Okta Stock: Leader In Identity Management At A Bargain Valuation

Okta – Can this sow’s ear ever return to silk purse status?

Stocks have been cratering! IT stocks have been cratering more! Even shares of cyber-security companies have fallen with the HACK (HACK) ETF, which incorporates the major cyber-security vendors down by 30% on a year-to-date basis. But Okta (NASDAQ:NASDAQ:OKTA), the leader in the identity management category, has seen its shares fall far beyond average. Just how much? As of the close on Friday, Sept. 30th, the shares are down by no less than 76% since the start of the year, and by 81% since they made an all-time high less than a year ago. They were the worst performer on NASDAQ for the 3rd calendar quarter, falling 37% Compared to other leading cyber-security names such as CrowdStrike (CRWD), down 22% since the start of the year, Palo Alto (PANW), down 13% since the start of the year, and Zscaler (ZS) down 50% since the start of the year, the performance of Okta is far worse.

Okta, by comparison, is all about pivots and turning, and rectifying past miscues of various kinds.

I have recommended the shares of the leading cyber-security vendors as “safe havens” in the coming recession. The fact is that all of the 3 companies above have recently reported strong numbers and guided for acceleration in previously anticipated growth and margin performance. Cyber security is not optional, and cyber-criminal don’t recognize recessions. Threat surfaces keep enlarging, and the consequences of breaches continue to escalate.

I recommend the shares of Okta from a contrarian perspective. As a former owner of the shares, I think it is fair to say that the operational performance of the company has left a bad taste. The company executed a strategic merger, with AuthO and then basically fumbled the ball in terms of achieving sales synergies that were a key justification for the substantial purchase price. But all of that is now on view, and the shares reflect the disappointment surrounding the fumble, and no longer reflect the potential synergies and accretion from the merger. That, to my mind, is what makes a contrarian opportunity.

I don’t want to suggest that the cyber-security companies mentioned above are really quite analogs of Okta in terms of what they sell: CrowdStrike is still mainly a vendor of endpoint security although it recently has begun to sell an identity management module that has proven to be very successful. Zscaler sells zero trust protection for web based networks, while Palo Alto sells both a zero trust solution and next generation firewalls. None of those is identity management, and most users will need a combination of various solutions to develop reasonable protection against cyber-criminals. This is a very unforgiving market-the understatement of the year I suppose. Miscues are punished severely, while strong execution merely slows declines. Sadly, Okta has had its share of miscues including a couple of data breach and a flawed sales force integration strategy.

For some years I had been an Okta skeptic. Valuation and lack of profitability had kept me away. And I had wondered about the ability of a company to create a competitive moat around the identity management space. It’s an application that has been around a very long time. But then about a year ago, in the wake of Okta’s merger with AuthO, a principal competitor with advanced technology in part of the identity management space, i.e customer identity management, and a different sales focus which was centered on the developer community, I thought I saw an opportunity. I really saw an iceberg, and abandoned my position, down sharply, but down far less than the loss could have been, at the start of this year. I had been concerned that the breach the company had suffered in January, 2022 had been poorly handled and was not satisfied with the Okta’s response. And then reports of sales force integration issues began to emerge, and those were finally confirmed during the company’s latest conference call. I have had to wonder just how it is that a founder led company could mishandle such a key undertaking, which had to be a priority.

As mentioned, and to be perfectly clear, I recommend the shares of Okta from a contrarian perspective. I think most of the problems the company has are on full view. And I believe most current investors are expecting that the company will reduce multi-year targets to some extent when it next reports results in early December. The company’s latest guidance sets revenue growth goals at very modest levels. In this current quarter, its forecast is for sequential revenue growth of just greater than 2%-that metric was 11% in the same quarter of the prior year, followed by sequential growth of 5% in what will be a fiscal Q4 compared to 9% the prior year. Sequential revenue growth in the just reported quarter was actually 9%. The results of the quarter just reported were a 5% upside when compared to prior guidance for revenues, and non-GAAP profitability was noticeably improved as well compared to the prior forecast. The growth in RPO balances was below forecast, but apparently was mainly a function of duration, as the growth in cRPO, at 36% was certainly acceptable for that metric. That said, the cRPO balance rose just 6% sequentially, which was apparently below prior expectations.

