April 29, 2024

High Oktane

Remembering The Setbacks

I often remark that I share with you some of the best businesses on earth. To be sure, these are not always the businesses that have been around the longest nor the businesses that have the most established and well-known economic moats, i.e., competitive advantages, in the eyes of the collective wisdom of the market.

But, while these businesses are not always universally seen as the best, their underlying growth and unit economics (proxy for profitability) metrics reveal their incredible quality.

And Okta certainly fits within this description, in the sense that it is certainly one of the best businesses on earth as evidenced by its exceptional, highly profitable growth of the last decade or so:

Okta Grew From ~$100M In Sales To $2.3B In Sales In About 10 Years, An Astounding Feat Of Growth

This represents genuinely otherworldly growth and represents a business deserving of the moniker, "One Of The Best On Earth."

Interestingly, the market understood this very well from the time of Okta's IPO to the first half of 2022; then, in what appeared to be a sudden bout of amnesia, totally lost the plot of this business' meteoric rise, which was the result of its exceptional quality.

Evidence for the market's understanding of Okta's quality can be seen in its valuation dynamics from the time of its IPO to roughly the first half of 2022:

The Market's Evolving Perspective Of Okta

With all of this being said, I would be remiss to not mention Okta's difficulties, which can be neatly and concisely summarized in just two points:

  1. In 2022, following Okta's acquisition of Auth0, a platform used by the likes of OpenAI, it mismanaged its overall sales motion, i.e., go to market approach, resulting in slowing growth and executive flight. Okta has since made great progress in righting its sales motion for both its legacy Okta business and its new Auth0 business.
  2. Okta experienced security breaches that impacted its customers in 2023. Okta's only job is to prevent breaches such as these for its customers, i.e., its product is meant to eliminate cybersecurity attacks and threats, so this created fear for investors that Okta would experience slower growth as prospective customers turned to other solutions that had not experienced recent breaches.

While these were legitimate business concerns, in no sense should they have merited the valuation re-rating that Okta has experienced, especially when we consider that Okta's vastly smaller, slower growing, and lower quality/less dynamic peers have traded at valuations 50% to 100% higher than Okta over the last 24 months.

In no uncertain terms, Okta is the best cloud-native identity platform on earth, both in terms of scale and in terms of product breadth and quality.

"That is very differentiated. No one else has that. [A comprehensive, vertically integrated identity platform]. No one else has access management, privilege access and governance. CyberArk has privilege, of course, super strong in that. And they have some access management with an acquisition they did and governance is lacking. Other vendors don't have privilege as well as governance and we're the first vendor to have all three. So if this theory is right and customers want this converged platform, and it can lead to better security outcomes and more flexibility, we're going to benefit from that for a long time."
Todd McKinnon, CEO, Q4 2023 Okta Earnings Call

In the next section, I will more comprehensively dissect the nature of the Okta business and how it has designed its platform in such a way that it is vertically integrated and more valuable/differentiated than ever. To conclude this brief introductory section, I'd like to share CEO Todd McKinnon's articulation of his top priorities, which lend to the idea that Okta has experienced the aforementioned dual setbacks over the last couple years but is now operating from an exceptional position of strength:

"At the start of each new fiscal year, I'd like to you show you our top priorities as an organization. As you might expect, security is our top priority as a company for FY '25. This covers everything from driving a company culture with a security-first mindset to our own security architecture as well as our products and services. The second priority is reigniting our growth. The obvious end result pertains to topline across regions and products, but to get there, we need to focus on our overall go-to-market operational excellence, further increase our competitiveness in our core markets with enhancements to both our workforce and customer identity clouds and strengthen our growth vectors in key industries, newly introduced products and cross-cloud initiatives. Our third priority is scaling Okta from a technical perspective. Our goal is to set the company up for success in order to be a $5 billion and then a $10 billion-plus company. This means investing in changes to reduce operational friction and drive global scale. This priority is intended to help fuel the first two priorities of security and growth."
Todd McKinnon, CEO, Q4 2023 Okta Earnings Call

Quite notably, as evidenced by the market's valuation of Okta, even years before the bubble of late 2020 and 2021, the market understood the incredibly long runway for growth that stood in front of Okta. The market understood that cloud identity was a giant attack vector for hackers, and there were tens of thousands of giant corporations around the world who would need to enlist Okta's category-defining platform to secure this vector for cyber attacks, i.e., identity.

With these ideas as platform, let's now turn to a more nuance consideration of the Okta platform, in which we will leverage LAS' four foundational investment frameworks to better understand the dynamics under the hood of Okta.

Better Understanding Okta

I would say that a large component of the aforementioned discount to fair value at which the market has priced Okta is as much about market participants not fully paying attention to the company's evolution as it is about the missteps the company has made in recent years.

Even as an ardent bull on the stock myself, I have been surprised by Okta's development/evolution of its platform, which has resulted in the most comprehensive and dominant identity platform on earth.

To better understand this development, let's apply the three foundational investment frameworks to Okta within which the business fits.

