The Darktrace (LSE:DARK) share price hit an all-time high in September that was 200% above its April 2021 IPO price, but has since fallen back to around 510p. I have declined to buy Darktrace in the past, but the drop might be a buying opportunity, so it’s time to take another look.
Darktrace focuses on cybersecurity solutions that leverage artificial intelligence. The need for cybersecurity solutions is growing as more activity shifts online. The variety and sophistication of attacks are increasing, requiring more advanced defences. Darktrace has a compelling product that stands to benefit from these trends.
Demand for Darktrace’s solutions is growing. In 2018. Darktrace had 1,659 customers; it reported 5,605 in June this year. Although revenue growth is slowing — 41% in 2021 versus the peak of 158% in 2018 — the five-year compound annual growth rate in revenues is 75%; that is impressive and supports the view that what Darktrace is selling is in hot demand.
I still have concerns about Darktrace
My quibbles about Darktrace have not changed much. The company is still running operating losses. I know that profitability is often ignored in tech investing because it’s all about building a presence first. But, Darktrace is not like the types of tech companies for which this is true. Its products and services do not have significant network effects (more valuable as more people use them). Nor do I think they are truly plug-and-play and can be produced and sold at minimal variable costs, although Darktrace’s gross margin suggests they can be.
Comparing Darktrace to other cybersecurity businesses is instructive, as shown in table 1. Darktrace’s comparable sales and marketing spend is much higher than its competitors. Darktrace is relatively new to the space, so getting the word out seems reasonable. But, the size of the spend leaves me wondering about the aggressiveness or complexity of the sales process.
Table 1. Darktrace selected income statement line items in comparison with Avast and Norton
| Darktrace | Avast | Norton | |
| Revenue | 281,341 | 892,900 | 2,551,000 |
| Cost of Revenues | 28,456 | 196,000 | 362,000 |
| Gross Profit | 252,885 | 696,000 | 2,189,000 |
| Sales and Marketing Expense | 188,936 | 134,700 | 576,000 |
| Research and Development Expense | 28,814 | 86,100 | 267,000 |
| Operating Profit | (38,514) | 335,400 | 896,000 |
| Gross Margin | 90% | 78% | 86% |
| Sales and Marketing Expense as a % of Revenue | 67% | 15% | 23% |
| Research and Development as a % of Revenue | 10% | 10% | 10% |
| Operating Margin | na |
38% |
35% |
Darktrace’s product suite should require higher relative R&D spending but it spends about the same as competitors. I think this means the company is prioritising sales over R&D. Competitors are moving towards similar AI-based solutions, and Darktrace could lose its edge if this continues.
I would not buy at the current Darktrace share price
Darktrace faces risks from its associations with Mike Lynch, the target of a fraud investigation by the US government. Lynch founded Autonomy, which Hewlett-Packard bought in 2011. With the proceeds of the sale, Lynch founded Invoke Capital Partners, which was an early investor in Darktrace. Until fairly recently, Invoke and Lynch also provided managerial and technical support to Darktrace and senior Darktrace employees also worked for Autonomy and Invoke. Darktrace has acknowledged that it will be at risk until the US has finished with Lynch.
The legal proceedings compound my other concerns and mean that I would not buy Darktrace for my Stocks and Shares ISA. The completion of legal proceedings will be welcome, and I am interested to see how Darktarce’s new cybersecurity solutions perform. Perhaps Darktrace will develop plug-and-play software in the future. Darktrace is an exciting stock to follow, and I will keep a close eye on it.
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James J. McCombie does not own shares in any of the companies mentioned in the article. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
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