This guidance would seem to incorporate the current state of both economic headwinds and the specific sales execution challenges that the company has acknowledged. While self-evidently, the company’s management structure has seen some upheaval, and sales turnover is elevated, with much sales force dysfunction, presumably that is why the shares are valued as they are.

There are many investment opportunities these days in the enterprise software space. Skepticism abounds about company forecasts. Just the other day, a forecast affirmation by Splunk (SPLK) brought on a relief rally, albeit of brief duration. The reason is that many commentators think that all forecasts are suspect and will have to be reduced. One well known hedge fund leader, Dan Niles, recently provided an interview forecasting that the estimates of software companies were still exposed and would see further cuts.. One economist, Nouriel Roubini, notorious or not, depending on the disposition of the reader, is forecasting a long and deep recession with the potential for a further 40% drop in the S&P.

At the moment, while Todd McKinnon, the company CEO remains in his position, Fred Kerrest, the company’s COO is taking a one year sabbatical. The company has realigned its product development efforts with the former AuthO CEO leading product development efforts for customer identity while the CRO leads the development of workforce identity cloud products. Lots of moving parts, and signs of organizational stress. That said, the company’s CFO, Brett Tighe has been with the company for more than 7 years, and before that he was with Salesforce (CRM) in senior financial roles for 11 years. And the company’s President of Field Operations, Susan St. Ledger has been in her position for about 2 years, while the company’s Chief Revenue Officer, Steve Rowland has been in his position for 18 months. . Ms. St. Ledger held a similar role at Splunk for 4 years, while Rowland, not terribly surprisingly, is also a Splunk alumni. Can this leadership team right this troubled ship?

Almost all companies make mistakes and miscues from time to time. The same obviously can be said about analysts except our mistakes are on full view every day from 4:01PM on and often earlier than that. Recently, the analyst at Guggenheim, John DiFucci upgraded the shares, while calling Okta, a company in disarray. Last week, the analyst at Cleveland Research, Ben Bollin, downgraded the shares from buy to hold. He feels that the company is facing more significant fundamental challenges, mainly competitive, and will have to reduce guidance more substantially than has already been the case. The company, during its most recent conference call, suggested it was revisiting its targets for FY ‘26 and I doubt that anyone either owning the shares or providing recommendations is doing so based on a target

My reason to revisit the investment thesis is simply that identity management is an enormous, and under-penetrated market, and Okta remains the leading participant in the space. And I have a strategic disposition to increase my portfolio weighting in the cyber-security space, as I believe it will be the most recession resistant segment within IT. There are certainly other choices in the cyber-security space these days other than the 3 companies I already own. Checkpoint (CHKP) has shown some signs of life in terms of its operational performance, and shares of Rapid7 (RPD), now substantially rerated, have interest. CyberArk (CYBR), is also a competitor with a very competitive solution in what is called privileged asset management. But it is infrequent that a software category leader also has the potential for really significant returns. But I think that Okta is one such company.

The questions, of course, are whether, and at what cadence, Okta’s leadership can restore its momentum and start to realize the opportunities inherent in the acquisition of AuthO and resume its share gains in the space. This is not a short-term project. Restoring a broken sales force, and crafting the right go-to-market strategy and messaging almost always takes longer than expected. But fortunately for Okta, cyber-security and identity management will be less affected by recessionary headwinds than most other segments of the IT space. That said, unlike most of the other cyber-security vendors, Okta did call out macro headwinds in its prepared remarks, although it is easy to question whether this was real, or an excuse for sales performance.

I am not going to uncover some existential valuation metric regarding Okta that hasn’t been analyzed and dissected many times already. After falling by 75%, even while continuing to grow, the EV/S ratio has dropped noticeably below average for the company growth cohort, even when haircutting the company’s expected growth rate to a cohort of around than 30%. But the company is projecting just a modest free cash flow margin, and that is a significant negative in the current investment environment.

Despite, or perhaps because of the valuation compression, the shares are not well loved by analysts. In addition to the Cleveland Research downgrade a couple of days ago, the MoffettNathanson analyst started coverage of the shares just a couple of days ago with a sell rating and a $71 price target. At the start of September, the Morgan Stanley analyst lowered his rating on the shares to hold, but set a $93 price target. One of the many reasons why I simply don’t set price targets on companies that I cover is that they frequently follow rather forecast stock prices. Of course, no one would reasonably have a price target 20%+ above a current valuation with a sell rating, and it more than a bit difficult to decipher the logic of a price target more than 60% above the current valuation with a hold rating. But one of the reasons I am reviewing Okta, and not something else, is that actually quantifying the outlook, and using some kind of DPV analysis, really does leave targets far, far above current levels. Therein lies the significant potential.

