Author: Chong Ser Jing

Veeva Systems (NYSE: VEEV) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Veeva shares for the portfolio in November 2017 at a price of US$61 and subsequently made three more purchases (in September 2018 at US$100, in November 2018 at US$98, and in June 2019 at US$165). I’ve not sold any of the shares I’ve bought. 

The purchases have mostly worked out well for my family’s portfolio, with Veeva’s share price being around US$181 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to invest in Veeva shares.

Company description

The process to develop medical devices and drugs is highly complex and time consuming for the life sciences industry, which includes pharmaceutical, biotechnology, and medical device companies. For instance, clinical studies for drug development can take anywhere from six months to several years. Proper documentation is also necessary all the way from drug development to commercialisation and there are easily hundreds if not thousands of documents involved. Veeva provides cloud-based software to help pharma, biotech, and medical device companies better handle all that complexity. 

Here’s a graphic from Veeva showing all the software products it has that support the commercial and research & development (R&D) activities of the life sciences industry:

There are a lot of software products that Veeva has, but the company groups them into three categories:

• Veeva Commercial Cloud: It supports a life sciences company’s sales & marketing activities. Some of the products within Veeva Commercial Cloud include a commercial data warehouse, customer relationship management (CRM) apps, data management apps, and key opinion leader data.
• Veeva Vault: It houses software that helps life sciences companies to manage content and data from R&D through to commercialisation.    
• Veeva Data Cloud: A new service introduced in March 2020 that is scheduled for launch in December 2020. Veeva Data Cloud is a patient and prescriber data service and will initially focus on patient and prescriber data solutions for the US specialty drugs distribution market. Veeva Data Cloud will be built on existing technology from Crossix, a privacy-safe patient data and analytics company that Veeva acquired in late 2019.

In FY2020 (fiscal year ended 31 January 2020), 49% of Veeva’s total revenue of US$1.1 billion came from Veeva Commercial Cloud while the remaining 51% came from Veeva Vault. The table below gives an overview of the geographical breakdown of Veeva’s revenue in FY2020:

At the end of FY2020, Veeva had 861 customers in total. These customers range from the largest pharma and biotech companies in the world (such as Bayer, Eli Lilly, Novartis, and more) to small players in the same space (such as Alkermes, Ironwood Pharmaceuticals, and more). 

In recent years, Veeva has started selling content and data management software services to companies outside of the life sciences industries. Veeva is targeting three regulated industries: Consumer goods, chemicals, and cosmetics. I don’t have data on the exact split for Veeva in terms of revenue from life sciences and outside life sciences. But the lion’s share of the company’s revenue is still derived from the life sciences industry. 

Investment thesis

I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Veeva.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

The total market opportunity for Veeva is currently over US$10 billion, which is around 10 times the company’s current revenue of US$1.1 billion in the last 12 months. The chart below shows the breakdown of Veeva’s market opportunity:

I also think it’s likely that Veeva’s market opportunity will grow over time. In Veeva’s September 2016 Investor Day presentation, management shared the charts below, which illustrate the company’s market opportunity back then. Management showed that Veeva’s market had expanded from US$5 billion in September 2015 to US$6 billion in September 2016 because of software innovation at the company. (More on Veeva’s innovation later!)

2. A strong balance sheet with minimal or a reasonable amount of debt

As of 31 January 2020, Veeva held zero debt and US$1.1 billion in cash and short-term investments. That’s a rock solid balance sheet.

For the sake of conservatism, I also note that Veeva had US$54.8 million in lease liabilities. But that’s a tiny sum compared to the cash and short-term investments that the company had on hand.

3. A management team with integrity, capability, and an innovative mindset

On integrity

Leading Veeva as CEO is Peter Gassner, 55. Gassner is a co-founder of the company, and has served as Veeva’s CEO since the company’s founding in 2007. From 1995 to 2003, he was Chief Architect and General Manager at PeopleSoft. And from 2003 to 2005, Gassner was Senior Vice President of Technology at salesforce.com, one of the pioneering software-as-a-service companies. In my view, the relatively young age of Gassner, his years of experience in leadership roles in other tech companies, and his long tenure with Veeva, are positives.

The other important leaders in Veeva, most of whom have multi-year tenures and relatively young ages (both are good things in my eyes), include: 

Veeva’s compensation structure for management makes me think that my interests as a shareholder of the company are well-aligned with management’s. Here are the key points:

• From Veeva’s IPO in October 2013 to FY2019, the company (1) was paying its key leaders cash compensation that were below market rates; (2) never offered any short-term cash-incentives to management; and (3) placed heavy emphasis on long-term stock awards, in the form of stock options and restricted stock units that vest over multiple years.
• In FY2019, all of the aforementioned leaders of Veeva were paid the same base salary of US$322,917, and nothing else – they were not given any equity awards. Management instead derived more compensation from vesting of stock awards that were given in previous years. The base salaries paid in FY2019 to Veeva’s management are rounding errors when compared with the company’s profit and free cash flow of US$230 million and US$301 million, respectively, for the same year.
• Gassner’s base salary also increased by only 0.7% in FY2018 and 7.6% in FY2019 despite much faster growth in Veeva’s business in both years (I will be sharing a table of Veeva’s financials later).
• In FY2018, Gassner was given US$87.8 million in stock options, which started vesting in February 2020 and will only finish vesting in February 2025, provided that Gassner continues to serve as CEO.
• A new compensation structure was implemented in March 2019 for Veeva’s management. There are positives and a negative with the changes, though I think the pros outweigh the con. The positives: (1) The base salary is going to be US$325,000; and (2) there will be long-term equity incentives (in the form of stock options) that will form the lion’s share of each leader’s annual compensation and that vest over four years. The negative: There will now be a short-term incentive program made up of restricted stock awards that will vest over one year.  

