CrowdStrike Is Priced Like A Superstar

Summary

• CrowdStrike annual revenue growth is over 100%.
• The share price has gone up 2.5x in 1 1/2 months since IPO and my relative valuation analysis suggests that the share price is overvalued.
• Gartner's peer reviews suggests that CrowdStrike is preferred over Cylance and Carbon Black for endpoint security solutions.
• I expect that there will be a dip in share price or pause in share price growth in the next 6-12 months due to insider lockup expiration.
• At present, I give CrowdStrike a neutral rating due to overvaluation and insider lockup.

CrowdStrike Holdings, Inc. (NASDAQ:CRWD) is the talk of the town, as the share price has gone up 2.5x since its IPO, from $34 to $86.50 in 1 1/2 months. CrowdStrike appears to have hit the sweet spot of the endpoint security market. I believe that CrowdStrike has a superior product and that is reflected in strong revenue growth. But the lofty valuation is an issue and because it is an IPO, investors need to be concerned about insider lockup expiration. I feel it is prudent to wait at least 6-12 months then look for a better entry price before buying this stock. For now, I have to give the stock a neutral rating.

(Source: CrowdStrike prospectus)

Competition

CrowdStrike’s competition falls into 3 categories: legacy antivirus product providers, alternative endpoint security providers, and network security providers.

Legacy antivirus product providers such as McAfee and Symantec (SYMC) are the old guard and are quickly being replaced by modern solutions built from the ground up. Legacy vendors require constant software updates and can’t respond to threats with the speed of a real-time, crowd-sourced, end-point solution enhanced by AI.

Alternative endpoint security providers such as Carbon Black (CBLK) and Cylance which is owned by BlackBerry (BB) are the prime competitors for CrowdStrike, but they are proving to be no match. Both Carbon Black and Cylance have YoY revenue growth of approximately 30%. Meanwhile, CrowdStrike is growing at a rate of more than 100% per year with a very sticky product.

The dollar-based gross retention rate is a phenomenal 98% and dollar-based net retention is 147% due to a large number of apps in the suite. Cylance is CrowdStrike’s biggest threat, but it is unlikely to undertake a “win-at-all-costs” strategy that SaaS companies generally employ to gain market share. Such a capital-intense strategy would be difficult for BlackBerry's management at this point in time. Given BlackBerry’s history, the company’s management is under intense pressure to start showing profitability in the near future.

The Gartner's peer reviews provide reviews of these companies' software products and gives CrowdStrike a strong edge:

(Source: Gartner Peer Insights)

Note that the above data is based on reviews from the last 12 months.

Network security providers such as Palo Alto Networks (PANW) and FireEye (FEYE) offer firewall-based security solutions augmented by endpoint security. FireEye is laboring with single-digit revenue growth and should not be considered a threat. Palo Alto Networks has a comprehensive suite of security products but lags behind in AI capability, and is not focused specifically on endpoint solutions. It is also transforming into a SaaS company, and that process will cause customer churn and possible distraction for management. The company has YoY revenue growth of 30%, significantly below that of CrowdStrike.

Total Addressable Market

CrowdStrike estimates that the Total Addressable Market ((TAM)) will be $29 billion in 2021. Critics argue that CrowdStrike’s MktCap is already $18 billion and given strong competition, future growth will be tempered.

It is my opinion that disruptive market leaders grow and expand as they execute against their road map. It is literally impossible to predict how far this will take them. It is really about customer satisfaction, sticky products, company vision, competent management, and a “win-at-all-costs” attitude, all of which CrowdStrike has.

The forward-looking opportunities are highlighted in CrowdStrike’s most recent earnings call transcript:

In looking at our future growth prospects, it is common for those new to the CrowdStrike story to only think about the opportunity as endpoints such as desktops and servers. However, we think about the opportunity differently and more broadly than that. We expanded our market opportunity by securing a wider array of workloads which includes desktops and servers, virtualized and cloud environments, IoT devices, and containers. In Q1, we expanded our market opportunity even further when we introduced Falcon for Mobile that supports Android and iOS. This is a powerful vector for growth. These workloads need to be protected and they are growing with every new connected device and every new cloud instance.

We also intend to grow by broadening our reach into new international markets and customers segments including smaller organizations as well as acquiring customers in the federal government vertical. And lastly, we see significant longer term opportunity with new workloads and applications within the CrowdStrike store. The CrowdStrike Store offers the first and only unified security cloud ecosystem of trusted third-party applications. This sets the stage for us to further expand our TAM and grow in segments outside of security, such as IT operations and compliance.”

Company Fundamentals

As I explained in a recent article on Workday (WDAY), high-growth companies generally aren't understood by analysts. These companies can't be measured by the standard metrics that analysts are used to. The result, if you follow analysts' advice, will be a lost investment opportunity.