That said, other analysts do see some of the opportunities inherent in category leadership in a key part of the enterprise cyber-security paradigm. The Jefferies analyst, Joseph Gallo, described Okta shares as a “one-of-a-kind” buying opportunity with 50% upside. Of course the upside percentage is greater now, with the shares down more than 15% since the date of the research report.

I was recently accused of using touchy-feely analysis in my review of Adobe (ADBE). The problem with that recommendation, and this one as well, is that there isn’t some kind of specific valuation flag that says, “buy me.” One thing about buying wounded assets, as this one appears to be, is that forecasting the timing of a turn is basically impossible. When the sales force is fixed, and observers believe it to be fixed, the shares will most likely appreciate markedly in just a day or two. Much of that is because Okta is the kind of investment that can be very popular with hedge funds due to its size/liquidity and easy to understand functionality. Even now, over 80% of the shares are held by institutions. While that is a substantial percentage, there are no aggressive hedge funds listed as large holders, suggesting a potential significant source for share demand.

Another thing to note. Okta is not going to achieve a turn-around from its current condition in a quarter or two. The company has suffered from heightened sales turnover, basically because many previous AuthO sales contributors have felt that their sales targets were unattainable and that the comp plan was deeply flawed. About the most that one might expect in the short term is that the company stops digging. Fixing sales execution issues, which means dealing with lots of unhappy people, doesn’t happen at the flip of a switch. The odds are that Okta will right its ship. I have been surprised that a company of this stature, having a clear priority, which was to create a unified sales platform, failed to do so in a timely fashion. About the most I can say is that this is the opportunity to do so is what is being presented to subscribers/readers at this point.

Finally, I should mention Okta uses stock based compensation, and lots of it, and there are readers and commentators who refuse to consider companies using SBC. One of the things that need to be noted about SBC is how the calculation works out for that metric in particular quarters. SBC is calculated based on when an option is vested and not when an option is granted. Because of last year’s acquisition of AuthO, the level of options reaching their vesting conditions has increased. On the other hand, that increase is abating, and thus SBC expense fell year-on-year in the quarter recently reported, and it was flat sequentially. But it is still elevated at 38% of revenues, although the ratio will almost inevitably decline going forward, as the company has moderated its hiring plans. The reality is that SBC is tightly correlated with the number of hires, so a decline in hiring, as the CFO foreshadowed in the latest conference call, will lead to lower SBC. Since I do not use GAAP estimates or data in addressing valuation, it is necessary to adjust estimates and projections for dilution. This company does forecast outstanding shares on both a quarterly and an annual basis. Based on trends, I use annual dilution of 3.5% in calculating valuation metrics.

Macro headwinds: Just how much of the guidance shortfall is a function of a deteriorating economy

There is obviously lots to consider when a company which has achieved an organic growth rate in the high 30% range (actually in the mid 40% range-all organic-last quarter) for some time, sees growth atrophying to the mid-20% range in a single quarter. Looking at both Glassdoor reviews and reviews from Best Place to Work, Okta’s evaluations are fairly typical, maybe a bit above average for an relatively large enterprise software company.

While Okta’s management did call out macro headwinds in its prepared remarks on this latest conference call as one reason for its reduced guide, management went on to say that the preponderance of its guide down was a function of sales integration, and the concomitant issue of elevated sales turnover. At some level, I would suggest that the scenario being portrayed is quite similar to many of the problems that had upended the Alteryx (AYX) growth outlook before the company took some hard steps and remediated the problems that had crippled its growth.

I think at this point almost all investors are aware of demand headwinds for most IT vendors. The company wound up reducing its guidance; in terms of revenues, the guide down for the last 6 months of the year was about 2% ($17 million). It might be noted that because this guide down was 2% and not some considerably greater number, the company’s forecast for its full year non-GAAP operating loss didn’t change, although this was more a factor of the Q2 beat on that metric than any dramatic change in the trajectory of opex. The company suggested that the macro headwinds being experienced weren’t all that substantial, at least at the time that guidance was provided. The company is forecasting that it cRPO balance will increase by 3% sequentially, and that is where the issues of sales force integration and macro headwinds are most visible. While cRPO has its own limitations as a proxy for current bookings, it is the best metric available to portray the strength of demand growth, and the forecast reflects a sharp slowdown in expected sales performance.