I also note that Gassner controlled 16.0 million Veeva shares as of 31 March 2019. These shares are worth around US$2.9 billion at the moment. This high stake lends further weight to my view that Veeva’s key leaders are in the same boat as me. 

I want to highlight too that Gassner’s shares are all of the Class B type. Veeva has two share classes: (1) Class B, which are not traded and hold 10 votes per share; and (2) Class A, which are publicly traded and hold 1 vote per share. As a result of holding Veeva Class B shares, Gassner alone held 46.1% of the company’s voting power as of 31 March 2019. In fact, all of Veeva’s senior leaders and directors combined controlled 57.6% of Veeva’s voting rights (this percentage dipped only slightly to 53.2% as of 31 January 2020). This concentration of Veeva’s voting power in the hands of management (in particular Gassner) means that I need to be comfortable with the company’s current leadership. I am.

On capability 

Over the years, Veeva’s management has done a great job in growing the company’s customer count (up 31.7% per year from 95 in FY2012 to 861 in FY2020). This is illustrated in the table below:

But there’s more. Management has also been adept at driving more spending over time from the company’s customer base. This can be seen in Veeva’s strong subscription services revenue retention rate. It essentially measures the change in subscription revenue from all of Veeva’s customers a year ago compared to today; it includes the positive effects of upsells as well as the negative effects from customers who leave or downgrade. Anything more than 100% indicates that Veeva’s customers, as a group, are spending more. The table below shows Veeva’s subscription services revenue retention rate over the past few years. There has been a noticeable downward trend in the metric, but the figure of 121% in FY2020 is still remarkable.

Impressively, Veeva has produced subscription services revenue retention rates of significantly more than 100% for many years because the company has succeeded at (1) getting its customers to adopt more products over time, and/or (2) winning more users at a customer for the same product; the strong subscription services revenue retention rates did not come from Veeva raising prices for its software solutions.

For another perspective, we can look at the growth in the average number of products that a Veeva Commercial Cloud and Veeva Vault customer is using:

But there is a key area where Veeva’s management falls short: The company’s culture. Veeva has a 3.3-star rating on Glassdoor, and only 57% of reviewers will recommend the company to friends. Gassner has an approval rating as CEO of only 74%. Veeva has managed to post impressive business results despite its relatively poor culture, but I’m keeping an eye on things here. 

On innovation

Peter Gassner co-founded Veeva in 2007 with the view that “industry-specific cloud solutions could best address the operating challenges and regulatory requirements of life sciences companies.” He saw the market opportunity and grasped it with both arms, leading Veeva to become the first company to introduce a cloud-based CRM app – Veeva CRM – that caters to the global life sciences industry. It was not an easy ride for Gassner. Here’s a comment he gave in a 2017 interview with TechCrunch:

“Starting Veeva, I had the idea or vision you could make very industry-specific software in the cloud and it would be bigger than anyone would have thought. In 2007, [most] people thought that was incorrect.”

To me, the founding stories of Veeva are a great sign of an innovative management team.

Over time, Gassner and his team have also continued to lead successful product-innovation at Veeva. There are three examples I want to point to.

First, Veeva Vault was introduced in 2011, and has grown rapidly from around 5% of Veeva’s revenue in FY2014 to 51% of total revenue in FY2020. 

Second, Veeva has been relentless in creating new products. Here’s a chart showing the growth in the number of applications within Veeva Vault from 2011 to 2016:

Third, the company is now selling content and data management cloud-based software to regulated industries outside of life sciences, as mentioned earlier. It’s early days for this recent foray, but the signs are promising. Here’s a comment from Gassner in Veeva’s FY2020 fourth-quarter earnings conference call:

“Outside life sciences for CPG [consumer packaged goods], chemicals and cosmetics, we had a number of expansions and added some big wins with new companies, including a top 10 CPG company, who will adopt QualityOne, and a top 10 cosmetics company to standardizing on RegulatoryOne. In reflecting on the year for this business and looking ahead, we set the right course in the Veeva Way. We kept our focus on customer success and doing the right things for our early adopters, which is helping establish Veeva as a trusted provider in these new industries.”

I also want to point out the presence of Gordon Ritter as Veeva’s Chairman. Ritter is a founder of Emergence Capital, a venture capital firm that is one of the earliest backers of salesforce.com (Ritter was a driving force behind Emergence Capital’s decision to invest in salesforce.com). Emergence Capital is also one of the early investors in Veeva. Having Ritter as a director allows Veeva’s management to tap on a valuable source of knowledge. Ritter has been a director of Veeva since 2008 and he controlled nearly 3 million Veeva shares as of 31 March 2019, a stake that’s worth around US$485 million right now.

