DRKTY - Darktrace: Great Topline Growth But Hard To Value

2023-06-08 01:48:07 ET

Summary

• Darktrace's revenues grew 36% YoY to $260m in H2 2023, but net profit was only $0.5m, raising concerns about profitability.
• The company's unclear reporting metrics and use of alternative measures make it difficult to assess its financial prospects.
• Despite strong revenue growth, the translation into substantial profits remains uncertain, making Darktrace's valuation challenging.

Cybersecurity provider Darktrace ([[DRKTF]], [[DRKTY]]) is growing sales fast. But profits are tiny and it remains difficult to value the business.

I last covered Darktrace in my September piece "Darktrace: No Bid And Oblique Earnings Outlook" with a “sell” rating, since when the share price has increased by 3%.

Revenue Has Been Growing Strongly

In the second half of last year (the first six months of the company’s financial year), revenues grew 36% year-on-year to $260m.

The wider picture was mixed, though. Net cash inflow from operating activities fell 53% to $27m, largely due to tax costs related to employee options vesting, while net profit was just half a million dollars. The company said that it saw strong revenue growth across all geographic markets and customer sizes.

Profitability is an ongoing concern for me. In 2020 and 2021, the newly listed company was lossmaking. In 2022, it reported a net profit of $1.5m (a net profit margin of well less than 1%, as in the first half of the current year). As for the current year, the company’s unhelpful reporting metrics mean that it is unclear what if any net profit it expects. It has forecast “adjusted EBITDA margin to at or around 19%” but I do not see that as a meaningful measure from an investing perspective.

But what is clear is that the business is growing apace. It has a substantial addressable market and white space in which to grow. I think that bodes well for ongoing revenue growth. The challenge I see for now is Darktrace’s thus far poor record of converting revenues into profits.

Valuation

With a tech cool off and the prospect of a takeover in the rearview mirror, the Darktrace share price is far off former highs.

Overall, though, the picture may be less bad than the chart suggests. The stock is down 11% since its 2021 listing which, although not good, is not disastrous either. It has rallied this year and is up over 30% since February. That gives it a market cap of £2.1bn, around six times last year’s sales and around 26 times last year’s free cash flow.

The issue for me as an investor remains how to value the company. Earnings remain minimal and, if the company continues on its current course of doling out share-based payments (a $47m cost last year, separate from the taxes mentioned above related to the vesting of previously granted options), things might remain that way. My concern is that strong revenue growth will not translate into substantial profits.

At least at the free cash flow level, things look better. $100m last year was almost quadrupling from the prior year. The company has said (surprise surprise) that options vesting will hit free cash flow this year, but refers to a “more normal 75% to 105% (of adjusted EBITDA) range”. Although I see adjusted EBITDA as a junk measure, that at least gives us some sense of what to expect. Or does it?

Here’s the chart I compiled, using data from company reports.

So the norm is barely a norm, just a summary of two years. The 2021 results were later restated, so the data in the above table is not the only data set available.

Not only that, but “reported cash flow” in the 2021 and 2022 reports (in the table above) was described as “Cash inflow/(outflow) before financing activities” in 2020. But surely operating free cash flow and free cash flow are different things? Operating cashflow is only one element of free cash flow, and investing and financing cash flows also matter in any business.

Darktrace’s use of unclear alternative measures is something I discussed in my previous piece. But while its own measures may be one thing, I note that it also seems unhappy with industry standard measures. Here is how the company defines “free cash flow”:

“Net cash from operating activities less purchases (other than purchases made in connection with business combinations) of intangible assets and property plant and equipment (PPE), and payments for leases.”

In other words, something akin to operating cash flow. On that basis, last year’s “free cash flow” of $100m reported at the very start of the final results in fact turns out to be free cash flow of $56m if simply subtracting the company’s negative investing and financing cash flows from its positive operating cash flows.

That is elementary accounting and the fact that the company presents its accounts in this way is a massive red flag to me.

On a valuation basis, that means that the firm trades at around 38 times last year’s free cashflow. That is too expensive for my taste, but given strong revenue growth, I also expect strong free cashflow growth. The prospective multiple could look quite a bit lower.

The issue is, it’s hard to tell. Darktrace’s use of alternative measures even for standard accounting concepts makes it hard to assess the company’s financial prospects clearly. That may change over time as it develops a longer history as a public company, though the confusing approach to accounting already puts me off putting my money into the firm.

There seems to be a real growth opportunity here somewhere, as shown by the revenue, but how much of that will benefit the share price remains unclear. To be investable for me, I would want Darktrace to have a more profitable proven business model and less complex accounting.

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