SentinelOne continues to be the strongest cloud stock on the top line. This earnings report did not disappoint on the top line with 109% revenue year-over-year of $78.3 million compared to consensus of $74.64 million. ARR was up 110% year-over-year to $339 million. Customer count with ARR over $100K also outpaced revenue growth at 131% increase. Net retention rate grew to 131% which is above the 130 line.
The company is expecting growth of 109% at the midpoint for next quarter with $8 million coming from the Attivo acquisition. My notes have analysts expecting $84.83 million so if we add the $8 million for $92.83 million, the company is beating those estimates (consensus would have been for 103% growth including Attivo). Organic is expected to be in “the low to mid 90%” range, which reflects a raise from the 85% consensus for Q2.
The company raised full year organic revenue to “the midpoint of 80% range” up from the previous guidance of 80%. The full year guidance was raised to 98% including Attivo for revenue of $405 million. The company stated Attivo would contribute $30 million to full year revenue (although one analyst felt the math was off and has Attivo contributing $35 million). Previously, organic revenue growth was guided at $368 million for FY2022 with analyst consensus slightly higher at $370 million.
To SentinelOne’s credit, the company offers clear communication about margins. It’s one of the few companies where the CEO will discuss this at the onset of the opening remarks.
Per the analysis on compartmentalizing cloud stocks here, we went into the earnings report wanting to see an improvement in operating margin. The company was expected to report (86%) to (84%) Non-GAAP operating margin and provided a beat at (73%). This is up from (127%) last year for an expansion of 54%.
The GAAP operating margin remains an eyesore due to stock-based compensation at (115%) of revenue, up from (165%) in the year-ago quarter.
SentinelOne demonstrated strong improvement in gross margin from 51% in the year-ago quarter to 65% in this quarter. It’s up 2 basis points sequentially and up 15% YoY and is the highest GM for the preceding four quarters.
The one thing that could have weighed on the AH price action was the guide on operating margin for Q2 being (75%) to (73%) – as the critical point here for SentinelOne is that the full year guide management has provided for two quarters is for Non-GAAP op margin for FY2023 to be (60%) to (55%). Even though Q1 was a beat on Non-GAAP margin, the path to delivering on the guidance becomes a bit obscure the longer we remain above this level.
The reason we’ve accepted the weaker (albeit improving) margins is that the company is working towards being FCF positive by 2025 and is not likely to raise cash before this occurs. Any change to this would cause us to look at our thesis again.
The company expects to improve adjusted gross margin to 69%-70% and if we assume similar GAAP percentage as this quarter, it would be about 66% GAAP GM for FY2023.
Singularity Cloud was the company’s fastest growing module, growing over 50% sequentially.
Management focused on the strength of their MITRE Attack results with 100% protection, 100% detection, 100% real-time protection, 99% visibility, 99% analytic coverage. I’m sure we will hear Crowdstrike’s response to this on Thursday 🙂
One analyst asked about the European segment and management stated there is a wholesale movement away from Kaspersky either by choice or by mandate and this is a tailwind for them. Secondly, the Broadcom-VMWare acquisition is favorable for them as they are now capturing CarbonBlack business. In terms of taking business from these two vendors: “We expect that to accelerate in the quarters to come.” I’ll expand more on this when I get the transcript.
“Will SentinelOne be able to provide a meet/beat on operating margin in the upcoming quarter and a meet/beat for the full year guide? This must happen and we also need revenue to remain strong.”
SentinelOne’s operating expenses were front-end weighted last year with Q1 being the steepest operating loss and the year getting progressively better (nearly 100% improvement on weak numbers).
If last year is any guide, then SentinelOne is capable of meeting their full year guidance of (60%) to (55%). The company did beat its operating margin guidance this quarter and revenue was strong including key metrics.
I continue to believe the key to this stock is the ongoing revenue strength and its ability to prove to analysts and institutions that it’ll generate cash by 2025. Due to Crowdstrike being a close comparable, it’s likely SentinelOne can (and must) follow in Crowdstrike's cash efficient footsteps, which is what the market will want to see. The product continues to prove itself as exceptional and there was evidence of this in terms of high ARR customer growth, beat/raise on revenue, strong growth on cloud product, and we are likely to see nice movement in the identity product soon. We are keen on SentinelOne's ability to standardize multiple areas of cybersecurity and to do so at a high MITRE ranking.
Despite the red AH on the stock, I see no notable issues with this ER from my perspective.
IBM released upbeat results recently as the company beat consensus analysts’ revenue estimates by $740 million and adjusted EPS by $0.06. Even though IBM is not a pure-play cloud company, it has increased its focus in the cloud segment to stay in the race. IBM’s cloud revenues increased 16% YoY in Q4 and the results brought some relief to the investors after the recent volatility in the stock market.
On the other hand, Microsoft beat analysts’ revenue estimates by 1.9% and adjusted EPS by 6.9%. Microsoft Cloud revenue grew 32% to $22.1 billion. This is a positive sign for the broader cloud market. The company’s capex has also been strong, suggesting that management believes demand is structural.
Our Cloud companies’ earnings preview includes Dynatrace, Unity Software, JFrog, DigitalOcean, UiPath, Palantir, and BigCommerce. To understand valuations across the cloud companies and how the sector is positioned moving into earnings, please reference our analysis, “I/O Fund’s Cloud Q4 2021 Earnings Overview.”
The company’s revenue in Q2 FY22 grew 34% YoY to $226.35 million. According to the analysts’ consensus estimates, revenue is expected to grow 28% YoY to $234.6 million in the next quarter. The management has been positive on the long-term growth prospects due to the digital transformation across industries. In the last earnings call, they mentioned that the near-term market expansion opportunities include the U.S. government's investments in cloud platforms.
Barclays analyst Raimo Lenschow has lowered the price target to $65 from $85. He has an Overweight rating. According to the analyst, the main question for software investors in 2022 is not around end demand, as there are "no issues there," but the correct valuation level for the space. "Are we going back to the long-term average, or should software bounce back to the more recent highs given the exciting structural growth profile? We are in the former camp,” says the analyst as he gets a bit cautious on the sector.
Jefferies analyst Brent Thill also lowered the price target to $60 from $75 and has kept the hold rating. He adjusted his targets across the app, infrastructure and security software spaces. “Software underperformed the S&P 500 by 15% in 2021 as overall valuations contracted 10%,” according to Thill, who thinks multiples in the space will continue to compress in 2022 as 80% of software names are expected to decelerate with "digital digestion" happening coming out of the pandemic.
Please note that the I/O Fund may or may not agree with the above financial analysts, yet we objectively report what the Street is saying. You may view our previous analysis of the company below:
Unity’s revenue grew by 43% YoY in Q3 and is expected to grow 34% to $295.29M in the next quarter. The company recently completed the acquisition of Weta Digital. Weta is a digital visual effects company known for its work in Lord of the Rings, Avatar, and Wonder Woman. The management believes that the company’s addressable market will increase by about $10 billion from the acquisition.
Piper Sandler analyst Brent Bracelin made an interesting point that the company is an indirect beneficiary of Activision and the Microsoft deal due to its unique position as the leading 3D creator platform for gaming, movies, AR/VR, and metaverse applications. The analyst also believes that Unity can expand its footprint as a 3D creator platform in the coming year.
Stifel analyst J. Parker Lane has initiated coverage of the company with a buy rating and a price target of $190. According to the analyst, “Unity's broad set of solutions has made the company a market leader in the gaming industry and positioned its platform to address emerging use cases in other industry verticals.” Lane further adds, “Additionally, the company's continued investment in research and development, tuck-in acquisitions, and presence in gaming has helped it withstand the headwinds of IDFA and gain market share in a competitive advertising market.”
The company’s revenue grew by 38% YoY in Q3 and the consensus analysts’ estimates suggest revenue to grow 36% to $58.1 million in the next quarter. The management expects revenue in the range of $57.5 million to $58.5 million and adjusted earnings per share of break-even to $0.01. For the full year, management expects revenue in the range of $205 million to $206 million, representing a growth of 36% YoY at the mid-point.
Stifel analyst Brad Reback has a buy rating and a $45 price target. He sees the company is well positioned to sustain 30%-plus revenue growth as it leverages its "unique position within the DevSecOps workflow.” He further believes that JFrog has a growing suite of solutions to help customers build, manage, distribute, and secure their respective applications more effectively and efficiently.
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Needham analyst Jack Andrews has a buy rating and a $71 price target. The analyst is positive on its leverage to strong macro demand trends for DevOps tools and practices, expects its key financial metrics to inflect higher. He further believes that the company is trading at a discount to the broader software companies creating a favorable risk/reward. At the time of the writing, the company was trading at 6.0x EV/Fwd revenue multiple.
The company’s shares got listed in March 2021. The stock rose about 30% since its IPO. The consensus analysts’ estimates suggest revenue to grow 36% YoY to $119.02 million. The company’s net dollar retention rate (NDR) has shown improvement from 105% in Q4 20 to 116% in the last quarter. On the other hand, the growth rate has also shown acceleration for three consecutive quarters.
William Blair analyst James Breen has initiated coverage of the company with an Outperform rating. He notes, “DigitalOcean is a comprehensive cloud platform designed to simplify cloud infrastructure for developers, start-ups, and small to midsize businesses.” He is also positive on the large and growing addressable market, which is expected to reach $116 billion by 2024.
UiPath Inc – Tentative Earnings date is February 15th
UiPath had a successful listing in April 2021. The company’s revenue grew 50% YoY in Q3 and the consensus analysts’ estimates suggest revenue to grow 36% to $283.25M. The company is betting on the robotic process automation market (RPA). According to Precedence Research, the Robotic Process Automation market is expected to reach $23.9 billion by 2030, growing at a compound annual growth rate of 28% from 2021 to 2030.
Oppenheimer analyst Brian Schwartz has upgraded the company to Outperform with a $56 price target. In his opinion, “UiPath as the RPA market leader should benefit from a strong top-line driver with good business efficiency tools demand this year. At the same time, valuation risk has lessened considerably.”
Wells Fargo analyst Michael Turrin upgraded the company to Overweight with a price target of $60. The analyst sees a "potential tailwind emerging" for the company from a tightening labor market, which he thinks could benefit automation-centric vendors.
Palantir Inc – Tentative Earnings date is February 15th
Palantir's revenue grew 36% YoY in Q3 and the consensus analysts estimate revenue to grow 30% to $418.07 million. The company's initial focus was on the government sector. The company's first platform Gotham was mainly built for government operatives in the defense and intelligence sector. The company continues to win deals from the public sector. On the other hand, the commercial revenue segment has also shown strong growth in the past few quarters.
Jefferies analyst Brent Thill lowered the company’s price target to $24 from $31. He kept a Buy rating on the shares and adjusted his targets across the app, infrastructure, and security software spaces.
Deutsche Bank analyst Brad Zelnick lowered the firm's price target to $18 from $25 and kept a Hold rating on the shares. The analyst is bullish on software industry fundamentals but recommends a balanced approach with greater valuation sensitivity than in recent years.
The company’s revenue grew 49% YoY to $59.3 million in Q3. It included $5.9 million from the recently acquired Feedonomics, a data feed optimization platform. The consensus analysts estimate revenue to grow 43% to $61.82 million in the next quarter. Management expects revenue in the range of $61.3 million to $61.7 million, representing a growth of 42% to 43%. The guidance includes expected Feedonomics revenue of $7.1 million to $7.3 million. For the full year, the management expects revenue in the range of $216.2 million to $216.6 million, representing a growth of about 42%.
Needham analyst Scott Berg has been positive on the recent acquisition and also has a bullish stance on the company. In his words, "We came away incrementally more confident in BIGC’s positioning in the market entering 2022 and its growth opportunity upmarket as large organizations look to re-platform from legacy on-prem solutions to a flexible, multi-tenant SaaS platform." He has a buy rating and a price target of $85.
On the other hand, a few other Wall Street analysts have lowered the price target on the company due to overall weak market sentiment. KeyBanc analyst Josh Beck lowered the price target to $40 from $75. Barclays analyst Raimo Lenschow lowered the price target to $36 from $67.
The I/O Fund is a team of analysts that share their research publicly as they build a portfolio of 20 stocks. Our team has record results for a retail Fund and we also have four-digit gains on some of our free newsletter coverage. You can learn more about our premium service by clicking here or sign up for our free newsletter here.by clicking here or sign up for our free newsletter here.
Disclaimer: This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
Cloud reports in two waves, with the first wave of Q4 earnings ramping this week. Microsoft was the first to report on January 25th, and strength in cloud sales helped the company beat expectations. Specifically, Azure and other cloud services revenue increased 46% YoY in the quarter, which drove consolidated sales growth of 20% YoY, beating topline estimates by 2%. In the analysis that follows, I give a brief overview of the cloud industry and discuss key metrics that investors should be aware of heading into Q4 earnings.
Cloud: Top 10 EV/FWD Revenue Multiples
Below we ranked cloud stocks based on their EV/NTM sales multiples. Snowflake (SNOW) has the highest multiple in the cloud sector, as the cloud platform provider most recently reported accelerating topline growth coupled with improving retention and other key metrics. Snowflake is benefitting from increasing rates of data ingestion in the cloud environment, a secular tailwind that will likely continue to be strong in the near term.