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

Veeva generates the lion’s share of its revenue through subscriptions to its software services, which are recurring in nature. In FY2020, 81% of Veeva’s total revenue of US$1.1 billion came from subscriptions. The majority of the company’s subscriptions with customers are for a term of 1 year. The remaining 19% of Veeva’s revenue in FY2020 was from professional services, where the company earns fees from helping its customers implement and optimise the use of its software suite.

There’s some form of customer concentration in Veeva – 36% of its revenue in FY2020 came from its top 10 customers. That’s a risk. But I’m comforted by the high likelihood that Veeva’s software services are mission-critical in nature for the company’s customers. 

For instance, the distribution of marketing and promotional material for the life sciences industry is highly regulated. This is where Veeva CRM can help through one of its applications, which enables the management, delivery, and tracking of emails from life sciences sales representatives to healthcare professionals, while maintaining regulatory compliance. In another example, the US FDA (Food & Drug Administration) requires life sciences companies to maintain full audit trails for the handling of electronic records; in fact, changes in data cannot overwrite previous records. Veeva Vault’s suite of apps helps life sciences companies meet the strict regulatory requirements for documentation.

5. A proven ability to grow

The table below shows Veeva’s important financial figures from FY2011 to FY2020. I like what I’m seeing:

A few key points about Veeva’s financials:

• Revenue has compounded impressively at 49.8% per year from FY2011 to FY2020. The rate of growth has slowed in recent years, but was still really strong at 28.7% from FY2015 to FY2020, and at 28.1% in FY2020.
• Net profit has surged tremendously since FY2011. Growth from FY2015 to FY2020 has been excellent at 49.6%; in FY2020, profit was up by a solid 31.0% too.
• Operating cash flow has consistently been positive for the timeframe I’m looking at, and has also increased significantly over time. The growth rate for operating cash flow from FY2015 to FY2020 was impressive, at 45.3% annually; in FY2020, operating cash flow climbed 40.7%. 
• Free cash flow has also (1) been consistently positive for the time period I’m studying, and (2) stepped up strongly. Veeva’s free cash flow was up by 60.5% per year from FY2015 to FY2020, and was up by 43.9% in FY2020 – these are eye-catching numbers. 
• The company’s balance sheet remained robust throughout the timeframe under study, with zero debt the entire way.
• At first glance, Veeva’s diluted share count appeared to increase sharply by 111.4% from FY2014 to FY2015. (I only started counting from FY2014 since Veeva was listed in October 2013, which is in the second half of FY2014.) But the number I’m using is the weighted average diluted share count. Right after Veeva got listed, it had a share count of around 122 million. Moreover, Veeva’s weighted average diluted share count showed a negligible growth rate of just 1.9% per year from FY2015 to FY2020.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

There are two reasons why I think Veeva excels in this criterion. 

First, the company has done very well in producing free cash flow from its business for a long time. Its free cash flow margin (free cash flow as a percentage of revenue) has also increased steadily from an already strong level of 18.5% in the year of its IPO. In FY2020, Veeva’s free cash flow margin was an incredible 39.2%. As a cloud-based software company, I don’t see any reason why Veeva cannot maintain a fat free cash flow margin in the future.

Second, there’s still plenty of room to grow for Veeva. Over time, I expect Veeva to significantly increase both its customer count and the average number of products used per customer. These assumptions mean that Veeva should see robust growth in revenue in the years ahead. If the free cash flow margin stays fat – and I don’t see any reason why it shouldn’t, as I mentioned earlier – that will mean even more free cash flow for Veeva in the future. 

Valuation

I like to keep things simple in the valuation process. In Veeva’s case, I think the price-to-free cash flow (P/FCF) ratio is an appropriate metric to value the company. That’s because the SaaS company has a strong history of producing positive and growing free cash flow. 

Veeva carries a trailing P/FCF ratio of around 66 at a share price of US$181. That’s a pretty darn high valuation at first glance. But as the chart below shows, Veeva’s P/FCF ratio has been much higher in the past. Moreover, the P/FCF ratio has averaged at 54 since the company’s listing, according to Ycharts, and that is not too far from where it is now.

In addition, there are strong positives in Veeva’s favour too. The company has: (1) Revenue that is low compared to a large and possibly fast-growing market; (2) a software product that is mission-critical for users; (3) a large and rapidly expanding customer base; and (4) sticky customers who have been willing to significantly increase their spending with the company over time. I believe that with these traits, there’s a high chance that Veeva will continue posting excellent revenue growth – and in turn, excellent free cash flow growth – in time to come. 

The risks involved

I see seven big risks with Veeva. In no particular order…

First, I think there’s key-man risk with the company. Peter Gassner – and his co-founder Matt Wallach – were the ones with the vision. And over time, I think Gassner has been instrumental in leading Veeva to success. Wallach relinquished an active management role at the company in 2019. Should Gassner leave for any reason, I will be concerned.