  • Vertically integrated product capturing market share in stagnant mature industry: We target businesses that have created a fully vertically integrated product, within a fragmented, low NPS, and mature industry, whereby that vertically integrated product offers materially better value; thereby, it captures significant market share rapidly. [As an example, Monday.com's platform has become more and more vertically integrated, as it's added MondayCRM, MondayDev (for developers), and its app marketplace products in addition to its core work management product, all of which sit atop Monday's proprietary, open, and configurable architecture. It's a true, vertically integrated work operating system, which, with the creation of MondayDB is more scalable than ever, the evidence of which can be seen in the company's enterprise customer growth]

As we read, LAS targets businesses that vertically integrate large swaths of the industries in which they compete and operate. I shared the example of Monday in the bullet point above; however, there are many such examples, e.g., Crowdstrike (CRWD), Tesla (TSLA), Adyen (OTCPK:ADYEY), and many other businesses out there.

Notably, this process of vertical integration does not happen overnight for younger businesses: a business starts with one product that it faithfully delivers to the marketplace, which thereby "wedges" the business into its customers' wallets; after which the business gradually upsells its customers on new products over time.

In the case of Okta, it began the wedging process roughly 15 years ago with its cloud-native Single-Sign On product (essentially a portal that allows enterprise employees to access all their apps and data using one set of credentials).

Over the last three years or so, it has expanded its product suite to include a variety of other products and services, which it has upsold those original SSO customers on.

"Of course, all of this has to be backed up with great products. Okta has long been the leader in modern access management. We've started tapping into two more large market opportunities with the launch of Okta Identity Governance last year and Okta Privileged Access just a few months ago.
Okta is changing the game with our unified platform approach and we already have several customers that have turned to Okta for the combined benefits of our Access Management, Governance, and Privileged Access. We're helping organizations make it easier for their employees and users to safely access their applications and help protect them from today's threat actors."
Todd McKinnon, CEO, Q4 2023 Okta Earnings Call

Unified platform approach is synonymous with a vertically integrated platform, and Okta has built just this over the decade or so in which it has served identity products to enterprises at scale.

Now, of course, a key requisite for executing this first foundational investment framework point is the ability to not only launch that first product and wedge into customers' wallets, but also to organically develop new products that Okta then upsells to its existing and future customers, creating a vertically integrated platform in the process.

And this brings us to the second foundational investment framework within which Okta fits (i.e., LAS' third foundational investment framework):

  • Quality cultures that breed innovation within the larger conglomerate: In some sense, this framework is the foundational framework of all America's and earth's most notable franchises, e.g., Tesla, Apple, Amazon, and Microsoft. This framework details a company's ability to launch, or propagate, new successful line of business after new successful line of business, creating a nucleus of explosive, compounding sales and free cash flow growth. This is the idea that a business creates a culture in which its employees create new products, provide these products to the marketplace, and these products ultimately find product-market-fit. Upon finding product-market-fit, the product begins its climb on its S-Curve, which will vary in size and value for each product. With multiple products growing rapidly simultaneously, the business overall grows more rapidly and, importantly, more durably. Some of my favorite examples that fit within this framework are Axon (AXON), Monday (MNDY), Adyen (OTCPK:ADYEY), Sea (SE), Tesla (TSLA), Amazon (AMZN), and MercadoLibre (MELI). Indeed, many of our businesses possess this incredible cultural structure, and that is why we've chosen to provide coverage of these companies.

As I noted earlier, I believe one of the key issues with the market's pricing of Okta has been simply its lack of due diligence on what's been going on under the surface.

"That is very differentiated. No one else has that. No one else has access management, privilege access and governance. CyberArk has privilege, of course, super strong in that. And they have some access management with an acquisition they did and governance is lacking. Other vendors don't have privilege as well as governance and we're the first vendor to have all three. So if this theory is right and customers want this converged platform and it can lead to better security outcomes and more flexibility, we're going to benefit from that for a long time."
Todd McKinnon, CEO, Q4 2023 Okta Earnings Call

Somewhat quietly, likely drowned out by price action driving narrative over the last couple years (Okta's stock, as you know, declined a lot in 2022), Okta has successfully fielded two new additional products, complementing its long-offered SSO product: Okta Identity Governance [OIG] and Okta Privileged Access Management [PAM].

While it's difficult to say precisely how well these products have been received, we can actually be certain to a fairly high degree that they been experiencing success by assessing how well Okta has done in making deals with its largest customers.

I say this because Okta's largest customers are those with the resources to execute purchases of new Okta offerings as soon as they launch, and Okta has been doing phenomenally in the large enterprise segment of its addressable market.