SentinelOne (S), Zscaler (ZS) and Cloudflare (NET) follow Snowflake’s valuation and have been rewarded a relative premium in the cloud category. Each of these companies provides cybersecurity solutions, which is a market that will likely continue to see strong demand as companies increasingly digitize and migrate online. As companies move online, their attack surfaces increase, driving demand for cyber security solutions.
It is noteworthy that cloud valuations have normalized in 2022 following the heightened volatility in financial markets. Nonetheless, these leading cloud companies highlighted below will likely continue to report robust growth in the near term as cloud adoption remains a strong secular tailwind for the foreseeable future.
Cloud: Top 10 Three-month Forward YoY Growth Rates
Below is a chart of forward sales growth expectations for cloud stocks expected to grow the fastest in the upcoming quarter. Bill.com (BILL) is expected to report the fastest growth rate in our cloud universe heading into Q4 earnings at nearly 140% YoY. However, Bill.com recently completed its acquisition of Invoice2go, which impacts the company’s as-presented topline growth rate.
Absent M&A, Bill.com’s sales are still strong and recently grew 78% YoY on an organic basis, up from the 73% YoY organic growth rate in the prior quarter. Also noteworthy are the differing growth rates between Monday.com and Asana, two work productivity platforms that are both rapidly growing.
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Monday.com is expected to grow sales 75% YoY to $88 million while Asana is expected to grow sales slower at 54% YoY to $105 million in quarterly sales. The next few quarters will likely shed light on which platform is the leading work productivity solution going forward. Strength in enterprise will be a key metric to monitor to gain insight into which company is the leading work productivity platform.
Top 10 Weekly Share Price Movements
Below is a table of the weekly change in share price for our universe of cloud stocks (week ended 01/21). Markets have been volatile and every cloud stock in our universe was down last week as the Nasdaq declined by 7%. However, there were some relative outperformers, such as Workday (WDAY) and Zuora (ZUO), both of which support back-office operations, and the market may be expecting these companies to perform well given the labor shortage. Furthermore, Anaplan (PLAN), Box (BOX) and Dropbox (DBX) have also outperformed well on a YTD basis, and were up 4%, 2% and 3% relative to the Nasdaq’s 7% YTD decline. Lengthening the timeframe to 1-year and Box has performed the strongest of the three and is up 38% YoY. Likely contributing to its outperformance, Box has reported three consecutive quarters of acceleration topline growth, with sales rising 14% and billings increasing 25% YoY in Q3. The outperformance in billings suggests sales may continue to accelerate, and management guided for Q4 sales to accelerate to 15% YoY.
Top 10 Changes in sales growth estimates – last 90 days
The table below ranks cloud stocks by their topline revisions over the last 90 days. An increase in topline revisions signals that the Street believes that the company will grow faster than initially believed, which can result in outperformance. Confluent (CFLT) has had a 16% topline revisions over the last three-months, which leads cloud stocks. Confluent raised its FY2022 sales guide in November by 8% at the mid-point and also announced a partnership with Alibaba in December, both of which likely contributed to the higher topline estimates. Another standout is New Relic (NEWR), which saw a 9% rise in estimates over the last 90 days, driven by a strong earnings report as the company reported an acceleration in sales and guided for a further acceleration in Q2. New Relic’s shares are up 27% over the last three-months as the company recently revamped its product offering and migrated to a consumption billing model. Time will tell if the recent changes resulted in sustainable growth or if the recent changes provided only a short-term boost to growth.
Update on EV/Fwd revenue multiples:
Overall stats:
Overall cloud forward median: 8x
Top 5 cloud forward median: 24x
Overall cloud forward average: 10x
EV/FWD SALES:
As shown below, the median and average cloud EV/NTM sales multiple was trending up throughout 2021 but has since corrected in 2022 to levels last seen in early 2020. For instance, the median cloud EV/NTM revenue multiple was 8x in the most recent week, which is below the 9x median cloud multiple in May 2020. Furthermore, the delta between the average and median multiple has narrowed recently as the top valued cloud stocks have had their valuations compress, reducing the distortion on the average calculation. If Q4 growth comes in strong for the cloud category, expectations for forward growth will likely be revised higher, leading to a recovery in valuations.
Top 5 EV/FWD SALES:
In the chart below, we can more clearly see the large dispersion in cloud valuations, as the top 5 premium valued cloud stocks have had their EV/Fwd sales multiples expand since 2020. However, the top 5 valued cloud stocks have had their valuations halved since November. The median cloud stock has also experienced a multiple compression in recent weeks.
EV TO FWD Sales Growth Buckets:
We can further dissect the change in cloud valuations by breaking up the group into high growth (>30%), mid growth (>15% and <30%) and low growth (<15%). The below chart shows the historical valuations for stocks in various growth buckets. Each growth bucket has had their valuations compress since November, with the high growth bucket experiencing the steepest decline. The market may be expecting a deacceleration in growth in the near term, which would explain the correction in high growth valuations. If growth in cloud remains robust in Q4 and estimates come in strong, then valuations may rebound in the next few months. Microsoft’s strong cloud results discussed above suggest that cloud will continue to grow strongly in the near term.
Top EV TO FWD SALES:
The below chart provides a more holistic view of the cloud landscape heading into Q4 earnings, sorted by EV to Fwd revenue multiples. As mentioned above, Snowflake (SNOW) sports a premium multiple, driven in part by its accelerating topline, followed by three cyber security firms: SentinelOne (S), Zscaler (ZS) and Cloudflare (NET). Snowflake’s premium multiple is 380% above the cloud median of 8x, which may be warranted given its triple-digit accelerating topline growth rate.
The last chart is based on EV to FWD sales but also takes into account forward growth expectations. By scaling valuation relative to forward growth, we can more clearly see which companies are cheapest relative to forward growth. A low value in the below chart means that a company is cheap relative to growth. Note that some names may be skewed due to acquisitions. It is interesting to note that Snowflake drops from having a 380% premium valuation relative to the median to a 33% premium after taking into account its strong growth rate. Alteryx and Splunk move to being some of the most expensive cloud stocks once we factor in their forward growth.
Finally, the last table we will be discussing includes aggregate cloud operating metrics. The below table illustrates the median topline growth, margins and FCF generation for the cloud industry. The median growth rate was 36%, and the market expects the median cloud stock to grow sales by 28% YoY in Q4. Gross margins remain robust at over 73% and cashflows are slightly positive at 3% of three-month sales for the median cloud company. Cloud remains a category exhibiting rapid growth, with strong margins but relatively low cashflows. As the category matures, cashflows will likely materially improve, rewarding investors in the long run.
While cloud valuations have been volatile in recent weeks, the category remains one of the fastest growing areas in the market. The I/O Fund believes in the long-run success of the cloud category, and we remain invested Find out what the Street is saying about cloud stocks headed into Q4 earnings in our I/O Fund’s Preview of 7 Cloud Stocks for Q4 Earnings.
The I/O Fund is a team of analysts that share their research publicly as they build a portfolio of 30 stocks. Our team has record results for a retail Fund and we also have four-digit gains on some of our free newsletter coverage. You can learn more about our premium service by clicking here or sign up for our free newsletter here.by clicking here or sign up for our free newsletter here.
Disclaimer: This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
We recently initiated a position in CrowdStrike and want to take the opportunity to update you on the company. Previously, I covered CrowdStrike in October 2020 here. In the report, I explained how cybersecurity would continue to be a key initiative for organizations in the remainder of 2020 and beyond. I also covered CrowdStrike’s product offerings and explained how the company was uniquely positioned as the top vendor in a critical subsector of cybersecurity. We discuss the previous coverage below and examine why the company has become even stronger, as well as numerous industry catalysts.
We continue to see strong C-level survey results for cybersecurity in 2021, in particular, with CrowdStrike and Zscaler the undisputed leaders. We discuss why we have chosen CRWD, yet it seems ZS is a strong second choice. We also cover Cloudflare and why we have passed for our own portfolio.
Security Software: Top Priority for 2021
Security software has consistently ranked as a top spending priority among C-level executives, but our research shows it has become the #1 priority in 2021. The Covid-19 pandemic and shift to a more remote workforce uncovered a number of major gaps in the cybersecurity of organizations.
The high-profile Sunburst hack further highlights the need for businesses to transform their legacy security architectures, as legacy tech is no match for today’s adversaries. As a result of the Sunburst hack, the current administration has talked about how cybersecurity spending is a top priority, calling on Congress to “launch the most ambitious effort ever to modernize and secure federal IT and networks.”
Credit Suisse’s recent CIO survey suggests that security spending is the top spending priority in 2021, even more so than in July.
We view CrowdStrike and Zscaler as the best positioned cybersecurity companies to benefit from the growing security spending cycle. We are still in the early innings of the shift in security architecture towards Zero Trust and SASE, of which we believe CrowdStrike and Zscaler will benefit the most.
Here’s a snapshot of government spending and the triple-digit increase in FY2020 growth in federal spending for Zscaler and CrowdStrike. The current administration’s commitment to cybersecurity should also benefit CrowdStrike and Zscaler as they continue to gain more share of federal spending.
1. CrowdStrike (CRWD)
In my past coverage of CrowdStrike here, I explained why the company would thrive as the fastest growing endpoint security vendor. Endpoints are frequently the first point of entry for attackers, so endpoint security is an integral part of a multilayered security strategy. CrowdStrike has thrived in this area, leading to the addition of a record 1,480 new subscription customers in Q4.
While CrowdStrike has demonstrated tremendous expertise in endpoint security, the full CrowdStrike Falcon Platform now encompasses much more. The full CrowdStrike platform, designed to define Cloud Security, includes managed services, security & IT operations, threat intelligence, identity protection, and log management. The power of CrowdStrike’s platform is demonstrated in the financial data, as 63% of CrowdStrike’s subscription customers have 4 or more Cloud Module Subscriptions. This number has grown from 47% two years ago and 55% last year.
The growth of this metric is important to CrowdStrike’s growth, as they have expanded their TAM through acquisitions and the launch of new modules that cover untapped areas of cybersecurity. We are now seeing the majority of CrowdStrike’s subscription customers, almost 2/3, adapt 4 or more modules meaning most customers are subscribing to the idea of having CrowdStrike handle most of, if not all of, their cybersecurity needs. CrowdStrike management has talked in the past about how most customers typically sign up for 1 or 2 modules but adapt more modules over time. This shows the success of the CrowdStrike customer life cycle. From the time the company onboards a new customer to the adaption of more modules, they are able to add new sources of revenue from already existing customers.
In Q4, CRWD grew revenue 77% YoY and added a record 1,480 new subscription customers (+82% YoY), with a number of marquee customer additions including Pfizer. CRWD also enjoyed a record quarter in profitability metrics with its best ever quarter of non-GAAP EPS (+$0.13), Free cash flow (+$97M), FCF margin (+37%), EBITDA (+$45M), and EBITDA margin (+17%).
CrowdStrike guided for 50% YoY revenue growth in FY 2021 and EPS of $0.29. The projected growth rate leads the security SaaS industry and our comparisons of ZS and NET, despite the stock trading at a slightly lower valuation than those stocks.
As previously discussed, with its recent acquisitions of Preempt and Humio, CrowdStrike has enhanced its capabilities beyond endpoint security to also encompass cloud workload security and identity protection. With Preempt Security, CrowdStrike is leading the charge with a Zero Trust solution focused on endpoints and workloads. In its Q4 earnings call, CrowdStrike CEO George Kurtz talked about how customers have become increasingly interested in its Zero Trust offering derived from Preempt following the Sunburst hack.
The acquisition of Humio will combine Humio's data ingestion and analysis engine with CrowdStrike’s technology. CEO George Kurtz discussed the Humio acquisition the company’s Q4 earnings call:
“With Humio, we are now redefining next-gen XDR through a platform that spans endpoints, identities, applications, the network edge and the cloud… Humio provides us the ability to expand our data leg and to solve more security and non-security use cases in real time… providing CrowdStrike with a greater time advantage over the competition and the adversary.”
It has become evident that CrowdStrike has continued to successfully enhance the capabilities it can offer and has taken a big step toward its goal of providing the “fastest, most cost efficient, and extensible cloud data platform that will deliver best-in-class visibility for security as well as observability for IT operations.”
2. Zscaler (ZS)
Zscaler ranks #2 behind CrowdStrike on our list of cybersecurity stocks to own. Like CrowdStrike, we believe Zscaler is well positioned to capture the industry wide shift to Zero Trust and SASE. We covered Zscaler’s Fiscal Q1 Results here. Fiscal Q2 was another solid quarter for Zscaler as they continue to show their strength as a major cybersecurity player. In Fiscal Q2, Zscaler grew revenue 55% YoY and gross billings an impressive 71%. Although Zscaler is an industry leader with strong fundamentals, our analysis shows that the company is not as strong fundamentally as CrowdStrike despite having a slightly higher valuation.
Over the next 12 months, Zscaler is projected to grow revenue 37% versus CrowdStrike’s 51%. ZS has slightly higher gross margins over the trailing 12 months at 78% versus CRWD’s 75% but lags CRWD in Operating Margin and FCF margin. We compare ZS to CRWD and NET fundamentally in the table below.
3. Cloudflare (NET)
We covered Cloudflare’s Q4 earnings here. Although Cloudflare is not purely a security company, approximately half of their products are security related. A lot of Cloudflare’s focus on the future is related, according to CEO Matthew Prince. In its Q4 earnings call, Cloudflare management talked about their expectations for a big shift in 2021 from a traditional hardware-based security approach to a much more modern Zero Trust approach. Cloudflare is well positioned to be one of the leading companies in enabling organizations to make this shift. However, we still view CRWD and ZS as better ways to play the shift in cybersecurity spending.
