Slack Technologies (NYSE:WORK) is at the point where fast-growing technology companies turn sustainably profitable on a free-cash-flow basis. As a result, Slack stock might move higher over the next year, but its valuation already appears stretched.
Moreover, its cloud-based and subscription-based revenue model is currently in favor with Wall Street. Slack provides email and communication products for corporations that allow them to essentially thrive on a virtual office basis.
This is where it’s at these days. Corporations are turning virtual, ditching the need for office space. Slack offers a free product and, for larger enterprises, a paid subscription model for their email products. As subscribers’ user base grows, they became paying clients from their increasing need for remote-working and collaboration tools.
Slack’s Improving Free Cash Flow
Slack’s revenue is expected to grow over 38.5% this is fiscal year ending Jan. 2021 to $873 million. Moreover, next year, analysts expect it to rise another 31.7% to $1.15 billion.
However, so far, net income has been elusive for the company. Not to worry, though. Many of these fast-growing companies report losses due to very high stock-based compensation (SBC) expenses, like options and restricted stock units. These are not cash expenses.
So I tend to look at free cash flow. This is cash flow from operations minus capital expenditures (capex). Slack produced its first free cash flow in the most recent fiscal quarter ending April. Cash flow from operations was $8.7 million and capex was $5 million, leaving free cash flow of $3.7 million.
This should continue to grow exponentially as sales rise, based on operating leverage. In return, it will make Slack stock more valuable, especially with the Wal Street crowd.
What Analysts Say About Slack
Several analysts on Seeking Alpha are impressed with the company’s ability to keep up sales growth during the pandemic. One analyst, Vincenzo Furcillo, is impressed with Slack’s recent collaboration deal with Amazon (NASDAQ:AMZN) and their 875,000 employees.
He points out that Slack will allow employees access to transcripts of calls using Amazon’s Chime video-calling service. He points out that not only will this greatly increase Slack’s revenues going forward, but also help them in their fierce competition with Microsoft (NASDAQ:MSFT) and their Teams product.
Another analyst, The Abstract Investor, writes that Slack stock has one of the more reasonable valuations among the SaaS stocks (Software as a Subscription). Here is what that really means. Slack has a market capitalization of $18.3 billion. Given its fiscal year January 2021 expected revenues of $873 million, that puts it at around 21 times revenues. Even assuming the Jan. 2022 sales reach $1.15 billion, the valuation is still 16 times.
This is interesting since these are multiples that normally are used to measure much lower baseline numbers like net income, or even cash flow. In other words, what passes for a bargain with SaaS stocks are beyond expensive for most other stocks.
What to Do With Slack Stock
Nevertheless, I guess everything in the market is relative these days. For example, Salesforce.com (NYSE:CRM), which is joining the Dow Industrials index, just reported a blowout quarter. It had the effect of pushing other cloud-based SaaS stocks, including Slack, higher as well.
Let’s see if we can do a simplified valuation using reasonable assumptions. Let’s project out two years past January 2022 and assume that revenues increase on average 33% each year. That means they will rise 77% above $1.15 billion projected for January 2022. This puts revenue at t $2.034 billion by January 2024, or 3.4 years from now.
Next, let’s assume Slack’s free cash margin reaches a normal 35% by that time for most software companies. That puts its projected FCF at $712 million.
Moreover, the valuation will skyrocket. At a normal 4% FCF yield, Slack’s market cap would be 17.8 billion. But that is very close to where the stock is trading at right now with a $17.4 billion market cap.
In other words, the market assumes that revenue will grow by at least one third for over the next three years annually. In addition, FCF profits will be better than 35% of sales at that time.
These are all heroic assumptions. And I haven’t even discounted them back to the present for the time value of money. Here is the bottom line. Slack stock has a very high valuation, very stretched. This is true especially if you are the kind of investor who assumes that cash flow and profits are important in the long run.
On the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.