SentinelOne IPO: An example of the challenges in IPOs

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Cybersecurity company SentinelOne (NASDAQ:S) has decided to raise the price further on its IPO this week. Reuters reported on Monday that the company now plans to raise up to $1 billion by selling 32 million shares at a price between $31 and $32. This would give the company a valuation of up to over $8 billion.

SentinelOne is in many ways a very typical IPO company. It is growing rapidly and offers potential in a viable technological field but is up against heavy competition and has some troubling financial numbers. While no one will be closing the company soon, there are a few reasons for why investors should be cautious about this upcoming IPO.

The Cybersecurity Field

The importance of cybersecurity these days barely needs to be stated, especially after the ransomware incidents which affected Colonial Pipeline and made national news earlier in the year. But the primary weak points in any cybersecurity network is not some giant server, but rather the numerous computers used by ordinary workers connected to a company’s network. All it takes is one inactive or careless user who clicks on the wrong thing, and a company has a data breach.

SentinelOne’s cybersecurity platform aims to solve that problem. In its most recent S-1/A, the company states that cyberattacks are fundamentally about stealing or destroying data, and so better data is needed to counter such attacks quickly. Furthermore, traditional antivirus systems, powered by human-generated signatures, are too slow to counter attacks.

SentinelOne uses a platform called XDR which runs “highly optimized AI models in a single lightweight software agent” which lets humans and AI work together to stop threats in milliseconds. As a result, the company was able to protect its clients completely from the recent SolarWinds Sunburst cyberattack.

SentinelOne can report on as many successes as it wants, yet the fact that it continues to accrue and maintain customers shows that this is not hot air. Sentinel currently has 4,700 customers, mostly large to mid-sized companies due to heavy spending on sales and marketing. The number of customers is increasing, and SentinelOne reported an excellent net retention rate of 117%.

All of these are good signs for the company. But while the cybersecurity market has plenty of growth potential, it is also a highly fragmented and competitive market with SentinelOne going up against much bigger players. The most relevant competitor is Crowdstrike (NASDAQ:CRWD), another endpoint cybersecurity company which has a market cap of over $50 billion. Other major competitors include McAfee (NASDAQ:MCFE) or Microsoft (NASDAQ:MSFT).

It is true that SentinelOne’s name has been able to grow and maintain customers against this competition in the past, which does indicate that they can keep this up in the future. But all it takes is one slip-up or data breach and SentinelOne’s reputation will be harder hit than if a similar incident happened to one of the tech giants. This rapidly evolving field is one where smaller companies have to be innovative, yet somehow cautious at the same time.

Finances and Valuation

The concerns about competition are particularly important when we consider SentinelOne’s finances and its planned valuation of over $8 billion. Like most tech IPOs, SentinelOne is growing rapidly at the expense of profitability. The company’s revenue from 2019 to 2020 more than doubled to reach $93 million in 2020, as well as $37 million in the first quarter of 2021. By contrast, SentinelOne reported net losses of $117 million in 2020 and $62 million in the first quarter of 2021.

The revenue growth is great, but the losses are concerning as SentinelOne does not appear to have a clear path towards profitability. This is further evidenced by the fact that its gross margin has steadily shrank from over 60% in 2019 to just 51% in the 2021 1Q, which is rather low for a cybersecurity company. Other financial numbers are a mixed bag. SentinelOne had a negative free cash flow of $72 million in 2020, but only had $19 million in long term debt and over $362 million in cash on hand.

Given these numbers, it does appear that SentinelOne can run viably for some time even after the IPO, and so there is plenty of time to turn things around. But that is not a good reason for why investors should choose to invest now as opposed to in the future.

Finally, there is the matter of SentinelOne’s $8 billion valuation, which creates an enterprise value of about $7.9 billion. Let us assume that SentinelOne’s valuation can double yet again to reach around $185 million for all of 2021. With those factors in mind, SentinelOne will have an EV/Revenue ratio of about 42.7. This is substantially lower than Crowdstrike which sits at 56.3. But Crowdstrike is larger, has a better path towards profitability, and has been more successful despite being only two years older.

Final Thoughts

SentinelOne is a company which has plenty of merits for investors. It is offering a strong product in an important and growing market and has continued to grow in terms of customers and revenue. Compared to other companies like Crowdstrike, though not to other companies working in cybersecurity like McAfee or Microsoft, it is not that expensive. SentinelOne purports to be sitting in the middle, offering major growth potential while being less expensive relative to competitors.

But there are a few problems with this sales pitch. While it is true that the cybersecurity market is growing and important, SentinelOne faces intense competition which makes it extremely difficult to see a viable path towards profitability. While SentinelOne will likely continue to grow rapidly thanks to the popularity of its product, that is far from a sure thing and investing at this price is a major risk.

Given the above issues, I believe that it is better to wait on this IPO rather than immediately jump on. If SentinelOne can stabilize its net losses or improve its gross margin while not losing too much in its growth rate, then this may be a worthwhile investment.