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Slack Stock Upgraded -- Twice! Here's What You Need to Know

Rich Smith, The Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Newly public Slack Technologies (NYSE: WORK) popped as much as 61.5% on its first day of trading (by some estimates) -- but it's been all downhill since. Slack stock has shed 20% of its value since that first day of trading.

But now, two Wall Street bankers think it's finally cheap enough to buy.

Five dice labeled buy and sell on top of LCD screen displaying stock charts and numbers

Image source: Getty Images.

No more slacking off

With Slack on deck to report earnings Wednesday, Sept. 4, analysts at MKM Partners (last night) and Stephens (this morning) stepped up to initiate coverage ahead of the news.  

Both bankers expect shares to trade higher -- if not immediately after earnings, then at least within a year -- with Stephens assigning the stock an overweight rating and a $43 price target, and MKM giving a straightforward buy rating and a price target of $40, according to TheFly.com.

Why the sudden enthusiasm for Slack and its steadily declining stock? MKM explains, in this note carried on CNBC:  

Slack has evolved into a central repository of information around key corporate workflows such as sales, customer service, hiring and recruiting, accounting and expense management, employee benefits and payroll, and many other functions core to any organization. As more organizations digitize workflows, Slack's value proposition becomes even more compelling as a means to connect employees, applications, and data.

Slack by the numbers

And the numbers appear to bear this theory out. Over the past couple of years alone, Slack has ramped up revenue by four times, growing from $105 million in sales in 2017 to $454 million booked over the past 12 months, according to data provided by S&P Global Market Intelligence.

Cost of goods has quadrupled, too, but only to $60 million, leaving Slack with trailing gross profits of $395 million and an enviable gross profit margin of 87%. And while operating costs have risen in tandem, they're growing more slowly -- about 134% -- such that the trend appears to show a point in time when the company's growing revenue will begin translating into higher and higher profits.

Although Slack is presently unprofitable, analysts are forecasting positive operating income will arrive by 2023 or thereabouts.

The future for Slack

Will that happen? MKM isn't 100% convinced, citing Slack's "lack of profitability" and "ongoing deceleration in revenues" as key risk factors to the stock.  

Revenue that quadrupled in two years is expected to grow only 50% next year, then decelerate into the 30s in subsequent years, according to S&P Global data. The hope, though, is that Slack will turn profitable before its sales growth slows much more than that -- at which point it will be earnings growth investors turn their focus to, and not mere revenue growth.

In the meantime, MKM is placing its faith in historical analysis of how hot tech stocks like Slack have performed in the period immediately following their public debuts.

For example, the analysts highlights the surge of insiders unloading shares when the lockup period expires as a key risk to stock performance in "traditional IPOs." Historically, explains MKM in a note covered on StreetInsider.com, this dynamic has shaved about 20% off the stock price of your average tech IPO "during a six-week period around lock-ups."

And yet, this risk is absent in Slack, says MKM, because instead of taking the traditional route, the company went public through a direct listing. Because there was no lockup period after the IPO, investors need not fear a torrent of selling depressing the price of their Slack shares in the immediate future.

And yet Slack stock is down 20% regardless.

What it means for investors

So in a nutshell, what MKM seems to be thinking here is that Slack's 20% decline allows investors the chance to buy a typically depressed-by-risk tech stock...without taking on the risk that typically depresses the stock price!

Granted, there are still other risks: The aforementioned slowing of sales growth and lack of profits, to name a couple, as well as the possibility that Slack will lose market share to industry titan Microsoft and its competing Teams collaborative communication software, which already has 30% more active users than Slack.  

There's also the valuation, which at 35 times sales "isn't for the faint-hearted," deadpans MKM. And personally, I'd add the risk that investors might have to wait four years before they can begin valuing Slack on earnings, rather than revenue. Not all investors will be that patient.

Then again, if Slack's upcoming report shows sales growing stronger than forecast, or contains guidance suggesting profitability will arrive sooner than analysts expect, they might not have to wait four years for Slack shares to rise again.

Fingers crossed.

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Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends MSFT. The Motley Fool owns shares of Slack Technologies and has the following options: long January 2021 $85 calls on MSFT. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com