Shares of Slack (WORK) are down by almost 47% from their highs of the year, and there is plenty of negativity around the stock. Short positions have materially increased in recent months, and the number of shares sold short now represent 24% of the total share float. However, taking a short position in Slack could be an expensive mistake.

Data by YCharts

It is relatively easy to build a short case against Slack. The stock is expensive, the business is unprofitable, and competitive pressure from all-mighty Microsoft (MSFT) is increasing. However, the bearish argument against Slack is rather obvious and simplistic, and short-sellers could be exposing themselves to enormous risks in the near term.

Slack Is A Great Product

Stock analysts tend to put a lot of attention on financial variables and quantified metrics when analyzing a stock. This is remarkably important, and investment decisions based on hard data as opposed to opinions generally lead to superior returns and reduced mistakes.

However, it can be easy to miss the forest for the trees when you look solely at the numbers. Users love Slack, and the company's products are top-notch. This is clearly reflected in customer retention and engagement, as well as user reviews and industry experts' opinions.

Slack is rated as the Editor's Choice in the Best Business Messaging Apps for 2020 by PCMag.

Source: PCMag

The user reviews from G2 are also quite strong, with most reviews giving the company five stars and the average qualification being four and a half out of five stars.

Source: G2

Based on customer retention rates, Slack is doing an impressive job of not only maintaining its existing clients but also expanding its relationship with them and making more money per client over time. This shows that users are clearly finding in Slack a valuable solution.

Source: Slack

A great product is not necessarily a good investment. If the company cannot generate enough profitability from such a product or if the stock is overvalued, then returns for investors will still be disappointing, even if the product is outstanding.

But we also need to consider that a great product tends to generate strong pricing power, and pricing power has big implications in terms of profitability over time. Also, product quality is a major growth driver, and a company that looks expensive based on current sales and earnings can be much more reasonably valued when projecting those sales and earnings into the future.

You should not buy a stock solely because the company makes a great product. But product quality is a major consideration when projecting the company's ability to deliver sustained growth and expanding profitability over time. In any case, betting against a company with a top product in its industry is remarkably risky, to say the least.

The Competitive Threat From Microsoft Is Overblown

One of the main factors weighting on Slack stock is increased competition from Microsoft Teams. This is an important development to watch going forward, but there is no reason to believe that Teams is going to displace Slack anytime soon.

The top players in the software sector generally get huge market share, and the industry is prone to concentration. However, this does not mean that there won't be enough room for both Slack and Teams to do well over the long term.

The following paragraph from a comparative review by Digital Trends is quite telling in that respect:

Overall, Slack is a bit more familiar, a bit more “comfortable” given it led the collaboration pack for so many years. It’s also an independent application that might work better for a group that’s more platform-agnostic. For that reason, it’s the ideal choice for the majority of businesses and teams looking for a reliable collaboration tool.

Microsoft Teams, however, certainly has its place. It’s better for larger, more complex companies. If a company already subscribes to Office 365, connecting with Teams is a great solution in terms of features and pricing. In particular, Teams’ more robust video conferencing should be a huge attraction for companies with remote workers scattered across the globe.

During the most recent earnings conference call, Slack management highlighted the fact that demand has remained strong in spite of the fact that Microsoft is aggressively pushing Teams in recent months.

Importantly, Slack keeps gaining traction among Office 365 users, which speaks well about its ability to continue expanding rapidly in the face of growing competitive pressure from Microsoft.

In the words of co-founder and CEO Stewart Butterfield:

Although Microsoft markets Teams as a Slack competitor and there's no doubt this causes confusion in the marketplace, in practice, these are different tools, used for different purposes and our customers achieve markedly different results. Just look at the week engagement numbers that Microsoft themselves report and a much deeper level of engagement you see among Slack users.

