DRKTY - Darktrace: Strong Growth And A Relatively Cheap Valuation

2023-03-20 17:52:03 ET

Summary

• Despite a slowdown in new logos, DRKTF's focus on enterprise-level clients and cross-selling of new solutions is expected to improve net retention and accelerate growth.
• The early adoption of the Prevent solution and the upcoming launch of the Heal are expected to drive growth in the near to medium term.
• DRKTF's strong margin profile and high growth rates make it an attractive investment opportunity, especially given its relatively low valuation.

Description

Using an AI-enabled Immune System platform, Darktrace ( DRKTF ) aids businesses in enhancing their cybersecurity. By utilizing a number of different AI and ML tools, the technology is able to learn the typical interactions between users and resources, allowing the platform to spot and react to any outliers. For this reason, I believe DRKTF is positioned to reap the benefits of the structural development of the cybersecurity industry and produce explosive growth. In my opinion, the TAM for cybersecurity is hard to pin down, but it's bound to keep expanding at a rapid clip given the world is getting more and more computerized. Notably, DRKTF is exposed to fast-growing end markets, including network detection and response and email security. To add, I think DRKTF's innovative technology and growth model will help the company capture a sizable portion of the market and produce strong growth. So far as I can tell, DRKTF has been reinvesting in the company to spur expansion, and I anticipate this trend to continue (e.g., invest in its sales team). I expect DRKTF to maintain its high rates of growth (25+%) in the absence of any major disruption in the world (i.e., another covid). At 3x forward revenue, I think the stock is cheap, and I recommend a buy rating considering its high growth rate and attractive margin profile (gross margin is near 90%) that is improving (1H23 EBITDA margin at 23%).

1H23 results

DRKTF reported $556.6 million in ARR, with a net ARR retention rate of 105.1% and a gross ARR churn of 6.5%. The company's total revenue was $259.3 million in the first half of 2023, and its adjusted EBITDA was $59.7 million, indicating a margin of about 23%. The company's strong margin performance was largely due to lower S&M costs.

Targeting enterprise

Despite the impressive results, I've noticed that DRKTF's sequential growth in new logos slowed dramatically from 1Q23 to 2Q23, a trend that management attributes to the challenging macroenvironment. More specifically, DRKTF now has 8,178 customers, an increase of 741 from the previous count. If it's any consolation, management has somewhat set expectations correctly by factoring in these falling close rates and lower POV volumes in guidance. I think management has done an excellent job of relaying this message, as it not only sets new goals but also leaves room to exceed them: DRKTF is reinvesting in its customer success team and shifting its focus to enterprise-level clients to whom it can cross-sell its new solutions. Since DRKTF has only been a "land story" so far, with the "expand" part of the equation not fully reflected, I believe that cross-selling these products will improve Net Retention, which has remained in the 105% range.

New product traction

Early adoption of DRKTF's Prevent solution has been impressive, especially among large Enterprises operating in complex settings. In addition, management highlighted the early enthusiasm for the company's upcoming Heal product, which will round out the AI-driven Security feedback loop once it launches later in CY23. In my opinion, these items are a solid accelerator of growth in the near to medium term and a potential counter to the slowing expansion of new logos.

FCF

Looking at the cash flow statement, we can see that cash flows were weaker than expected due to the payment of taxes. Aside from taxes, deferred revenue and receivables were a headwind as well - the decrease in deferred line items can largely be attributed to the slowdown in new ARR (which should turn better as DRKTF starts to upsell). In spite of the fact that I would prefer a more robust cash flow profile, it is important to remember that FY22 was a tough comp for DRKTF because of the positive impact of post-covid collection efforts.

Guidance

The midpoint of the guidance remains the same for various growth metrics, such as ARR growth of 30%, net ARR added growth of 2%, revenue growth of 30%, and margins of 16% to 18.5%. However, the cash conversion for FY23 is revised to 50-55% of adjusted EBITDA from 60-65%, but I expect the conversion to return to a typical range after FY23. Management also mentioned that the results for the first two months of 2H23 are on track with expectations, leading me to believe that the guidance is very likely achievable.

Summary

DRKTF is well-positioned to benefit from the increasing demand for cybersecurity solutions in a world that is becoming more digital. With its AI-enabled Immune System platform and innovative technology, the company is poised to capture a significant portion of the fast-growing end markets, such as network detection and response and email security. Despite the slowdown in new logos, management's focus on enterprise-level clients and cross-selling of new solutions is expected to improve net retention and accelerate growth. The early adoption of the Prevent solution and the upcoming launch of the Heal product are also expected to drive growth in the near to medium term. Although the cash flow profile could be more robust, the company's strong margin profile and high growth rates make it an attractive investment opportunity, especially given its relatively low valuation. Overall, I recommend a buy rating for DRKTF.

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