New Slack Shares Hit the Market Pretty Quietly
Initial public offerings, or IPOs, usually generate a fair bit of excitement one way or the other, and are known to be quite volatile. The excitement isn’t always there though.
Slack is a maker of business software, with their particular focus being on offering enterprises a better way of communicating than using traditional e-mail. E-mail is very widely used by business as well as for personal use, and to the extent that a company can show them a better way, there is certainly a lot of potential for this market.
Slack stands for Searchable Log of all Conversation and Knowledge, and although that’s a pretty ambitious goal, they have made some serious inroads with their cloud-based collaborative software already, with a billion messages sent each day by 10 million active users in 600,000 organizations spread across 160 countries.
In the old days, we were limited to face-to-face communications and by telephone and mail. We still communicate face-to-face to some degree, and you could always pick up the phone for as long as we have had such things. Using mail involves a gap though as you have to wait until the message is delivered, which takes several days, and therefore it is not practical in a lot of situations.
There used to be a lot of inter-office mail with businesses and other organizations though, but this has all but become replaced by electronic communication and especially by e-mail, which travels at the speed of the internet and arrives at its destination in seconds not days.
Beyond that, there has emerged a number of ways that people can collaborate by sharing not only ideas but documents and other materials, and can also provide virtual workspaces accessible to multiple users and allow for more efficient communication and organization than had been previously possible. Companies who make the software to allow for these improvements also benefit, especially the more successful ones such as Slack.
There are a lot of competitors out there though, including software giant Microsoft, which has moved to include these solutions within their Office suite of products, called Team. Team is actually a good word to describe the functionality of collaborative software, as it brings teams together and makes their interactions more efficient.
Like a lot of new stocks, Slack isn’t making money yet, in spite of all of their success. While it may not make sense to invest in a company that is losing money, the reason people do is similar to the reasons why anyone invests in a start-up, to get a piece of a company’s future potential.
Some of these companies prosper and some do not. Among those who do end up making a a real go of it and benefit their investors, this does tend to vary a lot as we may expect, so whether we want to take what is essentially an entrepreneurial gamble on a company like Slack depends on one’s risk appetite. There is certainly more risk when buying shares in a company with a negative income flow, but if we are patient enough, this can indeed work out.
It’s Really About Where Stocks Are Headed, But Losing Stocks Require More Caution
We might not even care about eventually seeing positive earnings from a company that we trade shares in, and given that the real goal of stock investing is to seek capital gains from the stock itself and not necessarily the company, this also can make sense, providing that the stock can indeed be reasonably expected to gain in value in a satisfactory manner in the time frame we desire to hold it.
Slack stock hit the market for the first time on Thursday, and this is indeed a company that is mired in the red with the hopes of getting into the black one day as their expectations of achieving enough scale and growth manifest.
There are two main things that we look for with an emerging company that is not yet profitable, which basically come down to the company continuing to grow at an acceptable rate and their losses continuing to decline as they move further toward profitability. In the end, all that really matters is that they arrive there, but we do monitor their progress toward this and this becomes reflected in changing share prices along the way, along with everything else that affects share prices.
In terms of revenue, things are expected to keep moving forward for Slack, and they are predicting an increase of about 50% in fiscal 2020, ending in January, over the previous year. This is impressive growth and will take them to the $600 million a year level if these predictions are accurate, which is a pretty nice growth rate for a company this size.
The direction of their operating losses is another story though, and they are expected to increase from the $141 million they suffered last year to projected losses of $182 to $192 million this current year. That’s not a good sign at all as we want to see scaling up at least producing less losses rather than just expanding the scale of their overall losses like this.
When your revenue is in the range of $600 million a year, and your software has made such significant inroads into your market, we would prefer and even expect that you would have figured out things better than this, and it therefore would be quite reasonable to be concerned here.