Although it is difficult to really know, I imagine many investors believe that there are additional shoes to drop with regards to Okta’s guidance. And despite the published consensus that calls for 28% growth in what will be FY ’24, I doubt that many analysts covering the company really expect that kind of performance, although I think the likely trajectory of expected margin improvement as shown by the 1st call consensus will prove to be too conservative. Obviously the question was raised during the conference call. The answer isn’t particularly surprising:

Josh Tilton

Hey, guys. Thanks for squeezing me in. Just a quick one for Brett. Given all the challenges that you guys mentioned, what gives you the confidence that you’re not going to have to take numbers down again in the back half of the year?

Brett Tighe

Look, we’ve baked everything in that we know at this point, right? We’ve taken into account from regardless of what number you’re looking at, it’s current RPO, revenue, billings, we baked in those headwinds that we’ve talked about today, whether it be the sales integration issues we’ve talked about the attrition or even the macro. So we do feel confident in the guidance and taking a similar approach and being very prudent about that like we have in the past.

Okta’s basic issues and how the company is moving to fix its problems

The most significant issues for this company has essentially been that of sales force execution, and go-to-market messaging. These are the issues that have upended revenue projections for now. Those kinds of errors should never happen as they are entirely within the control of the company. That said, were there not these issues, the shares would never have imploded to this valuation, even in this toxic market for growth shares. I believe that the greatest percentage returns are going to come from identifying those companies with a strong competitive position in a hot space that is generally recession resistant and that is what Okta is, despite the unforced miscues.

The CEO had much to explain in terms of what has been happening to Okta and how it can be fixed. One issue, which seems to be very basic, relates to defining which product within the Okta offering is appropriate for which use case. There is overlap between identity management for employees and customer identity management and apparently the overlap has led to salesforce dissension and elevated turnover. The problem surfaced in the wake of combining the two sales forces at the start of this current fiscal year. Okta, before the merge, had a solution for customer identification, as well as a solution for employee identification, essentially its core business. AuthO only focused on identity management solutions that are incorporated by developers into web sites that customers access. The customer identity space is newer, and enjoys stronger growth. The TAM of both spaces is comparable. AuthO certainly has had marketplace momentum in the customer space, most often called CIAM (customer identity access management), and that continued long after the merger. When the sales forced were merged, it became very difficult to match use cases with solutions. The company needed to offer a single customer identity solution, and that solution needed to be transcendent for all B2B SaaS applications that developers are building.

While it sounds as though it ought to be a simple problem to remediate, like many other things the devil is in the details, and apparently, the details were not carefully considered in advance of combining the two sales forces. Even on the conference call, after explaining about the two product families that are offered by Okta, some analysts were a bit confused about how the integration of the two sales forces might actually work in practice. There was a need to consolidate and train the sales forces with messaging that identified which solution was appropriate for which use case.

One of the advantages that Okta has is that it is a platform neutral solution that offers enterprises the opportunity to optimize their identity management paradigm by standardizing on a single vendor. To sell that paradigm, the company has to reach the CEO level of its prospects to explain why identity management of both customers, and of a workforce are priorities that cannot be properly handled by software in which identity management is an afterthought. The message is simple; it is desirable to partner with a vendor who can offer the whole range of identity management solutions on a multiplicity of cloud deployments and for many different use cases. It seems obvious from afar, but part of the sales force integration issue was dysfunction in Okta’s go-to-market sales motion. At least the company has identified the problem; fixing the sales motion is not going to happen instantaneously but is more of a process.

The most visible element of the integration issue comes from the salesforce attrition/turnover rate. Depending on the place in the economic cycle, Okta indicated it had averaged about 15% turnover or a bit less in the years before the pandemic. Turnover is now a bit greater than 20%. And much of that turnover has been amongst the former salespeople of AuthO. Here is some of the comment from Todd Mackinnon specifically on the issue.

Like if you’re working for Auth0, this pre-IPO company your — it’s smaller, your territory is probably eight states in the US. And now you’re working for Okta and you’re expected — as of the first of this year, you’re being asked to sell to these multiple buyers with multiple products and your number of states or your territory really got smaller, because we have this much more scale that sales team. I could see why some of them decided to go maybe work for a smaller company and so forth.

