Darktrace upgrades forecasts as it slowly wins back market confidence

Given the consistent revenue growth Darktrace (DARK) has achieved over the past few years, it looks a lot cheaper than it used to.

The weakness in its share price is because of a sell note written by Peel Hunt a few years ago questioning its total addressable market size and a short-seller’s report published by Quintessential Capital questioning the quality of its revenue.

However, since then, EY has conducted an audit of Darktrace and cleared it of concerns, and the cyber security company has just delivered another strong set of results. In the six months to December 2023, annual recurring revenue (ARR) was up 24.4 per cent year on year. Meanwhile, net cash flow from operations rose 142 per cent to $65.6mn.

The company has increased its full-year revenue and adjusted cash profit (Ebitda) margin guidance. It is now forecasting full-year revenue growth of between 23.5 per cent and 25 per cent, which is 0.5 percentage points higher. More significantly, it is expecting an adjusted Ebitda margin of no less than 21 per cent, up from the previous range of between 18 per cent and 20 per cent.

A tweak to the way it pays its sales team means free cash flow conversion will drop to between 50 per cent and 60 per cent. It is now paying its commission all up-front, rather than half at the beginning of the contract and half at the end. However, Darktrace expects it to switch back to 100 per cent conversion next year once this is worked through.

Admittedly, last year it said that cash flow conversion was temporarily lower due to “net settlement of tax obligations”: it has history in making ‘temporary’ adjustments that impact cash flow.

Another slight concern is that R&D spending has dropped in absolute terms by 7.4 per cent from $25.7mn to $23.8mn, and as a percentage of revenue it is a little below what you would want from a software business.

Ultimately, there aren’t that many businesses with 25 per cent top-line growth and decent cash conversion. Meanwhile, it is inevitable that demand for cyber security services will increase in demand as artificial intelligence (AI) lowers the cost of attacks.

There is potential value here, but we would like a set of results with no adjustments. Stick to hold, for now.

Last IC View: Hold, 253p, 6 Sep 2023