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The Valuation Impact of Lost Trust
Who will be caught naked when high growth comes crashing down? Lessons from SentinelOne
*Not investment advice. Author may own positions in securities discussed
SentinelOne reported earnings last Thursday and it wasn’t pretty…The stock is down 40% or $2.2B in EV (as of June 5th). Here are the results:
$133M revenue vs $137M consensus (3% or $4M miss)
$141M next quarter guidance vs $151M consensus (7% or $10M miss)
Reduced the full year guide by $41M (or 6%)
(24%) FCF Margin
These results led to a wipe out of ~$2.2B in enterprise value (EV) — from $5.3B to 3.1B.
Seems excessive for just a $41M drop in revenue, right? Let’s dive into why the valuation cratered.
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Understanding the Valuation Drop
How can a $41M decrease in revenue lead to a drop of $2.2B in enterprise value?
The $2.2B drop in EV represents 54x of the decreased revenue guidance of $41M, while the stock itself hovers ~5x EV/Rev multiple.
Stocks don’t react to misses in estimates at the same multiple the stock trades at, but this drop is significant.
Destroying Value by Lost Trust
Yes, the SentinelOne earnings report/forecast was really bad, but what made matters even worse was their $27M adjustment in ARR reporting.
They made an adjustment to reported ARR as a result of:
An error was discovered that they were reporting contracts that included both a renewal + upsell as 100% incremental ARR versus just including the upsell portion. In other words…they were double counting the ARR associated with the base renewal for these contracts.
A methodology change: “We elected to tighten the methodology for calculating ARR for consumption and usage-based agreements to reflect committed contract values”. Previously they were using current usage: “We had seen steadily increasing usage and consumption patterns by our large customers, which we accounted for real time in quarterly ARR.”
When I hear stuff like this I go back to one of my favorite Warren Buffet quotes below.
If SentinelOne’s rocket ship growth continued then the methodology change may not have been needed and the ARR error may have never been discovered, but when growth came crashing down…SentinelOne’s finance team/processes were definitely not fully clothed.
No forecast is perfect and everyone has made financial modeling errors, but I would expect a company at the scale of SentinelOne to have things a bit more buttoned up. There should be controls, multiple checks, etc on the most important financial metric for software companies. How they react and change is important.
A basic control that would have caught this would be to flag any significant changes (e.g. anything above 30% change) in ARR by customer. All of these errors would cause the ARR per customer to change >100% because it was double counting the base renewal amount.
The error combined with the change in methodology has caused investors to lose trust in SentinelOne and the public markets hate nothing more then a company that can’t forecast and then hit/beat that number.
This is why before a company goes public they should “act” like a public company for at least 3 - 4 quarters first. If your finance team can not provide accurate forecasts for at least a few quarters then the stock price will suffer as trust is lost.
What is the $ value of trust?
Hypothetically, what would SentinelOne’s EV be if the error never occurred and they guided FY24 revenue based on their new methodology?
I wish I knew, but I do think the valuation impact could have been very significant if trust was maintained (forecasting was good and the error didn’t happen). SentinelOne would have taken the valuation hit a few months ago when they guided for this year but if they then hit/beat that forecast for Q1 the market would have reacted positively.
So even if nothing had changed operationally with SentinelOne, the enterprise value would likely be much higher than it is today.
The lost of trust was clearly evident throughout the earnings call and crystal clear from a question from Brad Zelnick at Deutsche Bank:
You know, the ARR statement is very unfortunate. The environment is very tough. I think you guys have said it yourselves, and you're being asked a lot of tough questions.
So, I mean, as long as we're in this forum, I'm going to add to those, which I guess for you, Tomer, most appropriately, what is your strategic end game?
No one was trying to be too polite on the SentinelOne earnings call. It was one of the most brutal calls I have listened to.
A similar level of scrutiny is placed on private companies. This trust becomes incredibly important when fundraising conversations happen. Yes, investors get that the market is tough right now and lots of folks are missing their orginal revenue targets, but if you continue to miss targets (or revised forecasts) then your board and potential investors are going to lose trust in you real fast. VCs are already being extremely cautious with deploying capital…losing their trust will probably kill any chance you have.
The most important thing is to get the right folks on the team. If you have the right people then they will do the things necessary to build trust with your board and investors. Building financal accountability and trust does not just sit with the CFO, but with all executives to varying degrees.
Having the right tools in place can help these folks drive accountability and trust.
Since we are talking about forecasting/planning, let me plug today’s sponsor —Pigment
Pigment is an intuitive business planning platform which enables businesses to bring together people, data, and processes in one platform to quickly execute and adapt plans at speed.
Companies use Pigment to budget, forecast, and build flexible plans to manage and future-proof their business.
Excel works great when things are simple and/or forecasting accuracy is not critical, which might be true when times are good and better than expected growth hides any forecast modeling issues. But as complexity rises, various scenario modeling is important, and volatility increases then having the right software tool can be a major advantage.
We won’t ever really know how much of the $2.2B drop in enterprise value is related to lost trust vs everything else, but I am confident that the lost trust aspect is significant.
If SentinelOne can quickly regain investor trust and move toward its longer term targets then maybe there is an opportunity for investors.
When times are tough the bad finance leaders, companies, and processes will be found swimming naked. Companies that have the right folks and quickly remove the bad ones will do great on the other side of this tech recession.
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