We feel NET is not as strong fundamentally as CRWD or ZS. The stock is also not as attractive from a valuation standpoint. For these reasons, NET ranks third behind CRWD (#1) and ZS (#2) on our list of security SaaS stocks to own moving forward.
Source: YCharts; data as of 3/25/21
Conclusion:
Selloffs are tough, but the silver lining is getting quality companies at much more reasonable valuations. CrowdStrike is a company that we think will do well when the market remembers that tech is not going anywhere and growth in this sector is not Covid dependent. CrowdStrike is my favorite company that had a stretched valuation throughout this past year and we see the selloff as a buying opportunity.
In the excitement about SPACs and the flood of IPOs that have listed recently, it'd be easy to forget about the tried-and-true.
Quick Note on the Current Climate …
My main thesis about cloud has not changed: it's secular and insulated from geopolitical risks and economic drawdowns. Generally speaking, cloud software reduces costs for enterprises and SMBs. Therefore, the category is more insulated from economic drawdowns. You can read more about my views on cloud’s resiliency here.
There's a caveat to this, which is that the market is flooded with cloud software solutions and tools – both in the public markets and private markets. This is because cloud software has a low barrier to entry. The costs to develop cloud software and go-to-market is very low compared to hardware or a solution that requires specialty engineers, like AI, ML, robotics, etcetera. Venture capitalists are drawn to cloud software because it's relatively cheap to create, and the margins are healthy due to recurring subscription revenue.
The window of time that you have to be wary is between years 8 and years 12 for a software company. Prior to year 8, it's common for software and new tech startups to report rapid growth. VCs know this and are taking companies public sooner to capitalize off momentum traders (and trading machines), that indiscriminately pile into companies with high growth rates.
In this case, a VC firm can see a very large exit and move onto another company while the public markets sort out the long-term growth rate and the company's ability to scale. Every startup looks strong at the beginning of the marathon but which ones endure past mile 13? VCs don't have to worry about this as the goal in today's market is to exit before the marathon is half-over.
The ramp-up period for startups is exciting because the product finds early adopters. Can the product sustain long-term after year 8 and continue to take market share? This is a much more complex question. Private investors exit before the long-term viability of a company surfaces and (us) public investors have to extrapolate the longerterm trajectory.
Consider the fact that 9 out of 10 startups fail. If you’re a VC, you’re going to get the startup to the public markets as fast as possible to get your exit. If the company fails or the growth slows down, as it does for most tech startups, then it's of no importance as the exit was made. Because of this dynamic (that startups are essentially experiments) and there are many new SPACs bringing to market roughly 165 unvetted companies, I believe we will see a string of failures at the peril of public investors. According to these statistics, we could see 148 fail out of the 165, or on the low-end, 132 of the 165 fails. The low-end is the 80% failure rate for VC-backed companies indicated by the statistics.
SPACs are not inherently wrong (and David pointed out a few benefits compared to IPOs). However, young companies fail very frequently and the public markets are becoming the exit grounds for pre-revenue companies. This piece is new and public investors aren’t prepared for the high failure rate that is a daily reality in the private markets.
That’s a bit of a tangent to say we will continue to have plenty of exposure to cloud in our portfolio as a hedge against any high-fliers we take. The fact that cloud is out of favor in the market right now is not a concern to us because we know cloud has a resilient growth rate.
We also want to communicate that we are well-diversified. We have exposure to SPACs and small caps, but we use cloud and semis as a safe haven. I think these comments will become more apparent as we move through the year. Basically, I am contrasting why cloud deserves attention right now despite the fact speculative trading in SPACs and Momentum has been in the driver’s seat.
Regarding valuations — I've stressed this point with companies like Snowflake because we will see more of this as time goes on and investors need to be careful of merely providing exits for VCs at sky-high valuations. Being patient is an important tool in a retailer's arsenal when a valuation is high.
Please keep in mind, that we discouraged readers from buying Zoom Video when trading in the forward P/S range of 50 despite owning this stock at a lower cost basis. Therefore, I am not singling out Snowflake but instead using it as an example to illustrate why we have not bought this excellent company as "growth at any price" can lockup your money for a few quarters while the financials catch up to the valuation. This is exactly what has happened with Zoom Video (it took a long breather) although the forward P/S is much more reasonable now.
Our Focus: Product-Market Fit and Valuations
For our portfolio, cloud is a hedge as valuations may fluctuate, but growth will march onward for the companies with product-market fit in this resilient category. The best illustration of product-market fit is Shopify and Zoom Video as both their top and bottom lines prove they are efficiently meeting market demand.
An example of a company that I have picked on for not having product-market fit is Uber and Lyft as they must subsidize rides. The market price that customers will pay is lower than its operational costs. The market may still move the stock based on the promise of autonomous vehicles or robotaxis but today's financials do not suggest there is product-market fit.
Opendoor has a similar issue. The financials are upside down as the more the company makes, the more the company loses, and this is inherent to the current business model (not a one-time event or the cost to scale).
Opendoor was hoping to charge 10% in commissions which is about 4% more than Realtor fees for the convenience of buying the house in cash. The market will not pay this extra 4% and Opendoor is forced to match Realtors at 6% commissions. Like Uber, the price does not cover the operational costs. However, we are in a period of historic liquidity and QE. The market may pile in based off sentiment or other speculative reasons (we’ve entered this stock ourselves and it’s performed well), but the financials today do not show a company that has achieved product-market fit.
You could argue Fubo does not have product-market fit as seen in the financials. The cost of licensing the content does not cover the cost of operations. So, why am I invested? Because this is the yearthe year for CTV ads and OTT live content so we think the trend is so early and so massive that we are comfortable taking a flier on this company. I’ve said before that OTT live sports is the holy grail and cable networks/media conglomerates will do what it takes to own this transition. There are many market forces at play here and Fubo is centered perfectly in the middle. Therefore, this is an investment in the trend of Live Sports OTT.
Product-market fit is important to this discussion because finding the gems will protect us from any downside in the market. Even if the market temporarily sells-off in certain names, we can rest easy if we stick to quality.
The best examples of product-market on the public markets are the FAANGs – where the top line defies the odds, and the bottom line continues to deliver. There are others in the $200B+ market cap range that illustrate this: Salesforce for CRM, Adobe for design and its developer moat, Nvidia for the CUDA platform and its developer moat, etc. Sticking with these companies through market ups and downs did well for early investors.
Cloud investing was fairly predictable in the previous years because there were clear winners in terms of forward growth. Due to tougher comps, nearly half of all cloud stocks guide between 20% and 40% with very few above this range and priced dearly if they are (see the chart below).
The other factor we will be considering as we move into 2021 is valuation. There is a disconnect in a few names where the market has not been perfectly efficient. Below, we pull out a few names that have room and rely on Knox for any breakouts in valuation.
As was posted on the forum last week, those with room in valuation include Bandwidth, Asana and Crowdstrike. We are also pleasantly surprised to see Kingsoft Cloud having quite a bit of room although some of this likely represents the risk in China. In the Macro section, you'll see that China's Cloud IaaS is set to take off with Alibaba surpassing Google Cloud for the number three spot. We think this foreshadowing growth for Kingsoft.
Macro Outlook:
The big takeaway from the cloud market going into 2021 is that hybrid work-from-home is here to stay. The market is pricing cloud productivity software as a temporary COVID tailwind but the analysis shows a permanent shift that will accelerate this year.
According to IDC, the cloud market will grow at a CAGR of 15.7% through 2024 to become a $1 trillion market in 2024. This forecast includes software-as-a-service (SaaS), platform-as-a-service (PaaS), and infrastructure-as-aservice (IaaS).
The research firm also states that by 2021, 90 percent of enterprises will be relying on a mix of onpremise/dedicated private clouds, multiple public clouds and legacy platforms. Therefore, IDC predicts this to be the year of multi-cloud, which we covered in our Microsoft earnings report write-up here. We see multi-cloud as the first step towards edge computing to where servers from various hyperscalers or CDNs work cooperatively to deploy 5G workloads.
On a trailing basis, cloud spending grew from $183 billion in 2018 to $233.4 billion in 2019. This puts the $1 trillion prediction into context as IDC calls for roughly 400% growth over the next five years. In 2019, SaaS accounted for $148 billion, or about 64% of the public cloud market.
SaaS dominating the IT spend for cloud is important because it means there will be many winners in this category as it marches onward to the $1 trillion mark.
According to IDC, more than half of the global revenue in the PaaS and IaaS markets was captured by AWS (33.6%) and Microsoft (18.0%) leaving 34.90% for the rest of the market.
This is not the case with SaaS where the rest of the market captured 73.9% and the top two vendors, Salesforce and Microsoft, caught 7-8%.
This is also important for perspective as smaller companies own the SaaS market while Big Tech dominates IaaS and PaaS. Therefore, there is a solid opportunity for investors in cloud software now and into the future. The graph below helps to visualize the opportunity for smaller players:
According to Gartner, worldwide public cloud spending will grow 18% in 2021 to total $304.9 billion. Relative to overall IT spend, cloud still has a long runway and is projected to make up 14.2% of total global enterprise IT spend in 2024 compared to 9.1% in 2020.
Gartner’s survey indicates that there is still quite a bit of growth ahead despite the harder comps the cloud software leaders face in 2021. The data shows that 70% of organizations using cloud services plan to increase their spending, stating “the proportion of IT spending that is being allocated to cloud will accelerate even further in the aftermath of the COVID-19 crisis.”
The analyst firm points towards mobility, remote working and hybrid workforces as trends that will lead to further market growth.
In the graph above, we see survey respondents and Gartner forecast an increase in work-from-home. Meanwhile, the market has been cautious about cloud software post-vaccine, which may be unwarranted with hybrid workforces.
Here is what Gartner states, “For example, customers and citizens shifted their activity online during the lockdown, but that shift will increase, not reverse, in 2021.”
Forrester’s recent survey showed similar results with 47% of North American managers anticipating a permanently higher rate of full-time remote employees and 53% of employees wanting to work from home postpandemic.
Although budgets will only increase 2% in 2021, according to Gartner, CIOs' top priorities are digital workplace technologies to support work-from-home, and then AI/ML, robotic process automation (RPA), distributed cloud and multi-experience platforms.
Forrester states 35% of companies will double down on workplace AI with one in four workers supported by automation either directly or indirectly by the end of 2021. B2B sellers will rely on AI and automation with predictions that 60% will rely on tools with these functionalities embedded.
The analyst firm also states the hyperscale cloud market will “return to hypergrowth” of 35% to $120 billion in 2021. This is up from the original prediction that cloud IaaS would grow 28%. The analyst firm also predicts Alibaba will take the number three spot instead of Google Cloud.
Adopting serverless apps and containers will continue to grow with increased demand for multi-cloud container development platforms and public-cloud container/serverless services. Forrester also believes a leading trend will be disaster recovery moving to the public cloud.
Cloud Stocks for H1 2021
I wrote my first thematic PDF on cloud in December of 2019 during an intense cloud sell-off. The First Trust Cloud Computing ETF (SKYY) had posted 22% returns YTD at time of writing in December and closed the year with 24.55% returns for full-year 2019.
Last year, cloud performed much better due to its fundamental, secular strength during COVID with the SKYY ETF closing out with 57.41% returns in 2020.
We covered many cloud names at their lows during Q3 and Q4 2019 due to our thesis that cloud is insulated and secular. At the time, we pointed out that cloud services were expected to grow 4.5 times more than the IT industry and that future growth through 2022 would be 3 times higher than IT (page 3 from this report).
I believe we are here again in a very similar spot. The market thinks cloud is going to be stunted and forward guidance isn't saying otherwise. However, the analyst firms are predicting we will accelerate and are raising forecasts. We will side with Gartner, IDC and Forrester who do a particularly great job in the cloud category.
Prior to COVID, our thesis was this: “cloud software is more sheltered from overseas economies, supply chains, trade wars and shifting government policies” and “truly, there is few safer places to invest in technology if the trade war resumes or we see the recession that many economists are predicting.”
My thesis this year is that work-from-home and hybrid work environments will be the new norm which will keep cloud growth steady and that AI and ML will be another catalyst. You simply can’t compete with AI and ML with on-premise servers and software. Edge computing and 5G is another accelerant for cloud IaaS, PaaS and software.
Below are the top 35 cloud stocks listed by revenue growth that we consider to be in our universe. The top 10 are shaded in yellow.
In a Motley Fool podcast, I had said that this would revert to about a 30 forward P/S and we are here now.
Some Conclusions:
• Kingsoft Cloud has a compelling risk/reward ratio as the company will deliver Snowflake-level revenue at rock-bottom valuation.
• Bandwidth has the ingredients to pass the pack of cloud stocks stuck in the sub-40% growth range. Let’s see if the company can do this – and if the valuation will finally match its potential.
• Asana is not in our top 10 due to competition across productivity tools, but we see room here in the valuation. This will be something Knox spearheads as he sees the right setup including this one from last week.
• Crowdstrike and Zscaler are both leaders in revenue growth and EPS growth.
• Zoom Video and Shopify are both strongest in terms of a large base in EPS and we think the products will perform well in the face of tough comps this year.
