Darktrace has been struggling to win back investors, battling questions around the shape of its cost base and links to former Autonomy boss Mike Lynch, who is fighting extradition to the US to face charges for allegedly fraudulently inflating the software group’s value. But a weak valuation, high revenue growth and vast potential customer base means there is plenty to invite a bidding war.
News of an approach from tech-focused buyout group Thoma Bravo last week sent shares in the cybersecurity specialist up 24 per cent on the day. Even if a firm bid is no higher than the £3.7 billion market value currently attached to Darktrace, investors that bought in at the cut-price IPO should be happy enough, having doubled their money in less than 18 months.
Based upon forecast sales, Darktrace is still valued far below both last year’s peak and US peers such as CrowdStrike Holdings, with an enterprise value of just over seven times forecast sales. There is some justification for that valuation, stained with misgivings, which either a US tech investment group or rival with deep pockets could wipe clean.
Links with Lynch, who helped to establish Darktrace but has no management role, have cast a shadow over the group’s rating. He still owns 4.3 per cent, while his wife, Angela Bacares, has almost 8 per cent. Taking the group private would remove this connection, a factor of which bidders would be well aware.
The need for cybersecurity has been thrown into sharper focus by the geopolitical turmoil this year. Shares in Darktrace rose 43 per cent during the week after Russia’s invasion of Ukraine. Annual recurring revenue rose 42 per cent in the 12 months to the end of June, ahead of analyst expectations, and guidance for this year is similarly punchy at 31 to 34 per cent.
Darktrace seeks to differentiate itself from other providers through its use of artificial intelligence. Rather than trying to merely stop attackers breaching IT systems, it uses machine learning to detect unusual activity and autonomously fight back against any attacks.
Yet some analysts question the shape of Darktrace’s business. Irish brokerage Davy points to high marketing and sales costs, which equated to 45 per cent of revenue during the first half of the year. Roughly 65 per cent of sales come from direct sales. Davy argues that a closer tie with sales headcount could constrain sales growth and forecasts a compound annual sales growth rate of about 30 per cent for Darktrace from last year to 2024. But that compares with more than 70 per cent for American peer SentinelOne.
Research and development expenditure is below peers, at 7.5 per cent of revenue in the first half, a figure it expects to rise to between 10 and 13 per cent. Darktrace has pointed to the “self-learning” nature of its cybersecurity software, which cuts down on installation time and costs and means the core technology can be easily adapted.
Investors might look to the takeout premiums achieved by some of Thoma Bravo’s other targets, including software group Sophos at a 37 per cent premium in 2019 and last year’s purchase of US cybersecurity specialist Proofpoint at a 34 per cent premium to the share price.
Yet Darktrace is a less mature business, posting faster recent revenue growth but with a shorter proven record. The downturn in tech valuations in the face of sharply rising inflation could also prove an additional justification for a less meaty takeover premium.
Adding Darktrace to its stable of cybersecurity assets would provide Thoma Bravo with plenty of opportunity to strip out costs, an opportunity that won’t go unnoticed by larger rivals either.
ADVICE Hold
WHY A firm offer could solidify the shares’ recent gains or send them higher still
Empiric Student Property
Cost inflation and rising rates have caused Unite, the student landlord, to cut earnings guidance this year; will its smaller peer Empiric Student Property also come unstuck? Empiric’s shares trade at a 17 per cent discount versus the company’s net asset value at the end of June, which means the risks associated with rising interest rates and cost inflation are priced in.
Booked occupancy for the forthcoming academic year has recovered to 92 per cent, ahead of the pre-pandemic level. The strength of demand means management expects rental growth of 5 to 6 per cent for the next financial year, enough to offset cost inflation. But the cost base rising more rapidly than expected is one factor that could cause Empiric to disappoint earnings expectations for next year. Higher debt costs is another.
Roughly a third of its £420 million debt pile is at a floating rate, which means the 3.3 per cent average cost of debt should rise later this year and next. A one percentage point rise in interest rates would equate to a £1.4 million negative impact on profits, if that floating rate debt were to be fully drawn. That figure would not devastate the bottom line, based upon analysts’ forecast of adjusted pre-tax profits of £26.2 million for this year, but it still introduces an element of uncertainty over whether Empiric meets or misses market expectations. The student landlord is assessing whether to take the unusual step of locking in the rate attached to its £110 million revolving credit facility. High financing costs should also mean property values ease to reflect increased funding costs for would-be acquirers of assets.
Unlike Unite, Empiric does not have a lengthy development pipeline, with only two schemes under way. Those developments, which will add just over 200 beds, are due to complete by next month, so all costs are already locked in.
Real estate development brings with it greater risk, but then again, there is also the potential for higher growth in the value of the portfolio. The larger pipeline, together with the broader economies of scale, is one reason investors have priced Unite more generously than Empiric. Empiric’s current discount versus its own NAV seems prudent.
ADVICE Hold
WHY Discount to NAV is a good reflection of reality
