Help me understand Slack and the rule of 40

[wpr101]

Hey,

I invest in almost exclusively SAAS companies and have been trying to understand valuations better.

To give some context I work in software for a fin-tech company. A lot of my holdings are with companies that I have seen used in industry and which I believe had a good reputation.

However, I have done way too little work on the valuation side. This has led me to have large losses in PagerDuty and Slack, although I still believe in both companies and they are two of my largest holdings.

From what I’ve seen the rule of 40 is one of the main measurements of a SAAS company.

It appears the formula is: (profit margin) + (revenue growth) = rule of 40 number

For Slack we have: -90% + 57% = -33

Probably the worst rule of 40 number is all of SAAS land?

One thing I am confused about is Slack’s gross margins are 86%, which is one of the best out there. What are the implications if the profit margin is bad, but the gross profit margin is good?

Does this mean they spend way too much acquiring customers? Or too much on operations?

I remember recently the had a quarter where revenue growth was higher but expenses were much higher, leading to a bigger than expected loss.

Lastly, what do you think about Slack benefiting from the current crisis? From what I’ve seen they have been signing a number of clients, and it’s debatable about whether these will convert to paying (same thing with Zoom).

Also, how do people weight relative price changes? The stock IPO’d around 42, and is at 26 now.

[Rubenslash]

You should use FCF margin instead of net profit margin for rule of 40.
For Slack this would be: 49% (last quarter revenue growth) + -10% (TTM FCF margin) = 39% which is not too bad.

I haven’t studied Slack in detail but probably some of the reasons why the stock price is still below IPO price:

• Was excessively expensive at IPO price at more than 20 times forward revenue with negative non-gaap operating margins of -13% (YE 2020). Companies with similar or higher revenue growth and much better margins were actually cheaper on a P/S basis (AYX, OKTA, COUP, DDOG, CRWD all have better or similar revenue growth, much better margins and are cheaper vs Slack’s IPO price on a P/S basis). Slack IPO was massively hyped imo.
• Competition from Teams seems to be a drag on the stock price. Teams is part of O365 package which most companies have. So why pay a lot more for Slack? It’s popular among the workforce but if a company is looking for some additional cost savings they could always cut Slack and move to Teams.

One thing I am confused about is Slack’s gross margins are 86%, which is one of the best out there. What are the implications if the profit margin is bad, but the gross profit margin is good?
I had a quick look at cost ratios (on a GAAP basis) and S&M is 64% of revenue for 2019. I compared this to my 16 stocks (mostly SaaS + some others like Roku, TTD) and none of them have a higher ratio (Docusign being the first at 61%). It appears that Slack need to spend a lot of money in order to produce that high revenue growth. It also shows that they can easily get profitable by simply reducing sales spend but with likely a dramatic impact on the growth. G&A is 41% of revenue and this is again higher than all my stocks (LVGO first at 33%). Same story with R&D at 73%, higher than all my holdings (TEAM being first at 42%). There could be many reasons, we don’t have the details. There is probably more information in the quarterly conference calls.

I would guess that the stock takes off once they start showing some operating leverage and improving non gaap operating margins.

[wpr101]

Rubenslash,

Thank you for the informative post. Was wondering where you got the following number from:

-10% (TTM FCF margin)

I have a subscription to YCharts but they don’t seem to have that metric. Is there another site I can find this. Or some better way to calculate rule of 40, not by hand?

[rtichy]

https://www.thesaascfo.com/rule-of-40-saas/
https://www.bain.com/insights/hacking-softwares-rule-of-40/
From the Bain site: “Venture capitalists began to popularize the Rule of 40 in 2015 as a high-level health check for SaaS companies, but it’s broadly applicable to most software companies. The metric neatly captures the fundamental trade-off between investing in growth (including new products and customer acquisition) and short-term profitability. Analysts have differed on which measure of profitability to use—most use EBITDA, but some have proposed free cash flow, EBIT or net income as alternatives. We use EBITDA, a publicly available profitability metric that excludes the effect of taxes and accounting policies.”

I’m seeing a lot of acceptance of EBITDA margin, as it is much more accessible and less subjective?

[PaulWBryant]

I recommend ignoring the Rule of 40 and other metrics that distract from the bigger picture. A rule of thumb is:

a broadly accurate guide or principle, based on experience or practice rather than theory.

