2023-08-24 15:09:38 ET
Summary
- SentinelOne has underperformed despite trading at a discount to cybersecurity peers.
- The company's top-line growth disappointment is expected to delay its cash flow breakeven timeline, but I note that net cash makes up over 20% of the market cap.
- Reports suggest that SentinelOne is exploring a potential sale, which could be a near-term catalyst for the stock.
- I reiterate my strong buy rating as much pessimism is already priced in to the stock.
SentinelOne ( S ) has not performed according to expectations. This is a name which has traded at a sizable discount to cybersecurity peers but continues to underperform anyway after experiencing execution hiccups. The disappointment on top-line growth is expected to push out the cash flow breakeven timeline beyond this fiscal year, but the company still has $1.1 billion in net cash, enough to fund a handful of unprofitable years. S has been disproportionately impacted by the tough macro due to its smaller product portfolio, but cybersecurity remains one of the most promising long-term secular growth stories. Reports surfaced that they were exploring a potential outright sale of the company, adding a possible near-term catalyst. With shares continuing to trade very cheaply regardless, I reiterate my strong buy rating.
S Stock Price
S is one of the few tech stocks still trading near all-time lows - it is worth noting that its post-earnings crash helped it create new lows (though it has since recovered some of those losses).
I last covered S in May where I rated it a strong buy. The stock has lost a quarter of its value since - it is becoming clear that smaller tech operators are facing unique difficulties in this macro environment. Near-term execution issues aside, there is still much value to be had here.
S Stock Key Metrics
In its most recent quarter, S delivered 70% YOY revenue growth to $133 million. That's a strong result, but Wall Street had much to be disappointed about given that management had guided for $137 million.
FY24 Q1 Shareholder Letter
S saw its net retention rate decline to 125%. That is still a strong result, but I expect it to trend even lower over the coming quarters as the tough macro environment leads to a slowdown in IT spending. It is worth noting that better-known peer CrowdStrike ( CRWD ) has managed to sustain strong net retention rates even in spite of a larger revenue base due to having a deeper product portfolio. SentinelOne's smaller product portfolio appears to be posing near-term headwinds to both growth rates as well as valuations.
FY24 Q1 Shareholder Letter
On the bright side, S continued to add to its customer count including nearly 7% growth on a sequential basis. Unfortunately, I expect customer growth to slow down considerably over the coming quarters and not recover until an improvement in macro conditions. Management noted on the conference call that the customer count does not include customers served by their Managed Security Service Provider ('MSSP') partners, making it a rather conservative figure.
FY24 Q1 Shareholder Letter
S delivered its seventh consecutive quarter with at least 25 percentage points of operating margin improvement, as its operating margin loss came in at 38%. I suspect that Wall Street is focusing less on the improvement and more on the fact that S is still generating sizable losses even on a non-GAAP basis.
FY24 Q1 Shareholder Letter
Management disclosed an accounting change for how they account for ARR to reflect only "committed contract values." This is due to the company seeing great volatility in usage and consumption trends and management expects the revised methodology to lead to reduced ARR volatility moving forward.
S ended the quarter with $1.1 billion in cash, representing around 25% of the current market cap and enough to fund over five years of operating losses. Looking ahead, management guided for 37.6% YOY revenue growth to $141 million in the second quarter and for 42% YOY revenue growth to $600 million for the full year. The full-year guidance represented a steep reduction from the prior guidance of $640 million, which at the time was touted to be very conservative. Growth is expected to decelerate to around 35% in the second half of the year.
Management notably left the operating margin loss target intact at around 25%, but noted that it would need to undergo a "workforce optimization plan" to offset the disappointing projected revenue growth.
Management blamed the top-line struggles on macroeconomic pressures, noting impact to "deal sizes, sales cycles, and pipeline conversion rates." Management noted "some late-stage contract execution challenges on large deals caused a few deals to slip to next quarter." Given the strong results seen at other cybersecurity names like CRWD and Zscaler ( ZS ), it is clear that a lot of SentinelOne's struggles are execution-related.
Even so, management stated that "there is no fundamental change in the business or opportunity, and our win rates remain strong." Management did however note that some of the providers that they compete against have "become more aggressively defensive," which may be implying some pricing pressures.
Management had previously guided for a breakeven cash flow position by the end of this year, but is now expecting that milestone to be pushed into the next fiscal year due to the reduced revenue expectations. This indicates just how critical revenue growth is for operating leverage at high-growth tech companies.
Is S Stock A Buy, Sell, or Hold?
S is a cybersecurity company focused on endpoint protection (endpoints refer to things like desktops and mobile phones). S differentiates itself through its ability to resolve cybersecurity incidents autonomously.
SentinelOne
While S does not have the same deep product portfolio as CRWD, it should still benefit from the same cybersecurity tailwinds which have only become stronger due to the potential for generative AI to increase malware threats.
As of recent prices, S stock was not trading at the same cybersecurity premium seen at peers, with the stock trading at just around 8x sales.
The valuation discount appears to be due to both the slimmer product portfolio as well as the weaker profit margins relative to peers. Assuming 20% long-term net margins, 25% growth and a 1.5x price-to-earnings growth ratio ('PEG ratio'), I could see the stock trading at 7.5x sales in 2026, implying considerable upside over the coming years. For the stock to achieve its full potential (which arguably deserves a PEG ratio more in the 2x range), management will need to execute on profitability targets and fix their execution issues.
Yes, the ongoing operating losses are a negative, but equity dilution totals around 6% annually and the cash burn should total around $150 million or less. With $1.1 billion in cash on the balance sheet, I do not expect either dilution or cash burn to drag on the projected returns.
This is a good moment to discuss recent reports that S is exploring a potential sale of the company . Given that the stock trades at a deep discount to cybersecurity peers and at low prices overall, I would not be surprised to see private equity interest in the name. Throw in the fact that the company has a solid net cash position, and I expect any buyout progress to be held up only due to price. On the flip side, these rumors may suggest that S is seeing its execution issues persist, which may lead to downside surprise when the company reports earnings next Thursday (August 31). If buyout rumors fizzle before then, the stock might plunge upon such bad news.
What are the other key risks? Whereas I see considerable upside so long as S can execute mainly against its profitability targets, there is considerable downside if management fails in such efforts. It is possible that customers increasingly turn to market leader CRWD or even Microsoft ( MSFT ) due to perceived better reliability amidst tough macro conditions. If growth decelerates even further than expected, then S stock may see its valuation compress even more, as it does not have positive cash flow to help offer downside support. That said, I am of the view that valuation is not the greatest risk here as the stock trades at a steep discount to cybersecurity peers - for reference CRWD trades at around 12x sales in spite of slower forward growth estimates. I reiterate my strong buy rating for the stock as I expect the company to move past execution challenges and for the stock to eventually be rewarded with a higher multiple.
For further details see:
SentinelOne Rises On Potential Sale: Deeply Undervalued Cybersecurity Operator