Okta: Fully Priced Now, But A Strong Pick On Pullback (NASDAQ:OKTA)

Okta (OKTA) has been a big beneficiary of the COVID-19 pandemic. Although migration of software infrastructure to the cloud environment has been a trend for the past few years, the pandemic associated shelter-at-home restrictions and the need to work-from-home have definitely accelerated the corporate digital transformation process.

With shares already up by 110% YTD (year-to-date), IAM (Identity and access management) software player Okta has already benefitted significantly from what has already become a secular growth trend. This company with over 9,000 customers is expected to grow revenues YoY by 35%, close to $1.0 billion in fiscal 2021 ending January 2021. The company has also reported dollar-based net retention of 121% for the 12 months ending July 2020.

However, this stock is not cheap. Okta is currently trading at a P/S (price to last twelve-month sales) multiple of 44.6x, which is not cheap.

Hence, despite being a high-growth stock, I believe that it is fully priced as of now. Nevertheless, I believe that this is a fundamentally strong company, and investors should consider starting a small position in this stock on a pullback.

Okta is targeting a rapidly growing identity-based security market

The COVID-19 pandemic has changed the way businesses function and this has been a major growth driver for Okta in 2020. As more and more companies have shifted to hybrid cloud and public cloud infrastructure and are now relying on connected devices and distributed workforce, the concept of securing the company’s premises with firewalls is becoming more and more redundant. Then again, while the pandemic has made digital transformation a necessity for many businesses, it has also compelled many others to start thinking proactively about their digital transformation strategies. Finally, security consultants are increasingly pushing forward the concept of Zero Trust security. It is estimated that the global Zero Trust Security market is growing at a CAGR (compounded average growth rate) of 19.9% and will be worth $38.6 billion by 2024.

Identity is fast becoming “the new perimeter“, and businesses are increasingly opting for identity-based permission to network resources. Okta has already emerged as a leading player in the enterprise IAM market, thanks to solid penetration in the workforce identity and customer identity-based SaaS (software-as-a-service) segments. The company estimates its TAM (total addressable market) to be worth $55.0 billion, of which workforce identity accounts for $30 billion market potential and customer identity for the remaining $25.0 billion opportunities.

Clients deploy Okta’s workforce identity solutions to ensure immediate and secure access to applications and data to their employees, contractors, and partners. Workforce offerings include products and services such as Universal Directory, Single Sign-On (or SSO), Adaptive Multi-Factor Authentication, Lifecycle Management, API Access Management, Advanced Server Access, and Access Gateway. Although many of these products are considered commoditized, Okta’s broad workforce identity portfolio offers multiple cross-selling opportunities for more higher-margin products. Okta currently prices workforce identity solutions on per user per month basis. While there are multiple players in the workforce identity business, not many are able to offer a seamlessly integrated experience to employees as well as contractors and partners like that offered by Okta.

As the world increasingly goes digital, businesses also need mechanisms to validate the identity of their customers and provide an integrated experience across multiple applications. With Okta handling the customer identity part of the equation, businesses can focus exclusively on the user experience of their digital offerings. Here, the company deploys a tiered pricing model, where rates are decided based on the number of customers of the client corporation. This is a less saturated and rapidly increasing market opportunity, owing to the rapid increase in security requirements of on-premise infrastructure as well as those of hybrid or public cloud infrastructures. Here again, while there are few competitors, Okta stands out owing to its superior integration experience.

What differentiates Okta from the competition?

Network effect and vendor neutrality are the key differentiators for Okta. OIN (Okta Integration Network) has played a key role in building these advantages. OIN contains “over 6,500 integrations with cloud, mobile and web applications, IoT devices and IT infrastructure providers, including Amazon Web Services, Atlassian, Cisco, F5 Networks, Google Cloud Platform, Microsoft Office 365, NetSuite, Oracle, Palo Alto Networks, Proofpoint, Salesforce, SAP, ServiceNow, Slack, Splunk, VMware, Workday and Zoom.”

Clients use these integrations to build seamless identity access across these applications in accordance with their specific use cases. To further increase the scope of use cases that can be enabled by OIN, Okta has added products like Workflows, Hooks, and Identity Engine.

As more and more customers use Okta’s offerings for a range of use cases, the company gets insights about application usage trends and security threats. Hence, developers can expect further improvement in security offerings. Also, the network effects are a solid entry barrier for new players even if the latter price the products below Okta’s pricing levels. This is because businesses are well aware of the importance of security solutions and prefer to choose more experienced players even at a higher price.

Vendor Neutrality is also another advantage related to Okta. Although Microsoft already has a presence in the identity market, many customers prefer security providers to be different from their cloud service providers. Also, solutions that can work across multiple clouds are more preferred. Okta stands to benefit from both of these preferences.

Okta Access gateway can prove to be another major growth driver as the company increases its focus on the hybrid cloud market.

Robust growth metrics

Okta has demonstrated over 90% growth in total customer count from 4,700 at end of the first quarter of fiscal 2019 to 8,950 at end of the second quarter of fiscal 2021.

Here, while customers grew YoY by 28%, the customers with >100k ACV (annual contract value) grew at 38% YoY in the second quarter. At end of the second quarter of fiscal 2021, there are 1,685 customers with ACV exceeding 100k, almost double of 747 customers at end of the first quarter of fiscal 2019.

The solid increase in customer count is well-reflected in Okta’s revenue growth trajectory. A solid increase in subscription revenues also highlights increased topline visibility.

Okta’s dollar-based net retention rate has also recovered from the slight dip seen in the third quarter of fiscal 2020. Although this dollar-based net retention rate is nothing out of normal for high growth SaaS stock, it is nevertheless impressive considering Okta’s increased focus on large enterprise deals with big deal size. This implies that the potential for cross-selling in future time frames becomes limited.

Okta’s revenue growth is expected to be close to 30% in fiscal 2022 and fiscal 2023, which may be a stark departure from its performance in the past few years. However, analysts also expect the company to become EPS positive in fiscal 2022.

But there are risks

Okta is trading at pretty high valuation multiples. Lofty valuations expose share prices to significant downside risk even in the event of single unfavorable news or earnings miss even if it is due to seasonality.

Lengthening of sales cycles can result from an increasing focus on large enterprise deals. This can affect key SaaS metrics such as billings growth and RPO (remaining performance obligations). This again can have an untoward impact on share prices.

Competition from Microsoft (NASDAQ:MSFT), Dropbox (NASDAQ:DBX), and other private players may also affect the company’s future growth rates.

Finally, although the pandemic has been a net positive for Okta, it has definitely posed some challenges for the company. SMB (small and medium business) sector has been badly affected, with a high percentage of bankruptcies and closures seen in sectors such as hospitality, tourism, and even energy sectors. This can prove to be a challenge for attracting new business in the coming quarters.

Verdict

With the prolonged nature of the pandemic bringing about durable changes in consumer behavior, digitization is very much here to stay. This means more demand for security solutions, and leading IAM player Okta is set to benefit from this trend.

However, at current valuation levels, I believe that the stock is a tad bit expensive. RBC Capital Markets’ target price of $230 is a fair estimate of the 12-month consensus target price of this stock, considering its risk-reward prospects.

Hence, I believe that retail investors should start building a small position in this stock in case a pullback gets this stock to $190-$200 levels.

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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