Second, there’s customer-concentration, as I already mentioned.

Veeva’s relationship with salesforce.com is the third risk I’m watching. The two companies have a long-standing contract that ends on 1 September 2025. Based on the agreement, salesforce.com provides hosting infrastructure and data centers for portions of Veeva’s CRM applications. There is also a non-compete arrangement, where salesforce.com will not compete directly with Veeva’s CRM applications within the pharma or biotech industry. In return, Veeva has to pay salesforce.com a fee of at least US$500 million by the end of the contract. This agreement is important as parts of Veeva Commercial Cloud are built on salesforce.com’s Salesforce1 platform. (Veeva Vault is built on Veeva’s own proprietary platform.) 

Based on the change in language used in Veeva’s annual reports for FY2020, FY2019, and FY2018 to describe Veeva’s partnership with saleforce.com, there appears to be a deterioration in the two companies’ relationship in recent years. I’m watching what happens if and when Veeva’s contract with salesforce.com is terminated. Veeva has already clocked 13 years of experience in providing CRM software that is focused on the life sciences industry. This gives me confidence that Veeva will be able to stand on its own even if salesforce.com pulls the plug on the existing CRM-partnership. But only time will tell.

The fourth risk I have an eye on relates to legal wrangles between Veeva and IQVIA. Veeva named IQVIA as its most significant competitor in the CRM software market for the life sciences industry in its FY2020 annual report. It’s worth noting that IQVIA’s CRM software is also built on the Salesforce1 Platform. IQVIA competes against certain applications within Veeva Vault too. For some background, here are excerpts from a February 2020 announcement by Veeva: 

“Veeva Systems (NYSE: VEEV) today announced it is gaining widespread customer support for its antitrust lawsuit against IQVIA (NYSE: IQV). Six of the largest global pharmaceutical companies were among more than 70 depositions gathered as part of the fact discovery phase of the case. As its initial lawsuit successfully advances, Veeva filed a motion this week to expand its legal action to include additional Veeva software applications that IQVIA is excluding customers from using with IQVIA data…

…IQVIA has a long history of abusing its monopoly position to limit customers and competition. Since 2014, IQVIA has prevented companies from using OneKey reference data with Veeva’s master data management software, Veeva Network Customer Master. Over the past two years, IQVIA also began restricting the use of all IQVIA data with Veeva Nitro, a next-generation commercial data warehouse, Veeva Andi, an artificial intelligence (AI) application, and other Veeva software applications.

After three years of trying to work with IQVIA in good faith toward a resolution regarding Veeva’s master data management software to no avail, Veeva filed its first antitrust lawsuit in 2017 to end IQVIA’s long history of anti-competitive behavior. IQVIA’s motion to dismiss that case failed and fact discovery is now substantially complete. Trial is expected to take place in late 2021.”

Despite IQVIA’s fiercely anti-competitive behaviour in the past few years, Veeva has still managed to grow its business significantly. Veeva’s management commented in the company’s recent FY2020 fourth-quarter earnings conference call:

“IQVIA is our primary competitor, as you know, there’s certainly regional competitors that we have, but they’re the ones that are primary in terms of global kind of scope there. IQVIA has continued to be aggressive in terms of how they approach the market in of pricing and bundling. Some of their projects have been a bit more services oriented, instead of standard product. And I think over the short-term that sort of thing could work out. I think over the long-term custom projects are not great.

From Veeva’s perspective, we had really great success last year. I’m really proud of what we’ve accomplished. Peter highlighted that we had 63 net new CRM customers, compared with the year before, where it was 46. So we’ve grown and we’ve actually expanded our share last year. And of those wins, most of them came — most of them were head to head with IQVIA, and many of them were IQVIA replacements. So I’m really proud of what we’ve accomplished. That’s the results. The results, I think, speak for themselves in terms of what we’re doing, where — we think our strategy is the right one, which is focus on product innovation and focus on customer success. So we’re innovating within core CRM in many different ways.”

It’s hard to predict the result of the legal battle between the two companies. But even if IQVIA wins, my bet is that Veeva will still be able to continue growing, since Veeva was able to grow even though IQVIA had already been behaving aggressively for some time. Again, only time will tell.

The fifth important risk I’m seeing relates to competition in general. As Veeva expands, it’s likely that Veeva Commercial Cloud and Veeva Vault could increasingly butt heads with services from tech giants such as Oracle, Microsoft, and Amazon. These companies have substantially stronger financial might than Veeva.

Veeva’s high valuation is the sixth risk. The high valuation adds pressure on the company to continue executing well; any missteps could result in a painful fall in its stock price. This is a risk I’m comfortable taking.

Lastly, I’m watching potential impacts to Veeva’s growth from COVID-19. The outbreak of the respiratory virus has resulted in severe negative impacts to the global economy because of measures to fight the disease, such as the closing of businesses and the restriction of human movement. I think that the mission-critical nature of Veeva’s service means that its business is less likely to be harmed significantly by any coronavirus-driven recession. But there could be headwinds.    

