Shares of small cybersecurity company SentinelOne (S 1.70%) have rallied nearly 50% in the past month, including a 16% jump on Wednesday, the day after it reported third-quarter earnings. Congrats to shareholders that bet on a rebound this year.
The business is a technological leader in providing endpoint security -- helping enterprises protect employee devices like PCs and smartphones -- and it's putting up stellar growth amid difficult economic conditions this year. However, headed into 2024, financial issues remain that could cause investors fits. Is this stock a "value trap"?
SentinelOne beat revenue estimates
First, some good news that helped support SentinelOne's recent rebound. For the third quarter of fiscal 2024 (the three-month period ended Oct. 31), revenue increased 42% from the year prior to $164 million, surpassing management's guidance provided a few months ago.
That's great news, because the overarching story this year for SentinelOne -- as well as other cybersecurity companies -- has been slowing growth. Clearly SentinelOne isn't exempt. Sales rocketed 70% higher in Q1, and 46% in Q2, so the top-line sprint in Q3 is certainly a cool-off. And for the next quarter, the company's new outlook implies the slowing trajectory will continue. Management expects Q4 (the three-month period that will end in January 2024) revenue will be $169 million, implying year-over-year growth of "only" 34%.
Problems that could sneak up
Losing steam is one thing. After all, SentinelOne's more sluggish pace of expansion is still quite fast. But there's a much bigger underlying issue, and that's a lack of profitability. The company's GAAP operating loss was $69 million, a margin of negative 50% in Q3, or negative 11% on an adjusted basis -- with the difference between the two primarily being employee stock-based compensation (SBC), more on that in a moment.
As SentinelOne's revenue momentum slows, it will get harder for the company to turn the corner on profitability simply by outgrowing expenses. It will need to get more diligent with cost cuts. And cost cuts can do a number on growth momentum for a small cybersecurity business like this one, which is competing with far larger operations in a hypercompetitive and constantly changing cybersecurity industry.
Simply put, slowing growth and persistent operating losses can be an intertwined issue that continue to spiral out of control.
Of course, SentinelOne has means to deal with this. Its balance sheet remains flush with $798 million in cash and short-term investments, and another $325 million in long-term investments.
But there's another wrinkle to this story. This past summer, reports surfaced that SentinelOne was exploring a sale. Why would management consider selling out before a full righting of the ship can take place? It has to do with the company's shareholder structure, and with the majority of company voting rights being concentrated with early venture capital investors Insight Venture Partners and Redpoint Ventures. As I pointed out a few months ago, if these two key shareholders want to cash out and move on to a business that is smaller and has higher growth potential (because that's what venture capital does), they have the power to make a sale happen.
Waiting for profit margin improvement in a publicly traded company isn't exactly the venture capital game. Additionally, SentinelOne has that stock-based compensation working against shareholders. It shelled out $163 million in employee SBC through the first nine months of this year, worth nearly 3% of the current market cap, and a 38% increase from the same period last year. SBC is a key way a cybersecurity outfit retains its talent. Nevertheless, it's also another headwind against the company's financials and dilutes existing shareholders on a per-share basis.
SentinelOne stock has notched a respectable rebound this year, but there's a lot that could go wrong in 2024. This small stock could be a value trap for investors focused on the fast revenue growth but ignoring the other problems going on at the business.