In place of traditional value factors, I generally focus on other measures, such as the software company "Rule of 40" and relative valuation - a concept that I recently developed that compares forward sales multiple versus estimated sales growth.

The Rule of 40

One industry metric that is often used for software companies is the "Rule of 40." It is an industry rule of thumb that attempts to help software companies ascertain how to balance growth and profitability. There are different ways of calculating the Rule of 40; some analysts use EBITDA, and others use the free cash flow margin. I use the free cash flow margin, as I believe that it is the most meaningful factor from an investor perspective.

The Rule of 40 is interpreted as follows: If a company's growth rate plus free cash flow margin adds up to 40% or more, then the SaaS company has balanced growth and cash flow and is financially healthy.

To demonstrate the Rule of 40, I performed a backtest of those companies that meet the Rule of 40 and also a baseline composed of all stocks in my digital transformation universe. The digital transformation universe consists of 72 software stocks. The backtest was performed over a two year period using Portfolio123, and the results are shown below:

(Source: Portfolio123 / MS Excel)

Rule of 40 Applied to CrowdStrike

CrowdStrike's revenue growth from the most recent 12 months was 103%, while free cash flow margin was -26.3%. Therefore:

Revenue Growth + FCF margin = 103% - 26.3% = 76.7%

Since the calculation comes out much higher than 40%, I conclude that CrowdStrike is in fine shape despite the company’s high level of SG&A expenses, which was 120% of revenue. Note that SG&A includes Sales & Marketing, General & Administrative, and R&D.

Relative Stock Valuation

This is where things get interesting and somewhat controversial. It seems logical to me that high-growth companies should be valued higher than slow-growth companies. This can be shown by creating a scatter plot of Enterprise Value (EV) / forward sales versus estimated YoY sales growth for 77 stocks in my digital transformation stock universe.

(Source: Portfolio123 / MS Excel)

The sales multiple in the vertical direction is calculated using the “next year’s sales estimate” mean value from all analysts in the Portfolio123 database and the current EV. The estimated YoY sales growth is calculated using the “current year’s sales estimate” and “next year’s sales estimate.”

The reason for using analysts’ estimates is because SaaS stocks tend to make a lot of acquisitions, which can muddy the waters. The analyst estimates account for these acquisitions, and the estimates are updated frequently. This makes for a cleaner chart. The sales estimates, unlike EPS estimates, are usually quite accurate for most SaaS companies. Note that most SaaS companies tend to be quite conservative when it comes to revenue guidance, and analysts tend to come in slightly on the low side.

An exponential best-fit trend line appears to be more appropriate than a linear trend line for this application. As sales growth goes up, the valuation goes up exponentially, as shown in the chart. The exponential trend line was calculated using MS Excel. Stocks above the trend line are considered overvalued, while stocks under the trend line are considered undervalued.

As can be seen from the chart, CrowdStrike is well above the trend line. This suggests that CrowdStrike is overvalued relative to its peers.

Insider Lockup Expiration

The first item to consider is the insider lockup period, which may be 6-12 months post-IPO depending on the contract between the underwriter(S) and the insiders. The lockup period tends to keep a lid on stock price appreciation, as VCs and insiders may want to take profits once the lockup period expires.

Below are a few examples of how post-IPO stock price tends to fare.

(Source: Yahoo Finance / MS Paint)

While CrowdStrike has had a very strong first month, in all probability the stock price will cool off for a period of time, somewhere between 6 months and 12 months, waiting for insider lockup to expire.

Other Investment Risks

An investment in CrowdStrike comes with risks apart from the concerns already mentioned. For starters, the bull market is long in the tooth, and we could enter a bear market in the not-too-distant future based on a slowing economy or a resurgence in trade tensions between the USA and China.

In addition, SaaS stocks are on a tear, and many of them are reaching all-time highs. Some analysts believe that we are in for a second "dot-com" crash due to lofty valuation.

Also, the corporate headquarters is located in the San Francisco Bay Area. This is an area known for earthquakes. An earthquake or any or natural disaster could impact operations.

Summary

CrowdStrike had a very strong YoY revenue growth of 103%. CrowdStrike is running circles around the competition and is gaining market share at the expense of legacy players. While the company’s MktCap is encroaching on the TAM, I don’t believe that the current TAM will be a significant factor for a market leader with disruptive technology. The SG&A expense is extremely high, but I believe that it is justifiable based on high revenue growth.

While CrowdStrike appears to be an excellent company, my analysis suggests that it is overvalued relative to other SaaS stocks. In addition, there will likely be a pause in share price appreciation in the next 6-12 months due to expiration on post-IPO insider lockup. At present, I give CrowdStrike a neutral rating, while waiting for a better entry point.

Keep an eye out for my soon-to-be-launched Digital Transformation marketplace service!

Analyst’s 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.