The Good Investors’ conclusion

In summary, Veeva has:

1. A valuable cloud-based CRM and content and data management software platform that is mission-critical for companies in the life sciences industry;
2. High levels of recurring revenue;
3. Outstanding revenue growth rates;
4. Positive and growing operating cash flow and free cash flow, and fat free cash flow margins;
5. A large, mostly untapped addressable market that could potentially grow in the years ahead;
6. An impressive track record of winning customers and increasing their spending; and
7. Capable and innovative leaders who are in the same boat as the company’s other shareholders

Veeva does have a rich valuation, so I’m taking on valuation risk. There are also other risks to note, such as the company’s complicated relationship with salesforce.com, and its legal battles with IQVIA. COVID-19 could also place a dampener on Veeva’s growth. But after weighing the pros and cons, I’m happy to continue having Veeva be in my family’s investment portfolio.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Okta (NASDAQ: OKTA) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Okta shares for the portfolio in March 2019 at a price of US$79. I’ve not sold any of the shares I’ve bought. 

The purchase has worked out well for my family’s portfolio, with Okta’s share price being around US$128 now. But we’ve only owned the company’s shares for slightly more than a year, and it is always important to think about how the company’s business will evolve going forward. What follows is my thesis for why I still continue to invest in Okta shares.

Company description

Okta’s vision is to enable any organisation to use any technology. To fulfill its vision, Okta provides the Okta Identity Cloud software platform where all its products live. Okta’s cloud-based software products help other companies manage and secure access to applications for their employees, contractors, partners, and customers.

The internal use-cases, where Okta’s solutions are used by organisations to manage and secure software-access among their employees, contractors, and partners, are referred to as workforce identity by Okta. An example of a workforce identity customer is 20th Century Fox. The external-facing use cases are known as customer identity, and it is where Okta’s solutions are used by its customers to manage and secure the identities and service/product access of their customers. Adobe is one of the many customers of Okta’s customer identity platform.

There’s a rough 80:20 split in Okta’s revenue between the workforce identity and customer identity solutions.

At the end of FY2020 (fiscal year ended 31 January 2020), Okta had more than 7,950 customers. These customers come from nearly every industry and range from small organisations with less than 100 employees to the largest companies in the world.

For a geographical perspective, Okta sourced 84% of its revenue in FY2020 from the US. 

Investment thesis

I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Okta.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

Okta estimates that its market opportunity for workforce identity is U$30 billion today. This is up from US$18 billion around three years ago. The company arrived at its current workforce identity market size of US$30 billion in this way: “50,000 US businesses with more than 250 employees (per 2019 US.Bureau of Labor Statistics) multiplied by 12-month ARR [annual recurring revenue] assuming adoption of all our current products, which implies a market of [US]$15 billion domestically, then multiplied by two to account for international opportunity.”

For customer identity, Okta estimates the addressable market to be US$25 billion. Here’s Okta’s description of the method behind its estimate: “Based on 4.4 billion combined Facebook users and service employees worldwide multiplied by internal application usage and pricing assumptions.” I am taking Okta’s estimate of its customer identity market with a pinch of salt. But I’m still confident that the opportunity is huge, given the growth and size of the entire SaaS (software-as-a-service) market. A November 2019 forecast from market research firm Gartner sees global SaaS spending growing by 15% annually from US$$86 billion in 2018 to US$151 billion in 2022.

In FY2020, Okta’s revenue was just US$586.1 million, which barely scratches the surface of its total estimated market opportunity of US$55 billion. I also think it’s likely that Okta’s market is poised for growth. Based on Okta’s studies, the average number of apps that companies are using has increased by 52% from 58 in 2015 to 88 in 2019. Earlier this month, Okta’s co-founder and CEO, Todd McKinnon, was interviewed by Ben Thompson for the latter’s excellent tech newsletter, Stratechery. During the interview, McKinnon revealed that large companies (those with over 5,000 employees) typically use thousands of apps.

The high and growing level of app-usage among companies means it can be a massive pain for an organisation to manage software-access for its employees, contractors, partners, and customers. This pain-point is what Okta Identity Cloud is trying to address. By using Okta’s software, an organisation does not need to build custom identity management software –  software developers from the organisation can thus become more productive. The organisation would also be able to scale more efficiently.

2. A strong balance sheet with minimal or a reasonable amount of debt

As of 31 January 2020, Okta held US$1.4 billion in cash and short-term investments. This is significantly higher than the company’s total debt of US$937.7 million (all of which are convertible notes that are due in 2023 or 2025).

For the sake of conservatism, I also note that Okta had US$154.5 million in operating lease liabilities. But the company’s cash, short-term investments and long-term investments still comfortably outweigh the sum of its debt and operating lease liabilities (US$1.1 billion)

3. A management team with integrity, capability, and an innovative mindset

On integrity

Todd McKinnon cofounded Okta in 2009 with Frederic Kerrest. McKinnon, who’s 48 years old, has served as Okta’s CEO since the company’s founding. He has a strong pedigree in leading software companies, having been with salesforce.com from 2003 to 2009, and serving as its Head of Engineering prior to founding Okta. salesforce.com is one of the pioneering software-as-a-service companies. Kerrest, 43, is Okta’s COO (chief operating officer) and has been in the role since the year of the company’s founding. Kerrest is also a salesforce.com alumni; he joined in 2002 and stayed till 2007, serving as a senior executive. In my view, the young ages of McKinnon and Kerrest, as well as their long tenures with Okta, are positives.

