SentinelOne: My Top Pick Of 2023 (NYSE:S)
With so many tech stocks down 80%, even 90% from all-time highs, there are numerous buying opportunities in the sector. That could make it difficult to identify one top pick among the bunch. SentinelOne (NYSE:S) separates itself from the pack through its combination of fast growth, undervaluation, and compelling cybersecurity growth story. S has a cash-rich balance sheet which makes up most of its market cap after the stock price crash. While S is still bleeding cash, it has realized significant operating leverage in recent years and continues to project reaching an inflection point within 2 years. I view cybersecurity as having the potential to be a bright spot even considering a tough macro backdrop, as protection against cyberattacks retains importance regardless of the broader economy. S is my top pick of 2023.
S Stock Price
After coming public via IPO at $35 per share, S initially traded up to $75 per share but has since crashed around 80%.
I last covered S in August where I rated the stock a buy on account of the resilient fundamentals. The stock has since fallen by another 42% as its cybersecurity premium has all but vanished – likely due to the lack of positive cash flow generation. There are clear catalysts in view for a violent recovery in valuations.
S Stock Key Metrics
While many tech stocks are showing material deceleration due to macro, S delivered 106% revenue growth in the latest quarter. Cybersecurity is “mission-critical” and does not become less relevant in a recession.
S drove most of its revenue growth through rapid customer growth, with its largest customers almost doubling YOY.
Like cybersecurity peers, S has also sustained strong net retention rates, coming in at 134% in the latest quarter.
That said, S differs from its main competitor CrowdStrike (CRWD) in that it has a less complete offering. That may help to somewhat explain the relative discount, but investors may be underappreciating the shift toward managed security service providers (‘MSSPs’). Amidst a tough macro backdrop, small and medium sized businesses may be looking for a cybersecurity solution that is cheap and easy to implement – MSSPs offer such a solution. S is a favorite partner for MSSPs and management believes that it has only begun to realize the growth potential of that sales channel.
Unlike many cybersecurity peers, S is still not yet profitable on a non-GAAP basis, though it did realize 26 percentage points of operating leverage in the latest quarter. That represents the fifth straight quarter of 25% YOY operating leverage.
S ended the quarter with $1.2 billion of cash, more than enough cash to fund ongoing losses for many years even without further operating leverage. Yet on the conference call, management reiterated expectations to continue driving around 25% of margin expansion each year, culminating in profitability by fiscal year 2025 (the most recent quarter was the third quarter of fiscal 2023).
Looking ahead, management has guided for $125 million in fourth quarter revenues, representing 89% YOY growth. S even slightly raised full year revenue guidance to $421 million, up from $417 million.
Investors may be wondering how the macro environment is affecting the company. Management noted increased scrutiny on deals but viewed it a matter of being delayed rather than canceled. That led to many deals closing subsequent to the end of the quarter. Management also noted that pricing still remains strong – at this point it does not appear that S has had to concede on pricing due to macro.
Management gave preliminary guidance for “at least 50% total ARR growth” in the next year. Management also guided for “another 25 points of operating margin improvement” in the year and as stated earlier reiterated guidance for profitability within 2 years. Management expects positive cash flow generation to occur earlier than that, by the end of next year. Recall that tech companies typically generate stronger free cash flow than net income due to prepayment of deferred revenues.
While 50% projected growth represents steep deceleration from this year’s projected 105% growth rate, management did emphasize that the tentative guidance is “really a floor,” and should be viewed as an ultra-conservative number.
Is S Stock A Buy, Sell, or Hold?
Given how rapidly S is growing, this is the kind of stock that I wouldn’t be surprised to see trading at around 20x sales, even after the tech crash. Yet that is not the case. S is trading at only 6.8x forward sales – and that is not giving credit to the net cash making up 27% of the market cap.
Management has guided for 20% free cash flow margins over the long term. Assuming just 40% growth and a 1.5x price to earnings growth ratio (‘PEG ratio’), I could see S trading at 12x sales. That places S at 75% higher in a year – and that is not giving the typical cybersecurity premium. As S executes against profitability targets, I see its PEG ratio expanding to be more in-line with peers like CRWD and Zscaler (ZS). Those are names which continue to command rich premiums even after the crash. I wouldn’t be surprised if S eventually commanded a 2x or even 2.5x PEG ratio over time – the main catalysts being improved bottom-line margins and some recovery in overall tech valuations. That may even be understating the opportunity here. Like CRWD, S is capitalizing on the intersection of two trends. Cybersecurity is in itself a convincing secular growth story, but S is rapidly taking market share from incumbents like McAfee and Symantec as it offers a more innovative solution powered by artificial intelligence. I expect S to sustain more than 30% growth for a long time – just look at how CRWD and ZS have been able to sustain such rapid growth rates even as they lap tough comparables.
What are the key risks? Compared to CRWD, S may have greater risks to estimates mainly due to the smaller product portfolio. That is, CRWD may have an easier time sustaining growth in tough macro conditions due to being able to cross-sell existing customers against its wide product portfolio. S, on the other hand, may have greater reliance on onboarding new customers to sustain growth rates. The lower bottom-line margins may also lead to greater volatility in the stock price, though the net cash position looks like enough to fund many years of losses at the current run-rate. Cybersecurity firms may have greater existential risk than other tech names – if S were to suffer a cyber attack, then that might negatively affect their reputation and ability to grow let alone retain customers. I have discussed with subscribers to Best of Breed Growth Stocks that I have chosen a portfolio of undervalued tech stocks as my preferred approach to take advantage of the tech stock crash. S is my top pick in such a portfolio as it offers both high-growth and multiple expansion potential.