…so I submit that following a rule of thumb only works broadly. But when you’re examining an individual company as closely as you should when considering investment, rules of thumb are useless.

Let’s say a company is growing revenue at 80%. As fantastic as that is, let’s also suppose extreme spending and say their free cash flow is negative 60%. Sounds horrible! And they’re not even close on the rule of 40. (80 - 60 = 20)

But let’s say this is on a revenue base of $70 million per quarter. 60% of that means they will lose $42 million this quarter. But if they have $1.5 billion cash and no debt, is this really a problem?

More importantly, let’s say the next quarter their cash flow is negative $38 million, and the next quarter it is negative $33 million, and yet revenue keeps growing at 80%. Things are improving incredibly, even if the Rule of 40 isn’t met.

But even this isn’t enough to tell you much about the company. Is the gross margin 80% or 20%? Is it valued at $5 billion or $15 billion?

Get to know the bigger picture with the companies you follow. Make your own decisions about what to focus on and why. This board will help you learn how to do that. This will serve you immeasurably better than the Rule of 40.

Bear

[wpr101]

Get to know the bigger picture with the companies you follow. Make your own decisions about what to focus on and why. This board will help you learn how to do that. This will serve you immeasurably better than the Rule of 40.

Are you mostly evaluating based of metrics like revenue growth and net retention rate? I’ve found net retention rate to be a useful metric.

[SaulR80683]

Are you mostly evaluating based of metrics like revenue growth and net retention rate? I’ve found net retention rate to be a useful metric.

Hi wpr,
I think you have to use qualitative information about the company as well as quantitative quarterly results. What field are they in? Are they a luxury for their customers or do they save their customers money? What do you feel about their management leaders? How effective is their competition? Do they care about making a profit? Things like that that you can’t quantify with a number score.
Best,
Saul

[tamhas]

I think the point was that over-reliance on a metric or on a couple of metrics is the problem and that one needs to understand the business which is creating those metrics. Any given business at a particular stage of its business may produce metrics which would cause one to not select it, even though it is actually very desirable. And, vice versa, a business can have very nice metrics at a particular stage and yet be very much the wrong choice because of other underlying issues.

[wpr101]

I think you have to use qualitative information about the company as well as quantitative quarterly results. What field are they in? Are they a luxury for their customers or do they save their customers money? What do you feel about their management leaders? How effective is their competition? Do they care about making a profit? Things like that that you can’t quantify with a number score.

I’ve been investing in SAAS companies almost exclusively based off qualitative information before. Biggest holdings right now are ZM, WORK, PD, DDOG, and DOCU. All of which I have used before so have familiarity with exactly what their product is.

For WORK and PD specifically I wasn’t paying much attention to valuation metrics because I knew I wanted to be in these companies even if overpriced. Have accumulated large losses in these two so far although I believe in both products and companies.

What I’ve seen recently though is a number of opinions saying that mid 2019, that SAAS companies IPOing were priced way above what they should have been. For example PagerDuty has a 52-week high of 59, and currently sits at 22. However, their earnings have been pretty decent and on pace with what was expected of them.

As mentioned in a previous post above their was possibly too much hype behind the WORK IPO and was over-priced as well.

These results have led to believe that I should be doing some quantitative analysis on valuation. I don’t mean a traditional P/E or whatever… that valuation could be based on revenue growth, net retention rate, rule of 40, or something else. I’m having trouble determining what metrics to look at still.

[12x]

I think the whole point of Rule of 40 is to tell how efficient the company is and how easily it is becoming accepted in the marketplace.

If a company has to spend very little to grow revenue 80%, it is going to have a very high Rule of 40 and that is much better than a company that has to spend 70% of it’s sales on advertising to grow 80%. I don’t care how much money they have in the bank or how long they can keep it up. Clearly there is something wrong if they are having to spend so much to get so little.

That’s why Rule of 40 is important.

At the same time if a company is spending a lot on R&D because they are working on some big thing, I don’t think that should be looked at as the same way other opex is, so a company like that should probably get a little more slack.

OTOH when I look at ZM and CRWD I see that they tend to both spend 50% of their revenue on S&M. That is a very high number! However ZM spends much less on R&D due to exporting it to China, so it shows higher and better profitability metrics. Before Coronavirus, ZM was slowing revenue growth quicker than CRWD was.