The other important leaders in Okta include:

In FY2019, Okta’s senior leaders (McKinnon, Kerrest, Losch, Race, and Runyan) each received total compensation that ranged from US$2.3 million to US$5.1 million. These are reasonable sums. Furthermore, 72% to 88% of their total compensation was in the form of stock awards and stock options that vest over multi-year periods. This means that the compensation of Okta’s senior leaders are tied to the long run performance of the company’s stock price, which is in turn driven by the company’s business performance. So I think that my interests as a shareholder of Okta are well-aligned with the company’s management.

Moreover, both McKinnon and Kerrest own significant stakes in Okta. As of 1 April 2019, McKinnon and Kerrest controlled 7.98 million and 3.65 million shares of the company, respectively. These shares have a collective value of roughly US$1.5 billion right now. The high stakes that Okta’s two key leaders have lend further weight to my view that management’s interests are aligned with the company’s other shareholders.

I note that the shares held by McKinnon and Kerrest are mostly of the Class B variety. Okta has two stock classes: (1) Class B, which are not traded and hold 10 voting rights per share; and (2)  Class A, which are publicly traded and hold just 1 vote per share. McKinnon and Kerrest only controlled 10.1% of Okta’s total shares as of 1 April 2019, but they collectively held 50.7% of the company’s voting power. In fact, all of Okta’s senior leaders and directors together controlled 54.7% of Okta’s voting rights as of 1 April 2019 (this percentage dipped only slightly to 53.1% as of 31 January 2020). The concentration of Okta’s voting power in the hands of management (in particular McKinnon and Kerrest) means that I need to be comfortable with the company’s current leadership. I am.

On capability

From FY2015 to FY2020, Okta has seen its number of customers increase six-fold (43% per year) from 1,320 to 7,950. So the first thing I note is that Okta’s management has a terrific track record of growing its customer count.

To win customers, Okta currently offers over 6,500 integrations with IT (information technology) infrastructure providers, and cloud, mobile, and web apps. This is up from over 5,000 integrations as of 31 January 2017. The companies that are part of Okta’s integration network include services from tech giants such as Microsoft, Alphabet, Amazon.com, salesforce.com and more. Impressively, software providers are increasingly being told by their customers that they have to be integrated with Okta before the software can be accepted. 

In my view, the integration also creates a potentially powerful network effect where more integration on Okta’s network leads to more customers, and more customers leads to even more integration. During the aforementioned Stratechery interview, McKinnon shared about the competitive edge that Okta enjoys because of its efforts in integrating thousands of apps: 

“[Question]: The average enterprise — maybe it’s hard to say because it varies so widely — how many SaaS services does a typical enterprise subscribe to?

[Todd McKinnon] TM: Especially for any company with over 5,000 employees, it’s thousands of apps. Apps that they’ve purchased commercially, the big ones you’ve heard of, the ones that are in niche industries or verticals you haven’t heard of, and then the ones built themselves, it’s thousands.

[Question]: And then Okta has to build an integration with all of those

[Todd McKinnon] TM: Yeah. One of the big things we did very early on was we got really good at a metadata-driven integration infrastructure, which allowed us to have this burgeoning catalog of pre-packaged integrations, which was really unique in the industry because it is a hundreds or for a big company, it’s thousands of applications.

[Question] And it ends up being a bit of a moat, right? It’s a traditional moat where you dig it up with hard work where you actually went in and you built all of these thousands of integrations, and anyone that wants to come along, if they have a choice of either recreating all the work you did or, we should just use Okta and it’s already sort of all taken care of.

[Todd McKinnon] TM: Yeah, and it’s one of the things people misunderstand on a couple of different levels. The first level is they just get the number wrong. “I think there’s ten, right?” Or I’ve heard of ten big applications, so I think if I connected the ten, that would be enough, which is just off by multiple orders of magnitude.

And then the second thing they get wrong is they think that, especially back in the day it was like, “Oh, there it’s going to be standards that do this.” It’s going to be SAML as a standard. There’s this standard called Open ID. And what we’ve found is that the standards were very thin, meaning they didn’t cover enough of the surface area of what the customers needed, so it might do simple login but it didn’t do directory replication, or not enough of the applications adhere to the standard. So there’s a lot more heterogeneity than people thought of so that moat was a lot wider, a lot faster than people expected.

[Question] Is it fair to say that it’s your goal or maybe it has happened that people thought there would be a standard like SAML that would take care of all of this, but it’s going to end up being that Okta as the standard?

[Todd McKinnon] TM: That is the goal and I think it’s evolving to where there are de facto standards. A big shift is that we have big companies that tell software vendors that if you want to sell to us, you have to integrate to Okta and they have to go to our platform, build the integration, have it be certified. So that’s not a technical standard per se, but it’s a de facto standard of an application that can be sold to a large enterprise.”