I have to confess that in listening to that part of the conference call, and contrasting it with my own experience, I got quite agitated. What’s being described is a rookie mistake, and seems… well the term unforced error comes to mind. I can personally guarantee that the combination of smaller territories with an aggressive hiring plan that will make territories even smaller will inevitably lead to massive sales turnover because salespeople can’t see how they will be able to achieve objectives and make any money-no commission accelerators to be found. About the best thing about that is that it is relatively easy to fix, and from what I gleaned from the conference call, the company is taking steps to remediate that issue. Again, from Mr. Mackinnon:

But we’re starting to see a lot of these trends reverse already, which is great. We’ve talked about a lot of the things we’re doing. I’m sure those are having some effect, although some of them are recent. But just in terms of the industry, I think a lot of small companies; especially the prospects don’t look as good. The valuations aren’t as high. The money is not flowing there as much as it was. I’ve already seen a few go-to-market folks that left for smaller companies, and they’ve come back and the grass wasn’t always greener.

While I won’t accuse the rest of the answer as being the most articulate, it probably is reflecting some early trends in which salespeople are discovering that the environment has changed, and there prospects are currently better in a larger, more stable organization than in a start-up whose prospects of going public any time soon are limited. It isn’t terribly surprising that AuthO’s sales force has been composed of risk-takers who wanted to bet on a huge pay day from an IPO, and when, instead, the company was bought, and they weren’t catered to, they went to another situation that appeared to have a similar upside. Without the potential income from an IPO, selling identity management for Okta is probably a more attractive alternative currently than had been the case recently, particularly after some remediation of the comp plan as management has spoken about.

The other major issue is that of competition. Recently, Gartner held what it called an identity management conference. Yes, there really are such things as identity management summits. At the conference, some of the presenters and attendees talked about an increased presence by Microsoft (MSFT) in the space, and it was apparently these presentations that were a precipitating factor in the recent Cleveland Research downgrade cited earlier. The fact is, however, that the Microsoft solution is really focused on applications running in Azure. Microsoft has been in the space for almost 10 years at this point, and a company such as Microsoft that sells applications more or less has to have an identity management solution in order to be considered as a real vendor. Microsoft’s solution was initially built for to be an on-prem product-there was no Azure back when the product was first launched. Although, of course, Microsoft has a cloud based solution, it is unlikely to have the competitive chops that Okta brings to this market.

Most customers, at least those who are serious about identity management, are going to want a specialist vendor because almost inevitably they have a multiplicity of clouds, and they need to work with a vendor whose specialty is a multi-cloud environment-and that obviously is not Microsoft. Identity management can get far more complicated than it might seem, and when the subtleties are properly presented and explained, Okta’s position is very strong. But of course, the issue is carefully crafting the right message and making sure that sales reps are well trained to explain that message carefully and to the right audience. Okta’s problem isn’t that Microsoft had an enhanced set of functionality, but that the company needs to do a better job with trained reps presenting the benefits the company offers to the appropriate audience.

Other presenters at Gartner’s summit conference focused on what are called Identity Governance (‘IGA’) and Okta Privileged Access Management (‘PAM’) which are different sub-categories in the space, where Okta has introduced recent offerings. Of course I wouldn’t expect the CEO, especially given his role and history at Okta to ever admit to a competitive deficiency but I thought he response to the queries was credible and struck me as more likely to be accurate than some of what can be presented in Gartner forums.

And so when I hear people say that IGA is IGA light, it’s great because that means it’s working. That means it’s so simple that employees can do these access requests and improve these things just in their chat. They don’t have to go to some legacy tool. It means that the integrations are a snap. It comes pre-integrated to thousands of apps. So I think there’s — I think you’re going to — I think the industry is going to see that first of all, IGA is much bigger than we think it is because the solutions have been constraining the size of the pie. It’s kind of like everyone said that the ITSM market was very small in ServiceNow started, but a better product made the market bigger. I think you’ll see a similar thing here.

Investor concerns about competition aren’t going to abate just because of company presentations. And outsiders making some competitive assessment are always in a position of having to avoid sensational claims, or stories based on an agenda. I confess to the temptation myself; I know a couple of very satisfied Okta users in a large enterprise. But looking at the preponderance of the evidence, as best as I can, I don’t think Okta’s problems are competitive, but self-inflicted wounds stemming from very flawed strategies to integrate two dramatically dissimilar sales paradigms.

