each other, it’s viewed as a likely beneficiary of the coronavirus outbreak. That’s because its software would allow employees to collaborate with each other while working at home.

High Valuation, Unlikely Takeover Target, Low Moat

But even with all of those good attributes, the valuation of Slack stock looks high to me. Its forward price-sales ratio, based on analysts’ average 2020 revenue estimate, is 23. That’s a very high valuation for a company that analysts, on average, do not expect to be profitable until 2022, at the earliest. By contrast, another stock that’s usually considered among the market’s high fliers, Roku (NASDAQ:ROKU), is trading at a forward price/sales ratio of only eight. And Beyond Meat (NASDAQ:BYND) stock, which is well-known for its frothiness, has a forward P/S ratio of about 11.

One of the reasons Slack has such a huge valuation is that it;s viewed as a likely, even probable, takeover target. But I think it’s unlikely to become a takeover target.

Its current market cap is well over $14 billion. That means, at the stock’s current levels, an acquirer would likely have to pay over $20 billion to buy the company.

That’s a very high price. One reason it’s very high is that, although Slack has a first-mover advantage, first-mover advantages are worth less for business-to-business products like Slack’s. That because companies have much more time and resources than consumers to research alternatives to market-leading products. Further, since companies typically don’t collaborate that much with other businesses,  Slack’s products don;t have the type of network effects that consumer-facing names like WhatsApp, Instagram, and Uber have.

And although Slack has some patents, it doesn’t seem like it would be incredibly difficult for a large company to create a similar product. In fact, Microsoft has done just that with its Teams software. So rather than spend $20 billion on acquiring Slack, a large company would, in all probability, follow in Microsoft’s footsteps and create a similar tool in-house. The latter course of action would likely be much cheaper.

And the fact that Microsoft decided to create a similar product to Slack’s means that other large companies may indeed elect to follow in Microsoft’s footsteps and enter Slack’s market.

The Bottom Line on Slack Stock

Slack obviously has developed a very useful product that many large companies want. Moreover, Slack is growing rapidly and looks set to be profitable soon. But the company’s valuation is sky-high, new competitors can easily enter its space, and it lacks a strong first-mover advantage and network effects. As a result, it’s unlikely to be acquired and will probably face more competition in the future. Consequently, I would wait for the stock to pull back at least 30%-40% before buying it.

As of this writing, Larry Ramer did not own shares of any of the aforementioned companies. Larry Ramer has conducted research and written articles on U.S. stocks for 13 years. He has been employed by The Fly and Israel’s largest business newspaper, Globes. Larry began writing columns for InvestorPlace in 2015. Among his highly successful, contrarian picks have been GE, solar stocks, and Snap. You can reach him on StockTwits at @larryramer.

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