Why is OKTA down more than its peers in the software industry?

September has seen a significant correction in some of the cloud computing companies in the software industry. These momentum stocks have been outperforming broad market indices by a wide margin in 2019. Before the recent correction Okta OKTA:NASDAQ had returned 106% for the year as of July 31. Similar companies in the industry such as Twilio TWLO:NYSE, Appian APPN:NASDAQ and VMWare VMW:NYSE had returned market-beating returns of 59%, 48% and 31% respectively.

In the selloff that has affected these stock four stocks over the last three days Okta has suffered the largest decline. In the last 30 days it has retraced -23% compared to -17% for Twilio, -13% for Appian and VMWare has only lost -4.36%. Okta and Twilio have suffered the most significant correction with Okta declining the most.

Besides the selloff affecting stocks the Tech sector and specifically in the software industry Okta’s share price decline has most likely been exacerbated by its issuance of 1.0 billion convertible senior notes. According to the companies’ press release Okta intends to issue 1.0 billion in convertible debt with an option to issue a further 150 million in convertibles at face value of 1,000. The notes are convertible to 5.2991 shares per 1,000 face value. This will potentially dilute the existing shareholders by increasing the current number of shares outstanding in the float by approximately 6%. Additionally, the company issued 3 million in new shares to holders of a previous convertible debt issue due in 2023. This was part of a deal with these bond holders to exchange their current holding for the new convertible issue and thereby save the current shareholders from further dilution.

In addition to the dilutive effects of the convertible bond issue the actions of arbitragers may also be adding to the downward pressure on Okta’s shares as well. Hedge funds that implement convertible arbitrage strategies could be selling shares short while hedging their position with the convertible debt which is callable if the shares reach 188.

From a technical viewpoint Okta is struggling to stay above its 200 day moving average. For now it has found support there but if this support level breaks we can most likely expect to see the price fall to the $83-$88 range. This is the previous range the stock traded in for the year to date before it broke out in April and this is where the most concentrated amount of buying took place and would most likely serve as the next significant price support level:

Chart Courtesy of Stockcharts.com

On a relative basis Okta trades at a Price to Sales multiple of 24x’s sales. For this multiple to be justified Okta’s sales will need to continue to at the 56% CAGR that the company has achieved so far. If the current Sales per share grew at this rate for four more years and assuming all else equal, we can estimate that the sales per share would be approximately 25.05 by 2023.  

Current Sales/Share	CAGR	Sales/Share
		2020	2021	2022	2023
4.23	56%	6.60	10.29	16.06	25.05

A P/S multiple of 24 would generate a value for the stock at $601.20. Discounted at a long-term growth rate of 8% the present value of the shares would be around $442. This valuation is contingent on the current high growth rate sustaining for four more years. Using this single metric Okta would appear to be a buy on this current pull back. An investor would need to consider other factors.

Currently SG&A is more than 70% percent of sales and this will need to come down to more reasonable percentage for the company to become profitable and generate cash flow. Free cash flow is currently negative but the company has noted that free cash flow margin has been improving over the last two quarters and is expecting that that trend will continue. If SGA were to decline by 10% for the next three years the company could become cash flow positive and then a FCFE valuation model would also support the present value of $442.

This makes the assumption that Okta can maintain its superior growth rate while at the same time cutting SG&A. If we use a lower base case high-growth rate of 36% a FCFE model yields a present value of $156 for the stock.

Given this Okta does indeed appear to be an attractive investment at this level but investors would want to consider how much growth is still available to Okta and whether the entrance of new competitors will challenge Okta’s presence in the Cloud computing arena. An investor will need to consider if Okta will continue to achieve growth through more potentially diluting offerings of debt and stock and if they can reduce R&D spending going forward.