I also credit Okta’s management with the success that the company has found with its land-and-expand strategy. The strategy starts with the company landing a customer with an initial use case, and then expanding its relationship with the customer through more users or more use cases. The success can be illustrated through Okta’s strong dollar-based net retention rates (DBNRRs). The metric is a very important gauge for the health of a SaaS company’s business. It measures the change in revenue from all of Okta’s customers a year ago compared to today; it includes positive effects from upsells as well as negative effects from customers who leave or downgrade. Anything more than 100% indicates that the company’s customers, as a group, are spending more – Okta’s DBNRRs have been in the high-teens to high-twenties range over the past few years. There has been a noticeable downward trend in Okta’s DBNRR, but the figure of 119% in FY2020 is still impressive.

I also want to point out the presence of Ben Horowitz on Okta’s board of directors. Horowitz is a co-founder and partner in a venture capital firm I admire and that was partly named after him, Andreessen Horowitz (the firm, popularly known as a16z, is an early investor in Okta). Having Horowitz as a director allows Okta’s management to tap on a valuable source of knowledge.

On innovation

Okta is a pioneer in its field. It was one of the first companies that realised that a really important business could be built on the premise of a cloud-based software that secures and manages an individual’s digital identity for cloud-based applications. To me, that is fantastic proof of the innovative ability of Okta’s management. Stratechery’s interview of Todd McKinnon provided a great window on the thinking of him and his team in the early days of Okta’s founding:

“[Question] When Okta first came on the scene, it was Single Sign-on, so you could sign on in one place and then you’d be logged into other places, now it’s an Identity Cloud. Is that an actual shift in the product or strategy or is that just a shift in a marketing term?

[Todd McKinnon] TM: It’s interesting. When we started the company, you could see that cloud was going to be the future. We started 11 years ago, so in 2009, Amazon Web Services was out, Google Apps for Domains was out. So you could kind of see that infrastructure was going to go to the cloud, you could see that collaboration apps were going to go to the cloud. I was working at Salesforce at the time, so it was really clear that the apps stack was going to be in the cloud and we got really excited about what could be possible or what new types of platforms could be built to enable all this.

When we started, it’s funny, we called the first product, which was going to be a cloud single sign-on, we called it Wedge One. So not only was it the wedge, but it was like the first, first wedge. Now it turns out that in order to build cloud single sign on you had to build a lot of pretty advanced stuff behind the scenes to make that simple and seamless, you had to build a directory, you had to build a federation server, you had to build multi-factor authentication, and after we were into it for two or three or four years, we realized that there’s a whole identity system here so it’s much more than a wedge. In fact, it really can be a big part in doing all that enablement we set out to do.

[Question] That’s very interesting, so are you still on Wedge One? Did you ever make it to Wedge Two?

[Todd McKinnon] TM: (laughs) The Wedge keeps getting fatter. The Identity Cloud is pretty broad these days. It’s directory service, it’s reporting analytics, it’s multi-factor authentication, it does API Access Management. It’s very flexible, very extensible, so really the Identity Cloud now is an Identity Platform, it’s striving to really address any kind of identity use cases a customer has, both on the customer side, customer identity, and on the workforce side.

What’s interesting about it is that at the same time over the last eleven years, identity has gone from being something that’s really important maybe for Windows networks or around your Oracle applications to there are so different applications connected from so many types of devices and so many networks that identity is really critical, and we’re in this world now where ten years ago people were telling me “Hey, I’m not sure if it’s possible to build an independent identity company” to now it’s like everyone says, “Oh, it’s such an obvious category that the biggest technology companies in the world want to own it.” So it has been quite a shift.”

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

Okta runs its business on a SaaS model and generates most of its revenue through multi-year subscriptions, which are recurring in nature. In FY2020, 94% of Okta’s total revenue of US$586.1 million came from subscriptions. The company’s average subscription term was 2.6 years as of 31 January 2020 and iInterestingly, Okta’s contracts are non-cancelable. The remaining 6% of Okta’s revenue in FY2020 was from professional services, where the company earns fees from helping its customers implement and optimise the use of its products.  

It’s important to me too that there’s no customer concentration in Okta’s business. No single customer accounted for more than 10% of the company’s revenue in each year from FY2018 to FY2020.

5. A proven ability to grow

There isn’t much historical financial data to study for Okta, since the company was only listed in April 2017. But I do like what I see:

A few key points to note about Okta’s financials:

• Okta has compounded its revenue at an impressive annual rate of 70.2% from FY2015 to FY2020. The rate of growth has slowed in recent years, but was still really strong at 46.7% in FY2020.
• Okta is still making losses, but the good thing is that it started to generate positive operating cash flow in FY2019 and positive free cash flow in FY2020.. 
• The company’s balance sheet remained robust throughout the timeframe under study, with significantly more cash and investments than debt.
• At first glance, Okta’s diluted share count appeared to increase sharply by 29.5% from FY2018 to FY2019. (I only started counting from FY2018 since Okta was listed in April 2017, which is in the first quarter of FY2018.) But the number I’m using is the weighted average diluted share count. Right after Okta got listed, it had a share count of around 91 million. Moreover, Okta’s weighted average diluted share count showed an acceptable growth rate (acceptable in the context of the company’s rapid revenue growth) of 9% in FY2020.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

Okta has already started to generate positive free cash flow and positive operating cash flow. Right now, the company has a poor trailing free cash flow margin (free cash flow as a percentage of revenue) of just 4.7%.