Slack represents a new category of software and regardless of which app opens when you click on a calendar reminder for a video call, if you need to work closely with colleagues in an environment that can integrate deeply with all the software you use, there is a clear choice and our customers know it. That's why we've continued to add Office 365 using enterprise customers at $100,000 plus level and at the $1 million plus level. Just as you can expect more Skype for Business users forced over to Teams, you can expect more of these customer wins from us as well.

According to company management, nearly 70% of Slack customers are also Office 365 customers, and the company continues to see "tremendous adoption" among customers of the Office suite.

The Numbers

Growth is slowing down versus prior quarters, and it is reasonable to expect a further deceleration in the years ahead, since it is obviously more difficult to sustain rapid revenue growth from a larger revenue base. However, Slack is still growing at an impressive speed as of the most recent quarter.

• Total revenue was $168.7 million during the period, an increase of 60% year over year.
• Calculated billings reached $186.1 million, an increase of 47%.
• The company ended the quarter with over 105,000 paid customers, up 30% year over year.
• The net dollar retention rate was 134%.
• The number of paid customers with greater than $100,000 in annual recurring revenue was 821, up 67% year over year.

Slack is still losing money at the operating level, but this is due mostly to the exceptionally high stock-based compensation and massive investments for growth.

To put some numbers in perspective, Slack generated $448.5 million in revenue during the past nine months, and stock-based compensation amounted to over 80% of that money at $363.3 million.

This obviously related to the fact that stock-based compensation recognition has accelerated in the first year after going public. Management expects stock-based compensation as a percentage of revenue to trend down meaningfully over the next year. As a reference, stock-based compensation was a much smaller $18.3 million in the same period during the previous year.

Source: SEC filings

Not only is stock-based compensation exceptionally high in recent months, but chances are that investments in R&D, sales, and general and administrative expenses are going to slow down in comparison to revenue growth in the years ahead. As the business matures, reinvestment needs tend to decline as a percentage of revenue, which increases profitability levels.

Source: SEC filings

Expensive, But Not Necessarily Overvalued

Slack trades at an Enterprise Value-to-Revenue ratio above 20. This means that the company is obviously expensive, in the sense that it trades at a high valuation multiple in comparison to current revenue. But this comes as no surprise - the best growth stocks generally trade at valuation levels that reflect strong growth expectations.

The table provides some comparison data for Slack versus CrowdStrike (OTC:CRWD), The Trade Desk (TTD), Shopify (SHOP), Alteryx (AYX), and Veeva (VEEV). Data includes estimated revenue growth over the next five years, enterprise value-to-revenue, and growth-adjusted enterprise value to revenue, which is calculated by taking the EV/R ratio and dividing it by growth expectations.

The companies in the table operate in different segments, and they have higher profit margins than Slack. However, Slack has the lowest valuation ratios when growth expectations are incorporated into the equation.

Data from S&P Global via Portfolio123

Taking a short position on a stock only because it looks expensive is a very common mistake among short-sellers. In fact, there is statistical evidence showing that short positions based on valuation considerations tend to lose money over time.

It is one thing to stay away from Slack because you consider the valuation too high to provide an attractive risk and return trade-off. However, shorting the stock because valuation ratios are high could be a serious misstep.

The Stock Price Seems To Be Bottoming

Looking at the price chart, the downtrend was broken in November, and the stock found a bottom at $20 per share since then. The price has been consolidating sideways in recent weeks, and now it looks like it wants to start moving higher. Also, the RSI is making a series of higher lows, indicating that momentum is improving.

With short positions amounting to 24% of the float, if the stock starts rising sharply, this could trigger a vigorous short-covering rally as all the shorts run to the exit at the same time.

Source: TOS

Bottom Line

Don't get me wrong, I completely understand why some investors would never invest in Slack, and the company is certainly not for everyone. If you are looking for businesses trading at low valuation ratios and offering predictable financial performance, then it is clearly not the right choice. However, not buying a stock and taking a short position are two very different things.

Slack is the top player in a high-growth industry, the company has plenty of room for growth, and the stock price seems to be turning around. This combination of drivers could produce a lot of damage to short-sellers in the stock going forward.