Should I buy the dip in the Darktrace share price?

The Darktrace share price has fallen back from its all-time high but is still up 80% from its IPO price. Is now the time for me to get on board?

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Since I last wrote about Darktrace (LSE:DARK), its share price has risen 80%. At one point, it was up 145%. As someone who did not buy Darktrace after its IPO, should I buy the current dip in its share price?

I can see a compelling investment case for Darktrace based on its growth expectations. However, I think it is a richly priced share, and I still have some lingering concerns about the company. It’s time to take another look at this share.

Darktrace, cybersecurity, and artificial intelligence

More and more activity is moving online. Thus, the need for cybersecurity is growing. Moreover, the amount and variety of digital attacks and threats are growing. Thus, Darktrace’s cybersecurity solutions are well-positioned to benefit from this trend. Also, Darktrace focuses on solutions that leverage artificial intelligence, learning the normal behaviour of a network, to flag up changes that might represent a threat that has not been seen before.

There is little doubt that Darktraces services are in demand. Darktrace grew its revenues from $17m in 2016 to $199m in 2019. The company estimates its total addressable market to be in the region of $40bn, suggesting plenty of room to keep growing. Gross margins are around 90%, which is hugely impressive.

Although the company is loss-making at the operating and net profit levels, these losses have been narrowing over the last three financial years. That would suggest that if revenue continues to grow, Darktrace will turn a profit at some stage. Revenues are indeed forecasted to grow. Darktrace estimates $278m for 2021 (final year results for 2021 will be released on 15 September 2021) and $354m for 2022, and analysts are in broad agreement.

Why have I not paid the Darktrace share price?

I did not buy Darktrace in May. I would not buy the dip in the Darktrace share price now. For one thing, revenue growth is slowing. It was 158% year-on-year in 2018 and will fall to 27% YoY in 2022 if the forecasted revenue is delivered. Of course, companies often do not sustain the high growth rates seen early in their lives. But, the Darktrace share price trades at almost 18 times its sales per share. That’s a lofty valuation, given the slowing revenue growth.

But, the main reason I did and will continue to avoid Darktrace is that I cannot quash the feeling then or now of uneasiness I get when reviewing the company. For one thing, there are those links to Mike Lynch, who is currently facing fraud allegations in the US. Lynch was a founding investor in Darktrace via his investment company, Invoke. Darktrace admitted in its IPO prospectus that there exists financial and reputational risk from its relationship with Lynch.

Darktrace spent 82% of its revenue on sales and marketing in 2020. That’s down from the 115% of the revenue the sales team gobbled up in 2018, but even so, it’s abnormal for a cybersecurity company. In sharp contrast to the sales spend, Darktrace spent 6% of revenue on R&D in 2020, which again seems low for a cybersecurity company with a claimed cutting edge product.

The Darktrace IPO was just a few months back. As more financial and operating information is released and Lynch’s trial is concluded, my questions may be answered, and I might change my mind. But for now, I am not tempted by the Darktrace share price. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James J. McCombie does not own any of the shares mentioned in this 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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