Cybersecurity firm Darktrace is enjoying rapid growth, but the competition could prove too much

Darktrace, an AI-driven cybersecurity firm, is growing fast and beating its own earnings projections. But is it an undervalued growth stock or a disaster waiting to happen? Rupert Hargreaves investigates.

As technology continues to play an increasingly important role in our lives, the need to protect vital systems from bad actors is only growing. The global cybersecurity market is expected to expand at a compound annual growth rate (CAGR) of 12% over the next six years to be worth $366bn by 2028.

At the start of March, Google’s parent company Alphabet splashed out $5.4bn in cash for Mandiant, a cybersecurity company that specialises in tracking the activities of hackers and cyber spies. Other companies are also spending big bucks to build their defences. Last year, a record $77.5bn of deals were signed, up 300% from 2020.

The need to protect systems is growing every day. London insurer Hiscox, which specialises in cyber insurance, believes that in the UK, one small or medium-sized business is hacked every 19 seconds, and information technology group Chainalysis has calculated that ransoms totalling $1.3bn were paid to hackers in 2020 and 2021.

Due to the growing threat of hacking, the cost of insuring against data breaches and cyber attacks is spiralling. Last year, the cost of insuring against a cyber attack jumped more than 50%, with some buyers experiencing a 100%-300% increase in premiums.

The rising cost of insuring against breeches means corporations and individuals are spending more time and money trying to prevent attacks in the first place. And this trend is driving more spending and investment in the sector.

Using artificial intelligence to deal with cyber attacks

Darktrace (LSE: DARK) is taking a unique approach to dealing with cyber attacks. The company’s software works in the background to identify threats when they start to emerge. It uses artificial intelligence (AI) to track an IT system’s normal working pattern. When the system detects changes to the pattern which could signify a cyber attack, the software calculates the best action to take in the shortest period of time to limit the damage.

The company’s offering is not a replacement for other systems; it is designed to complement other defences. This is potentially a major sticking point for the group’s growth. As JPMorgan’s analysts have noted, as peers such as Google build out their own cybersecurity offerings, it will only “increase the competitive intensity” for Darktrace.

Still, demand for the company’s intelligent, responsive software is growing. At the end of March, the customer base stood at 6,890, up 37.3% year-on-year. Annualised recurring revenue (ARR) jumped 56.8% on an organic basis or 37% excluding the recent acquisition of Cybersprint. Overall revenue grew 51.5% year-on-year. These numbers suggest that the company is growing faster than the rest of the market, even after excluding the recent impact of acquisitions.

Following this growth, the company is now beating its own expectations for the year. Management believes the group’s earnings before interest, tax, depreciation and amortisation (EBITDA) margin will fall in the range of 15%-17% for 2022, up from the previously guided 10%-12%.

However, despite the company’s expanding top line and EBITDA profitability, high levels of R&D spending and marketing costs will continue to eat into Darktrace's bottom line. Analysts are not expecting any profits for the next couple of years, as the business tries to grow out of its losses.

Growth is difficult to project in a competitive market

Darktrace is stuck between a rock and a hard place. The company cannot afford to skimp on R&D as hackers are always looking for the next opportunity, and it needs to keep spending on marketing and sales to support revenue growth. That means profits could remain out of reach.

As JPMorgan points out, “With ARR growth tied to new customer acquisitions, we believe that higher customer acquisition and retention costs are likely to challenge the company's ability to deliver profitable growth."

So despite the booming global cybersecurity market, there are questions hanging over Darktrace’s growth strategy and its ability to compete with deep-pocketed rivals like Google. This makes it hard to decide whether the business is an undervalued growth opportunity – or a disaster waiting to happen. With plenty of other options in this fast-growing sector, investors are probably best to look elsewhere.

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