Okta (OKTA 1.21%) got off to a great start this year, with the stock ending the first quarter up 26%. It's a remarkable reversal of investor sentiment toward the company, which shifted from extremely pessimistic in 2022 to optimistic about the company's future in 2023.
There is little doubt that the company has many positive long-term attributes. But in the short term, the possibility of a recession in the U.S. (Okta's largest market) is still very much on the table. If a prolonged recession were to occur, sentiment toward the company could turn sour again, with the stock price quickly deflating.
With that said, should you take a chance and invest in the long-term upside of this identity management company, or should you stay on the sidelines?
Let's discuss the positives and negatives.
Why growth investors love Okta
Okta is a company that performs identity and access management services. It confirms a person's identity and securely connects them to applications they are authorized to access on any device. As companies increasingly adopt cloud computing, install automation tools throughout their organizations, and adopt identity security solutions to control access to company information, the demand for Okta's services has snowballed.
It grew customers by 18.4% year over year to 17,600 as of Jan. 31, 2023. Even more important, it grew customers with an annual contract value greater than $100,000 by 27% to 3,930, showing that it is rapidly gaining larger enterprise customers. This is significant since larger customers often prove more loyal and spend more money on more products compared to smaller customers.
Consequently, the faster Okta grows its large enterprise customer base, the stronger its customer retention might become. This in turn grants it the ability to upsell and cross-sell additional products; thereby, improving the dollar-based net retention rate (DBNRR).
Image source: Okta.
DBNRR is a ratio that measures the percentage change in revenue from existing customers, including cancellations and income gained from upsells and cross-sells over a given period. Okta consistently produces a DBNRR above 120%, meaning the company regularly earns 20% more revenue from its existing customers each period. These are healthy metrics for a company using a cloud-based subscription business model like Okta.
During a bull market, investors usually award a very high valuation to a subscription business that maintains a DBNRR above 120% for an extended period. For instance, in early 2021, Okta traded at a price-to-sales (P/S) ratio around 45. And even in today's challenging market, it trades at a P/S around 6.5 compared to the cloud computing and data analytics industry average P/S valuation of roughly 3.
Okta also has above-average revenue growth. It grew quarterly revenue by 33% over the previous year's comparable quarter to $510 million, showing solid demand for what Okta sells, despite a terrible market environment.
Last but not least, the company has only penetrated 2.32% of its total addressable market, leaving plenty of room to continue expanding.
Image source: Okta.
However, if everything is so rosy, why did investors sell off the stock in 2022?
Everything that could go wrong did go wrong in 2022
Persistently high inflation and rising interest rates are like "Kryptonite" to an early stage, unprofitable growth stock like Okta. Unfortunately, this company's margins and profits started falling off a cliff in mid-2021, just as inflation started to heat up. To fight inflation, the Federal Reserve began hiking interest rates starting in March of 2022. So, it was only a matter of time before investor sentiment shifted to negative on Okta's stock.
OKTA Operating Margin (TTM) data by YCharts
Several execution issues exacerbated investors' fears over Okta's unprofitability. The most significant of these issues being its failure to unify the sales organization from its Auth0 acquisition with its existing sales organization. As a result, its second-quarter fiscal 2023 quarterly revenue growth fell below management's expectations.
If you tack on the fact that investors were also worried about whether Okta would lose customers in reaction to management's poor response to a breach from hacking group Lapsus$ to begin 2022, there was little wonder the stock fell out of favor during the year.
So, if 2022 was such a mess, why are growth investors looking to buy the stock in 2023?
The skies look sunny again
Through the first quarter of 2023, investors learned that management's cures for many of the company's 2022 ills were working.
First, management soothed its customers' fears about the Lapsus$ hacking incident by the second quarter of 2022 by beefing up its security and promising to keep customers better notified about future security incidents.
Next, the company solved many of its sales integration issues with its Auth0 acquisition by creating a new marketing plan, and it appears its sales team has bought into the new structure, evidenced by increased sales.
Last but not least, management had already been battening down the hatches over the past several quarters in anticipation of the economy getting worse. As a result, it has cut unnecessary costs, while simultaneously investing in areas where it can get the most bang for its buck.
Okta's moves are already yielding positive results. Operating expenses have dropped, and the operating margin has sharply increased.
OKTA Total Operating Expenses (Quarterly) data by YCharts
So, investors are once again excited about Okta's prospects. The only question is, should you buy it?
If you believe in Okta's long-term success and can withstand the possible short-term downside should a significant recession occur, now is a great time to collect a few shares.
