Sentinel One (S) Gross Margins

This is my first real post on the board, I hope it is useful. I don’t remember if it was in the knowledge base or some post of Saul’s, but he gave a couple of principles on what to do in turbulent market.

  1. Consolidate your portfolio into your highest conviction companies.
  2. Scrutinize your companies to make sure your convictions are correct.

In that spirit I have been taking another look at the companies I am invested in. Sentinel One (S) is set to announce earnings on March 15. One thing about S that has me questioning my conviction with them is their gross margin. This table lists their gross margin for the last 5 quarters. It has been improving, but is still quite a bit lower than the other SaaS companies discussed on this board. The other companies range in the 80% to 90% range.

     Q1  Q2  Q3  Q4
2021         58% 54% 
2022 53% 62% 67%

Sentinel Cost of Revenue
From their last 10-Q report, Sentinel One says their cost of revenue (what eats into the gross margin) is:

Cost of revenue consists primarily of third-party cloud infrastructure expenses incurred in connection with the hosting and maintenance of our platform…Our platform is hosted through Amazon Web Services, or AWS. Our software and systems are designed to use computing, storage capabilities, bandwidth, and other services provided by AWS, and currently our cloud service infrastructure is run on AWS.

They also list customer service and support as a cost of revenue.

Finally, a large part of their revenue is generated through third party partner sales. It is not clear to me if they include commissions or cost of these third party sales in cost of revenue. I suspect not. I think the portion of the sale that goes to the third party is not counted as revenue in the first place. It is something to keep in mind though, because it is still a cost of revenue. In other words, if the third party was not keeping a cut, S would have more revenue from the same sale and the gross margin would be bigger. This is one area where there is not much visibility. The partnerships are a big part of S business model, but they don’t talk about what it is costing them.

So the gross margin is really the difference between what S can charge for its products and the cost of the cloud services. Gross margin will improve if S can increase prices, or lower cloud service costs.

Improving Gross Margin - lowering cloud service costs
In the Q3 investor presentation they say this about the improving GM:

Our GAAP and non-GAAP gross margin meaningfully improved both sequentially and year-over-year, driven by higher revenue, increased scale, and improved processing efficiencies.

This implies that their cloud service costs, and customer service costs decrease with scale.

Improving Gross Margin - Increasing prices or at least maintaining them
From the Q3 conference call:

And in fact, year-over-year, our prices – our land prices are rising. And that’s a function of product enhancements, the innovation that we show, our customers as well as our module attach rate. And really SentinelOne competes and wins because of the differentiation of our data and AI-driven technology.

Also from the conference call, a note on the automation that S is developing. This allows customers to have less human intervention and a greater ROI.

One thing I would add is commonly our public company peer competitor force bundles in a myriad of human-powered services into their deals…So I think one thing that constantly delights our customers is that they’re able to get automated technology that doesn’t require heavy handed services to deploy and maintain. And that overall return on their investment, they get higher ROI and they get to that much faster with the Singularity platform.

This implies that higher automation creates a greater ROI for their customers and allowed them to charge a premium.

What to expect over the next 1-2 quarters and beyond
On the Q3 conference call S indicates that gross margins will be lower the next 1-2 quarters as they continue to migrate customers from the old backend to the new Scalyr backend. The reason this lowers margins is that both back ends are hosted in the cloud while the migration happens. This effectively doubles the cloud services costs for those customers during the migration.

So I see this to be depressed for a couple of quarters as we finish this migration, and then I think we’ll be back in this range and operate for improved margins from that going forward.

Long term they claim gross margins will approach 80%

We’re seeing the efficiencies from the Scalyr products for our own back end. And then you’re also seeing some of the benefits of the cross-sell and the AWS renegotiation we’ve done. So all of that is – are great tailwinds for us going into the future.
I think we haven’t changed anything in regards to our long-term goal, which is in the 75% to 80%-plus.

I am satisfied for now on S explanation of their lower gross margins. They are still a relatively small company and are not benefitting completely from scale.

Over the next 2 quarters, based on the Q3 conference call, I would expect gross margins to be in the low 60s as they finish migrating customers to Scalyr. Anything lower would be a red flag, and need a good explanation.

Long term, if revenue continues to grow at a good pace, but gross margin does not rise, that would be a red flag. That would indicate to me that S is not maintaining their prices and needing to lower prices to maintain revenue growth.

-The Sea
5.1% allocation in S