• This year is very unique for cloud software because so many stocks are sub-40% growth and tightly ranked (see the chart above). We are not surprised to see mixed-reactions to the earnings reports as the market is holding its breath to see what the covid comps will be for the March quarter.
• We are not too concerned about the market taking a breather or responding to uncertainty. There is only one way forward for SMBs and enterprises (which is adopting cloud IaaS, platforms and software).
Traditional IT is expensive and will only hinder a company from taking advantage of AI and 5G. Competitively it can be very harmful to not transition to cloud right now as we've seen in my past reports citing McKinsey.
• The last time I talked about cloud on the Motley Fool podcast, I thought valuation was a serious risk as we saw many names trading in the 50 forward P/S range whereas 30 forward P/S is the mean for highgrowers and 20 P/S is the mean for average growers.
• Now that we have reverted to the mean, we plan to allocate for cloud while the trend is out of favor.
My Top 10:
We stand by Zoom Video and Shopify as the relationship between the top-line and the bottom-line proves product-market fit. We understand there will be harder comps this year but these companies are releasing new products to grow market share and continue to be centered in important trends. These were strong companies prior to COVID and we thnk they will be strong companies post-COVID.
Crowdstrike and Zscaler are stocks that David follows closely and are the best positioned cybersecurity companies to benefit from the growing security spending cycle. The Covid-19 pandemic and the Sunburst hack uncovered a number of major gaps, highlighting the need for organizations to transform their legacy security architectures. Credit Suisse’s recent CIO survey suggests that security spending is the top spending priority in 2021, even more so than in July.
Kingsoft Cloud and Bandwidth are both undervalued in terms of forward-growth. China's cloud IaaS should be in the breakout year as Alibaba takes over Google Cloud as number three. Bandwidth is centered in the hardwareas-a-service trend, which may not be as exciting as EVs or SPACs but is essential to the digital transformation we've seen this past year and a hybrid work environment.
We could not be more bullish on Twilio’s long-term trajectory. The company has a moat in cloud communications for native apps and the management is taking on the omni-channel marketing to increase the addressable market. Should the management pull this off (and we think they will), then Twilio is setting up to be a leader in marketing and sales data with Adobe/Salesforce long-term potential.
Datadog has auspicious positioning for hybrid cloud and multi-cloud. The three analyst firms agree that the public cloud is going to accelerate this year and we want exposure. The market taking a breather does not affect our conviction and we think DDOG is the best way to participate in the growth of Azure, AWS and Google Cloud plus the trend towards multi-cloud (which also directly relates to edge computing).
Teladoc’s low forward P/S (comparatively) is a mystery as this is a mega-trend that will be unstoppable as artificial intelligence continues to merge with health care. We can't think of an industry more ripe for disruption as health care costs have risen 400% in the last decade while wages have stagnated. AI and genomics are able to cure terminal diseases, although TDOC is centered in the first problem (health care costs).
DocuSign is a steady performer with solid top-line and solid bottom-line growth. The market tends to overlook this one, but we like DocuSign as the primary choice for legal, real estate and financial industries. There is very little room for competitors as DocuSign delivers a superior product that can become the universal standard. We do not think the world will reverse to paper.
We continue to want exposure to telehealth and so have allocated to Amwell as an 11th position in cloud.
A periodic transaction report filed on September 3rd revealed Nancy Pelosi and her husband Paul Pelosi purchased 5,000 shares of CrowdStrike for a total investment of roughly $650k. It’s easy to speculate why the Speaker of The House would be purchasing shares of a cybersecurity company that has a history of working with the Democratic National Convention and FBI. CrowdStrike was instrumental in alleging Russia interfered in the 2016 election, an allegation that led to a multi-year investigation.
The timing of this purchase, just weeks before the 2020 election, makes one contemplate her reasoning. Perhaps the Speaker of The House believes CrowdStrike will once again be instrumental in maintaining the integrity of the 2020 election results. Perhaps she believes CrowdStrike is positioned to win a large government contract. Perhaps she believes cybersecurity will become a bigger priority in the future in the government and commercial sectors. Or perhaps we are overthinking this, and the Speaker of The House had nothing to do with this and her husband is simply bullish on the company’s fundamentals and technicals.
In any case, seeing the Speaker of The House purchase 5,000 shares of CrowdStrike adds confidence to my conviction in the stock.
Nancy Pelosi has not been the only one to make a large investment in CrowdStrike recently. In fact, CrowdStrike saw institutional ownership increase 15% in Q2 from Q1. The stock has become a favorite of hedge funds and tech/growth focused funds, which further adds to my confidence that the company has a bright future ahead of it.
Below, I discuss this bright future in regards to security leading budgets and current initiatives. I also dissect areas of strength in the previous earnings report and why I expect this strength to continue in the future.
Cybersecurity: More Prevalent Than Ever
The COVID-19 pandemic has increased the importance of cybersecurity, with 3 out of 4 business leaders seeing cybersecurity as a top priority in COVID recovery. The speed and size of change to a remote workforce has uncovered some gaps in the cybersecurity of many organizations. Data shows that business leaders are aware of these gaps and cybersecurity spending is expected to increase to address them.
Through the end of July, CrowdStrike observed an increase in eCrime activity up over 330% since the start of the year versus in 2019. In its Q2 earnings call, CrowdStrike’s CEO claimed that in the first-half of 2020, the company saw a 154% increase in distinct and sophisticated intrusions and stopped 41,000 potential breaches, which is more than all of last year combined.
This survey from Credit Suisse shows Security Software is the top priority among business leaders surveyed. The 10- percentage point increase from January to July indicates that business leaders are prioritizing security software more than ever in the age of COVID and remote work.
Morgan Stanley recently held a survey on key initiatives in 2020 and found that cybersecurity is the top priority among business leaders. 95% of the leaders surveyed agreed cybersecurity is a priority, with 38% expecting to engage a service provider. These numbers indicate that cybersecurity is the #1 priority for business leaders and that the industry is expected to see more engagement than any other.
CrowdStrike: Product Overview
CrowdStrike was founded with the goal of reinventing security for the cloud era. CrowdStrike’s Falcon platform delivers comprehensive breach protection against today’s most sophisticated attacks on the endpoint, where the most valuable corporate data resides.
The company offers 11 cloud modules on its Falcon platform via a subscription-based model that covers numerous security markets, including endpoint security, security & IT operations (including vulnerability management), and threat intelligence.
CrowdStrike’s AI based security model is focused on collecting large amounts of data, centrally storing it in a single model, and continuously training its algorithms with vast amounts of data. The more data that the Falcon Platform collects, the more intelligent the platform becomes in detecting and stopping breaches.
CrowdStrike: Opportunity
With cybersecurity spending expected to increase at a 10% CAGR over the next 3 years, CrowdStrike is in an ideal position to continue its momentum. Endpoint security is expected to be the 2nd biggest priority among security spending.
Endpoint security is a critical element of a multilayered security strategy, as endpoints are frequently the first point of entry for attackers. Specific to endpoint security software, CrowdStrike’s market share has nearly doubled over the last year. The company has been identified as the fastest growing endpoint security software vendor by IDC Worldwide.
In a recent survey conducted by Morgan Stanley, CrowdStrike is shown to be the top endpoint protection vendor among the business leaders surveyed.
CrowdStrike’s Falcon is armed to fight sophisticated threats and stop breaches through a combination of malware prevention, enterprise detection and response (EDR), and threat hunting. Specific to enterprise detection and response, CrowdStrike has been named 1 of 3 leaders by Forrester research and 1 of 5 by Gartner.
Financials:
CrowdStrike reported excellent Q2 results on September 2nd, comfortably beating revenue estimates with an 84% YoY growth rate. Subscription revenue grew 89% YoY, ARR grew 87%, and the company now boasts a total of 7,230 subscription customers (+91% YoY), 57% of which have greater than 4+ modules.
CrowdStrike has exhibited consistent growth in the number of its customers using 4+ module subscriptions, indicating that existing customers are happy with the platform and continue to spend more to add additional protection.
The company now has 49 of the Fortune 100 companies as customers. Moreover, CrowdStrike took a significant step towards profitability in Q2 with its first quarter of positive operating margin (4%). The company also generated positive free cash flow for the quarter at an impressive 16% FCF margin. This was CrowdStrike’s second consecutive quarter of positive adjusted EPS, and the company is expecting to breakeven for the full year with a $0.05 EPS estimate at the midpoint of their FY21 guidance.
Management raised revenue guidance for Q3 and FY21, calling for 71% YoY growth in Q3 at the midpoint. This outlook bakes in logical conservatism and represents a fairly easy target for CrowdStrike to beat.
CrowdStrike has a history of outperforming estimates, averaging an 8% revenue beat over consensus in the last 4 quarters. In its 6 quarters of public history, CrowdStrike has never missed on revenue or EPS estimates.
Looking ahead to Q3, consensus estimates are calling for 71% YoY growth, exactly in line with the outlook management gave after Q2. CrowdStrike’s history of outperformance will likely continue as the company has posted consistent growth rate percentages of 89-89-85-84 in its last 4 quarters.
Risks:
The biggest risk for CrowdStrike is related to the intense competition they face within the cybersecurity industry. The market for security and IT operations solutions is intensely competitive and characterized by rapid changes in technology, customer requirements, and by frequent launches of new or improved products to combat security threats.
CrowdStrike remains the fastest growing endpoint security platform, but if they are unable to react to new competitive changes, they will see a decline in growth and lose market share. The company must continue to adapt in a highly dynamic industry to sustain its growth levels.
Competitive pricing pressure could end up damaging CrowdStrike’s profit margins and forcing the company to lower its prices to compete.
Many of the company’s competitors, including Microsoft and VMware, have deep pockets and the threat of a price war remains one of the biggest risks to CrowdStrike. Microsoft is a $1.7T company with the assets and resources to challenge CrowdStrike’s margins in the future.
Relative to its total addressable market, CrowdStrike appears pricey. The company is valued at a market cap of $31.3B. The most recent estimate of CrowdStrike’s TAM comes from its S-1, where management estimated a total global opportunity of $29.2B in 2021. However, its fair to assume CrowdStrike’s TAM has grown significantly since that report was released in June of 2019. In that report, management estimated that the global market for endpoint security would reach $8.7B in 2021, but more recent data shows the endpoint security market will be worth $18.4B in 2024.
Conclusion:
CrowdStrike is ideally positioned to continue its strong momentum as the company continues to benefit from increased security spending. Within the realm of increased security spending, endpoint protection has been revealed as the 2nd biggest priority among business leaders, where CrowdStrike is the fastest growing vendor. Nancy Pelosi’s vote of confidence bodes well for the company as we head in to the 2020 election, where CrowdStrike may again play a crucial role. I believe CrowdStrike will grow faster than expectations over the next few quarters as the company achieves FY profitability for the first time in its history.
DISCLOSURE: I am Long CRWD call options expiring June, 2021
This article was originally published on Forbes on Sep 29, 2020,11:17pm EDT
The Economist was correct when it recently stated that Palantir is “more than a technological project, it is a philosophical, even political one.” Palantir has a mythical and esoteric reputation in the Bay Area. The name is well-known and what the company does has circulated for years, which in a nutshell, is data mining for the government — and now, commercial clients.
Until recently, a customer list and any level of transparency has gone against the core purpose of the company. Therefore, I was somewhat surprised at the leak in 2018 that Palantir was considering a public offering as it seemed odd the company would operate openly and transparently. In fact, about five years earlier, the CEO had said an IPO was unlikely as it would make “running a company like ours very difficult.”
Nonetheless, the company is wanting to attract more commercial accounts and going public should help facilitate this. The old adage, “you can’t sell a secret” may be hindering Palantir’s growth especially as artificial intelligence startups raise their first and second rounds. Now is a good time to make sure to penetrate commercial accounts before AI brings more direct competition.
Below, I go over some of the folklore that surrounds Palantir and then I discuss the S-1 filing.
The Folklore around Palantir
Palantir can neither confirm nor deny if the software was used to kill Osama bin Laden, but the CEO required a body guard as of 2013, and it was generally understood for about a decade that Palantir had only one customer: the CIA; and then three customers: the CIA, the FBI and the NSA.
By 2015, a leaked document from TechCrunch dated in 2013 confirmed twelve government agencies were using Palantir, including the “CIA, DHS, NSA, FBI, the CDC, the Marine Corps, the Air Force, Special Operations Command, West Point, the Joint IED-defeat organization and Allies, the Recovery Accountability and Transparency Board and the National Center for Missing and Exploited Children.” Palantir’s leaked document was the first time the CIA and the FBI had databases linked rather than siloed.
Nearly twelve years after Palantir was founded in 2003, that leaked document was the only record that indicated who used the company’s software. Palantir can be a divisive company that draws strong opinions from supporters and critics. Regardless of how you feel about the work Palantir does, one thing is for certain: when the stock trades on the public market, the company will dominate headlines.
Often those headlines will get it wrong in an attempt to frame Palantir in various lights. For instance, I don’t think anyone in Silicon Valley batted an eye at Alex Karp’s letter when the company exited for Denver. He stated that engineers “may know more than most about building software but they do not know more about how society should be organized or what justice requires. Our company was founded in Silicon Valley. But we seem to share fewer and fewer of the technology sector’s values and commitments.”
