Okta: Bracing For Another Correction

Nov. 07, 2019 3:41 PM ETOkta, Inc. (OKTA)TEAM14 Comments7 Likes
Kayode Omotosho profile picture
Kayode Omotosho
6.05K Followers

Summary

  • Okta's near-term risk/reward suggests another correction.
  • This will occur near and after earnings.
  • Investors should brace for the upcoming volatility.
  • Notwithstanding, Okta remains a long-term growth stock for bulls that have the appetite.

Image result for be calmSource: Tiny Buddha

Okta (NASDAQ:OKTA) is a solid stock with strong growth. Management has executed well in recent quarters, and there are ample catalysts to propel the stock in the long term. However, recent macro developments have made the stock more sensitive to another correction. Given the earnings performance of most SaaS stocks, it's safe to conclude that the market is expecting nothing less than a beat and guidance raise for a SaaS stock to preserve or enjoy multiple expansion. Anything short of that and the stock gets punished. That's how brutal it has gotten.

Source: Author (using data from Seeking Alpha)

The P/S graph above details the ranking and median TTM P/S ratio of 17 SaaS stocks. Nearly all of them are unprofitable. Okta has the second-highest TTM P/S ratio in this ranking. From a peer-average valuation, it's safe to assume Okta is overvalued. However, the P/S ratio is a function of future revenue growth. The P/S ratio is easily diluted if the forward revenue growth rate is high. For example, given that the P/S ratio has a direct correlation with the market cap, a 100% forward revenue growth has a 100% dilution impact on the price to sales ratio. A company with a P/S ratio of 10x projected to grow at 100% will have a forward P/S of 5x. Therefore, we can't say such a company is overvalued, given its huge growth rate.

Source: Author (using data from Seeking Alpha)

To quickly identify stocks trading at a premium to their forward revenue growth estimate, we only need to find stocks below the red line on the forward revenue growth chart and check to see if their P/S ratio is above the red line in the TTM P/S chart.

Okta and Atlassian (TEAM) are the only stocks that satisfy this condition. If all other conditions remain constant, Okta will be trading at a P/S ratio of 16x if it delivers on its 2018 revenue promise. That's still above the average TTM P/S ratio of its peers.

The Street has an average price target of $146 on 41% revenue growth in FY2020 and 31% revenue growth in FY2021. Within that period, EPS is expected to remain negative.

I have a PT range of $88-100. This is driven by my belief in management's ability to drive the growth narrative, coupled with Okta's strong positioning in the cloud security space. However, given the recent spate of volatility amongst SaaS stocks, coupled with Okta's vulnerability to more correction, given its bloated valuation compared to its peers, investors should not overrule their exposure to more market correction. Some investors have also shared similar concerns. I will be highlighting Puche's comment as it echoes my current sentiments about the current state of the SaaS space:

The SA community knows extremely well what my views on OKTA have been. No need to repeat them all here. I've been long since shortly after the IPO. A while ago started commenting regularly that OKTA's valuation was stretched and I had put on a hedge via options to protect against the likelihood of a correction. With the correction more than 50% complete, I am starting to believe utilizing a naked ladder writing put strategy to continue to build a long position may be appropriate in the near future.

At the current price, Okta is tough to hold, and it's not clear if algos wouldn't react to the slightest softness from the next earnings call.

Source: Nasdaq

Using data from Nasdaq, short interest is now near an all-time high. This has been fueled by macro uncertainty with regards to the US-China trade war driving a sector rotation into safe havens, and also by the aftermath of the WeWork (WE) IPO, which has birthed a new generation of short-sellers who are suddenly more confident to go after overvalued SaaS plays.

Here are the charts fueling confidence.

Source: Author (using data from Seeking Alpha)

As you can see, Okta is far from profitability. There is a long road before earnings contribute positively to free cash flow. As a result, cash flow from operations will continue to be driven by stock-based compensation and working capital. Again, the chart isn't the most attractive.

Source: Author (using data from Seeking Alpha, revenue in millions of USD)

To visualize the level of return volatility I'm describing, the chart below serves as a useful guide. A 5% daily price swing, either way, has been the norm since Okta's IPO.

Source: Author (using data from Seeking Alpha)

As recommended in my previous thesis, Okta is a long term buy. However, I won't recommend that investors add more shares at this point. Rather, investors should wait for the pullback into $88/share.

Lastly, here are the assumptions driving my $88/share valuation.

Source: Author (using data from Seeking Alpha)

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This article was written by

Kayode Omotosho profile picture
6.05K Followers
Kayode's strategy aligns only with businesses that have competitive moats, solid financials, good management, and minimal exposure to macro headwinds.-------------------------------------Coverage tilted towards tech stocks (IoT, Cybersecurity, Cloud, DevOps, Data management)
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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.

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