- Accusations date to deals done before its IPO
- Some stockbrokers are dismissive of their relevance
Cyber security company Darktrace (DARK) has rebutted claims from New York short seller Quintessential Capital Management accusing it of beefing up its revenues by selling products to resellers even when they didn’t have customers lined up. If the resellers then failed to find customers, Quintessential alleged that Darktrace paid to host joint marketing events with them as a way of supporting resellers.
Analysts have previously argued that Darktrace has underspent on research and development (R&D) compared with spending on other parts of the business, such as marketing. Last year, sales and marketing costs were $233mn (£193mn). This was up 23 per cent on the previous year and five times the R&D budget. This investment in marketing has translated into strong growth, with revenue up 45.7 per cent and annual recurring revenue up 42.6 per cent.
Last year, the primary concern around the company was not around its sales practices, but that the product could fall behind its competitors through lack of investment. In November 2021, Peel Hunt published a Sell note stating that Darktrace’s total addressable market was much smaller than anticipated and that its product was badly reviewed by customers. The share price more than halved after that note and, despite a string of positive results, its share price finished last year 38 per cent lower than it started. It didn't help that a number of directors sold shares in the company during the period.
Quintessential last week pointed to events that happened prior to Darktrace’s IPO and connections between Darktrace and Autonomy – a software business that was sold to Hewlett-Packard (HP) for $11bn in 2011. Mike Lynch was a co-founder of both businesses and is currently battling extradition to the US after the High Court ruled he defrauded HP by manipulating accounts. He has denied the accusation.
In its initial response to Quintessential's claims, Darktrace said it has “rigorous controls in place across our business to ensure we comply fully with IFRS accounting standards”. Darktrace then issued a more comprehensive reply later last week, saying it reviews its channel controls to make sure they are up to scratch and to weed out any that aren’t. It admitted “there were a small number of contracts that were not validated under the reviews done in the run-up to the IPO and these have not been included in any of our public company financial statements”.
It also defended its partner marketing events, saying they were “normal course of business” for software firms and that they made up less than 0.5 per cent of its revenue.
House broker Jefferies came out in defence of its client, saying Darktrace provided a “robust rebuttal” to Quintessential’s claims. Part of its justification was that Darktrace had produced cumulative cash flow from 2018-22 of $58mn, which outstripped its reported adjusted cash profit (Ebitda). In cases of fraud at software firms, such as at AIT, iSoft and Wirecard, there is usually “a mismatch” between the amount of profit being declared and the cash generated.
Broker Numis called Quintessential’s report “a swing and a miss” and thinks it refers to partner control weaknesses from two to three years ago that have “limited scope”. It raised Darktrace’s earnings per share (EPS) forecast by 5 per cent due to the £75mn share buyback Darktrace announced the day after Quintessential published its report.
Despite the support of a few analysts, broker Stifel thinks the market will remain sceptical about Darktrace until it makes changes. These include replacing parts of the management team, electing a new chairman of the board, and launching a forensic audit.
A potential deal with US private equity firm Thoma Bravo collapsed at the end of last year. News keeps coming out around Darktrace and it is often negative. But for the six brokers that still have the shares on a buy, this is just noise.