These sensational headlines and CEO-centric storylines can be a bit distracting. When looking at things rationally, it’s probably better that Palantir be in Denver as government is a major industry in Colorado and being centered in the country will position Palantir closer to Washington D.C. Palantir’s investors are not traditional Silicon Valley VC-firms, either. The company was likely in SF/SV to attract top talent. There is also the theory that it was Silicon Valley that turned cold towards Palantir, as voiced by a privacy and technology advocate Harrison Rudolph.
In-Q-Tel, one of the venture firms that invested in Palantir, is located in Virginia and is funded by the CIA. This group has funded many projects, including Google Maps, Gitlab, Pure Storage, MongoDB, Cloudera and FireEye – but Palantir is on a different level as the CIA was the primary customer for many years. For these other companies, the CIA was not a primary customer. In-Q-Tel does not typically disclose funding rounds, amounts or dates. However, according to CNBC, Palantir received a $2 million funding round in 2004. Other investors include Peter Thiel, Stanley Druckenmiller and Tiger Global.
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On the positive side of things, Palantir is believed to have helped with counter-terrorism, human trafficking and disaster response. On the more questionable side, the company has admitted to helping ICE deport immigrants. The company embodies taking the good with the bad. A former Marine, Samuel Reading, was quoted saying “it’s the combination of every analytical tool you could ever dream of. You will know every single bad guy in your area.” That, of course, implies having to know every good guy in the area too.
In the past, the Board has included Condoleeza Rice and former CIA director George Tenet, who said “I wish we had a tool of its power” before 9/11. The software was also allegedly used to convict Bernie Madoff.
Just when you think Palantir couldn’t be steeped in any more controversy — there’s more. In 2016, the company sued the United States Army for unlawful procurement solicitation for the Army’s internal intelligence software suite. Palantir argued the Army should be stopped from developing a risk-prone software project that would cost more than using Palantir’s software. In the end, Palantir won and the Army signed a $800 million contract over the course of 10 years.
So, why is Palantir going public now? Well, for one, it will be easier to gain corporate clients if the company becomes a stock market darling. The stock market is becoming a phenomenal source of free press and Wall Street will glamorize the company if it produces solid returns. This, in turn, will help Palantir attract more commercial customers and perhaps bury any ethical opposition.
The markets came close to burying the ethical issues around Uber. Perhaps this time it will succeed with Palantir. I also personally believe Palantir’s wide lead and lack of direct competitors (moat) will erode with artificial intelligence and machine learning. Time is of the essence to go public as AI startups need another few years before they can compete on this level.
Palantir’s Product:
Founded in 2003, Palantir is described as a company specializing in big data analytics. Palantir’s specific expertise in government intelligence and its existing ties to national security and the intelligence community differentiate its offering from competition.
Palantir will say the company does not provide the raw data, rather discovers patterns in large data sets. Investigative reporters have asserted the company helps some agencies use mass surveillance systems, and therefore, this line is blurred. Those are two of many opposing facts about this company.
The company has two platforms: Gotham and Foundry. These platforms allow organizations to combine core data with critical tools into a single platform to help users obtain actionable insights from a unified data asset. What Palantir tackles is the issue of data being siloed and ineffective for problem solving. These problems may relate to manufacturing, product development or customer experience.
The data Palantir gets is from the customer themselves and their existing databases although Palantir can crawl and scrape data that is freely available. For instance, Palantir can easily scrape public social media profiles but probably does not have access to private profiles except when the FBI issues government requests to Facebook.
The traditional deployment involves hosting Palantir servers in a customer’s data center. There is a cloud-based offering, as well, so the company can work across a range of hosting environments.
The company differs from a business intelligence solution like Tableau, Alteryx or Cloudera by answering questions that a model cannot answer. An example might be “how do we service car loans to people least likely to default” or “how do we catch fraud before it happens.” With traditional BI, it’s assumed you have the complete data set. Palantir tackles situations where a company may not have the complete data set. This is a crucial difference.
Palantir Gotham was the company’s first platform, built for government operatives in defense and intelligence sectors. The platform enables users to identify patterns hidden deep within datasets using semantic, temporal, geospatial and full-text analysis.
Here are some ways the platform is used:
Graph: This application allows data objects to be seen as nodes and edges. Users can visualize events, filter objects and plot characteristics in a logical manner.
SOURCE: PALANTIR.COM
Map: This brings geospatial capabilities to track geo-located objects and events and to create heatmaps for the density of the objects.
SOURCE: PALANTIR.COM
Object Explorer: This feature is powered by the Horizon in-memory database, which competes with Apache Spark by letting users query billions of objects. The database provides further analysis for Map and Graph data.
SOURCE: PALANTIR.COM
Browser: This enables search queries for investigations and surfaces information, runs relevant searches, displays key data points and answers analytical questions.
SOURCE: PALANTIR.COM
Palantir Foundry is the commercial offering and has four layers of tooling: Foundry Core, Data Foundation, Ontology and Workflows.
This four-step process does the following:
brings volumes of data into one place,
transforms the data into a format that analysts can work with and enables validation in any number of programming languages
the “ontology layer” allows datasets to be turned into real-world concepts with the ability to accelerate on the company’s core ontology to reduce redundancy
workflows is where it all comes together in an integrated environment for object exploration, point-and-click top down analysis, code authoring, time series analysis, data science and application development. When a user has a question, it answers it using all layers and tools available.
Palantir describes Gotham and Foundry as the “ability to construct a model of the real world from countless data points.” Unlike a SQL database, natural language is used to query data and return results in real-time rather than through strings.
The truest, closest competitor for Palantir is Semantic AI, which supplies graph-based analytical platforms to the DoD and other government agencies. As stated, I think Palantir’s real competition is being developed as we speak as machines will answer questions from incomplete data sets once the AI/ML market is built out.
Some real-world uses for Palantir include Hershey’s using the software for global food distribution and to correlate weather patterns with snack consumption. Chase Bank and other financial firms have used Palantir’s data analysis to identify troubled properties and ensure employees are not committing fraud (the employee monitoring took a nosedive — more on this below). Pharmaceutical companies use Palantir to expedite the development of new drugs – this being a substantial use case this year and perhaps why Palantir’s revenue has accelerated.
Palantir’s Financials
The company grew revenue 25% year-over-year to $742 million in 2019. This accelerated to 49% year-over-year to $481 million for the six months ending June 30th. According to a Reuters article in June, the company is expecting $1.5 billion in 2021, which looks easily achievable. The company’s annual run rate based on the current quarter is about $1 billion.
Net losses for 2019 of $579 million were flat year-over-year compared to net losses in 2018 of $580 million. On an adjusted basis, net losses in 2019 were $337 million. The losses are shrinking with H1 2020 reporting a loss of $164.7 million compared to $280.5 million in the year-ago period.
On an adjusted basis, the company was profitable in the first six months of this year at $17.2 million compared to a loss of $167.6 million in H1 2019. This improvement in operating results was driven by increasing revenue and reducing the number of engineers needed to install and deploy software programs.
Gross margins for H1 2020 are at 73% and the company spent only 42% of revenue on sales and marketing.
The company has cash of $1.5 billion and debt of $297.6 million as of June 30th.
Contribution margin is a Non-GAAP key metric that represents the revenue the company generates relative to the costs incurred. It strips out variable costs related to deploying and operating the software and identifying new customers.
You can think of it as falling somewhere between gross margins and operating margins. For comparison purposes, Palantir’s gross margins are at 72.3%for the six-month ending June 30 and the company has negative operating margins of -48.5% and negative net margins of -78%.
Source: S1 Filing
The company states the addressable market is $119 billion across commercial and government sectors. The TAM in the government sector is $63 billion and the TAM in the commercial sector is $56 billion. Within the government TAM, domestic is $26 billion and international is $37 billion.
The commercial sector is the growth story. For example, Skywise is a solution that connects in-flight, engineering, and operations data to break down siloed systems around maintenance, flight management and aircraft monitoring and safety. Palantir is partnered with Airbus who offers this solution as “the leading data platform for the aviation industry.”
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This example can extend to many industries, such as pharma for drug development data to better understand population dynamics and drug outcomes. This is for the pre-clinical and clinical stages, mapping treatment pathways, and automating reporting. Manufacturing can benefit from Palantir Foundry by managing inventory, saving on distribution costs and prevent delays while increasing sales.
There are also solutions for financial compliance, insurance, automotive and sales.
Valuation:
Palantir is doing a direct public offering (DPO), which means there will be no new shares offered and no underwriters. The goal of a direct listing is not to raise money rather to allow existing investors to sell their shares. However, unlike Spotify and Slack who did DPOs, Palantir will have a lock-up period. I find a lock-up period to be more favorable for retailers as Spotify took nearly two years to break out from its opening DPO price and Slack is taking more than a year to break out beyond its opening price.
The company’s founders, Peter Thiel, Alex Karp and Stephen Cohen, own 30.2% of the company’s stock. Peter Thiel owns additional stock through various investment management funds that own stock, such as Founders Fund. Thiel has 28.4% corporate voting power, Karp has 8.9% and Cohen 3.1%.
There will be three classes of stock: Class A, Class B and Class F common stock – which is unusual to have three tiers. Class A will allow for one vote, Class B will allow for 10 votes and Class F will share 49.99% of the voting power for Palantir. Class F is for the founders who will retain just under 50% of the voting rights at all times. This is reminiscent of Facebook where insiders control about 70% and Zuckerberg controls 58%.
The reference price for Palantir’s direct listing is $7.25 per share, which would value the company at $15.7B. This is lower than the expected price range we saw throughout the month. Palantir was initially thought to open in a range of $10-$14, which would have given the company a $26B market cap at the midpoint. Palantir received a private valuation of $20.4B in 2015.
At the reference price, Palantir would trade somewhere between 10.5x-15.7x FY 2020 revenue depending on the estimate. At a reasonable $1.25B FY revenue estimate, Palantir would be valued at 12.6x 2020 sales. With a more generous estimate of $1.5B in 2020 revenue, Palantir would trade at 10.5x sales.
BETH.TECHNOLOGY
The reference price does not mean Palantir shares will open at this price on Wednesday. If Palantir follows the trend of recent tech IPOs, it will open trading well above its offering price. For comparison, Snowflake (SNOW) opened 105% above its offering price, JFrog (JFROG) 62%, Sumo Logic (SUMO) 21%, and Unity (U) 44%. A $25B valuation would be roughly 59% above Palantir’s reference price, a number that is in line with this trend.
Looking at the current IPO market, it’s very likely that Palantir will open above its reference price, but still well below the valuations we have seen in some recent IPOs. A few recent IPOs have traded at historically high valuations. Zoom Video, Agora, Datadog and Lemonade have all hit the 50 EV/Revenues level. More recently, Snowflake opened above 100x EV/Forward Revenue and JFrog above 40x. Early indications show that Palantir will open at a more reasonable valuation.
Below, I review the risks that may be contributing to this lower valuation.
Risks
Palantir’s biggest risk is customer concentration with the top 20 customers accounting for 67% of revenue and the dependence on government contracts at 54% of revenue. The Army’s attempt to develop a more expensive in-house solution illustrates there is a risk that government agencies eventually move away from Palantir in the future.
Reputation and social acceptance is also a risk. Tech companies often see employees engage in protests when a company contracts with the government on AI-driven war missions and privacy issues that potentially threaten human rights. Palantir’s biggest obstacle today is the work it does with ICE which pits the company’s internal employees against the CEO on social issues.
For instance, this week, Hootsuite stated the company would terminate its ICE contract due to disagreements within the company. The CEO tweeted: “We typically do not make public facing statements about specific customers or contracts. However, due to the attention around this particular case we can confirm that Hootsuite has decided not to do business with the U.S. Immigration and Customs Enforcement.”
In the past, Google ended a contract with the Pentagon when employees protested using AI for lethal purposes. Karp became controversial and challenged Google on this decision, saying it was a “loser” position.
This can backfire as Palantir may not be able to attract top talent as AI companies begin to compete from a small pool of AI developers and engineers who have proven to protest and walk-out of company projects they feel are unethical. Amazon, also, banned facial recognition for law enforcement for one year following the George Floyd protests. Therefore, Karp’s personality could be considered a risk as the tech world begins to explore and support ethical AI development.
Despite government-backing, Palantir’s products are certainly not bulletproof. The company attempted to launch a platform called Metropolis to help hedge funds with trading and to spot patterns in the markets, among other things. Metropolis, formerly known as Palantir Financial, did not succeed as hedge funds already possessed AI tools that were cheaper and the project was shut down. According to a lengthy response by Joe Lonsdale, Co-Founder of Palantir, the issue was that funds would not pay as much for the platform as other customers and the company may have been charging too much to go to mass market.
Chase Bank used the platform to monitor its 250,000 employees for fraud by mining trading data, emails and phone calls, yet this backfired when it was found out the platform had been used as surveillance for top executives. The information gathered from surveilling the executives led to a press leak (taste of own medicine, perhaps?).
There are also rumors that the CIA has been cold towards the company since the CEO chose to be more in the public eye, especially around Osama bin Laden’s death. Palantir began linking to articles asserted their software was responsible for bin Laden.
Conclusion:
To conclude, Palantir must be sensitive enough to win over commercial clients and top talent yet must not lose government contracts from being too overt. This IPO carries a great deal of speculation as there is no reason the company should not have stronger revenue growth and profits from the guaranteed government contracts. As of now, Palantir does not have product-market fit as it’s specialized and hard to scale (proven by its financials). We’ve also seen some issues with scale due to the pricing of the product, as noted by the Metropolis platform.
