Slack Technologies, a provider of workplace collaboration software, is slated to go public on June 20 in a high-profile direct public offering of shares. The first — and most important — question any business-focused investor ought to be asking is, Does Slack have an “economic moat,” that is, a sustainable competitive advantage? The vast majority of companies don’t, and reviewing a company’s moat situation before buying shares can save you a lot of heartache and lost money.
In September 1999 — a(nother) period during which technology companies were being floated at stratospheric valuations — billionaire investor Warren Buffett said that, “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
That central concept is the basis for my five-minute analysis of any company going public to determine whether it’s worth a closer look. (I lay out the rationale and steps of the methodology in more detail here.) And here I will apply the analysis to Slack’s Form S-1, a legal document all companies must file with the Securities and Exchange Commission before going public, describing the offering and the company.
The magnificent fortifications of Xi’an, also known as the Xi’an City Wall, include a wide moat. Image source: Getty Images.
Does Slack’s filing mention “competitive advantage”?
Yes, once. Unfortunately, it’s in reference to its rivals’ competitive advantages: “Many of our existing competitors have, and some of our potential competitors could have, substantial competitive advantages such as greater brand name recognition and longer operating histories, larger sales and marketing budgets and resources, [and] broader distribution.”
The list goes on, but you get the idea. It’s not an auspicious start in this analysis for Slack, which strikes out at its first at-bat. Perhaps we’ll have more luck with the next question.
Does Slack’s filing mention “pricing” in relation to its services or its industry?
“Pricing” appears 23 times in the filing, but only two passages are relevant in this context. First: “We expect this trend [of large merger and acquisition transactions in the technology industry] to continue as companies attempt to strengthen or maintain their market positions in an evolving industry. Companies resulting from these possible consolidations may create more compelling product offerings and be able to offer more attractive pricing options, making it more difficult for us to compete effectively.”
And second: “Demand for Slack is also sensitive to price. Many factors, including our marketing, user acquisition and technology costs, and our current and future competitors’ pricing and marketing strategies, can significantly affect our pricing strategies.”
Again, these mentions are not encouraging, as they suggest that Slack has little to no pricing power, the hallmark of a business protected by a moat. The wider the moat, the greater the discretion a company has in regard to setting prices.
With two of three questions answered, the verdict so far is underwhelming. But let’s keep in mind that the S-1 is a legal, not a marketing, document and the company has an obligation to present a comprehensive discussion of the risks it faces. The three passages I’ve cited so far are from the “Risk Factors” section, which runs to 42 pages.
How does Slack qualify its competition/industry in the filing?
One can usually find elements of an answer to this question in the “Business” section of a prospectus, in which the company can be a bit more promotional than when it is enumerating risks. Sure enough, this section in Slack’s filing contains a subsection under the heading “What Sets Us Apart,” with one differentiator — “strong increasing returns dynamics” — that is particularly noteworthy (the emphasis is mine):
As Slack usage increases inside an organization, more value is created for each additional user who might join, as well as for all existing users. As organizations continue to use Slack over time, the value of their archive increases and they realize more utility in their usage. We believe shared channels between organizations will increase the value of the overall Slack network for each new organization that joins as well as for all existing network members. Slack also generates more value for developers as more users and more organizations join Slack, and users and organizations are more attracted to Slack as more apps are integrated into or built on our platform.
Although the expression is not used explicitly, this paragraph highlights Slack’s emerging “network effect,” whereby the value of a service increases with each additional user. This is true within a single company and it is exponentially true if the company begins to use Slack to collaborate with other organizations to which it has ties (suppliers or clients, for example), at which point the service is like a barnacle stuck to a rock — difficult or impossible to dislodge. The network effect is a very powerful competitive advantage.
Slack’s “stickiness”: The proof is in the numbers
If Slack benefits from a network effect, and given the scale that it has already achieved, we’d expect the service to be “sticky,” with high customer retention/low turnover. (On the topic of scale: 600,000 organizations use Slack, and it has a total user base of 10 million.)
And that’s exactly what the data shows. Theta Equity Partners is an advisory firm that has pioneered a methodology to value firms by forecasting what their current and future customers will likely do. It ran Slack’s operating and financial data through its model and concluded:
Strong customer retention. The model infers that only ~10% of newly acquired paid customers churn in the first year after acquisition, and that 80% of paid customers will still be paying 5 years later. This strong retention profile implies that acquired customers have extremely long lifetimes and can be thought of as annuity-like once they have been acquired.
That’s the type of observation that causes me to sit up and start listening (or reading) with greater attentiveness. Annuity-like customers are just the sort a value investor cherishes, as they are the basis of a robust and profitable franchise.
Despite a poor start in this analysis, our three question-filter turned up evidence that Slack is blessed with an economic moat, thanks to a combination of first-mover advantage and network effects. That makes the company worth a closer look, with attention to the valuation at which it comes public. Rremember: Even a great business can be a mediocre investment at the wrong price!.
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