Okta’s Opportunities – Identity management at a high level is required as part of a cyber-security solution

There are two primary components to the access market, one having to do with the ability of employees to sign on to applications within their corporate firewalls, and the other market in which customers can sign on to manage their accounts and to order from vendors. There are obviously similarities between both markets, but until Okta bought AuthO competitors had focused on one segment or the other. As mentioned earlier, the key to Okta’s future operational performance is to present to CEO’s and other C-suite decision makers, the benefits they will enjoy by partnering with a leading vendor who has the most complete set of identity management solutions in both spaces and whose solutions are basically cloud-neutral. While market share data can be slippery at best, the Okta future is predicated on its ability to grab market share, and to achieve the kind of market dominance it enjoys in the Single User Sign-on market, a subset of employee identity management.

The employee identity management market where Okta started is currently estimated to have revenues of $13 billion rising to $37 billion by the end of the decade. Identity theft use cases continue to rise. They actually increased 45% in 2020, and rose further last year. Just in North America, the cost of identity theft was said to be $56 billion, according to the study linked here. Attackers use machine learning to generate multiple variants of malicious code every day.

The Consumer Identity Access Management market is thought to be a bit smaller at this time than the workforce identity market, but it is growing more rapidly. This linked analysis forecasts that CIAM, as it is often abbreviated, has a multi-year CAGR of 17%. Okta developed a solution of its own in CIAM. But with the acquisition of AuthO it now has the leading market share in the space. AuthO had been Okta’s leading competitor.

Okta’s investor presentation speaks to a TAM of $80 billion, composed of Workforce Identity+ IGA and PAM of $50 billion, with the TAM of the CIAM space being estimated at $30 billion. The TAM is based on estimates for 2025 Regardless of the precise number of the TAM, the identity management space is very large, and affords Okta a substantial growth opportunity for years to come. The issue is sales execution, messaging and overall go-to-market tactics and not demand opportunities for the solution.

Okta has the leading market share in both categories. The analysis linked here by a market research firm puts its market share at 37%. It has a higher share than that in Single User Sign-on, perhaps the most basic identity management solution. As the analysis linked here shows, there is considerable overlap in terms of functionality between CIAM and IAM, which plays strongly to Okta’s strength.

I have linked here to the latest Gartner Magic Quadrant analysis for Access Management which continues to show Okta and AuthO in the leaders quadrant along with Microsoft. I also have used Forrester’s Wave analysis which shows Okta with an unambiguous lead in the space. The Forrester Wave review basically suggests that Microsoft, despite efforts to move beyond its own base of Azure and other Microsoft-centric users is far better suited for Microsoft-centric users than as a general competitive offering.

There are, to be sure, many competitors in the identity management space. And there are even more analysis of the vendors in the space. I have chosen one to link here identifying many competitors, but there wasn’t anything particular about its analysis that makes it better than the others. For some years now, Okta has been gaining market share in the space as it continues its move upmarket and to add features, functions and integrations, which is a key differentiator for most users.

Okta has been able to gain market share because of best of breed functionality, and because it is platform/cloud neutral, and because it has always been a cloud first solution. So, when looking at CAGR estimates, it is important to note that they do not differentiate between on-prem and cloud. Thus, Okta’s CAGR estimates are always going to be greater than the CAGR for the market as a whole since cloud is growing far faster than on-prem in access management. In addition, almost all application software vendors have some kind of identity management built into their software. But increasingly, users want more sophisticated solutions with more features and which work across multiple clouds than are offered by stack application vendors. Most market research analysts highlight that trend, and it should, over time, be the other major factor in Okta’s market share gains.

Okta’s revenue forecast obviously should be considered as quite disappointing when considering the trends in the market. While it is probably impossible to identify which factor is causing a specific percentage of the decline in bookings (cRPO) balances, I think it is fair to conclude that even with such macro headwinds as their might be, the company should be able to grow its revenues by near-30%, so the forecast it has presented, of 2% sequential growth, followed by 5% in a quarter that usually has significant positive seasonality, is far below what I think ought to be a realistic goal for Okta.