But over the long run, I think it’s likely that there is plenty of room for Okta’s free cash flow margin to expand. I showed in my recently published investment thesis for Alteryx (NYSE: AYX) that there are other larger SaaS companies such as Adobe, salesforce.com, and Veeva Systems that have much fatter free cash flow margins. Here’s the table I showed in my article on Alteryx:

Valuation

Okta has a target to grow its revenue by 30% to 35% annually from now till FY2024, and to have a free cash flow margin of between 20% and 25% at the end of that period. These goals were communicated by management just earlier this month during Okta’s Investor Day event. For perspective, Okta is projecting total revenue growth of 31% to 33% in FY2021.

Right now, Okta has a market capitalisation of US$16.08 billion against trailing revenue of US$586.1 million, which gives rise to a pretty darn high price-to-sales (PS) ratio of 27.4. 

For perspective, if I assume that Okta has a 25% free cash flow margin today, then the company would have a price-to-free cash flow ratio of 110 based on the current P/S ratio (27.4 divided by 25%).

But there are strong positives in Okta’s favour. The company has: (1) Revenue that is low compared to a large and possibly fast-growing market; (2) a software product that is mission-critical for users; (3) a large and rapidly expanding customer base; and (4) sticky customers who have been willing to significantly increase their spending with the company over time. I believe that with these traits, there’s a high chance that Okta will continue posting excellent revenue growth – and in turn, excellent free cash flow growth – in time to come. 

The risks involved

Okta has a short history in the stock market, given that its IPO was just three years ago in April 2017. I typically stay away from young IPOs. But I am willing to back Okta because I think its business holds promise for fast-growth for a long period of time (the company’s identity-as-a-service business is very important for the digital transformation that so many companies are currently undergoing). But Okta’s young age as a publicly-listed company is still a risk I’m keeping tabs on.

Competition is a risk I’m watching too. In its FY2018 and FY2019 annual reports, Okta named technology heavyweights such as Alphabet, Amazon, IBM, Microsoft, and Oracle as competitors. In its FY2020 annual report, Okta singled out Microsoft as its “principal competitor.” All of them have significantly stronger financial might compared to Okta. But I’m comforted by Okta’s admirable defense of its turf – the proof is in Okta’s strong DBNRRs and impressive growth in customer-numbers over the years. Moreover, in late 2019, market researchers Gartner and Forrester also separately named Okta as a leader in its field. 

Okta’s high valuation is another risk. The high valuation adds pressure on the company to continue executing well; any missteps could result in a painful fall in its stock price. This is a risk I’m comfortable taking.

Hacking is also a risk I’m keeping an eye on. Logging into applications is often a time-sensitive and mission-critical part of an employee’s work. Okta’s growth and reputation could be severely diminished if the company’s service is disrupted, leading to customers being locked out of the software they require to run their business for an extended period of time.

The COVID-19 pandemic has resulted in severe disruptions to economic activity in many parts of the world, the US included. I think that the mission-critical nature of Okta’s service means that its business is less likely to be harmed significantly by any coronavirus-driven recession. But there are still headwinds. In an April 2020 statement, Okta’s CFO William Losch said:

“We continue to closely monitor the business environment and impacts related to COVID-19. We remain optimistic about the demand for our solutions. Our highly recurring business model enables a high degree of predictability and allows us to maintain confidence in our revenue outlook for the first quarter and fiscal year 2021, which we are reaffirming.

We do, however, expect some near-term billings headwinds as customers adjust to the current business environment. Conversely, we expect our operating loss and loss per share to be better than expected as a result of reduced spend. This is primarily related to lower sales and marketing costs, driven in part by temporary travel restrictions, lower employee-related costs, and moving Oktane and other events to virtual formats. We have the ability to further adjust spend depending on the market environment and will be flexible in how and when we invest to extend our market leadership.”

Lastly, the following are all yellow-to-red flags for me regarding Okta: (1) The company’s DBNRR comes in at less than 100% for an extended period of time; (2) it fails to increase its number of customers; and (3) it’s unable to convert revenue into free cash flow at a healthy clip in the future.

The Good Investors’ conclusion

In summary, Okta has:

1. A valuable cloud-based identity-as-a-service software platform that is often mission-critical for customers;
2. high levels of recurring revenue;
3. outstanding revenue growth rates;
4. positive operating cash flow and free cash flow, with the potential for much higher free cash flow margins in the future;
5. a large, mostly untapped addressable market that could potentially grow in the years ahead;
6. an impressive track record of winning customers and increasing their spending; and
7. capable leaders who are in the same boat as the company’s other shareholders

Okta does have a rich valuation, so I’m taking on valuation risk. There are also other risks to note, such as competitors with heavy financial muscle, and headwinds due to COVID-19. But after weighing the pros and cons, I’m happy to continue having Okta be in my family’s investment portfolio.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.