What's next for Darktrace (DARK) as it exits FTSE 100?
By Jenni Reid
12:19, 14 December 2021
Darktrace (DARK) had one of the UK’s most successful initial public offerings (IPOs) of the year, raising £165m; but the cybersecurity firm is set to be demoted from the FTSE100 this week after spending just one quarter in the blue-chip index.
The Cambridge, England-based company went public on 30 April after selling 57.4 million new shares at 250p. Existing shareholders sold another 8.7 million shares in the flotation.
The stock remains up more than 20% on its listing price, but has slid from 957p per share on 14 October to 397p two months later.
What’s happened between then and now, and what comes next for the information technology company?
What Darktrace does
Darktrace was founded in 2013 by academics at the University of Cambridge, along with Artificial Intelligence (AI) specialists and security experts from GCHQ, the UK’s intelligence, security and cyber agency.
The firm has offices in Cambridge and San Francisco, California and offers AI-powered cyber defence services across “cloud and email, SaaS and virtual collaboration tools, devices, Internet of Things and industrial networks.” Its client base of more than 6,000 includes major companies and governments.
Chief executive Poppy Gustafsson has said demand for its autonomous technology is needed “as advanced cyber-attacks continue to outpace the human capability of security teams”.
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Darktrace’s flotation on the London Stock Exchange in April this year was considered an exciting moment for a market sometimes described as lacking innovative, future-facing companies.
Unlike food delivery company Deliveroo (ROO), whose shares plunged 31% within the first few minutes of trading on 31 March, Darktrace shares soared 40% on its first day of trading on 30 April, rising from 250p per share (valuing it at £1.7bn) to 340.3p within a few hours.
“Our company is deeply rooted in the UK’s tradition of scientific and mathematic research, so we are especially proud to be listing on the London Stock Exchange,” Gustafsson said at the time.
Enthusiasm for the stock continued through the summer and autumn, as it rose – with a few periods of decline – to a peak of 985p in late September.
By 1 November its stock had risen even further to give it automatic admission to the FTSE 100, ranking among the UK’s biggest listed companies, with a valuation near £7bn.
The autumn full-year results showed the company had grown revenue 41.3% to $281m through expanding its customer base, though its operating losses widened, from $24.9m to $38.5m.
Analysts such as Dan Lane at Freetrade warned that “investors need to keep a close eye on renewals as well as new business,” and that “it’s a competitive space and the easy money made by scaring unprepared companies into buying its products is in the bank.”
“There’s enough fire power behind the likes of IBM, Cisco, and Dell to really upset the apple cart in years to come if the incumbents really choose to make a go of it,” Lane said.
Peel Hunt note
More significant criticism came on 25 October, when analysts at Peel Hunt raised concerns about Darktrace and initiated a Sell recommendation on the stock, giving a target price of 473p at a time when it was 803p.
“Darktrace’s success is driven more by its go-to-market strategy than its product strength,” the analysts wrote, adding: “We do not believe (network detection and response) products will be relevant to all businesses, limiting Darktrace’s potential market opportunity.”
A follow-up note in response to criticism – in which they acknowledged not all analysts agreed with their assessment – described a “disconnect between the valuation and the revenue opportunity” for Darktrace and said a “primary concern is with the core technology, which does not appear to be very proficient at figuring out which anomalous activity is malicious.”
The note observed that technological improvements had been made and the company’s research and development (R&D) spending had accelerated, but also warned that buyer maturity would eventually push the cost of services down or require more sophisticated products, putting Darktrace’s free cash flow growth at risk.
Darktrace upgraded its revenue forecast in mid-October, but the market still reacted negatively. DARK stock fell over 25% on the Peel Hunt note, wiping out about £2bn of market capitalisation within a week.
Major shareholders including Vitruvian Partners, KKR, Summit and Balderton Capital sold stakes in the following weeks, spooking the market further.
On 1 December, FTSE Russell announced that Darktrace would be demoted after just a quarter in the FTSE 100. This Friday (17 December) will be Darktrace’s last day in the index. It will move to the FTSE 250 with chemicals company Johnson Matthey (JMAT). The pair are being replaced by Dechra Pharmaceuticals (DPH) and Electrocomponents (ECM).
A small share price boost, though not enough to reverse the downward trend, came on 8 November, when analysts at Berenberg issued a Buy note and set a target price of 1,000p following a visit to the Darktrace site.
“Any share price capitulation is a result of fear not fact,” they said, highlighting a greater focus on upsell campaigns, an upcoming product category that could see significant uptake, reassurances on R&D spend (due to factors like the average salary of a software engineer at Cambridge coming in at roughly half of one on the west coast of the US), and a large potential market still to claim.
Based on a global security market worth $125bn with a compound annual growth rate (CAGR) of 9% until 2025, according to Gartner, the analysts forecast Darktrace could address $62bn of this.
“With a scalable business model, we believe Darktrace could be multiples of its size if it successfully executes on its growth strategy,” the note concluded.
Last week, Darktrace began a share buyback programme of up to four million shares to be completed by the end of next year. A maximum £30m has been allocated to the programme which is an effort to boost shareholder value.
Meanwhile, opinions remain mixed on whether Darktrace will indeed fulfil its growth potential. Most analysts currently do not expect Darktrace to make a statutory profit until at least 2025.
Analysts at Jefferies reiterated their Buy rating last week and said that “underlying trading is robust,” and “the balance of forecast risks is on the upside” given recent contract wins.
Duncan Brown, vice president of European Enterprise Research at the International Data Corporation, told Capital.com: “Darktrace can’t make a profit and, in a growing market, that seems odd. They are investing to scale the business, but from a CISO (chief information security officer) point of view, they are additive technology. They don’t replace existing tech with something better, so they add to the tech stack, not simplify it.
“CISOs are wary of new tech, so this will have a drag on Darktrace's growth, unless they can demonstrate substantial increases in efficiency and cost effectiveness.”
Russ Mould, investment director at AJ Bell, pointed to wider factors impacting the company’s valuation.
“Investors appear to have become more nervous about paying high prices even for growth stocks, as the collapse in the share price of Cathie Wood’s ARK Innovations ETF attests,” Mould told Capital.com.
“Whether this signals some air seeping out of a bubble market or concerns over whether interest rates may have to rise in the face of galloping inflation is hard to divine, but if history is any guide then Darktrace is not the sort of stock that may thrive in an environment of rising interest rates.
“The lower the interest rate, the less aggressively you discount back cash flows (during growth forecasting) to get a net present value (NPV), and the higher the company’s valuation becomes.
“The opposite happens when rates rise. Discount rates rise so the NPV goes down and the shares can head lower as a result. That is maybe what we are seeing today, and not just at Darktrace.”
Just the beginning
Darktrace declined to comment on its share price movements and FTSE 100 exit to Capital.com, but noted the firm still executed one of the most successful IPOs of the year.
At a Times newspaper tech conference last week, Gustafsson spoke with optimism, defended current R&D spending rates as central to the business, and said there were still misunderstandings about the company’s model and prospects.
“The IPO isn’t the event, it’s just the beginning,” Gustafsson said.
“When it comes to the market, people are used to understanding software companies that are (for example) designed to sell into a large multinational bank, or maybe they’re designed to sell into small (businesses), the public sector or a specific niche of the market. We can sell our software into any organisation, of any size that does anything.
“That is an enormous opportunity that sits ahead of us,” Gustafsson added.