Slack’s Price to Revenue Ratio is Out of Sight, and Not in a Good Way
What is even more concerning perhaps is the market cap that the market has just given Slack, which is over $23 billion. To put this into perspective, this would place them around the middle of the pack within the S&P 500 in terms of market capitalization. They are clearly fighting well above their weight so to speak by any reasonable measure, which would be the kindest way to put this.
Slack chose the direct route to the stock market instead of the traditional route, where companies would issue new stock to the primary market, which would then be put into play in the stock market. The purpose of this newly issued stock is to raise money for the company, instead of just taking already issued private stock and just making it available on an exchange, which does not raise money for the company.
We don’t see this direct IPO approach very often, but we did see it last year with Spotify and Slack decided to go this route as well. Slack does already have almost $800 million in cash so it’s not that they need the money, they just need to discover how they can better leverage the money that they do have to eventually turn a profit.
When you issue new stock, this ends up diluting the value of existing stock, so the revenue that this new stock generates does help the company but comes at a price. Both approaches seek out additional valuation arising from the much greater liquidity that going public offers, where if there are people who are willing to overpay so to speak, you will find a lot more of that out there on stock exchanges than you could ever see with shares remaining privately held.
Other than that, it’s a wash for the most part, as shares become diluted by the new issues and the company itself pockets the difference less the costs of the IPO launch. Unless your company can benefit from this new revenue, it’s actually better to do what Slack is doing, but companies do tend to be pretty cash hungry and this is why almost all IPOs are launched by investment banks with a substantial lead-up time.
Direct IPOs don’t have a real reference point, since they aren’t offered to investors prior to their launch, but we still see a guess being made. The guess does tend to be on the low side so that when the stock does start to trade, it appears to have accumulated in value, just like underpricing it with institutional investors prior to its being listed on the exchange creates an illusion of value.
Slack was given a reference point of $26 a share, which is in itself meaningless really, but it can serve to puff things up when you see it start trading at $38.85 as Slack did when it finally opened. The hope here is that seeing a stock be up 49% right out of the gate might excite some people and cause them to think that this is a hot stock that may be worth riding.
This was not the case this time though, as Slack stayed within a very tight range. It rose to $42 in the first 10 minutes, then the fun was over already and it ended up closing just about exactly where it started, finishing the day down 20 cents at $38.65.
What might concern us the most about this price is that it is set so high versus the company’s revenues. Normally, we use valuations based upon earnings, where if a company’s stock price is 20 times their projected earnings people start getting concerned. This is not always a bad thing though as people’s appetites do extend beyond this, but as this ratio gets higher and higher, more and more people worry and this does set real limits on how high a stock can go.
Slack doesn’t have any earnings though and instead has an abundance of losses, so we need to value it another way. The way we do it with companies that lose money is to set the ratio with revenues instead, and Slack just started trading at a whopping 38.5 times projected revenue.
While this is not completely unheard of, and is something that people seem to be more willing to do with cloud-based software companies, this is still some heady stuff indeed. While this is all basically artificial, as all stock valuations are, meaning that there’s no real reason why we cannot make these ratios as high as we have the appetite to do, investors who are focused on the long term and aren’t just looking to take a little ride here may want to be concerned with this number.
Given that the stock has done nothing on its first day on the market, this also does not appear to be a play that can be expected to take off or perhaps not go all that far from here, and these valuations do serve to limit the short term as well.
While some IPOs can be very exciting, like Beyond Meat’s this year for instance, some can be terrible as well. Slack appears to fall in the middle at best, and in fact we may even expect that their extreme valuation will come down over the next while as all those private investors look to cash out at these prices.
This is not a play that we particularly like to say the least, from either a long or short perspective, and we will have to see quite a bit more to be able to say very much about where it will end up in the near term. What bias there is does appear to be more on the downside, but this should never be a guessing game, as we need a certain threshold of probability to want to risk our money. When you’re left to just guess, it’s just better to wait until we have more information.
Editor, MarketReview.com
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.
Contact Robert: robert@marketreview.com
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