"We signed a record number of million dollar plus ARR contracts in Q4, capping a year in which the number of million dollar ARR contracts increased by over 30%. We added 150 customers in the quarter. The sequential decline in new customer adds reflects ongoing business trends of increased weighting of upsell versus new business resulting from the current macro environment and strength with large enterprise customers versus SMBs."
Brett Tighe, CFO, Q4 2023 Okta Earnings Call

As I noted following Okta's Q3 2023 report on X, the business has seen incredible success in the large enterprise space, and this is likely attributable to the quality of Okta's platform, yes, but, also as importantly, the product roadmap and comprehensiveness (vertical integration) of the platform as well.

Okta Has Done Exceedingly Well In Selling To Larger Contract Customers

Q4 2023 Okta Earnings Presentation

Now, organically developing new products that attach to a platform that serves enterprises holistically is an important component of a business' success; specifically important for Okta and the SaaS businesses I share with you, but inorganic development can be just as important.

That is, as a business matures, if it wants to be included among the ranks of Salesforce and Adobe over the long run, it must demonstrate the ability to allocate shareholder capital into value accretive acquisitions, which brings us to our fourth foundational investment framework.

  • Growth through quality, moat-building acquisitions: Lastly, we will briefly explore the capital allocator framework by way of an exploration of Meta's (META) business. In this investment framework, a very large business materializes through prudent and judicious uses of shareholder capital via acquiring quality businesses and growing them over time within the larger conglomerate. Meta has acquired Instagram and WhatsApp, both of which have solidified its global monopoly. Microsoft has also made employed this framework masterfully, and, of course, the CPG companies, such as Unilever or Proctor & Gamble, have been quintessential examples of this framework, creating pricing power in low barrier to entry industries through industry consolidation.

Because Okta is a rather young business, it has naturally not been very acquisitive, as it has been able to grow via its original products and organic product development.

However, in 2021, it did execute its first major demonstration of M&A (mergers and acquisitions) by acquiring Auth0 for $6.5B.

I could summarize the success or failure of this acquisition in one sentence: Okta has not had to write-down any of the $6.5B price tag, and it very much appears that, as of today, it will not write it down (which would create a big dent in EPS and send the stock down quite a bit, as it would represent the destruction of shareholder capital).

While that is certainly a sufficient articulation of the success of the major acquisition, especially when juxtaposed with M&A write-downs that took place over the last two years as a result of bad capital allocation by a handful of other tech companies, it's also worth noting that Auth0 is a fantastic platform whose customers include the likes of OpenAI, the creator of ChatGPT.

Furthermore, Auth0 expanded Okta's TAM, and increased the comprehensiveness of its vertically integrated identity platform, which has lengthened Okta's runway for growth.

To summarize our exploration of Okta through the lens of our foundational investment frameworks:

  1. Okta now operates the only vertically integrated cloud-native identity platform, further differentiating itself from its only real competitor, Microsoft (MSFT) (which I actually see as a bull thesis because most software companies have many competitors and Microsoft as a competitor; whereas, Okta only truly has Microsoft, and CyberArk to a lesser degree).
  2. Okta has demonstrated the ability to organically build new products, which will likely continue to be the case, which will serve to lengthen its runway for growth and nudge it in the direction of re-accelerating growth at some point in the future (though it should be noted that Okta is growing at 20%+ still).
  3. Okta has demonstrated the ability to identify quality M&A targets and execute the acquisitions in such a way that they fold the businesses into Okta without destroying the business in the process, which is no small feat, to be sure.
Concluding Thoughts: Okta's Overly Conservative Guidance

One of the most perplexing elements of the Okta thesis has been its guidance philosophy over the last 2-3 quarters.

Despite all of the attractive qualities of the business detailed for you today; namely, its ability to launch new TAM expanding products and acquire new TAM expanding products, both of which serve to either accelerate growth or sustain it at elevated rates, Okta has continued to guide for slowing growth.

Curiously, however, Okta has continuously beaten this guidance by a fairly wide margin, surprising the market as a result (as evidenced by its recent 25% share price increase in a day) and sustained growth of ~20%, which is incredible for a business of Okta's scale.

While Growth Has Slowed, Okta Has Continued To Grow At Rates That Exceed Its Guidance

That said, this growth rate is indicative of the qualitative factors that we discussed today:

Okta has consistently evolved its platform, launched new products, and made intelligent M&A decisions, all of which should serve to lengthen its runway for growth and ensure that it sustains elevated growth well into the future.

Today, Okta has guided for ~10% revenue growth in 2024; however, I believe this growth, in light of everything we've discussed today, could come in closer to 15%, if not higher.

Q4 2023 Okta Earnings Presentation

In closing, Okta is one of the best software businesses on earth, and the most dominant cloud-native identity platform on the market.

Okta has demonstrated an exceptional ability to evolve its identity security platform, which serves to extend its runway for elevated growth, in the growing and rapidly evolving market that is cloud-native identity.

"85% of data breaches involve identity, and there's an identity attack, there's an account loss, there's a password stuffing attack in part of the attack chain. And so it's a big opportunity to prevent and impact overall cyber by elevating the whole industry's posture toward identity-based attacks."
Todd McKinnon, CEO, Q4 2023 Okta Earnings Call

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