[PaulWBryant]

These results have led to believe that I should be doing some quantitative analysis on valuation. I don’t mean a traditional P/E or whatever… that valuation could be based on revenue growth, net retention rate, rule of 40, or something else. I’m having trouble determining what metrics to look at still.

I use Price to Sales to get a rough idea of relative valuations. Enterprise Value to Sales is better. Enterprise Value to Gross Profit is probably best.

But relative valuation is…relative. All other things equal, a company growing at 100%+ Yoy should of course have a higher PS ratio than a company growing half as fast. But also, all other things are never equal.

Saul does just fine basically ignoring valuation and focusing on finding the fastest horses. So I wouldn’t make too much of a study of it. But I find that it’s good to have at least a rough idea.

My math has Slack at a PS of 24 which is more than AYX (which has grown faster) at a PS of 19, but less than Okta (which has grown slower) at a PS of 32. I would classify Slack as “reasonably priced” – neither a bargain nor crazy expensive.

I hope that helps. Now I have a request of you.

This board is built on us all contributing to the discussion. And the above is good to know, but we’re not looking for bargains. We’re looking for great companies (with staying power). Like Okta which is not a bargain but which I think has a ton of staying power and even clout in the cloud world.

My request: Will you take some time and put together a post on your case for why the world needs Slack? How companies can benefit from having Slack instead of other solutions (or just email and older technologies)? How you think Slack will benefit from the WFH environment? Some companies that use it and what they say about it? Etc.

That would be helpful to the board.

Bear

[wpr101]

My request: Will you take some time and put together a post on your case for why the world needs Slack? How companies can benefit from having Slack instead of other solutions (or just email and older technologies)? How you think Slack will benefit from the WFH environment? Some companies that use it and what they say about it? Etc.

There is a movement within the DevOps community that used to be called ChatOps which most people just call SlackOps now since that’s really the main tool that people use for this purpose. Last spring I attended a DevOps conference which had a break out session about this topic, and almost everybody in the group of 30 from different companies was using Slack for ChatOps.

I would define ChatOps as the ability to do operations through chat. Say you need to onboard a new client to your system, you can build a bot to do this, so that sales can onboard a client with no engineering effort.

Say something goes wrong in your operations, PagerDuty, DataDog, and Okta can all alert your through operations channels. Atlassian’s JIRA integrates with Slack to help keep track of the status of tickets.

If you have a collaboration with another company you can setup a secure “Shared channel” in which both companies can participate. This was rolled out about 6 months ago, and on the last conference call has shown enormous sign ups.

Zoom has an integration as well, and Stewart Butterfield and Eric Yuan talk which each other multiple times a week. The two tools are meant to be used to together. Oracle is a company which has been public about the impressive combination of Slack and Zoom.

Other well known customers: Zendesk, Fastly, HubSpot, Splunk, IBM, Lyft, Shopify

From recent conference calls, it has been highlighted how many of the biggest customers coming online are switching from Microsoft Teams, or coexisting with Teams.

[12x]

Do you have any take on the Shared Channels component of Slack? This seems to be a true potential driver for moat and possibly network effect as shared channels allow for external communication via slack with suppliers and customers. Anyways it seems at the very least a way to become deeper embedded within a company and it’s processes besides just being some chat tool that could easily be replaced and switched out.

My main concern with slack, aside from Teams, is the continued slowing in revenue growth. 49% last quarter. Compared to the 80+ they had when going public. That and growing losses I think are what drove the stock down. On top of this, their Billings continue to grow slower than sales. I know companies say to ignore Billings and they are misleading, but the continue to find it is a pretty reliable indicator for where sales are going. Their RPO is up 77% YOY as of last quarter but they say a big part of that is multi year deals. They do not break down short term RPO that would be recognized over the next year.

So those are the reasons I have been out of the stock. The main moat I see is the record of all conversations that slack has that would seemingly make it harder to pull out than videoconferencing, other then any other integrations each bay have with different applications. Just looking for something else in that regard other than just being a chat tool that would give them a huge network effect or moat.

[wpr101]

Do you have any take on the Shared Channels component of Slack?