If you choose to be an investor, you’ll also have to get comfortable with ethical controversy as Amnesty International has now slammed Palantir’s human rights record on the eve of the IPO. Like Uber, the company is clouded by serious ethical issues. Wall Street may not care but internal employees and customers of Palantir could very well care. On that note, keep an eye out for “ethical AI” competitors in future years.
Similar to Snowflake, the headlines and FOMO can pump this company for a while, but bi-annually —- or even more often, rotations happen in tech growth. I’ve found price-to-sales revert to the mean during these rotations.
Palantir’s most promising aspect, in my opinion, is the acceleration in revenue that perhaps came from coronavirus-related research. This is something to monitor in future quarters.
The Economist was correct when it recently stated that Palantir is “more than a technological project, it is a philosophical, even political one.” Palantir has a mythical and esoteric reputation in the Bay Area. The name is well-known and what the company does has circulated for years, which in a nutshell, is data mining for the government.
But until now, a customer list and any level of transparency has gone against the core purpose of the company. Therefore, I was somewhat surprised at the leak in 2018 that Palantir was considering a public offering as it seemed odd the company would operate openly and transparently. In fact, about five years earlier, the CEO had said an IPO was unlikely as it would make “running a company like ours very difficult.”
Nonetheless, the company is wanting to attract more commercial accounts and going public should help facilitate this. The old adage, “you can’t sell a secret” may be hindering Palantir’s growth especially as artificial intelligence startups raise their first and second rounds. Now is a good time to make sure to penetrate commercial accounts before AI bring more direct competition.
Below, I go over some of the folklore that surrounds Palantir and then I discuss S-1 filing. We aren’t dealing with a company where one has to wonder if the company or product will be popular on the public markets. Rather, we need to drill down into valuation and decide how much we are willing to pay.
The Folklore
Palantir can neither confirm nor deny if the software was used to kill Osama bin Laden, but the CEO required a body guard as of 2013, and it was generally understood for about a decade that Palantir had only one customer: the CIA. The company then grew to have three customers: the CIA, the FBI and the NSA.
By 2015, a leaked document from TechCrunch dated in 2013 confirmed twelve government agencies were using Palantir, including the “CIA, DHS, NSA, FBI, the CDC, the Marine Corps, the Air Force, Special Operations Command, West Point, the Joint IED-defeat organization and Allies, the Recovery Accountability and Transparency Board and the National Center for Missing and Exploited Children.” Palantir’s leaked document was the first time the CIA and the FBI had databases linked rather than siloed.
Nearly twelve years after Palantir was founded in 2003, that leaked document was the only record that indicated who used the company’s software. Palantir can be a divisive company that draws strong opinions from supporters and critics. Regardless of how you feel about the work Palantir does, one thing is for certain: as the IPO approaches, the company will dominate headlines.
Often those headlines will get it wrong in an attempt to frame Palantir in various lights. For instance, I don’t think anyone in Silicon Valley batted an eye at Alex Karp’s letter when the company exited for Denver. He stated that engineers “may know more than most about building software but they do not know more about how society should be organized or what justice requires. Our company was founded in Silicon Valley. But we seem to share fewer and fewer of the technology sector’s values and commitments.” These sensational headlines and CEO-centric storylines are distracting (i.e. who, then, does know how society should be organized and what justice requires? This is fairly presumptive and one of the many dramatic sentences from the filing).
When looking at things rationally, it’s probably better that Palantir be in Denver as government is a major industry in Colorado and being centered in the country will position the Palantir closer to Washington D.C. Palantir’s investors are not traditional Silicon Valley VC-firms, either. The company was likely there to attract top talent.
Palantir’s venture firm, In-Q-Tel, is located in Virginia and is funded by the CIA. This group has funded many projects, including Google Maps, Gitlab, Pure Storage, MongoDB, Cloudera and FireEye – but Palantir is on a different level as the CIA was the primary customer for many years. For these other companies, the CIA was not a primary customer. In-Q-Tel does not typically disclose funding rounds, amounts or dates. However, according to CNBC, Palantir received a $2 million funding round in 2004. Other investors include Peter Thiel, Stanley Druckenmiller and Tiger Global.
On the positive side of things, Palantir is believed to have helped with counter-terrorism, human trafficking and disaster response. On the more questionable side, the company has helped to deport immigrants and allegedly track law-abiding United States citizens without consent (i.e. spy software).
The company embodies “taking the good with the bad.” A former Marine, Samuel Reading, was quoted saying “it’s the combination of every analytical tool you could ever dream of. You will know every single bad guy in your area.” That, of course, implies having to know every good guy in the area too.
In the past, the Board has included Condoleeza Rice and former CIA director George Tenet, who said “I wish we had a tool of its power” before 9/11. The software was also allegedly used to convict Bernie Madoff.
Just when you think Palantir couldn’t be steeped in any more controversy — there’s more. In 2016, the company sued the United States Army for unlawful procurement solicitation for the Army’s internal intelligence software suite. Palantir argued the Army should be stopped from developing a risk-prone software project that would cost more than using Palantir’s software. In the end, Palantir won and the Army signed a $800 million contract over the course of 10 years.
So, why is Palantir going public now? Well, for one, it will be easier to gain corporate clients when (not if) the company becomes a stock market darling. The stock market is becoming a phenomenal source of free press and Wall Street will glamorize the company if it produces solid returns. This, in turn, will help Palantir attract more commercial customers and perhaps bury any ethical opposition.
The markets came close to burying the ethical issues around Uber. Perhaps this time it will succeed with Palantir. I also personally believe Palantir’s wide lead and lack of direct competitors (moat) will erode with artificial intelligence and machine learning. Time is of the essence to go public as AI startups need another few years before they can compete on this level.
Product:
Founded in 2003, Palantir is described as a company specializing in big data analytics. Palantir’s specific expertise in government intelligence and its existing ties to national security and the intelligence community differentiate its offering from competition.
The company has two platforms: Gotham and Foundry. These platforms allow organizations to combine core data with critical tools into a single platform to help users obtain actionable insights from a unified data asset. What Palantir tackles is the issue of data being siloed and ineffective for problem solving. These problems may relate to manufacturing, product development or customer experience.
The data Palantir gets is from the customer themselves and their existing databases although Palantir can crawl and scrape data that is freely available. For instance, Palantir can easily scrape public social media profiles but probably does not have access to private profiles except when the FBI issues government requests to Facebook.
The traditional deployment involves hosting Palantir servers in a customer’s data center. There is a cloud-based offering, as well, so the company can work across a range of hosting environments.
The company differs from a business intelligence solution like Tableau, Alteryx or Cloudera by answering questions that a model cannot answer. An example might be “how do we service car loans to people least likely to default” or “how do we catch fraud before it happens.” With traditional BI, it’s assumed you have the complete data set. Palantir tackles situations where a company may not have the complete data set. This is a crucial difference.
Palantir Gotham was the company’s first platform, built for government operatives in defense and intelligence sectors. The platform enables users to identify patterns hidden deep within datasets using semantic, temporal, geospatial and full-text analysis. Here are some ways the platform is used:
Graph: This application allows data objects to be seen as nodes and edges. Users can visualize events, filter objects and plot characteristics in a logical manner.
Object Explorer: This feature is powered by the Horizon in-memory database, which competes with Apache Spark by letting users query billions of objects. The database provides further analysis for Map and Graph data.
Browser: This enables search queries for investigations and surfaces information, runs relevant searches, displays key data points and answers analytical questions.
Palantir Foundry is the commercial offering and has four layers of tooling: Foundry Core, Data Foundation, Ontology and Workflows. This four-step process does the following:
brings volumes of data into one place,
transforms the data into a format that analysts can work with and enables validation in any number of programming languages
the “ontology layer” allows datasets to be turned into real-world concepts with the ability to accelerate on the company’s core ontology to reduce redundancy
workflows is where it all comes together in an integrated environment for object exploration, point-and-click top down analysis, code authoring, time series analysis, data science and application development. When a user has a question, it answers it using all layers and tools available.
Palantir describes Gotham and Foundry as the “ability to construct a model of the real world from countless data points.” Unlike a SQL database, natural language is used to query data and return results in real-time rather than through strings. To some extent, Palantir resembles Elasticsearch in its ability to use a search stack to answer complex questions. For instance, Elastic is used to pair a passenger with an Uber driver or to process billions of log events from Sprint for outages or Fitbit to validate failures and for data discovery. Kibana can be used with Elastic to visualize the data. Another company where Palantir could potentially share the customer pool is Splunk or perhaps Sumo Logic. It’s not clear though if Palantir is price competitive with these other tools to be used in their place for analysis or if Palantir’s offerings are overkill for the analysis most companies require (to justify a higher price).
The truest, closest competitor for Palantir is Semantic AI, which supplies graph-based analytical platforms to the DoD and other government agencies. As stated, I think Palantir’s real competition is being developed as we speak as it will machines will answer questions from incomplete data sets once the AI/ML market is built out.
Some real-world uses for Palantir include Hershey’s using the software for global food distribution and to correlate weather patterns with snack consumption. Chase Bank and other financial firms use Palantir’s data analysis to catch fraud. Pharmaceutical companies to expedite the development of new drugs – this being a substantial use case this year and perhaps why Palantir’s revenue has accelerated.
Financials
The company grew revenue 25% year-over-year to $742 million in 2019. This accelerated to 49% year-over-year to $481 million for the six months ending June 30th. According to a Reuters article in June, the company is expecting $1.5 billion in 2021, which looks easily achievable. The company’s annual run rate based on the current quarter is about $1 billion.
Bloomberg reported from an unidentified source that Palantir’s revenue in the second half of the year is often larger during the fourth quarter due to government contracts being finalized. According to the article, Palantir books roughly 60% of revenue during the fourth quarter. For valuation purposes, we will run three instances between $1 billion and $1.5 billion. The higher number assumes Q4 is strong and the revenue acceleration we are currently seeing will continue. To simplify things, we will offer a scenario with $1.25 billion in revenue (see below).
Net losses for 2019 of $579 million were flat year-over-year compared to net losses in 2018 of $580 million. On an adjusted basis, net losses in 2019 were $337 million. The losses are shrinking with H1 2020 reporting a loss of $164.7 million compared to $280.5 million in the year-ago period.
On an adjusted basis, the company was profitable in the first six months of this year at $17.2 million compared to a loss of $167.6 million in H1 2019. This improvement in operating results was driven by increasing revenue and reducing the number of engineers needed to install and deploy software programs.
Gross margins for H1 2020 are at 73% and the company spent only 42% of revenue on sales and marketing.
The company has cash of $1.5 billion and debt of $297.6 million as of June 30th.
Contribution margin is a Non-GAAP key metric that represents the revenue the company generates relative to the costs incurred. It strips out variable costs related to deploying and operating the software and identifying new customers.
You can think of it as falling somewhere between gross margins and operating margins. For comparison purposes, Palantir’s gross margins are at 72.3%for the six-month ending June 30 and the company has negative operating margins of -48.5% and negative net margins of -78%.
The company states the addressable market is $119 billion across commercial and government sectors. The TAM in the government sector is $63 billion and the TAM in the commercial sector is $56 billion. Within the government TAM, domestic is $26 billion and international is $37 billion.
The commercial sector is the growth story. For example, Skywise is a solution that connects in-flight, engineering, and operations data to break down siloed systems around maintenance, flight management and aircraft monitoring and safety. Palantir is partnered with Airbus who offers this solution as “the leading data platform for the aviation industry.”
This example can extend to many industries, such as pharma for drug development data to better understand population dynamics and drug outcomes. This is for the pre-clinical and clinical stages, mapping treatment pathways, and automating reporting. Manufacturing can benefit from Palantir Foundry by managing inventory, saving on distribution costs and prevent delays while increasing sales.
There are also solutions for financial compliance, insurance, automotive and sales.
Valuation
Palantir is doing a direct public offering (DPO), which means there will be no new shares offered and no underwriters. The goal of a direct listing is not to raise money rather to allow existing investors to sell their shares. However, unlike Spotify and Slack who did DPOs, Palantir will have a lock-up period. I find a lock-up period to be more favorable for retailers Spotify took nearly two years to break out from its opening DPO price and Slack is taking about a year to break out beyond its opening price.
The company’s founders, Peter Thiel, Alex Karp and Stephen Cohen, own 30.2% of the company’s stock. Peter Thiel owns additional stock through various investment management funds that own stock, such as Founders Fund. Thiel has 28.4% corporate voting power, Karp has 8.9% and Cohen 3.1%.
There will be three classes of stock: Class A, Class B and Class F common stock – which is unusual to have three tiers. Class A will allow for one vote, Class B will allow for 10 votes and Class F will share 49.99% of the voting power for Palantir. Class F is for the founders who will retain just under 50% of the voting rights at all times. This is reminiscent of Facebook where insiders control about 70% and Zuckerberg controls 58%.
Palantir’s last valuation at $20 billion from 2015 is outdated as is the $26 billion valuation from last year. There were rumors in 2018 that Palantir was privately valued at $41 billion and this is probably closer to where it will trade on the public markets.
If we give Palantir a generous $1.5 billion in forward revenue, it’ll be trading at 20 price-to-sales at a $30 billion valuation and 27.3 price-to-sales at the $41 billion valuation. At the more reasonable $1.25 billion in current revenue, Palantir will be trading at 24 price-to-sales at the $30 billion and 32.8 price-to-sales at the $41 billion.
