Darktrace: Is The Market Right Or Wrong? (OTCMKTS:DRKTF)

This might well be terribly unfair

If people lose the confidence of the market then they’ll be underrated by that same market. If people never really did have that confidence then it takes time to gain it.

Whether or not people should have the confidence of said market is the real point here. If it’s a good, even grand, business that people have no confidence in then the price for what is on offer will be low. So, buy and hold until repeated sets of results show that the market was wrong by not proffering that confidence. This could take some time.

On the other hand, maybe the market is right in not being confident in the claims being made. People have been – umm, to be mild about it – less than open with the whole and complete truth about business before now. Mr. Bankman-Fried comes to mind as the current example.

While that lack of confidence in management statements might be terribly unfair, it’s simply a reality that we and everyone else has to deal with. The investing opportunity is when the market is not confident and yet we are confident. Well, if we’re correctly confident that is.

Darktrace (OTCPK:DRKTF) (LON: DARK)

There’s also another OTC quote, (OTCPK:DRKTY), but that has very little trade and can usefully be ignored there. The major volume is in London. DRKTF is liquid enough to provide a useful entry point for investors if they should so wish.

This market confidence is the problem that Darktrace has. As I explained back 10 months, Darktrace suffers from the overhang of Autonomy and Mike Lynch.

Mike Lynch was the co-founder of Autonomy and so too at Darktrace. He was undoubtedly the driving force at Autonomy and probably so in the early days at Darktrace – he’s stepped back from that intense involvement more recently.

The whole problem here is that when Autonomy was taken over by HP it all fell apart. The arguments are about why it fell apart. The implication is that if – and what’s alleged is what follows – one Mike Lynch founded firm? If the “did” never happened, then there’s no worry, – except among those who might still worry. And so on.

Given that this is all still being fought over in the courts let me be mild in my description. Effectively, on the one side is the claim that hardware sales were allegedly being described as software – low margin things being described as high, one offs being touted as the beginnings of repeating revenues. This is stoutly denied and the court battles rage on. Mike Lynch was the driving force behind Autonomy.

The most recent short sellers report making such commentary is from Quintessential Capital Management. Commentary on the Darktrace response is in the FT here. The actual Darktrace response here.

Mike Lynch also at least aided in setting up Darktrace and the pondering is that perhaps some of his management techniques got baked in when this happened. A certain aggressiveness about sales is to be greatly welcomed, of course it is. Being aggressive enough that certain lines get crossed over how sales revenue is described is not.

Given the court cases, hope you understand the slight hand-wave nature of the description.

But the exact details don’t matter for the point to be made here. Which is that Autonomy is thought to have – rightly or wrongly – suffered from a certain aggressiveness in financial reporting. Darktrace was partly set up by the same person. Does Darktrace suffer from that same problem?

No, we don’t know. The general view in London is that enough folk are wary about the thought that Darktrace is undervalued. Or, at least, is undervalued on the assumption that the accounts, as presented, are a conservative view of matters. If they’re an aggressive view, aggressive as were the accounts of Autonomy, then perhaps Darktrace is overvalued.

Whether that’s fair or anything isn’t the point at all. That’s what the general and average view is.

Objective reality

The base idea seems entirely sensible. As I said before, network security is important. A network should show a certain repeat pattern of usage – it gets used to do much the same thing time after time of course. Variance in what the traffic flows are might well be evidence of someone hacking the network. So, set up an AI to monitor the network. Pattern recognition is not just what AIs are good at – it’s what they actually do. So, we now have an alarm system for things that perhaps shouldn’t be happening.

Sure, I buy that story, makes sense to me. Now, whether the Darktrace AI actually does this well enough that people will keep buying it is well beyond my limited technical capabilities. For that it’s necessary to look at the financial results.

These look good:

And for the next quarter:

For Q1 FY 2023, Darktrace demonstrated continuing strength and resilience in its sales performance, growing its customer base by 320 net new customers to 7,757, a 29.1% year-over-year increase.

With new customer additions continuing to be the primary driver of constant currency Annual Recurring Revenue measures, this resulted in net ARR added for Q1 FY 2023 of $26.6m, up 13.4% over the same quarter of FY 2022. This was in line with Darktrace’s expectations for first quarter net ARR additions, in what is traditionally its slowest sales quarter of the year. The net ARR added during the first quarter, on top of strong performance in recent periods, resulted in constant currency ARR at 30^th September 2022 of $511.5 million, reflecting year-over-year growth of 40.5%.

A fast growing tech company. They’ve got through the massive investment phase, have grown revenues to more than cover overhead, marginal revenue is near pure profit – what’s not to like?

But that’s the thing

Yes, OK, there was the diversion over the summer as there was that takeover bid which didn’t quite come through. That bounced the share price up and down again.

The numbers look just fine, admirable even. If we were working on those alone we’d expect Darktrace to be worth much more than it is. But that’s the point. We’re not working just on those numbers alone. We’re dealing also with the belief on how aggressively those numbers are being prepared.

Again, that belief may be wrong, but the base fact is that it’s there. That’s what we’ve got to deal with as investors, reality.

My view

I tend to the argument that the numbers are real. Perhaps a little aggressive, given the sales culture I expect to be there. But sound still, even if a little forward. I have no proof of this at all. Either way, either that it’s just a bit forward but still a bit, or that it’s not some ephemera of hopes. But given that this section is my view, then that’s what it is.

What this means is that I think that – absent that market opinion – Darktrace is undervalued. The question then becomes, well, what happens next?

An unease – let’s put it that way – about accounting reports is not something that simply vanishes overnight. It’s necessary to have a consistent series of good accounting periods for people to start to believe the numbers fully. So, we’d not expect some sudden lurch upwards as a result of some overnight change in belief. On the other hand, assuming that my view is correct, we would see an outperformance over time. That achievement of belief in the numbers is something that will happen slowly, therefore the under-pricing is something that will fade slowly.

That makes Darktrace a long-term investment. If, of course, the base view is something that you as the investor buy.

Why I’m wrong

Well, it’s always possible for a company, however good it is right now, to find that it’s not so good in the future. That’s a problem with taking a long-term view of anything.

It’s also possible that the market is right here, to be wary of those reported numbers. No, not an accusation of anything wrong. But we all know that accounting numbers depend upon the approach taken to them, aggressive or conservative. As long as we know which approach is being taken then we can adjust our valuation multiples to account for that. The entire case here is that the wrong multiple is being applied because the view is that the accounting methods are more aggressive in revenue recognition than they actually are. But maybe that’s not true.

The investor view

This isn’t a recommendation to buy into Darktrace. Rather, it’s to make the case as to why the share price doesn’t seem to be matching the reported accounts. So, the case for the investment is that people are too wary of the reported numbers given the earlier events at Autonomy.

If the market is “too wary” then Darktrace is undervalued and we should see a rise compared to the sector over time. But the decision on that is, well, do you as the investor think the market is too wary? Or not wary enough, or about right?

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