The blog for Slack has a lot of good details about the growth of channels. https://slackhq.com/shared-channels-growth-innovation

It has taken some time for the growth to set in there. Here is one of the key take-aways about how it has evolved from the CEO:

For the entire beta period, people practically had to walk over broken glass to start using shared channels: for me to even send you an invitation, I’d first have to find out your “workspace URL” which very few people knew. Yet the usage kept growing, and customers kept inventing newer and more valuable uses.

The spread was truly viral: we saw that companies first introduced to shared channels by one of their vendors or partners went on to send invitations themselves to their customers or service providers (who then went on to invite more and more people, and so on). The feature was deemed so essential that some customers even delayed planned upgrades to Enterprise Grid until shared channels were added. The levels of satisfaction and recommendation are through the roof and we’re just getting started. I’ve honestly never seen anything like it.

Here’s a customer story on how Fastly users Shared Channels: https://slack.com/customer-stories/fastly

“Slack was the thing that made the most sense,” says Kami Richey, Fastly’s director of customer experience. “We used it internally for cross-department communication and realized we could use it with customers too. It was a way to get that chat feel in a more scalable, accessible manner.”

As part of its premium support package, Fastly offers enterprise customers a shared Slack channel. “We hear back from our customers that we’re like an extension of their team, and part of that feeling definitely comes from the fact that we use Slack,” Richey says.

Relating to work from home trends, there have been massive traffic increases and signups (similar to what Zoom and Teams are seeing). I don’t believe this is reflected that much in projections going forward as much as it should. https://slackhq.com/march-2020-update

It felt like the shift from inboxes to channels which we believed to be inevitable over 5-7 years just got fast-forwarded by 18 months. Good for our business.

Graph of new customers: https://slackhq.com/wp-content/uploads/2020/03/Slack-chart-3…

Early signs of a surge in teams created and new paid customers unlike anything we had ever seen.

For us as a company, however, the shift is dramatic. In each of Q3 and Q4, we added around 5,000 net new paid customers.

By last Tuesday, halfway through Q1, we had added 7,000. Yesterday, a week later, we crossed the 9,000 mark.

Meanwhile, existing customers are expanding. Enterprise deals are getting done. More new teams are signing up. More upgrading to paid plans. And the intensity of usage is also increasing: people are spending more time in Slack. Average messages sent per day per user is up 20%.

Keep in mind these updates were at the end of March, there have been no updates for over a month now.

[gmcnatt]

I initially became interested in Slack from a high level because I saw it as email 2.0. Or not even email 2.0 but … just the next primary form of communication inside businesses. In the 80’s and 90’s it was phone calls and fax machines. In the 2000’s it was email. Now it will move to something different. Will Slack be able to monetize it … maybe?

What helped me visualize it is when I experience email gaffes or faux pas from people who grew up using phones and fax machines. Things like not hitting ‘reply all’, or changing the subject of an email instead of starting a new thread, or when a person constantly starts new email threads instead of continuing on the previous discussion, or when people email a document from Excel with “FWD FWD FWD” as the subject, or not putting in a subject at all, or putting a really long sentence as the subject, or not reattaching documents when you hit ‘reply’. All these things are deficiencies of email not the people using them.

Also filing is a HUGE waste of time in email. Either you have to file constantly or the info is difficult to find. I’m constantly baffled at how bad the search function is across email platforms.

Programs like Superhuman (which I use and is great) and Sanebox (which I used to use before Superhuman) try to fix these but ultimately I think a paradigm shift is the way forward. Younger professionals will want something new. And Slack and Teams could be that. If nothing else these products will operate in addition to email.

And I imagine these will be difficult to tear out of companies once they are in use.

So for me, the story for Slack is there … now I just want to see the numbers in the earnings reports back it up. I took a 2% position in March and hoping I can increase it.

[rtichy]

They function great as communication among teams. A ‘problem/issue’ can be posted, and responded to, hopefully solved, all visible to the entire team. Reduces overlap in resource attention, imo, greatly.

Email does not perform well for this kind of event; other messaging apps are too focused on deliveries to participants or too delayed, resulting in cross-talk and confusion. ‘Subscribing’ to a ‘chat room’ is the better model and how I would generally describe Slack. The integrations with other tools is a performance step above ordinary chat rooms, but is not exclusive to Slack, obviously.

When does Slack become an enterprise resource that necessitates paying for it? That’s an answer that eludes me.