Switch To Calls Going Into Okta Earnings Season

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About: Okta, Inc. (OKTA)
by: Patrick Doyle
Summary

It's obvious that, for the moment at least, the market is willing to look past the negative relationship between revenue and net income here.

The company has just turned free cash flow positive, suggesting that valuation may not be excessive.

Given my ambiguity about this name, I recommend shareholders switch to calls at least for the time being. They capture most of the upside at far less risk.

Over the past year, the shares of Okta Inc. (NASDAQ:OKTA) have increased by about 170%. In my view, this is an extraordinary return for a company that seems to grow losses as it grows sales. My recommendation is twofold in this case. I think shareholders would be wise to take profits ahead of next month's full year earnings release and replace their shares with the call options that I outline below. My reasons for suggesting this relate to the fact that the company has a history of growing losses as they grow sales. In my view, the company is on a treadmill of sorts, where they must spend on R&D, SG&A etc. in order to keep revenue alive, so suggestions that they can reduce these expenses with no ill effects to revenue is a stretch, in my view. That said, they have managed to turn cash flow positive during the most recent quarter, and as a result, the shares are not excessively priced, in my view. So, I think there are reasons to be optimistic and reasons to be pessimistic. It's therefore prudent in my estimation to switch from shares to calls. If the market likes what it hears next month and the shares rally, call holders will capture much of that upside. If the market sours on this high flyer, calls will suffer along with shares, but much less so.

Financial History

I have to confess that I liked looking at the financial history here because there's so little of it. This fits nicely with my innate laziness. The first thing that pops off the page when looking at the financial history here is the fact that demand for Okta's services is quite robust. This is evidenced by the fact that over the past few years, revenue has grown at a CAGR of about 44%. In my view, that's what investors seem to be fixated on, because there's little else that's positive about the financial history here. In spite of the fact that sales have grown so dramatically, the company has so far failed to turn a profit. In fact, the more the company sells, the more it loses. I decided to quantify this relationship, so I ran a correlation between revenue and net income. There is a very strong (r=-.96) relationship between revenue and net income. This prompts the very obvious question: if growing sales won't lead to profits, what will?! Also, if rising sales actually lead to rising losses, something may be fundamentally flawed here. Whatever the answer to that question, theme of "revenue and losses ballooning in tandem" seems to be persisting, given that the first nine months of FY 2019 saw revenue up 58% and net loss up 9%. On the "bright" side, loss per share has actually declined on the back of fairly sizeable dilution of 39% from the last period to the most recent.

Part of the reason for the increased losses relates to the fact that R&D, sales and marketing, and G&A expenses are also up dramatically. They're up at a CAGR of 35%, 30%, and 39%, respectively. Bulls obviously believe that something will happen in future to allow the firm to continue to grow sales while reducing these expenses. In my view, increased R&D and sales expenses are a necessary part of this sort of business. They are the glue that ties clients to the firm. If Okta eases off on these, revenue will likely fall. Thus, we're in a situation where the company is on a kind of treadmill: they must spend ever larger sums to attract and keep customers, which leads to losses. If they don't, it's very likely that someone else will. In my view, that sums up the existential threat associated with this business.

Source: Company filings

The Stock

The interesting thing about investing is that we're not only looking for businesses that will make money, but we're looking to pay a reasonable price for that. Such an idea may sound revolutionary to "investors" who are willing to bid companies to extraordinary valuations because of (hushed tones) "the cloud", and "security" and "SaaS" I'd say that we've seen this story before, and it didn't end well. That said, I think it's possible that even a company that has such a poor financial track record as this may be an excellent investment if the price is right. For that reason, I must keep an open mind and spend some time looking at the stock as a thing distinct from the underlying business.

I employ a host of methods to determine whether a stock is expensive, but in this piece, I'll talk about only one of them as I see no need to belabor the point. During the most recent quarter, Okta generated its first ever positive free cash flow in the amount of $1.4 million, or 1.3% of revenue. That means that the shares are currently trading at a price to free cash flow of approximately 75 times. If we assume that the free cash flow can be annualized over the next four quarters, the shares are trading at a forward price to free cash flow of ~20 times, which is not extraordinarily expensive, in my view.

The risk obviously comes down to whether this free cash is sustainable. Given that I'm fairly risk-averse, I'll wait for more confirmation, but I understand that more adventurous people would be willing to buy with a belief that free cash flow is about to explode.

Options to the Rescue

The company is about to report, and, given the mood of the market, it's likely that investors will focus entirely on the positives, which will cause the stock price to inflate even further. Although I'm not yet convinced that this is a reasonable investment at these prices, I want to hedge my bets. For that reason, I'm recommending a call option strategy as a means to capture much of the upside from this stock with far less risk. Given that the company is about to report, the shares are entering a period of maximum risk, and I would want to buy calls that expire after earnings are announced. The reason for this is that the risk-reward is quite favorable. For very little capital, investors can access much of the upside the company may enjoy. If the market isn't impressed by the upcoming earnings, far less capital is imperiled.

At the time of writing, the May call with a strike of $85 is being asked at $8.70. Thus, for 10% of the capital at risk, an investor will gain exposure to most of the mania-driven upside from here. If the shares drop, call holders lose much of their capital, but they are better off on a risk-adjusted basis, in my view. This is especially the case in light of the fact that this company doesn't (and likely won't for some time) pay a dividend.

Conclusion

There is much to like about this stock, obviously, and it could be argued that it's not extraordinarily expensive on a price to free cash flow basis. That said, I have some doubts. Given that there's no opportunity cost from a lost dividend, I strongly suggest that investors sell their shares and buy the calls mentioned. Doing so presents investors with a risk-return relationship that is positively skewed. If the shares continue to rise, they will capture most of that upside. If the market is disappointed by earnings, the options will tank, but in that case, the investor will be relatively less badly off than a shareholder.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I will take a flyer on the calls mentioned in this article. I expect that the market will continue to focus on the positives.