We can see below that trading higher than 32 forward EV/Revenues is very rare with most trading between 16 and 24.
However, IPOs have a way of pushing emotional buttons and there have been a few recent IPOs that have traded at exorbitant valuations. Zoom Video, Agora, Datadog and Lemonade have all hit the 50 EV/Revenues level.
Palantir is not profitable like Zoom Video and Datadog were at their IPOs. In fact, it’s a bit strange that Palantir has the losses it does with its vintage and guaranteed government contracts. I prefer to not pay over 40 P/S for any IPO as all of them have eventually settled under this number. I’m evaluating Snowflake next, which is a company I would value higher than Palantir due to fewer risks.
Point being, I’m a buyer in the $35 billion to $40 billion valuation on Palantir and then will respectfully wait on the sidelines. Beyond this valuation and I prefer to put my money to work elsewhere.
Risks
Palantir’s biggest risk is customer concentration with the top 20 customers accounting for 67% of revenue and the dependence on government contracts at 54% of revenue. The Army attempting to develop a more expensive in-house solution illustrates there is a risk that government agencies eventually move away from Palantir in the future.
Reputation and social acceptance is also a risk. Tech companies often see employees engage in protests when a company contracts with the government on AI-driven war missions and privacy issues that potentially threaten human rights. Palantir’s biggest obstacle today is the work it does with ICE which pits the company’s internal employees against the CEO on social issues.
For instance, Google ended a contract with the Pentagon when employees protested using AI for lethal purposes. Karp became controversial and challenged Google on this decision, saying it was a “loser” position. This can backfire as Palantir may not be able to attract top talent as AI companies begin to compete from a small pool of AI developers and engineers who have proven to protest and walk-out of company projects they feel are unethical. Amazon, also, banned facial recognition for law enforcement for one year following the George Floyd protests. Therefore, Karp’s personality could be considered a risk as the tech world begins to explore and support ethical AI development.
Despite government-backing, Palantir’s products are certainly not bulletproof. The company attempted to launch a platform called Metropolis to help hedge funds with trading, among other things. This platform did not succeed as hedge funds already possessed AI tools that were more of a complete package and the project was shut down. There are also rumors that the CIA has been cold towards the company since the CEO chose to be more in the public eye, especially around Osama bin Laden’s death. Palantir began linking to articles asserted their software was responsible for bin Laden.
To conclude, Palantir must be sensitive enough to win over commercial clients and top talent yet must not lose government contracts from being too overt. For valuation, I’ll cap it at $35 to $40 billion max.
Like many traditional hardware companies, F5 Networks is shifting from a hardware model to a software-driven business to accommodate an increasingly cloud-driven world. The effects of the shift to cloud services are not fully reflected yet in the company’s revenue growth, which was at 7% YoY in the most recent quarter. The company has been basically range bound with revenue growth around 5% since 2016.
F5’s cloud services are distinguished from running apps on virtual machines in a single cloud from being able to run distributed, container-based microservices across multiple clouds. The services have the added benefit of security, such as advanced web application firewalls. This is important because up to 40% of internet traffic comes from botnets with 20% being bad bots.
The three main products which work to consolidate networking tasks and deploy apps faster., are BIG-IP, the NGINX Controller and a new SaaS offering called Beacon. These three products tie together traffic management, API management, app security and end-to-end app visibility and analytics.
There are a few trends that help to support F5’s future revenue growth. Primarily, the shift away from monolithic architectures and towards microservices architectures (and the popularity of containers orchestrated by Kubernetes). Also, the complexity of multi-cloud and hybrid cloud environments.
However, it is the 5G catalyst that I am most interested in and the reason I am covering the company.
F5 Product Summary:
F5 Networks is well known for its hardware-based Application Delivery Controller (ADC) product offerings. The company recognized a need to move to cloud based workloads due to the decline in ADC hardware and the shift to software-based solutions.
As the number of applications grow, the complexity increases. Companies must deploy, manage and secure applications across private data centers, private clouds, public cloud, microservices environments and multi-cloud environments. This complexity is how F5 hopes to gain and defend its market share.
The customer base for F5 are companies that need to scale and deploy applications very quickly. Essentially, developers write the code for the applications (i.e. the business logic, backend components, and user interfaces). F5 helps to deliver the application to the device, machine and browser.
The company acquired NGINX for $670 million in May 2019. This helped the company to expand to new addressable market opportunities including web servers, application servers, and API gateways. The company is seeing promising early wins for NGINX Controller 3.0. It is also seeing real traction with the F5 and NGINX combination.
Another major recent acquisition was Shape security for $1 billion which helped the company to target the application security market. Shape is a leader in anti-fraud and abuse protection. The company’s existing Canadian banking customer is a BIG-IP customer and experienced an account takeover attack on their web application. With Shape in full mitigation mode, it was able to block a major attack.
Load Balancing
F5’s two products are the F5 BIG-IP Local Traffic Manager and the F5BIG-IP DNS. The local traffic manager balances loads across servers in a single data center. The DNS uses topology-based load balancing to determine the closest data center.
Load balancing refers to distributing requests across web servers to avoid overloading any one server. Load balancing distributes the requests based on the actual load at each server to ensure availability and helps with denial of service attacks.
Microservices
Microservices is a newer architectural framework designed so that changes won’t break the entire app. The core functions of a microservices framework can be deployed independently, meaning individual services can function without affecting the others. This is opposed to a monolithic approach where the source code is built into a single deployment. With a monolithic/single deployment, there is a lot of downtime as any update requires the entire app to be taken offline.
Microservices closely resembles service-oriented architecture (SOA). In this architecture, individual services communicate through the enterprise service bus (ESB). This allows for iteration and deployment without monolithic development cycles but it also creates a single point of failure (the ESB).
Containerized microservices allow applications to be run independently on the same hardware with much greater control. This is the foundation for cloud-native applications.
NGINX:
The main benefits to NGINX is the software approach to application delivery and API management, as well as the brand name in open source and DevOps. The acquisition creates end-to-end application infrastructure and allows F5 to transform into a more software and multi-cloud approach. The acquisition also helps to combine security technologies with web servers and load balancers.
The goal of F5 and NGINX is to combine the application teams, developer teams and operations under one umbrella to include AppDev, DevOps, NetOps and SecOps.
NGINX’s main competitor is Apache. F5 Networks is popular with the Fortune 500 and NGINX is popular with developers/open source community. More than 400 million sites use NGINX and NGINX Plus, including Netflix, Dropbox and Zynga. In 2019, it was reported that NGINX was closing the gap with Apache and Microsoft in webfacing computer market share to about 30% of the market.
This also provides F5 with inroads into servicing Kubernetes nodes. Kubernetes is a leading container platform that was designed by Google and is now used everywhere. Kubernetes has exploded in popularity with 78% of developers using it for cloud native projects. This is a tailwind for F5 (although not a major catalyst as NGINX is free, open source software).
The most recent product announced from the acquisition is the NGINX Controller 3.0 which helps development teams deploy applications in multi-cloud and hybrid cloud environments. In the recent quarter, F5 secured a leading oil and gas company in the Middle East from the new acquisition. The oil and gas company had both security and API management challenges, it opted to deploy NGINX for API management and F5’s advanced web application firewall for API security.
Shape Security:
Shape Security protects against automated attacks, botnets and targeted fraud. The company mitigates more than 1 billion attacks daily and is deployed on more than 200 million mobile devices worldwide. The company is used by eight of the top twelve U.S. banks. The company separates good traffic from bad traffic. Shape Security will augment F5’s application infrastructures.
According to F5, the acquisition will boost its software revenue growth from 35-to-40 percent to 60-to-70 percent next year. It expects to achieve breakeven non-GAAP EPS within 24 months of closing the acquisition.
5G: Network Slicing, Gi-LAN Consolidation and Edge Computing:
F5 Networks is positioned to help 5G infrastructure scale. The new 5G architecture will have the ability to “slice” the network into different segments from the radio network (RAN) to the core in order to help allocate resources according to various use cases and traffic spikes. The existing 4G core networks do not have networking slicing built into the system. F5 Networks can provide the existing 4G systems with GTP session directors and DNS session directors.
In addition to network slicing on existing 4G systems, F5 Networks can also improve the monolithic architecture of the Gi-LAN Networks, which are independent network functions on dedicated devices from a wide range of vendors. Latency increases with each hop in the chain the data packet has to traverse. The monolithic architectures — with individual service functions on different hardware — can have a major impact on latency. The monitoring of the system is challenging and security is also an issue.
The solution is to consolidate Gi-LAN into one instance/appliance to reduce the latency and simplify the network design. F5 Networks offers a Gi-LAN consolidation solution that includes TCP/IP optimization, firewalls, traffic steering, deep packet inspection, URL filtering and DNS security. Most importantly, F5’s solutions are available in both physical and network function virtualization (NFV) environments. The company’s in-house load balancing is also important to scale and eliminate redundancy.
F5 also facilitates edge computing with virtual edition software for load balancing, web application firewalls, service discovery and monitoring. The company is also well positioned for providing application delivery control and security services for microservices architectures within containerized infrastructures (i.e. Kubernetes).
5G Case Study: Rakuten Mobile
The case study with Rakuten Mobile is especially interesting as a model for how important F5 Networks could become in the near future as telcos can reduce capex and physical infrastructure needs with cloud networks and network functions virtualization capabilities (NFV).
Rakuten is Japan’s biggest mobile virtual network operator (MVNO). In early 2019, the company announced plans to build a network in 12 months without significant capex. The reduced capex is made possible through a cloudnative network. The goal is to shift towards Network Functions Virtualization (NFV) technology, which uses the principles of cloud computing to create service delivery platforms “with greater agility and customization.”
The end result is a Radio Access that is virtualized and running as a virtual network function on a private cloud. You can read more here and the press release regarding Rakuten’s partnership with F5 here.
Financials
F5 Networks reported fiscal Q2 2020 earnings at the end of April. Revenue increased 7% year-over-year to $583 million with EPS of $2.23. This beat analyst estimates by $20 million on revenue and $0.24 on EPS.
In the previous quarter, revenue increased 5% to $543 million.
On a non-GAAP basis, product revenue comprised approximately 45% of total revenue and it grew 10% year-overyear to $262 million. Of this, software represented 35% of product revenue and it grew 96% year-over-year. Excluding the partial contribution from Shape, software grew 65% year-over-year. Services revenue grew 5% to $324 million.
Full year revenue grew 4% to $2.2 billion with non-GAAP income of $626 million, or $10.36 per share, up from $612 million in fiscal year 2018.
The company has cash and cash equivalents and short-term investments of $820 million and $182 million in cash flow from operations. Long-term debt at the end of March 31, 2020 was at $380 million. The company repurchased $50 million worth of shares in the most recent quarter.
For the fiscal Q3, the company expects both GAAP and non-GAAP revenue in the range of $555 million to $585 million and non-GAAP diluted earnings per share in the range of $1.91 to $2.13.
The company withdrew the FY 2020 outlook provided in December 2019 when they announced the Shape acquisition. F5’s gross margins are forecast to be around 85% and operating margins to be 30-32% for full year 2020.
Following the Q2 report, F5 attracted some bullish analysts from Piper Sandler and Nomura who believe there is upside due to strong forward guidance and the current results coming from an acceleration of existing trends rather than a pull forward.
Despite these newly bullish analysts, the overall rating is neutral on F5. Notably, Goldman Sachs has a neutral rating due to the earnings stability being offset by the “less certain spending environment.”
F5 is holding up well with the current shift towards work from home. In the most recent earnings report, the company saw an acceleration in purchases of F5 solutions while some purchases were pushed out to future quarters.
Here are some examples from the earnings call on how F5 Networks has been used during the coronavirus:
• F5 enabled one of the largest banking and investment institutions in the United States to scale its VPN access from 400,000 to 500,000 remote users.
• The company helped a multinational mass media conglomerate to increase network capacity within one day, so that 100,000 additional employees could work from home in the U.S. and London.
• A fortune 10 Retail Healthcare Corporation added 160,000 remote workers to its network in under 24 hours.
Addressable Market & Valuation
F5’s biggest risk is the number of competitors relative to addressable market. Often this level of competition leads to pricing wars.
The total addressable market in the application security market has doubled to $8 billion from $4 billion with the Shape Security acquisition, according to F5’s Investor Presentation. Competitors include A10, Akamai, Cisco, Citrix, Imperva, Juniper, Radware, and Symantec.
The ADC market was valued at $2.9 billion in 2016 and will reach $4.2 billion by 2023, which is modest growth of 5%. According to MarketsandMarkets, the Application Security market size is expected to grow from $2.8 billion in 2017 to $9.0 billion by 2022. Competitors here include Citrix Systems, Radware, A10 Networks, AWS, Array Networks, Barracuda, HAPRoxy, Kemp, VMWare and Microsoft Azure.
Application delivery controller revenue declined 4% to 7% in 2018 with F5 owning 47 percent of ADC market share at that time. This prompted the shift towards software.
According to IDC, there were more than 700 million application instances in 2018 and this will grow to 3.7 billion by 2023 for growth of 500%. There were 314 million enterprise applications in 2018 and this is forecast to reach
1.8 billion by 2023.
The company trades at a forward PE ratio of 15 and forward PS ratio of 3.5. This is at the low range for comparable companies.
