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07 January 2022

Dark Side of the Web

It is fair to say the UK stock market has not been blessed with the high-growth, technology focused businesses that have become the centrepiece of the US market over the past decade. Instead, it has become commonplace for the UK market to be associated with slower growth, more traditional businesses that focus on exercising prudence ahead of any blue-sky aspirations. However, it appears that the FTSE 100 is now home to one of the world’s fastest-growing cybersecurity companies.
 
Founded and headquartered in Cambridge, Darktrace (DARK) was set up in 2013 by a group of mathematicians and cyber defence experts and has quickly grown to become one of the hottest names in cybersecurity. The technology itself champions a new category of cyber solutions based on Bayesian mathematics developed at the University of Cambridge. The business’ core platform is named “The Darktrace Immune System” and, like any functioning immune system, the platform will detect and neutralise foreign threats before using data from the attack to build defences that prevent any same breach from occurring twice. This is achieved via one of the first at-scale deployments of machine learning and artificial intelligence (AI) within a cybersecurity product. The immune system embeds itself within the customer’s operational systems, continually learning and evolving alongside the business to provide security, but also will likely deliver significant cost savings over time.
 
As the digitalisation of business and the economy continues to increase it is no surprise that the cybersecurity market is forecasted to grow rapidly in size. Short-term forecasts predict that the cybersecurity market will be worth over double what is today by 2026, growing to a total market value of US$398.3bn. However, perhaps a more important measure when assessing the value of such security systems is the potential cost of cybercrime to businesses and the global economy which analysts believe will hit US$10.5tn by 2025. Despite this clear market opportunity and the potentially ground-breaking nature of Darktrace’s offering, the stock itself hasn’t been without controversy and, with that, volatility.
 
Firstly, prior to the initial public offering (IPO) in April of this year the valuation was cut due to links to alleged fraudster and former Autonomy CEO Mike Lynch, who had been an early supporter of the business via his venture capital fund, Invoke Capital. While this may have spooked investment banks supporting the issue, the shares surged 43% from the issue price of £2.50 on the first day of trading. The shares then rallied further from this point touching £9.85 in late September when the business blew away previous expectations to deliver annual revenue growth of 41.3%, alongside 45.3% growth in new customers. Such strength continued into late October before the tide turned when questions were raised against the nature of the business’ product and their ability to compete with competitors who boasted larger research and development (R&D) budgets.
 
On the first point, it was suggested that the highly involved nature of the immune system product increased the complexity of integration and wouldn’t be suitable for all businesses, thus reducing the size of the target addressable market. On the second point, fears were raised against the ability of the business to defend its strong market position as larger, well-capitalised competitors begin to enter, who could effectively dwarf Darktrace’s R&D budget which, may result in Darktrace’s offering quickly becoming outdated. Given that the strong run since April had effectively led the shares to be priced for perfection, these fears created significant volatility with the shares shedding 20% of their value within a day. Such sentiment was then compounded as the 180-day investor lock-up period for those invested pre-IPO ended. As a result of the end of this lock-up period, Vitruvian Partners sold £63.8m worth of shares at an 8% discount to the market price. The sale accounted for approximately a third of their total stake and raised fears that more could follow suit. Shares appear to have settled down following the October chaos, but remain below previous highs, so the question for investors becomes whether the recent pullback was based on fact or fear?
 
The market opportunity for a company such as Darktrace is clear, and the product has gained credibility via collaborations with Amazon Web Solutions (AWS) which awarded the business two accreditations relating to the performance of infrastructure. Beyond this, the customer base has now grown to service over 5,500 businesses from a highly diversified range of industries demonstrating the wide-reaching application of the technology. However, given the rapidly changing nature of the sector as cybercriminals employ increasingly sophisticated methods of deception, a business’s ability to replenish its technology via R&D will be key to maintaining a competitive advantage and thus is a factor that will need to be closely monitored as well capitalised players enter the market. In addition, despite strong growth trends the business is still yet to turn a profit which will likely create future volatility due to valuation concerns. As is often common it is likely the truth lies somewhere in the middle, it is fair to say the exponential growth witnessed since the IPO led shares to get a little bit ahead of fundamentals and thus a pullback down to reality was likely due. With that being said, it is not often that the UK market provides an opportunity to invest in a technologically advanced business that is seemingly well-positioned to serve a structurally growing market over the long term.
 
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.
 
This article was taken from the November 2021 Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
 
Dark Side of the Web
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