Should Investors Buy Okta Shares Now/Reviewing the company’s business model

Okta shares are so beaten down that they could have a dead cat bounce, and at these valuations rumors of PE interest and potential investment by activist investors are likely – it was a significant factor in the initiation of the shares at a buy rating by the Jeffries analyst. That said, the ability of the shares to achieve sustainable appreciation will await a more benign market environment for high growth IT shares. And that in turn will be a function of changes in macro conditions such as inflation, changes in employment, and the tenor of Fed speakers.

But beyond that, Okta will have to demonstrate that it is returning to sustained market share gains. The opportunity is there, and Okta certainly has the most complete and functional set of solutions particularly for larger enterprises. And the need to prevent identity theft just keeps growing, and the consequences for ignoring solutions to remediate the threat are also escalating. So, it is really a matter of basic blocking and tackling.

The company management has articulated the tactics to achieve that, but it will almost certainly be 2-3 quarters between the identification of problems and their remediation becomes discernible. Replacing and training lost salespeople and seeing them reach full productivity is always a process of some duration. Okta is still in the process of realizing some cost synergies inherent in the combination with AuthO, and a bit of that was discernible in the results of the previous quarter.

Non-GAAP gross margins ticked up slight on a sequential basis, rising to 77% last quarter. Non-GAAP research and development spending actually declined sequentially, and was about 21% of revenues. The Non-GAAP sales and marketing expense ratio also showed a small sequential decline, although at 37% of revenues, there is still much room for improvement. Although general and administrative expense also fell noticeably, at 14% of revenues, non-GAAP, that ratio is still very elevated. The company has a clear path to profitability, given the progress it has been making in that direction and the unit economics of its business, and so far as it goes, even SBC expense fell from year earlier levels, although much of that has to do with the timing for the recognition of option expenses which are recorded when they vest in accordance with the Black-Scholes paradigm. As mentioned, SBC expense last quarter was still elevated at 38% of revenue, down from 41% the prior quarter. The year earlier figure was much higher, but is not terribly relevant given the timing of vesting.

The company’s operating cash flow margin last quarter was about nil. The year over year comparison is not relevant because of the impact of AuthO on year earlier results. The biggest element of the performance in free cash flow this past quarter was the increase in A/R balances. The quarter, according to the CFO, was more back-end weighted than usual, reflecting extended decisioning on the part of some enterprise customers, and some large deals were with government agencies such that average duration of contracts in the quarter declined, and impacted the increase in deferred revenues. The current quarter is also likely to see an elevated proportion of Federal cyber-security spend as it extends beyond the end of the government’s fiscal year, and cyber-security spending by the government is apparently at rates of close to 40%.

Okta shares, even after their mini-bounce since the low that was made in the wake of the downgrade by Cleveland Research, sell at an EV/S of about 4.5X. That ratio is noticeably less than the average EV/S for a low 30% 3 year CAGR. I expect that the company, after it remediates its sales execution issues, and in a less stressed economic environment, can return to mid-high 30% revenue growth.

The company has forecast that it will achieve single digit free cash flow margins this year, considerably greater than its forecast for non-GAAP EPS. Part of that is seasonal and p[art will be a function of the likely fall in receivables days outstanding. Changes in free cash flow are often a function of duration of larger deals and are thus notoriously difficult to forecast, but the path to non-GAAP profitability that is discernible, will also encompass rising free cash flow margins.

Having written analysis for donkey’s years (donkeys have a life span of 40 years so I suppose I have exceeded that), it is often the custom to provide a catalyst to support a recommendation. I don’t really like to suggest that a catalyst for this recommendation is the percentage by which shares have fallen, although, to be sure, Okta screens well on that dubious distinction. This is a contrarian call. No one really likes recommending companies with so many moving parts in senior management, or whose management team has made some significant unforced errors. But that said, Okta is still the leading company in a hot space, and despite some assertions to the contrary, I don’t see any degradation in its competitive position. And as I see it, its position is such that its long term market share gains should resume once it addresses sales force turnover and improves its messaging to the enterprise.

Okta shares, as mentioned, have many attractions for institutional investors including size/liquidity and a very specific position within cyber-security, a market space that many institutions want to overweight in this very perilous macro environment. Despite my previous unpleasant experience in owning the shares, I am planning to return for what is hopefully a more favorable experience this time around. As with most contrarian calls, timing is never exact or guaranteed, but my view is that by the time everyone agrees that the company’s problems are solved, its relative valuation will balloon. This is one case in which I would rather be early than late.

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