Conclusion:
There are reasons that F5 has a low valuation comparatively speaking. The company has been hit hard by the transition away from hardware and on-premise. The NGINX acquisition does little for F5’s top line, which has struggled to break out from 5% year-over-year growth. F5 Networks is also a company that has many competitors with a smaller addressable market than what I typically cover.
However, as companies seek to scale application deployment, there are infrastructure-level issues that cloud software companies will struggle to solve. F5’s experience with hardware and a pivot towards software could be a winning combination. This goes beyond end-to-end application infrastructure, where the company already has a solid reputation (i.e. Datadog and IBM’s RedHat both favor F5 as a partner here). F5 is also doing a good job of staying in front of the trends of microservices and the Kubernetes platform.
The more interesting catalyst for is whether F5 can solve major infrastructure and capex issues for telcos. F5’s network functions virtualization (NFV) capabilities can enable a higher throughput, low-latency network and ensure application availability for wireless networks. I believe F5 could be uniquely positioned to solve these issues which should be in high demand as global competition increases for scalable 5G deployment.
Identity and access management (IAM) helps to make sure the appropriate people access the appropriate networks and applications. Features include authentication, authorization, trust and security auditing for both onpremise and cloud-based systems.
Defining and managing roles is needed for both customers and employees. The goal is to have one digital identity per user, and to maintain, modify and monitor this digital identity to allow access to the appropriate assets and in the right context. This may include onboarding or offboarding the user. IAM systems allow for the administration of user access across an enterprise and ensures compliance.
IAM became more complicated once employee’s began to use their own devices and as companies transitioned to the cloud. This is because there was no longer a perimeter. Today there are on-site employees, off-site contractors, hybrid cloud environments, software-as-a-service applications, bring-your-own-device users, UNIX, Windows, Mac, iOS, Android – and soon there will be billions of machine to machine connections (internet of things) communicating through APIs.
IAM is important because these devices, user credentials and access points are where the majority of security breaches occur. According to IBM, 60% of data breaches are caused by an organization’s own employees.
According to Forrester, IAM is broken down into six technologies that have high business value.
• API Security: Allows for easy, single sign-on (SSO) access for B2B ecommerce and API integrations. This is especially useful for IoT, or the internet of things, device authorization as many devices must communicate seamlessly. This is important for machine-to-machine communication.
• Customer identity and access management (CIAM) enables organizations to capture and manage customer identity and profile data. Features include customer registration, self-service account management, access management, and directory services. Customer retention is much higher when there is less sign-on friction and fewer required steps. This is also important for omnichannel sign-in, such as switching from mobile to laptop.
• Identity Analytics (IA): Identity analytics evolved from the use of cloud and allows behavior analytics to identify usage and access patterns in data collected from the IAM. This creates risk profiles for the user behaviors and helps manage risk profiles based on application usage.
• Identity-as-a-Service (IDaaS): This provides single-sign on and identity management as a software service. The benefit is to remove servers, purchase/upgrade/install software, data backups and hosting fees from the provisioning process.
• Identity Management and Governance (IMG): IMG helps to minimize the risk of data breaches and improve end user productivity. Offers control and visibility into inappropriate access or policy violations. Helps to achieve compliance.
• Risk-based authentication (RBA): Allows for a variation of single-sign on and two-factor authentication.
Overview of Okta:
Okta is the preferred name brand in identity access management (IAM). When speaking to security professionals, the company is highly regarded. Okta’s Identity Cloud is an independent and neutral cloud-based identity platform that allows its customers to integrate with any application or scalable platform. One obvious benefit is that Okta does not lock customers into an ecosystem, like Microsoft or Salesforce, hence the word “independent” is frequently used in their marketing materials.
Workforce Identity simplifies the way an organization’s employees, contractors and partners connect to its applications and data from any device. This is the majority of the business.
Customer Identity Cloud enables organizations to transform their own customer’s experience making use of API- level access and seamless customer experiences. There is a large product range including Universal Directory, Single Sign-On, Adaptive Multi-Factor Authentication, Lifecycle Management and API Access Management.
The company recently launched new products, such as Access Gateway or advanced server access Dynamic Scale. This helps enterprises handle traffic bursts with up to 500,000 authentications per minute.
This month, the company announced end-to-end passwordless access with Okta FastPass. This will allow for a passwordless login experience across iOS, iPadOS, macOS, Android and Windows. The goal is to reduce friction while increasing security. The company believes that early access to FastPass will be available in Q4 2020.
There are a few reasons companies are more likely to go with a proven brand like Okta for identity access management. For one, IAM allows access to the company’s most critical systems and assets. Also, in order for IAM to work effectively, Chief Information Security Officers (CISOs) must put all of their eggs into one basket, as One Identity points out. Therefore, they will lean towards the independent solution that is also best in breed.
There are additional concerns and costs to integrating IAM with both on-premise and the cloud, and whether internal admins can properly work with IAM. Once IAM is implemented, CISOs and security teams want a solution that works effectively and does not duplicate workloads. In other words, this isn’t the place where a company cuts corners or goes with discounted solutions.
On the larger corporate-level, Microsoft is one of Okta’s main competitors. However, Microsoft’s goal of locking businesses into Azure, Skype and Office 365 is not ideal for all companies. Many prefer the freedom of multi-cloud and multiple vendors/cloud software solutions. Ping Identity is a competitor on the SMB level, yet does not have near the revenue growth or suite of products/solutions. Salesforce also has their hat in the ring but similar to Microsoft requires vendor lock-in with their software suite.
Addressable Market & Customer Use Cases
When Okta went public in 2017, the Workforce Identity addressable market was at $18 billion. According to Okta’s
Investor Day Presentation, Workforce Identity has now grown to $30 billion and Customer Identity has grown to $25 billion. Over the past three years, Okta’s revenue has grown at a CAGR of 54% from FY 2017 to FY 2020.
Okta derived 84% of its total annual revenue from the United States. The company believes that global demand will be a long-term opportunity.
Use cases for Okta:
• New Corp put 75% of its computer power into the public cloud and extended their workforce operations with applications like Google Apps and Dropbox. There are a total of 150 apps across all of News Corp’s digital sites and work flows. News Corp uses Okta’s single-sign on (SSO) access for easy access to applications, secure access with multi-factor authentication, and automates provisioning for new employees to onboard quickly.
• In the third quarter, the company won a workforce identity contract for Berry global, a Fortune 500 manufacturing and packaging company with tens of thousands of employees. The company wanted to protect itself from modern security threats. The company will improve the sign on experience for employees, reduce helpdesk request by enabling self-service password requests and enhanced security with multi-factor authentication.
• A Fortune 50 telecommunications company for its business customers to securely access key business services. Okta was selected over Microsoft to lower maintenance and infrastructure costs and provide faster time to value.
• Recently, Autodesk selected Okta Identity Cloud to centralize identity and access management for its customers. AutoDesk is the global leader in design and engineering software (Source: 4Q FY 2020 Earnings call transcript).
• Fortune 500 financial services company upgraded to Okta’s Access Gateway to UniFi access to both cloud and on-premise applications and enhanced security for its over 10,000 employees.
• For customer identity, a European film and television studio and distributor with over 8 million subscribers was recently onboarded.
• NTT data, a global top 10 global business and IT services provider, was a notable upsell in the quarter.
Coronavirus Effects
Although Okta has stated that billings will face headwinds this year, the company is not revising Q1 revenue guidance of $171 to $173 million. As of now, revenue guidance for fiscal 2021 ending January remains at $770 million to $780 million. The FY 2021 loss per share is slightly improved from $0.37-$0.42 to $0.31-$0.36.
The company expects slightly improved earnings per share of negative $0.16 to $0.17 compared to $0.23-$0.24 due to the reduced costs in Sales and Marketing from Okta’s employees working from home.
Despite the strength in Okta’s product during the work from home trend, a few analysts have placed a hold on the stock due to valuation concerns. Canaccord Genuity states they are on the sidelines due to valuation and Needham analyst Alex Henderson recently downgraded Okta due to little room for improvement in valuation.
Financials:
On March 5th, Okta reported Q4 and fiscal year 2020 results. Total revenue in the recent quarter grew 45% yearover-year to $167.3 million. In the previous quarter, revenue grew 45% YoY to $153 million.
Subscription revenue grew 46% to $158.5 million. Remaining Performance Obligations (or subscription revenue backlog) grew 66% YoY to $1.21 billion and calculated billings grew 42% YoY to $225 million.
Subscription revenue makes 94% of FY 2020 revenue while professional services and others make up 6%.
Okta is not profitable yet with non-GAAP loss per share of negative $0.01 EPS in the recent quarter compared to negative $0.04 EPS in the year-ago quarter.
Full year revenue grew 47% YoY to $586.1 million. Subscription revenue grew 49% YoY to $552 million and calculated billings grew 44% YoY to $703 million. Non-GAAP EPS was negative $0.31 EPS compared to negative $0.32 EPS in the previous year.
Revenue guidance for fiscal 2021 ending January remains at $770 million to $780 million. The FY 2021 loss per share is slightly improved from $0.37-$0.42 to $0.31-$0.36. This will represent a growth rate of 31% to 33%.
Consensus estimates for Okta is $771.65 million in FY 2021 and $1.0 billion in FY 2022.
In the earnings call, CEO and Co-Founder Todd McKinnon stated the company is investing in growing its base of large enterprise customers. The company added 142 customers with annual contract value greater than $100,000 bringing the total number figure to 1,467 – or an increase of 41% y-o-y. Total customer base is 7,950.
Operating cash improved 266% from $15.2 million to $55.6 million. Free cash flow also saw a big improvement from negative -$6.8 million to $36.3 million for fiscal year 2020. The company ended the year with $1.4 billion in cash, cash equivalents and short-term investments. Okta carries current liabilities of $546 million and long term debt of $837 million.
The company has been expanding internationally over the past two years, namely, Stockholm, Munich, Amsterdam, Paris, and Toronto.
Prior to the Coronavirus, the company’s operating expenses were expected to rise due to an increase in headcount. The company’s headcount rose 40% in the first half of FY 2020 and 44% in the second half of the year.
Valuation:
As stated, a few analysts pointed out that Okta is reaching maximum valuation. I believe most tech growth stocks will go through a valuation adjustment this year. Okta will not be an exception, although the company should fare better than most.
By my estimation, Okta will fare better than most because its core business of IAM for the cloud is a stable market (comparatively to others right now). We know Okta is not reducing guidance as of yet and I imagine this will be an anomaly come May/June when the majority of companies will have revised guidance or will decline to offer guidance.
When considering Okta’s valuation, it’s important to note that Okta spends more than 50% of its revenue on sales and marketing. I’ve been critical of this in the past and continue to question the runway of a few cybersecurity companies. Some companies spend heavily to stave off competition (this is my thesis for cybersecurity). Others move very quickly and spend heavily to gain market share while the opportunity is nascent. This is essentially what Amazon did and Netflix has been doing. I am initiating coverage on Okta because of the company’s name brand status in the B2B/enterprise world and because I believe it will be the de facto IAM company.
Okta has a current price to sales of 26 and a forward price to sales of 20.7. During the Q4 2018 selloff, Okta was at a current price to sales of 14-15 and its lowest forward price to sales has been 17. This would place Okta at a market cap of $12 to $13 billion with an addressable market around $50 billion (combining both workplace and customer identity markets).
Keep in mind, a $12-$13 billion market cap places Okta where the stock traded during the momentum rotation in Sep/Oct 2019; which was a 1-year low for many cloud stocks. Therefore, this is not a drastic discount given the current economic uncertainty.
However, you have to balance the fact that Okta’s customer base and market is more likely to stay intact this year compared to other tech companies. Assuming forward revenue will remain in the $770M range in the current fiscal year (as the company has stated it will) and $1 billion in the next fiscal year, then Okta will stand apart from companies that are lowering guidance.
Catalysts and Competitors:
Ping Identity carries a much cheaper valuation yet the low growth reveals a company that struggles to compete. Ping is forecasting full year revenue growth of 9%-11% from $242 million to $263 million. This growth is too low for me to personally consider, especially considering total addressable market in IAM has been growing rapidly.
It’s important to note that Gartner and Forrester place Okta above the competition. This matches the overall reputation of Okta in the tech industry. When I speak to companies about products, Okta is well received and spoken of very highly.
Regarding Salesforce, Microsoft, IBM and Oracle, many of these companies require vendor lock-in and are not able to innovate as quickly. Okta’s FastPass is a good example of how Okta is innovating.
On the topic of catalysts, Okta is a Coronavirus shopping list stock. Millions of employees will work from home this year and this will present operational challenges. Products like Okta will ensure only authorized users access their cloud applications. The CEO, Todd McKinnon, stated in a recent interview that the company is seeing an 80% increase in the amount of strong authentications.
We are covering Okta as a buy-and-hold due to hybrid cloud migrations, the popularity of multi-cloud (which prevents vendor lock-in) and the company’s future potential in blockchain. These are the more important catalysts, in my opinion, as valuing companies based on the Coronavirus is beyond my scope.
I feel fairly confident that blockchain will take off in the financial markets within a reasonable time span of 1-3 years and that Okta will be very well positioned when this occurs. Gartner and a few others place 2023 as the year when blockchain will be mainstream. The market will reach $3 trillion by 2030 (not all of this will be IAM, of course). Basically, I like Okta now for hybrid and multi-cloud and the $50 billion TAM …. but I really like Okta for the much bigger TAM that includes blockchain down the line.
Technical Analysis by Knox Ridley to follow this week.
