Slack and Zoom – Life after Lockdown

During the lockdown lots of us have started working from home, and that’s been made a whole lot easier by the new generation of companies providing remote working software. In this article we take a look at two of them, Zoom and Slack, companies that were growing quickly even before the pandemic struck.

This article is not personal advice. If you’re unsure whether an investment is right for you, please seek advice. All investments fall as well as rise in value, so you could get back less than you invest.

What do Zoom and Slack do?

Zoom and Slack are communication tools. They share some core features but also emphasise different things.

For example, they both offer group instant messaging as a supplement or replacement for standard email. However, Zoom places a heavy emphasis on video meetings. While Slack focusses mainly on the core instant messaging service, which it spices up with compatibility with a whole range of third party applications – including Zoom itself! This is an important point which we’ll come back to later.

We’ve found this type of software near enough essential to making home working work. We’ve been able to hold daily team meetings, quickly discuss projects face-to-face and have set up group chats for various teams. It hasn’t replaced email, but it’s been a really helpful supplement.

We think it will still be useful when we’re back in the office. However, Slack’s said the initial boost from the lockdowns has already started to subside and the churn rate is up. Zoom’s also warned that they might not be able to translate their recent surge in users into long term paying customers.

The business models

Both Zoom and Slack operate a “freemium” business model. You get the bare bones service for free and can then choose to pay a monthly subscription fee for extra features.

From a marketing standpoint this has real advantages. For example, “Zoom pub quizzes” seemed to become the nation’s favourite pastime at one point. This has driven brand recognition and helped the group become a fixture in plenty of offices. However, it does mean both groups have had to shell out to service a large number of users who aren’t paying anything.

Both pieces of software work on the cloud, which means costs are fairly flexible as the groups scale up. This means expenses can be kept in line and both groups have been reporting healthy gross profit margins.

Slack reported an 85% gross margin in the financial year ending in January, and Zoom managed 81%. Although costs have risen sharply over lockdown as more free users have signed up.

Growth and profits

Both Zoom and Slack have been growing quickly. Prior to the coronavirus outbreak Zoom’s revenue was growing at an annual rate of 92%, and Slack clocked in at 62%. Regardless of any trend towards more home working, demand for the services clearly isn’t lacking.

Quarterly Revenue

Past performance is not a guide to the future. Source: Thomson Reuters Eikon, 12/06/20

Profit is another matter though. While Zoom’s been profitable over the last two years, Slack’s yet to become sustainably profitable.

Zoom quarterly profit before tax

Past performance is not a guide to the future. Source: Thomson Reuters Eikon, 12/06/20

Network effects

There’s a chance that either Zoom or Slack could benefit from a network effect as they scale up.

A network effect is where the value of a service increases as more people use it. The classic example is Facebook. It didn’t matter if you thought MySpace or Google+ was better – if all your friends were on Facebook then you had to be too.

Industries with network effects tend to be winner takes all. One company can secure a dominant market position from which it’s very hard to dislodge. They can then charge high prices and make enormous returns for its shareholders, Facebook being a good example.

There’s a plausible argument that something similar could happen to the new generation of office productivity software, although we’re sceptical. The argument goes: if every other company is using Zoom then you’ll need to use Zoom too if you want to communicate with them. This catch is that companies are likely to always have other options like the phone or email.

And, as we mentioned earlier, you can actually use Zoom through Slack. Being able to mix and match different bits of software, or just send a one off Zoom link, means we think this isn’t likely to end up as a winner takes all market.

That’s probably for the best though. If we’re looking at a winner takes all market we don’t think Zoom or Slack will end up taking the top spot.

Microsoft Teams

Unfortunately for both Zoom and Slack there’s already a dominant player in office software, and it hasn’t taken the invasion of the start-ups lying down.

Microsoft has already struck back with Teams. Microsoft Teams also does video calling, group instant messaging and file sharing, making it a direct competitor to both Zoom and Slack.

But the size of the threat only becomes apparent when you look at the whole Microsoft Office bundle.

Zoom Pro, the cheapest paid level, costs £11.99 per month although you only need to buy it for hosts. Slack is cheaper at just £5.25 per month. Microsoft Office Business Standard costs £9.40 per month and you get the whole package: Word, PowerPoint, Excel, Outlook, Publisher, Access, Exchange, OneDrive and Teams.

When you look at it like this it becomes clear that competitors don’t just have to be a bit better than Teams – they have to be a lot better.

Many businesses will already have Office as standard, which means businesses will need a really good reason for the extra spending when Teams is there ready to use.

And Microsoft isn’t the only competitor. There’s Cisco Webex, Google G Suite and LogMeIn to name but a few.

Part of the problem is that the actual tech doesn’t seem that hard to produce. To illustrate the point: Zoom spent $122m dollars on sales and marketing but just $26m on research and development last quarter. Slack‘s been spending more, but R&D still lags behind marketing.

As a result, a significant part of the competitive advantage for these groups isn’t really in the technology – it’s the branding and the marketing. Brands can certainly be formidable, but corporate purchasing departments might be less susceptible to clever marketing than consumers.

A big goal for both groups will be to create a service that really can’t be replicated easily by competitors. In our view, Slack is probably closer to doing this. Its integration with a wide range of other apps gives it the chance to become a more flexible and potentially indispensable tool.

At the moment price competition isn’t a huge problem as there’s plenty of space for the groups to grow without directly stepping on each other’s toes. However, as the sector matures it could become a real issue, potentially putting severe pressure on margins and potential profitability.

Valuations

Both Slack and Zoom are trading on ambitious valuations, and that’s putting it mildly.

Zoom is currently valued at 34.9 times next year’s expected sales, and 176.0 times next year’s profits. Slack’s valued at 19.0 times expected sales, and isn’t expected to become profitable for another couple of years.

Young growth companies on these kinds of valuations can be very sensitive to changes in expected growth rates. This means we expect the shares to be volatile as the groups mature.

Investors should be aware that the path ahead won’t be easy, and neither Zoom nor Slack could end up justifying what investors are paying at the moment.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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